Financial fitness for homebuyers
A home is generally the biggest purchase you’ll ever make. Your financial habits will determine how much interest you pay on your home purchase, your stress level as you live in it, and your ability to find and buy your dream house. Laying a strong foundation with your finances is critical to having a low stress, high enjoyment home.
It’s relatively common for homebuyers to go to a mortgage broker to figure out what kind of loan they will be approved for. Most buyers take this at face value and consider any loan that would be approved to be a reasonable purchase. Instead, I think that a combination of metrics and lifestyle choices can lead to a happier home buying experience.
DTI (Debt to Income) Ratio
Debt to Income is the first thing that a mortgage broker is going to look at to give a maximum loan value. The simple calculation is (Monthly Debt)/(Monthly Income). For example, a person with a $100,000 annual salary and $3500 in monthly debt obligations will have a DTI of 35%. There are two types of DTI used in home buying, but the Back End or total DTI is often the most important.
Front End DTI
This is the sum monthly total of all household expenses that would typically be included in a mortgage and escrow account. The base mortgage, property insurance, property taxes, and any homeowner’s association fees are most typical. Depending on where you’re shopping, taxes, insurance, and HOA fees could be cutting down your total purchasing power substantially. Expect an acceptable front end DTI to be no more than 28% of monthly gross pay.
Back End DTI
This is the total of all debt obligations each month. This includes all home mortgage related expenses in the Front End DTI as well as credit card payments, car loans, student loans, personal loans, phone leases, etc. Traditionally, 36% is considered the maximum Back End DTI. Current federal guidance is allowing more than 40% for certain loan types. We’ll cover why this is a bad idea in most situations later in this article.
Loan to Value
Certain qualified buyers can borrow with very small amounts of money down using a variety of federally backed mortgage programs. I highly recommend avoiding this in almost all situations; borrowing without money to put down creates two problems. First, you’re almost always going to be paying PMI (Primary Mortgage Insurance) as you slip below 20% down. Some lenders will allow you to drop PMI when you reach an 80% LTV, but others will require you to get to 75% or refinance to get out from under PMI. We live in a rising interest rate environment, so refinancing may wind up costing you even more. The other problem when borrowing with less than 20% down is that you need to be working with these Federally backed programs that not all sellers are willing to accept. Timelines for closing tend to stretch on for a long time, and the programs themselves can make your offer seem less appealing when compared to conventional or all cash offers. If you’re in a non-competitive market or can afford a conventional loan for the right house, working with these programs makes a ton of sense. Otherwise, I suggest focusing on saving and credit score building to get in a better position.
Your budget is what actually determines affordability. Start by working out your current and proposed Back End DTI for the home value you’re looking at purchasing. You should be able to ballpark taxes, HOA, mortgage rates, and insurance to figure out your monthly mortgage payment using online calculators for your zip code. Once you’ve pulled all the info together, I like to use an online mortgage calculator such as mortgagecalculator.org to figure out the expected payments and the total interest for the life of different loan types. You might consider how moving to a different zip code affects your property tax rate and insurance costs. The difference can be bigger than you think!
Next, add in all your regular, irregular, and variable expenses for a given month. Be as honest as possible about this. Using a spending tracker like mint.com will help you track purchases from prior months, which can be used with a spreadsheet or budgeting software to plan for the future. I use a one year look back period to ensure that I’m fully aware of any changes in spending or cost of living. Irregular or variable spending like car maintenance, property tax, utilities, entertainment, clothing or insurance payments made in full for multiple months can be averaged to a monthly cost for budgeting purposes.
Once you’ve determined these numbers, compare them to your monthly take home pay. Do you still have some breathing room for emergencies? Can you handle saving for retirement? Are you able to have the lifestyle you want? Consider if you have major lifestyle changes coming up like marriage or parenthood. How does this impact your proposed budget?
My personal ratios for budgets are:
Front End DTI – No more than 25% Gross Income
Home Expenses Including Utilities – No more than 30% Gross Income
Back End DTI – No more than 30% Gross Income
We choose these ratios so we have plenty of money to do other things that we enjoy and have no trouble planning for the future. Travel, good food, and relatively low financial stress are very important to us. Our ratios would change if we moved somewhere we could consider adding or dropping a car, changes to our tax status, or if we decide to start a family.
I personally wouldn’t even consider a home unless I had an emergency fund of half my downpayment set aside in a relatively low risk investment. Consider this: every house we’ve ever moved into has had an immediate problem that took at least $5000 to fix. Our home in California had a major drain issue that had sewage backing up through the house, and our old Kentucky home had a raccoon eat a hole in the roof while we were out of town. Either of these could have been fixed for less if I was willing to drop everything and take care of them right then, but it takes a really brave soul to fix a roof in the rainy season or skip calling an emergency plumber as yesterday’s food comes out the shower drain. A healthy savings account reduces the stress of life’s little emergencies.
If I had kids, I’d double my emergency fund. Suddenly, free time to fix problems is in short supply and there are a wider variety of emergencies to prepare for. Expenses also tend to be higher, and it just feels good to be able to keep the bumpy patches smoothed out for dependents.
What’s the best way to build an emergency fund and a downpayment? Take a critical look at your present budget. You probably have some categories that you could trim down (I know we do!) Take each of these and add them up until you get to a house payment or close to it, and save that amount each month. Once you meet that goal, this turns into your regular house payment and your existing rent or house payment becomes your new savings payment. The best part about this strategy is that if you’re making that house payment to yourself every month without sweating it, you’re almost certainly in the range of affordability for housing.
In non-competitive markets or market periods, it is relatively common to see sellers offering to pay closing costs. In our current environment, you’ll probably need this money set aside to buy. In Cincinnati, average closing costs for a $200,000 home are just a little over 1%. Don’t be caught unprepared for this before you start your search. bankrate.com has a nice tool for checking average closing costs in your state, but you can get more granular information from your mortgage broker as you get closer to buying.
Significant investments change the math on home buying. If you’re expecting better long term returns on your invested capital than you would get by avoiding PMI or avoiding interest on your mortgage payment, you might consider a low down payment. Especially risk averse buyers might feel most comfortable owning homes outright or with a 50% or higher LTV. Any strategy is fine, so long as it fits in with your general investment risk tolerance.
One word of caution regarding non-rental investment property; even if it is owned outright you’ll be dinged for insurance and property tax as part of your Back End DTI.
Keep following from Part 2 – Credit Scoring and Part 3 – When to Rent Instead!