taxes, and homeowners insurance.
Understanding lenders’ ratios
For a given property that you’re considering buying, a mortgage lender calculates the housing expense and normally requires that it not exceed 40 percent or so of your monthly before-tax (gross) income. So, for example, if your monthly gross income is $5,000, your lender may not allow your expected monthly housing expense to exceed $2,000. If you’re self-employed and complete IRS Form 1040, Schedule C, mortgage lenders use your after-expenses (net) income, from the bottom line of Schedule C (and, in fact, add back noncash expenses for items such as real estate and equipment depreciation, which increases a self-employed person’s net income for qualification purposes).
This housing expense ratio completely ignores almost all your other financial goals, needs, and obligations. It also ignores property maintenance and remodeling expenses, which can suck up a lot of a homeowner’s dough. Never assume that the amount a lender is willing to lend you is the amount you can truly afford.
In addition to your income, the only other financial considerations a lender takes into account are your debts or ongoing monthly obligations. Specifically, mortgage lenders examine the required monthly payments for other debts you may have, such as student loans, auto loans, and credit card bills. They also deduct for alimony, child support, or any other required payments. In addition to the percentage of your income that lenders allow for housing expenses, they typically allow an additional 5 percent of your monthly income to go toward other debt repayments.
Calculating your mortgage payment amount
After you know the amount you want to borrow, calculating the size of your mortgage payment is straightforward. The challenge is figuring out how much you can comfortably afford to borrow given your other financial goals. This chapter should assist you in this regard, especially the previous section on analyzing your spending and goals.
Suppose you work through your budget and determine that you can afford to spend $2,000 per month on housing. Determining the exact size of a mortgage that allows you to stay within this boundary may seem daunting, because your overall housing cost is comprised of several components: mortgage payments, property taxes, insurance, and maintenance (and association dues if the property is a condominium or has community assets like a swimming pool).
Using Appendix A, you can calculate the size of your mortgage payments based on the amount you want to borrow, the loan’s interest rate, and whether you want a 15- or 30-year mortgage. Alternatively, you can do the same calculations by using many of the best financial calculators available for less than $50 from companies like HP and Texas Instruments. (In Chapter 8, we discuss the ubiquitous online mortgage calculators, which are often highly simplistic.)
Some people we know believe they can handle more mortgage debt than lenders allow using their handy-dandy ratios. Such borrowers may seek to borrow additional money from family, or they may fib about their income when filling out their mortgage applications.
Although some homeowners who stretch themselves financially do just fine, others end up in financial and emotional trouble. You should also know that because lenders usually cross-check the information on your mortgage application with IRS Form 4506T (the lender receives your actual tax return you filed, which certainly didn’t overstate your income), borrowers who fib on their mortgage applications are caught and their applications denied.
So although we say that the lender’s word isn’t the gospel as to how much home you can truly afford, telling the truth on your mortgage application is the only way to go. It may be painful to learn that you don’t qualify for the loan you need to purchase that home of your dreams, but you’re likely better off in the long run not overextending yourself with mortgage debt.
We should also note that telling the truth prevents you from committing perjury and fraud, troubles that catch even officials elected to high office. Bankers don’t want you to get in over your head financially and default on your loan, and we don’t want you to either.
As you’re already painfully aware if you’re a homeowner now, you must pay property taxes to your local government. The taxes are generally paid to a division typically called the County or Town Tax Collector.
Property taxes are typically based on the value of a property. Because property taxes vary from one locality to another, call the relevant local tax collector’s office to determine the exact rate in your area. (Check the government section of your local phone directory to find the phone number or search for the name of the municipality and “property tax” online.) In addition to inquiring about the property tax rate in the town where you’re contemplating buying a home, also ask what additional fees and assessments may apply. In California, many recently developed areas have special assessments (such as Mello-Roos districts), which are additional property taxes to pay for enhanced infrastructure and amenities, such as parks, police/fire stations, golf courses, and landscaped medians.
If you make a smaller down payment – less than 20 percent of the home’s purchase price – your lender is likely to require you to have an impound account (also called an escrow account or reserve account). Such an account requires you to pay a monthly pro-rata portion of your annual property taxes, and often your homeowners insurance, to the lender each month along with your mortgage payment. The lender is responsible for making the necessary property tax and insurance payments to the appropriate agencies on your behalf. An impound account keeps the homeowner from getting hit with a large annual property tax bill.
Now is a good point to pause, recognize, and give thanks for the tax benefits of homeownership. The federal tax authorities at the Internal Revenue Service (IRS) and most state governments allow you to deduct, within certain limits, mortgage interest and property taxes when you file your annual income tax return.
You may deduct the interest on the first $1 million of mortgage debt as well as all the property taxes. (This mortgage interest deductibility covers debt on both your primary residence and a second residence.) The IRS also allows you to deduct the interest costs on additional borrowing known as home equity loans or home equity lines of credit (HELOCs, see Chapter 6) to a maximum of $100,000 borrowed.
To keep things simple and get a reliable estimate of the tax savings from your mortgage interest and property tax write-off, multiply your mortgage payment and property taxes by your federal income tax rate in Table 1-1. This approximation method works fine as long as you’re in the earlier years of paying off your mortgage, because the small portion of your mortgage payment that isn’t deductible (because it’s for the repayment of the principal amount of your loan) approximately offsets the overlooked state tax savings.
TABLE 1-1 2017 Federal Income Tax Brackets and Rates
When
