This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.
Once a person has determined they will buy a home, there are two fundamental financial questions that need answered. “How much can I afford?” and, “How much will the monthly payment be, based on the purchase price?” A mortgage broker or lender can most easily answer these questions. You could go to your local bank and ask to get “pre-qualified” for a mortgage. You should not pay anything to get pre-qualified. The lender will ask you a few basic questions such as your income, how long you have had your job, what your debt payments are and so forth. They will then be able to give you a rough estimate of how much mortgage you qualify for, and what your monthly payments will be.
Be sure to ask if they can give you an estimate of your monthly payments including taxes, insurance, etc. Most online calculators only tell you what your monthly principal and interest payment will be. If your agent does not give you an estimate, call a local settlement company and ask about the averages in the local area. It is a good idea to find a settlement agent (or attorney) anyway, although your real estate broker may be able to recommend one for you. If you still can’t figure out how much to add for these other costs, assume you should add about 20% to your monthly payment. In other words if your pre-qualification shows your principal and interest payments will be $1,000, assume your total monthly payments will be about $1,200 (20% of $1,000=$200).
It is also a good idea to use an online calculator or a spreadsheet to calculate your payment on your own so you can compare your numbers with what the bank tells you. Don’t hesitate to ask them to explain any differences. This also applies with any type of loan such as a car loan, etc. You should always be prepared to have your own calculated numbers to compare with what the sales person tells you. Figure 9-1 will help you estimate your monthly payments (not including taxes and insurance).
Getting pre-qualified is the easiest way to get a decent estimate of what you can afford. If you are really serious about buying a home and you are in a tight market (more buyers than sellers), you may want to consider getting “pre-approved.” Pre-approval is more complex than pre-qualification. Your mortgage broker will ask for last year’s W-2 (The form your employer sends you at the end of the year so you can report your taxes). They will also want your last several pay stubs, several bank statements and so forth.
Once you are pre-approved, the bank is basically guaranteeing you will be able to get a loan for that amount, as long as the house is appraised to be worth what you are paying. This tells the seller they are taking very little risk with you as a buyer, because the bank has already said you can get the loan for that amount. If someone else makes an offer on the house, but is not pre-approved, the seller has to wait to see if that person will even be able to borrow the money. Since you have already been approved, you are at an advantage. In many cases pre-approval will cost you money (up to $500). However, if you buy the home and get the mortgage, that $500 will be applied towards your closing costs.
Before you get too excited about your new home-to-be, make sure you have enough money. I know you just went through the exercise above, but all you learned is what the bank is willing to lend you. That does not mean you have enough money or you can afford that much. Perhaps you like to take several vacations each year, or maybe you were saving to buy a new car. The bank doesn’t care about these things. They are letting you know the maximum amount of money that you can borrow. That doesn’t mean you should be borrowing the maximum amount.
You also have to look closely at the closing costs (we’ll discuss this more in detail in a moment). Many people are surprised they need to have several thousand dollars available at closing. There are attorney’s fees, inspection fees, courier fees, lending fees, etc. Usually you can expect closing costs to be about 3% – 5% of your total loan amount. If you are borrowing $100,000 then you will need at least $3,000 to $5,000 at closing, in addition to whatever your down payment is.
There are several types of mortgages, but I’ll try to break them down into simple categories. You can get a fixed rate mortgage (the same interest rate for the entire length of the mortgage), an adjustable rate mortgage (the rate adjusts according to one of the major financial indices) and the hybrid loan, which combines a fixed rate period, such as the first five years, with an adjustable rate period, which will be the remaining years on your loan.
The advantage of a fixed mortgage is that you never have to worry about your interest rate going up, which means your mortgage payments will remain relatively flat over the years (with the exception of the escrow, which may increase due to rising taxes and insurance). The disadvantage is that fixed rate mortgages are usually at a higher interest rate than their adjustable or hybrid counterparts.
With an adjustable rate mortgage, you almost always get a better rate initially, but the rates can rise (or fall in theory) according to one of the major financial indices. If you are only going to be in your house for a short period of time or have reason to believe rates will fall, this may be a good option for you. Otherwise, be careful with these mortgages. Some people use the low initial rate to qualify for a more expensive house than they could otherwise afford, but end up in foreclosure when the rates rise faster than their income. If you choose an adjustable rate mortgage, check to see how often the rates can rise (monthly, every six months, etc.), how much they can adjust each period (such as each adjustment can be no more than ½%) and how far they can adjust in total (rates may start at 6%, but can rise to as high as 10% for instance).
A hybrid loan is well suited for most young adults for many reasons. First, the rates are usually lower than a fixed rate mortgage, although slightly higher than an adjustable in most cases. The hybrid usually starts with five, seven, or ten years of a fixed rate, before the adjustable portion kicks in. If you have ever heard of the 7-year itch, then you know most people either move or refinance their mortgage within their first seven years in a home. Thus, if you pay more to get a fixed rate loan, buy down the interest rate by paying points up front, and then refinance in seven years, you wasted a lot of money compared to the person who had a 7-year or 10-year hybrid. Of course, even the hybrid is somewhat risky because you don’t know where the interest rates are going to be in seven years.
Within these categories, you also have loans for different periods, or years. You can usually get anywhere from a 15-year loan to a 30-year loan (in 5-year increments). Obviously your payments will be higher with the 15-year loan, but you can usually get a better interest rate. Also, your payments are less than double the 30-year loan, so it is a much better deal (not to mention you will be free of a mortgage in just 15 years compared to most everyone else with their 30-year mortgage).
If you refer back to Figure 9-1, you can compare the monthly payments (per $100,000 borrowed) for loans of different lengths of years. Keep in mind the main advantage of the shorter mortgages is that you will be done making house payments a lot sooner. That could mean a whole lot of extra cash to play with at the end of each month. The interest rates are usually lower for a 15-year mortgage than a 30-year mortgage because the bank knows they are taking less of a risk with you by lending money for 15 years instead of 30.
Taking all of the information into account, you should be able to decide about how much of your hard-earned money you are willing to spend each month on a mortgage, how much you will have available at closing, and how long of a mortgage you are willing to suffer through. With a little research on the web, and at your local banks and mortgage companies, you should be well prepared for the financial piece of the home-buying process.
Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.comor www.TheGraduatesGuide.com.