Know Before You Buy

You have a lot to consider when budgeting for your home purchase.  How much you can afford each month is the first order of business.  How much you need to have in the bank for inspections, earnest money, down payment and other closing costs is the second thing to do. 

Once you have figured out how much you can spend each month, keep in mind that lenders have their own standards, based on decades of experience with other borrowers.  Typically, lenders expect you to spend no more than about 30% of your gross income on housing and no more than 40% for all debts you have to repay.  This means if you earn $48,000 per year before taxes that only $14,400 per year can be spent on mortgage payments, or about $1,200 per month. 

This would include, principal repayment, interest, taxes and insurance.  If there is a homeowner's association, then that would be added in also.  Make sure your expected monthly payment for housing including all these items meets this test.  If it is close, it might be accepted, but payments that far exceed the guideline, such as $3,000 in the example, would likely be rejected by the bank. 

For other debts the total of housing payment and debt payments for credit cards, student loans, and so on should be under the 40% figure.  For the same $48,000 income, the total for all monthly payments would be under $19,200, or $1,600 per month.  If your mortgage is at maximum, then that leaves only $400 for all other debt payments. 

These are guidelines and some flexibility is possible.  Ask about your circumstances. 

Based on the monthly payment available, your loan officer can tell you what that translates into for a mortgage amount.  A 'rule of thumb' is 1% of the sale price of the house for monthly mortgage payment.  If you have $1,600 available for mortgage, then your loan amount will top out about $160,000.  In other words, $1,600 is 1% of $160,000, but with historic low interest rates that's really a maximum you'll pay. 

In the table below for a 30-year mortgage at 6% interest you'll see that each month you have to pay $5.99 per $1,000 of loan amount.  (Actually, it's a half cent higher than that.)  In addition to repaying the principal plus interest, the other charges for taxes and insurance have to be added, which is shown further down. 

Typically, you'll need 3-1/2% of the purchase in cash in your bank at a minimum.  On the hypothetical $160,000 mortgage you'll need about $5,600 in cash in the bank before you apply for a mortgage. 

If you have a chunk of money, say, $20,000 in the bank, you may want to set aside some of it for new curtains, additional furniture, and improvements or repairs to the property you're buying.  However, the more you have to pay as down payment, the better your interest rate will be, resulting in lower monthly payments. 

Suppose you have the $20,000.  With a maximum mortgage of $160,000 you could purchase a home priced at $180,000.  The mortgage loan package for this deal would most likely be a first mortgage of $144,000, because that's 80% of $180,000.  The remainder of $16,000 would be a second mortgage.  Second mortgages always carry a higher interest rate and often a shorter term. 

Between the two mortgages, $144,000 plus $16,000, you would need to pay an additional $20,000 in cash at closing to meet the full $180,000 price.  But, there are other costs you have to pay.  So, before we say that $20,000 is going to be used for down payment, let's look at closing costs. 

Lenders will offer you a single mortgage loan for the full amount, up to about 95% of the value, at a higher rate.  The higher rate is to take account of the mortgage insurance (MI) they'll have to carry on your loan.  Many times the MI will be shown as a separate charge, not included in your interest rate. 

Each year you're going to pay for homeowner's insurance to protect your property against fire and other hazards.  The lender will require it, and you will want it.  Each year the local taxing districts collect taxes assessed on your new home, too.  You will have to pay these taxes, when due, also. 

Normally, an escrow account is set up by the lender to receive a portion of your monthly payment and set it aside to pay taxes and insurance later.  The amount for these may change each year, which will make your monthly payment go up. 

At closing, that portion of taxes already due for the year should be put into the escrow account.  For example, if you close in July, then 7/12 of the taxes due should be placed into the account to begin with.  The monthly escrow amount for taxes is basically 1/12 of the last  year's tax bill.  The insurance bill has to be paid up front, but it is discussed below.  The monthly escrow amount for insurance is basically 1/12 of your first bill. 

In addition to the partial year's taxes, the lender will ask for some buffer, specifically two months in addition.  This applies to the taxes and to the insurance escrow amounts.  These are referred to as Prepaid Costs, or just Prepaids.  Homeowner's insurance is more comprehensive than just fire insurance.  It also includes coverage on contents and some amount of liability insurance to protect the property from lawsuits.  While Texas has rates much higher than some areas, you can budget roughly 0.8% of the house value for annual premiums as a minimum, but it could cost only 0.5%, depending on deductibles and coverage.  More coverage will mean higher premiums. 

Since house has to be covered by insurance from the time of purchase, your initial insurance policy will be a full year from date of closing and must be paid at or prior to closing. 

Closing costs are all the other costs to close, not counting the prepaids, and include inspections, appraisal, fees, lender charges and so on.  The two most significant events in the overall home purchase process after signing the contract are to get the home inspected for defects, and to have its value appraised for lending purposes.  These aren't the same.  You will also need an acceptable survey done on the land.  The seller may have one that is acceptable.  If not, this is another closing cost. 

When you apply for a loan, you will get a Good Faith Estimate of the closing costs, prepaids, and monthly escrows in addition to the monthly payments.