Determining The House You Can Afford
& How To Finance It

The purchase of a home and then the maintenance of it may be the largest single investment you will make in your lifetime. After you determine your housing needs and decide to purchase a house, it is important to know how much you can afford to spend for a home. A complete examination of your financial resources may prevent later disappointment and financial loss. Knowing your price limitations before starting your search for a home can save much time and effort.

Affordability Guidelines

The following guidelines have helped buyers determine how much house they can afford:

• The purchase price of the house should not be more than 2 to 2½ times your annual income.
• Monthly payments for principal, interest, property taxes, and homeowners insurance should not be more than 25 percent of monthly net (after-tax) income.

These guidelines have been quoted for years, but they do not take into consideration all financial aspects. The number of residents in the home and their earnings; the debt load, both long- and short-term; the amount of savings, equity, or other investments; and the varying interest rates all play roles in how much you can afford for housing.

After you compare your income with long-term obligations and expenses, you can more easily identify the amount of money available for housing. See Extension Publication 1738, Steps to Successful Money Management.

Additional Housing Costs

Following are some additional expenses that you will incur when owning a home:

PROPERTY TAXES.

The millage rate on real property will vary considerably. The rate is established by your local officials, and then taxes are paid on the current value of the house.

PROPERTY INSURANCE.

The lending institution normally requires insurance in the amount equivalent to the balance on the mortgage. To protect your full investment, you should purchase insurance that provides for full replacement if the house is destroyed.

MORTGAGE INSURANCE.

When the down payment is less than 20 percent of the mortgage amount, the lender will usually require mortgage insurance to protect him/her from loss if you fail to make your monthly payments. You can purchase another type of mortgage insurance that will pay off the mortgage in the event of your death.

MAINTENANCE.

An ongoing expense is the maintenance cost of keeping a house in good condition. Approximately 1 percent of the value of the home per year needs to be set aside for future maintenance expenses.

Applying for a Mortgage

Your purchasing power ultimately depends upon two things:

• how much you have available for the down payment.
• how much a financial institution will agree to lend you.

The financial institution will generally look for two income ratios as they evaluate your loan application:

• A monthly house payment (including mortgage payments, property taxes, and insurance) not more than 28 percent of your monthly gross (before-tax) income.
• Total obligations for housing and long-term debt should total no more than 36 percent of monthly gross income.

The "Four C's" of Credit:

CAPACITY.

The lender will determine if you have adequate income to repay the mortgage, based on a continuous employment history, your number of dependents, and your other outstanding obligations.

CREDIT HISTORY.

It reflects whether you have a stable credit record, how much you owe, whether you pay your creditors on time, and whether you live within your means.

CAPITAL.

This indicates whether you have enough money of your own to make a down payment and to close the mortgage.

COLLATERAL.

The lender wants to ensure that the property you are purchasing is worth at least as much as he/she is willing to loan.

Selecting a Mortgage

A mortgage conveys the ownership of property from the lender to the borrower over a period of time. During the process, the lender holds the property as collateral and you, the borrower, make monthly installment payments while residing on the property. Mortgage payments are usually weighted, with interest during the first years being most of the payment and with the principal being the smaller amount. In the later years of the mortgage, more of the payment goes to the loan balance and less to interest. As the principal or loan balance decreases, your equity or ownership increases. Equity also increases if the value of the home increases. The process of gradually increasing equity and reducing debt through payments of principal and interest is called amortization.

The traditional mortgage of fixed monthly payments, fixed interest rates, and full amortization over a 30-year period is not the only mortgage available now. Many newer mortgages actually make it easier for you to purchase more house than you could have with a traditional mortgage, but the risks are greater.

Examples of these risks are as follows:

• The interest rate and monthly payments may change during the loan to reflect market conditions.
• The interest rate may fluctuate, while the payments remain the same and the amount of principal paid off may vary.
• Some mortgages may offer a below-market interest rate, but it may not help you build up equity.

As you shop for financing, keep in mind the terms that are keys to the affordability of the home:

• The sales price minus your down payment equals the amount you finance.
• The length or maturity of the loan.
• The size of the monthly payment.
• The interest rate or rates.
• Whether the payments or rates may change.
• How often and how much the payments or rates may change.
• Whether there is an opportunity for refinancing the loan when it matures, if necessary.

Fixed-Rate Mortgage

The interest rate and monthly payments remain constant over the life of the loan. The fixed-rate mortgage protects you from rising interest rates by setting a maximum on the total amount of interest you pay during the loan. These mortgages are normally either 15- or 30-year mortgages. The shorter mortgages usually carry a smaller interest rate than the long-term ones.

Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage has an interest rate that increases or decreases over the life of the loan, based on market conditions. Normally, the initial interest rate on an ARM will be lower than the rate on a fixed-rate mortgage. Adjustable-rate loans can have different provisions, so evaluate each one carefully.

Following are some terms that will help you better understand adjustable-rate mortgages:

RATE CAPS.

These are limits on the frequency of interest rate changes, the amount of such changes, and the overall limit that you can experience as the borrower, which provides some protection for you.

PAYMENT CAPS.

If interest rates change frequently, the monthly payments are not adjusted at every change. When the interest rate does change, the allocation of the monthly payment between interest and principal changes. If the interest rate rises, more of the payment will go toward the interest. If the interest rate falls, more of the payment will go toward the principal.

If the interest rate increases drastically, the monthly payment may not be enough to cover the larger amount of interest. The interest not covered is added to the remaining principal. The result is the principal increases rather than decreases, presenting what is referred to as negative amortization. In reality, you are borrowing a little money each month in order to keep the payment fixed and, in the long run, will actually be paying interest on interest. At the end of the term of the mortgage, the principal may not be paid in full; therefore, you will have to make a single balloon payment.

VARIATIONS.

One such variation is to fix the rate for a period of time--3 to 5 years, for example--with the understanding that the rate will be renegotiated. These loans are also referred to as "rollover mortgages." Such loans make monthly payments more predictable, since the interest rate is fixed for a longer period of time.

When shopping for any type of adjustable-rate loan, remember to look for the following:

• the initial interest rate.
• the interest rate index on which payments will be based.
• how often the rate may change.
• how much the rate may change.
• the initial monthly payments.
• how often payments may change.
• how much the payment may change.
• the mortgage term.
• how often the term may change.
• how much the term may change.
• the limits, if any, on negative amortization.

Balloon Mortgage

A balloon mortgage usually has a series of equal monthly payments and a large final payment. The payments may be for interest only. The unpaid balance usually comes due 3 to 5 years from the date of the original loan, forcing the borrower to have the balance of the loan either through savings, refinancing, or the sale of the property.

Some lenders may offer automatic refinancing but not at a guaranteed interest rate. The rate could be higher than your present rate. Without a guarantee of automatic refinancing, you could be faced with shopping for financing as well as paying closing costs and front-end charges a second time.

As a home buyer, you should be sure of the following:

• exactly when the balloon payment is due.
• how large it will be.
• whether there is any safety clause, in case you could not raise the money.

Graduated-Payment Mortgage (GPM)

A graduated-payment mortgage is designed for home buyers who expect to be able to make larger payments in the near future. Payments are relatively low during the first years of the loan and then increase at a given rate over a period of years, usually 5 to 10 years. They then will remain stable for the duration of the loan. The interest rates on this type of loan are usually stable. During the early years of the mortgage, your payments will not be equivalent to what the interest rate dictates. During the later years of the loan, your payments will be higher to make up the difference. At the end of the loan, you will have paid off the debt in full.

Growing-Equity Mortgage

This mortgage has a fixed interest rate, usually a few percentage points below market, with a constantly increasing monthly payment. The increases are applied directly to the principal and, therefore, will decrease the length of the loan, often paying a mortgage off in less than 15 years. Your income must be able to keep pace with the increased payments. This mortgage will allow you to pay off your mortgage quicker as well as increase your equity faster.

Shared-Appreciation Mortgage (SAM)

This type of mortgage can be as much as 40 percent lower than fixed-rate mortgages. You must agree to share with the lender a sizable percent of the appreciation in your home's value when you sell or transfer the home to another mortgage after a specified number of years.

Your monthly payments are lower with a shared-appreciation mortgage, but you may be liable for the dollar amount of the property's appreciation even if you do not want to sell the property at the agreed-upon date. One thing you must be aware of is that if property values do not increase as anticipated, you may still be liable for an additional amount of interest.

Assumable Mortgage

An assumable mortgage is a mortgage that can be transferred to a new owner at the previous owner's interest rate. Lenders often hesitate to permit assumptions if the market interest rate is higher and instead will call the mortgage in under the due on sale clause. If you are considering a mortgage that is assumable, read the contract carefully and determine if the lender has the right to raise your interest rate upon assumption.

Seller Take-Back Mortgage

The seller will provide all or part of the financing needed to purchase the home with a first or second mortgage. He may offer a below-market interest rate, but usually there is a balloon clause requiring full payment in a few years, with refinancing required at market rate.

Wraparound Mortgage

In this mortgage, the seller of the house usually holds the original low-rate mortgage. He then finances the house himself at a higher rate and has the buyer send him the monthly payments. The seller, in turn, keeps the difference between the two payments and forwards the original payment to the lending institution. The lending institution may call in the old mortgage and require a higher rate of interest.

Buy-Down Mortgage

The developer usually provides an interest subsidy, which lowers the monthly payments during the first few years of the loan. The rate can either be fixed or adjustable. This mortgage will usually offer a break from higher payments during the early years, enabling buyers with lower income to qualify. At the end of the subsidy, the payments may jump substantially. One of the disadvantages is that the developer often will inflate the selling price.

Rent With Option To Purchase

The potential buyer usually pays a fee for an option to buy the house at a predetermined future date at a specified price. The rent that is paid may or may not apply toward the purchase. This enables the renter time to obtain a down payment while deciding whether to purchase the property. This option will lock in the price during inflationary times. Failure to purchase the property means the loss of the option fee and rental payments.

General Guidelines

Some general guidelines for choosing a mortgage include the following:

• Compare loan options from different lenders. With careful shopping, you may find a mortgage that suits your needs at a lower overall interest cost than others.
• Evaluate all available finances. Do you have adequate income to cover all the payments? Do you have a savings account to help cushion the effect of sudden or large increases in payment?
• Look for a fixed-rate mortgage first. If one is not available, consider a fixed-rate, graduated-payment mortgage.
• Compare interest caps on adjustable-rate mortgages. Look for one that limits the amount the rate can rise each year, as well as over the life of the loan. Your payments will be larger than with a payment-capped mortgage, but the interest rate increases will be covered.
• Compare payment caps. With a payment cap, you will make smaller payments at the beginning of the loan, but the total interest will usually be more than the interest paid on rate-capped mortgages.
• Check the index used for rate increases. Ask the lender to share some recent examples of how the index has moved and the effect it has had on payments. Choose a mortgage with rate changes based on an index beyond an individual lender's control.
• Avoid a balloon-payment mortgage without guaranteed financing.
• Know how much you will have to pay and when you will have to make the payments. If you are asked to sign a mortgage with variable provisions, assess what the worst possible case could be and decide if you could handle it.
• Don't set up a negative amortization, where the outstanding principal could exceed the value of the property.
• Check the prepayment penalty clause. At some future time, you might decide to refinance at a lower interest rate with another lender to pay off the first mortgage.
• Check other penalties that might apply if you cannot make an increased payment. Is the interest added to the principal, or can the loan term be extended?

Mississippi State University does not discriminate on the basis of race, color, religion, national origin, sex, age, disability, or veteran status.

Publication 1996
Extension Service of Mississippi State University, cooperating with U.S. Department of Agriculture. Published in furtherance of Acts of Congress, May 8 and June 30, 1914. Ronald A. Brown, Director