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The Essentials of Mortgage Budgeting
Authored by Jose Abuyuan on July 9, 2020
After a little soul searching, you found that it’s time to buy a house. You lived in your neighborhood long enough. The housing market in your area reached a sweet spot. Rates are good and homes aren’t that pricey. Maybe it’s getting a little crowded in your parents’ place. Perhaps your apartment’s getting cramped or your landlord’s become overbearing.
Not so fast, partner. You still have one more obstacle in your way: your budget. Before you seal the deal, you’ll need to know what you’re getting into. How much mortgage can you afford here and now? And will paying down your mortgage be an option?
Planning for Your Mortgage
Wanting and needing to buy a new house is one thing. When it makes financial sense to buy a new house is a different matter. These two financial situations are the chief reasons why people need to buy a house:
Rental costs: The longer you stay somewhere, the less cost-effective it is to pay rent. If you intend to live where you are for the long-term, it might be time to buy a new home. You may also be compelled to buy if the rents are exuberant. A mortgage may indeed be cheaper.Favorable market conditions: Are interest rates and home prices at their lowest? It might be wise to buy soon to take advantage of this window of opportunity. Because home prices are cyclical, this window can work to your advantage. Timing your purchase right can help you maximize your return of investment.Dozens of factors at play can impact your decision. Can your budget handle the cost of a mortgage? Is your credit rating good enough to get you a prime rate? Consider each factor on the table with care before deciding.
A house is often the biggest single investment you will make in your lifetime. Thus, your mortgage payments become one of the largest expenses on your budget. There is a limit to how big your mortgage payments should be before they strain your income. As a rule of thumb, it should not exceed more than 28 percent of your monthly salary. Let’s look at what an average family can afford with a median U.S. annual household income of $63,179 in 2018:
= ($63,179 / 12) x 0.28
In 2018, a household can afford to pay $1,474.18 a month on their mortgage. And that’s not including other everyday expenses. If you have recurring cost like childcare, your mortgage budget would be much lower. Examine your budget with care and determine which expense is your priority. You might need to first focus on other, short-term expenses like emergency funds.
Cash Payments
The cheapest way to buy a home is to use cash. This way, you don’t need to worry about interest rates or monthly mortgage payments. Most sellers do not say no to a large upfront sum. Yet few people can afford to use cash to buy a house. It can take almost a lifetime to earn that much money.
What most people can afford is a large down payment for a home. This, paired with a good mortgage deal, can help you secure the home you need.
Mortgage Qualifications
Apart from your funds, you should also prepare your credit score. A sterling credit rating improves lenders’ perception of your ability to pay on time. Credit authorities like the Fair Isaac Corporation (FICO) apply credit scores based on your financial history.
Lenders perceive people with higher credit scores as less risky. The better your score, the lower the rate you can obtain. The savings you make based on your credit score can amount to tens of thousands of dollars.
This chart from Experian examines the number of people who fall under each category. It also shows the impact the score has on their ability to finance major purchases:
Credit Score Rating Percent of People Impact 300-579 Very Poor 16% Applicants may be required to pay a fee or deposit, and applicants with this rating may not be approved for credit at all. 580-669 Fair 17% Applicants in this range are considered subprime borrowers. 670-739 Good 21% Only 8% of applicants in this score range are likely to become seriously delinquent in the future. 740-799 Very Good 25% Applicants in this range are likely to receive better than average rates from lenders. 800-850 Exceptional 21% Applicants in this range are at the top of the list for the best rates from lenders.
The FICO website lists down the credit score range and the annual percentage rates (APRs) they qualify. The table below is based on data for July 28, 2020 and assumes a 30-year fixed-rate mortgage for a loan amount of $300,000:
FICO Score (Range) Qualified APR 760-850 2.672% 700-759 2.894% 680-699 3.071% 660-679 3.285% 640-659 3.715% 620-639 4.261%
Credit scores are a major barrier for most prospective homeowners. Qualifying for anything other than subprime mortgages can be an uphill battle. And we’re not only talking about people struggling with debt issues. Because they lack a credit history, people with no debts to speak of can’t qualify for good rates, either!
Pigly's Tip!
If you use it responsibly, consumer debt can work to your advantage. A low-interest or secured credit card can help you build a good credit rating without incurring interest. The key is to spend only what you can pay in full before the due date. Making more than the minimum credit card payments can help lower you balance as well.
The strict standards in place today are not without precedent. Sal Khan of Khan academy explains that making the standards too lax sometime in the 1980s led to rising home prices. This set the stage for the subprime mortgage crisis that led to the Great Recession.
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Did You Know?
In the wake of the Late 2000s Recession, the Mortgage Reform and Anti-Predatory Lending Act was put in place. Lenders are no longer permitted to underwrite a mortgage unless they are certain the borrower can repay it within reason. It also put a cap on how much a mortgage must cost each month: no more than 35 percent of the borrower’s income. In practice, lenders are even more cautious, which led to the standard practice of placing no more than 28 percent of your salary to mortgage costs.
Required Debt-to-Income Ratios
Debt itself can be a big obstacle toward getting a mortgage. Your debt-to-income (DTI) ratio can make or break your ability to borrow. This measures the percentage of your total income that should go to debt payments. It is derived through the following formula:
DTI = Monthly Debt payments / Your Gross Income x 100
For example, if you make $5,500 a month and pay $825 in consumer debts each month, your total debt-to-income ratio is as follows:
DTI = $825 / $5,500 x 100
The above excludes the amount you would’ve spent on your mortgage. Your DTI would come in two halves, which are expressed in this format: x/y.
The first half, the front-end DTI, represents the percentage of your income that would go toward your mortgage and related costs. The second is the back-end DTI, which is your mortgage payments plus your other debts.
The maximum back-end DTI ratio you can have to qualify for a conventional loan is 43 percent, while the maximum front-end DTI is 28 percent. Most lenders prefer a lower back-end DTI of 36 percent. This increases your chances of securing a mortgage.
Lenders also consider the types of debt you incurred. Higher interest debts spell higher default risk. You won’t qualify for a conventional mortgage if your credit card bills comprise more than 7 percent of your monthly income.
Pigly's Tip!
You can improve your chances of approval by paying most of your debts before applying for a mortgage. Besides making your finances look good, this also improves your credit score and increases your cash flow.
Housing Prices and Their Impact
The property market works differently across different towns. The cost of housing has a far-reaching influence on how well you can afford a house. In ordinary circumstances, house prices are cyclical and stable. They rise and fall with the law of supply and demand. Buyer’s markets represent times of excess supply, making it an excellent time to look for homes on the cheap. Seller’s markets are the reverse. Too many buyers are competing for smaller inventories. This puts the bargaining chips on the sellers.
These cyclical windows are small, and can vary across regions. Major cities and their surrounding suburbs experience the biggest swings in prices as people are drawn in. If your hometown experienced an economic boom, expect house prices to rise fast.
Although real estate is affected by national events, it is still a largely local phenomenon. In 2019, the median listing price across the U.S. was $315,000, according to Realtor.com. Despite a nationwide price surge , some metro areas experienced a decrease in median price. Demand has yet to outstrip them of surplus inventory. Ultimately, the trend that matters the most to you are the ones in the city you’re moving into.
Types of Mortgages
Where you get your loan matters. Most buyers look to conventional mortgage providers. These are backed solely by private lenders such as banks, credit unions, and non-bank mortgage companies. Because the lender holds onto the most risk, they have more stringent requirements. Most prospective home buyers favor these mortgages because they offer lower interest rates, especially if you have a good credit score.
Government-backed mortgages include those from the Federal Housing Authority (FHA), the U.S. Department of Agriculture (USDA), and the Veterans Administration (VA). These loans are guaranteed by the federal government, which alleviates some of the risks to the lenders. Subsequently, these have more lenient requirements.
These mortgages are a viable option for people with limited savings or poor credit histories. Their major caveats is that they have much higher mortgage insurance requirements and higher APRs.
Requirements Available To Conventional Mortgage Credit score: 680, preferred is 700 Homebuyers with good or excellent credit ratings FHA Mortgage Credit score: 500 or 580, depending on down payment Buyers who can afford a small down payment
USDA Mortgage Credit score: minimum of 640 Low- to average-income buyers who reside in USDA rural areas (population below 35,000)
VA Mortgage Credit score: at least 620VA funding fee is required to offset taxpayers’ cost U.S. military service people on active duty
Mortgage Insurance
The major drawback of any mortgage with a smaller down payment is the added insurance costs. Although the buyer shoulders the costs, the coverage is meant for the lender . Conventional mortgages are protected by private mortgage insurance (PMI). Meanwhile, government-backed mortgages are covered by mortgage insurance premiums (MIPs).
Did You Know?
Lenders let you opt out of PMI when you own at least 20 percent equity of your home. This is why PMI is not required when you make a 20 percent down payment. Lenders are also required by law to cancel your PMI once your mortgage balance reaches 78 percent of your home’s value.
Although they serve a similar function, MIP is not the same thing as PMI. For starters, MIP is required for government-backed loans such as FHA loans. FHA borrowers must pay an upfront MIP that costs 1.75 percent of the home’s price. A home that costs $230,000, for instance, will have an upfront MIP of $4,025. The borrower must also pay a an annual MIP, which is rolled into your monthly payments.
For mortgages with a down payment of less than 10 percent, MIPs last throughout the lifetime of the loan. For mortgages with down payment greater than 10 percent, the MIPs last for 11 years. Before 2015, it was possible to bypass the FHA’s monthly MIP payments by owning 22 percent of your home’s equity.
In general, compared to PMI in conventional loans, MIP on FHA and USDA mortgages can cost more over the life of a loan. Likewise, the VA funding fee for VA loans can be more expensive compared to a conventional mortgage.
Mortgage Payment Structure and Terms
A housing mortgage is a type of amortizing loan. An amortization schedule shows the amount of your monthly payments and how many payments you need to make to pay a loan within the term. In this case, most borrowers usually take a fixed-rate loan with a 30-year term. It also details how much of your payment goes toward the interest and principal of your loan.
The principal is basically the amount you owe your lender. It is the outstanding balance, which shows how much you still need to pay. The higher your principal, the more interest it accrues.
The interest, on the other hand, is the amount lenders charge to service your loan. Higher interest also accrues when you take longer to pay your mortgage.
In a 30-year fixed-rate amortizing schedule, more of the payments go toward the interest during the early years of the loan. Toward the latter half of your mortgage, this shifts as your principal is significantly reduced. By then, more of your payments go toward the principal, while less is applied to interest.
Your monthly principal and interest payments, meanwhile, are calculated through this formula:
M = P [ i(1 + i)ⁿ ] / [ (1 + i)ⁿ – 1]
Where:
The term is measured in monthly increments. Thus, a 30-year mortgage comprises 360 payments and the annual interest rate is divided by 12. Assuming a principal of $184,000 and an APR of 3.5 percent (0.0029 percent monthly interest), here’s how much you’ll need to pay each month for a 30-year mortgage:
= $184,000 x [(0.0029 x (1 + 0.0029) ^ 360] / [(1 + 0.0029) ^ 360 – 1]
The amount of interest you pay depends on the size of your principal, your annual percentage rate, and the length of your term. The smaller their value, the more you save on interest. Many of these are decided long before you consummate a mortgage. Most buyers, however, do not choose the option that saves them the most money. This is because longer terms have more affordable monthly payments compared to shorter terms.
A shorter term of 15 or 20 years has higher monthly payments compared to a 30-year term. Since a lower monthly payment is attractive, many buyers opt for a longer term. However, a longer term means higher interest cost. That said, you save years’ worth of interest charges with a shorter 15-year loan compared to a 30-year term.
Sometimes, picking the pricey option is justified when there’s no other way to afford a home. This doesn’t mean you’re without options to lower them afterward. But making extra payments on your mortgage bring down interest costs by whittling away at your principal.
Mortgage Refinancing
Refinancing, or replacing your current mortgage with a new loan, is also a feasible option if rates are good. A refinanced mortgage can lower your monthly payments and decrease your interest rate. But note that if you refinance to a shorter term, your monthly payment will be higher.
A lower rate and shorter term translates to decreased interest payments over several years. Refinancing may be costly (around 3 to 6 percent of your loan), but it can save you a lot of money in the long run. If you refinance two percentage points lower than your current rate, you can offset your closing costs.
Escrow Charges
The final bill, however, will be much higher than your principal and interest combined. Your monthly mortgage payment is also composed of several expenses rolled into one.
State and federal property taxes Homeowners association (HOA) fees Private mortgage insurance (if applicable) Homeowner’s insurance Extra payments (if applicable) These are sorted into two different accounts. First, the mortgage account, represents your actual mortgage payments. This records both your interest and principal. Your extra payments toward your mortgage should go here.
The second is the escrow account. Most mortgage lenders demand you to open one. This is where your lender holds bill payments that they pay on your behalf. In ordinary circumstances, this should make things easier for you.
Taxes
It comes for us all. There are three certainties in life: death, taxes, and things going wrong. While you can’t stop the inevitable, you can plan around them. This way, you’re not caught with your pants down. When calculating your monthly mortgage payments, include home insurance and taxes.
Property taxes are based on your income and the value of your home. The key to living with taxes is to pay only your fair share (and nothing more). This can be a daunting task. Your tax payments will persist long after your mortgage. Moreover, your payments increase over time along with your home value. The amount you’ll be taxed is based on your income and the value of your home.
Pigly's Tip!
Some states have favorable property tax laws, while others do not. Do your research and find out how much property tax your state charges.
Taxes can also influence how your house would expand. General home improvement can increase your home’s value and the amount of taxes you owe. Likewise, specific, value-building improvements (such as solar panels) may come with tax benefits. Choose your home upgrades with care. As time goes by, reassess your tax situation and adjust your payments accordingly.
Home Insurance
That coverage was worth it. You can only do so much to avoid accidents. Sometimes, damage control is the best you can hope for when Murphy’s Law comes a-knocking. Insurance help safeguard your home from unexpected untoward incidents. The payouts would help cushion the financial impact of damage.
Your exact insurance needs will vary, depending on your associated risks. Insurance should cover these bases :
Rebuilding all or part of your home Replacing your furniture and personal effects Liabilities that happen in your property Your living expenses while your house is being repaired Insurance rates are influenced by location. Some places are more prone to specific disasters than others. However, do not downplay your threats to convince yourself you don’t need coverage. Your house can still be damaged by something even if you live nowhere near Tornado Alley .
Estimating your insurance needs is critical before you seal the deal with any seller. These are dependent on two major factors: the house’s area and the local costs of construction. Don’t neglect other, smaller details, though. Something as superficial as the exterior finishing could be expensive to insure.
Payment Breakdown
Now that we’ve identified the things you need to consider, let’s put it into practice. Our calculator above can help you define the budget for your new home. Our example will assume a home worth $230,000 in a low-cost area. You pay a 20 percent down payment ($46,000), which allows you to bypass mortgage insurance. You choose a 30-year term and receive an annual percentage rate of 3.5 percent. In this scenario, you do not finance your closing costs into your mortgage.
30-year Fixed Mortgage (Conventional) Loan Amount: $184,000.00 Rate/APR: 3.5 percent Private Mortgage Insurance: 0
Let’s assume, then, that your escrow costs are as follows:
Annual Property Taxes: $2,553.00 Annual Homeowner’s Insurance Premium: $1,230 Monthly HOA Dues: $200.00
Your monthly income in this scenario is around $7,200. You can dedicate a minimum of $1,500 each month. It also has room for up to $2,000 dedicated to your mortgage payment. Here’s a breakdown of where that money would go:
Monthly Principal + Interest Escrow Total Minimum $984.75 $515.25 $1,500.00 Maximum $1,484.75 $515.25 $2,000.00
In both examples, you would’ve paid off your entire mortgage before 30 years have passed. The maximum amount would’ve saved you more than a decade’s worth of payments.
However, you shouldn’t dive into extra payments right away. You must first consider the rules to avoid expensive fees. Making extra payments early on can lead to prepayment penalty and the loss of tax advantages. So try to secure a mortgage without prepayment penalty. Alternatively, you could wait it out. By law, prepayment penalties apply only for three years in mortgages consummated after January 2014.
Other Costs
This is going to cost a lot.
Pigly's Tip!
Before buying a house, be thorough with home inspection. Check for leaky insulation and other architectural issues. If you still decide on buying that house, have those issues fixed before you move in.
Mortgage costs are only the tip of the iceberg. Consider your practical needs when selecting a home. Will you have the time or resources to dedicate to your new home? As a homeowner, you are now responsible for the upkeep of your property. Include the costs of periodic maintenance and repairs in your budget. Consider creating a sinking fund for these larger occasional expenses. This way, periodic maintenance and sudden repair costs won’t get you by complete surprise.
Also consider how much your house’s utilities would cost. In general, the larger the home, the more it costs to power, heat, and cool. Homes may also have energy inefficient design flaws that add to the costs of heating and cooling. Savvy and eco-conscious buyers consider more compact or energy-efficient homes for this reason.
These factors affect the size of the home you can afford to live in. Not only are smaller houses less expensive in general, they are also cheaper to maintain. Some prospective retirees even plan on downgrading their homes because their current upkeep costs were too high. Your home may be your castle, but reconsider buying more house than you need.
Did You Know?
A study found that American homeowners aren’t more satisfied with their homes even as median home sizes increased. The study’s author, Clément Bellet, believes this to be an extreme case of one-upmanship. He theorizes that homeowners compare themselves to neighbors with bigger homes. This leaves them in an unfulfilling (and expensive ) cycle of renovations.
The Bottom Line
Your mortgage will be one of the biggest expenses you will make in your life. It’s important to know what you’re getting into before you sign a deal.
Remember, patience is a virtue for a reason. Wait until the time is right. Are the low rates in the market tempting? Compare them to your current financial standing. Make sure that you can afford your mortgage without derailing your budget. You’ll need to time your decision right to maximize your savings for a large-enough down payment. You’ll also need to bolster your cash flow in the process.
Shorter terms such as 15 or 20-year fixed-rate loans can provide the best savings. On the onset, aim for the highest payments you can reasonably afford. The amount you can pay today will determine how much money you spend overall. Sure, you’re paying more now, but you will have saved more money in the long run.
Once you’ve worked it all out, hop on over to our mortgage calculator and see how much home you can afford.
About The Author
Jose Abuyuan is a web content writer, fictionist, and digital artist hailing from Las Piñas City. He is a graduate of Communication and Media Studies at San Beda College Alabang, who took his internship in the weekly news magazine the Philippines Graphic. He has authored works professionally for over a decade.
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