A Tale of Two Borrowers
How Much House Can You Afford?
If you’ve been following our blog for a while you’ve noticed how much we write about the importance of financial health. One of the biggest purchases affected by your financial health is your home. Understanding the key elements that impact how much you actually pay for your mortgage can help prevent you from making an expensive mistake.
Your mortgage will most likely be the biggest monthly expense you have. It’s really important to plan carefully to avoid overextending yourself. In this post we will walk you through a comparison of two borrowers that purchase homes for the same price, with the same down-payment, yet one will pay significantly more for their home than the other. And it all comes down to their financial health.
How Much Will it Actually Cost?
Let’s take a look at two young professionals. They both work in Marketing and make $50,000 per year. After months of house hunting they each have an accepted offer for a purchase price of $250,000. Now they need to lock in a rate and secure a mortgage for closing. Let’s take a look at how their financial health impacts their final contract.
- Purchase price: $250,000 with 10% down-payment of $25,000
- 30- year fixed mortgage
- Property Taxes: $200 per month
|The Financial Zen Master||The Financial Challenger|
|FICO score 740||FICO score 660|
|Interest Rate 2.98%||Interest Rate 3.80%|
|Principal & Interest $919 per month||Principal & Interest $992 per month|
|PMI $71 per month||PMI $168 per month|
|Total PMI paid $4,100||Total PMI paid $11,100|
|Homeowners Insurance $68 per month||Homeowners Insurance $83 per month|
|Total Mortgage Payment $1,258 (PITI)||Total Mortgage Payment $1,443 (PITI)|
There are three major factors that contribute to the interest rate, Private Mortgage Insurance (PMI) and the Homeowners Insurance rate you might qualify for. Banks use your credit score to help determine your financial strength. They also look at the total loan-to-value of your mortgage application and your debt-to-income ratio.
Any loan that exceeds 80% of the appraised value of the property will require the purchase of Private Mortgage Insurance. Your credit score and total loan-to-value both influence the insurance rate you will qualify for. In this example, you can see that the lower credit score is “costing” the borrower almost $100 more per month. That adds up $7,000 more than the borrower with great credit.
Many mortgage lenders will approve up to a maximum of 45% debt-to-income (DTI) for borrowers. For someone making $50,000 per year, that would be $1,874 in monthly debt payments. The DTI calculation uses gross income rather than net income, which can be confusing. Your net income is what you actually have after taxes, insurance and other payroll deductions such as retirement and health insurance. A single person earning $50,000 per year is in the 22% federal tax bracket. Their take home pay is probably closer to $3,500 per month, which would only leave about $1,626 for any other expenses.
Invest in Your Financial Health First
As long as your financial health goes unchecked, it will continue to prevent you from getting the most out of your resources. In this example, the borrower with the best financial health saved $97 per month in Private Mortgage Insurance, $73 per month in interest payments and $15 per month in Homeowners Insurance. That’s $185 per month that can be used for savings, investments or other priorities.
This year, focus on improving your long term financial health. Use financial rules for your benefit. Here are a few suggestions to get you started:
- Reduce your total debt-to-income below 35%
- Reduce your total credit utilization below 30% of available credit lines
- Improve your credit score to 720 or better
- Increase your savings balance to afford at least a 10% down payment on a home purchase
- Shop around for better insurance rates
- Set benchmarks for yourself to reach before purchasing a home
- Ask your mortgage lender to break down each piece of your estimated payment and what you can do to get a better rate
Even if you already have a mortgage, you can improve your financial health and refinance to get a lower rate. Keep more of your hard earned money for yourself. Build financial strength and stability so you can accomplish the things that matter most to you.