This article is meant especially for first-time home buyers chasing the best mortgage loan. It will explain how lenders qualify people for a mortgage loan and show that for many the amount they qualify for is too high for them.
For many people, the best mortgage loan is the highest amount at the lowest interest rate. Which is often fine, but not always. Here’s a bit of background on how lenders qualify borrowers.
Mortgage Payments As They Relate To Income – Overview
After the 2008 mortgage meltdown, Congress passed some rules to make sure borrowers are not taken advantage of.
One of the is the Ability-to-Repay rule (ATR). Yes, like its name says, it forces lenders to make sure borrowers can repay the loans they’re given. (Seems like this should have always existed, but no, it’s new.)
The other one is Regulation Z (Dodd/Frank). This one covers many things, including caps on what part of a borrower’s income can go to pay for all the loans and housing expenses.
The cap is 43% but loans that are meant to be sold to Fannie Mae or Freddie Mac could have 45% till January 2021 while FHA loans cannot be 56% or higher. But Fannie Mae and Freddie Mac allowed 45% at first, then, for the less risky borrowers 50%.
Danger! Danger! Danger!
To see the danger, let’s look at a couple of examples, based on the lowest and highest limits.
Let’s say a borrower gets $5,000/month. 43% of that is $2,150; 55.999% of that is $2,799.50.
That means that the borrower has $2,850 or $2,200.50 left. From which the borrower has to pay Medicare and FICA and, maybe, federal and state taxes. A borrower’s FICA portion is 6.2% of their wages while Medicare is 1.5%, or 7.25% together.
7.25% of $5,000 is $375. Which means that the borrower has $2,475 or $1,825 left for food, clothes, etc. Less if they have to pay income taxes.
The etc. above includes things many first-time home buyers do not think about, such as lawn maintenance, replacing the furnace.
Let’s say a borrower get $3,000/month. 43% of that is $1290 while 55.999% is $1,679.97. That means the borrower has $1,710 or $1,320.03 left.
Those are pretty low numbers, so even if the borrower does not pay FICA, Medicare, federal or state taxes, having to pay for a new roof or furnace will hurt.
What Borrowers Should Do To Get The Best Mortgage Loan With No Regrets
It is simple, though not necessarily easy to implement: devilishly fun temptations are everywhere.
Add future expenses to the mix. I mean, sit down and make a list of all the expensive items in a home that will need replacement and of all the small repairs that are likely to happen.
For the first part, the best way to do things is to take into account the current cost of the item, divide that by the number of years the item is expected to be functional then divide that by 12 and add the result to the expense column.
So, let’s say the type of fridge you want costs today $1,200 (taxes included). According to the website Mr. Appliance, refrigerators last between 10 to 18 years, with 14 being the average (https://www.mrappliance.com/expert-tips/appliance-life-guide/). If you’re cautious, your math will look like this if you’re dealing with a brand new:
1200/10=120/year or $10/month.
Which, I know, does not sound like much, but it’s only one of the items you’ll need to replace.
Think of this too: you might not know the exact time some component of your house was last replace. Most of them last a long time, asphalt shingle roofs are expected to last 20 years, for instance.
But many cost a lot more than a refrigerator. If your asphalt shingles roof costs you $20,000, your math for roof reserves looks like this if you’re buying a house with a brand new roof:
If you suspected that your roof was installed 12 years ago, your math would look like this:
I am not trying to discourage you from buying a house and I know often a fridge lasts 19 years, an asphalt shingles roof 28. But I also know that some fridges kick the bucket in year 5 and some roofing dies at 14, for instance.
If you’re the borrower with $5,000/month, your reserves would probably be $400 to $700 a month. If you’re really cautious, you account for the power of the dollar to go down, so you might make them $450 to $750.
Once you’ve done your math on all appliances, furnace, patio, roof, windows, doors, etc., you take out your reserve number from your income, take out all your other loan, credit cards, property taxes, property insurance, mortgage insurance, and think about the result. Is it a number you will be happy with? Can you live the life-style you’re used to on that amount? Can you get all the beer you want? All the make up you want? All the shoes and clothes you want? Can you afford to go out? To eat? To take care of your teeth?
Used to be that I’d see a lot of articles saying that your housing expenses should be 25% of your income. Seems to me that number is a much better number than what lenders will qualify you for, when you take into account things in your new home breaking, your mortgage payment + property taxes + property insurance + mortgage insurance. When you take into account life, in other words.