In my last post, I discussed what drives a lending decision. I also want to take a look at payment ratios/formulas and how they impact the total monthly payment for a home. The dirt is in the details…let’s consider buying a house.
Whenever my team works with a client, maybe the most frequently asked question is, “How much will this house cost me every month?” It’s understandable….a necessary question. Buying a home is a huge financial investment. Not to mention one of the most important financial decisions a person will make. I find many clients are under informed about what home ownership truly costs.
The mortgage loan is simply one variable in the grand scheme of things. Instilling confidence by providing “how to” details is important…with financial clarity comes less anxiety.
To determine your monthly cost, first we need to take a look at what is termed Payment Ratio – the cost per every $1000 provides an approach that most any individual can calculate rather easily. This is the portion of your monthly payment that goes directly toward the loan, and is determined by what amount you borrow. Your monthly payment ratio will also vary depending on what type of loan you do (FHA, USDA, Conventional, Veterans Affairs, etc.).
If you borrow $100,000, and your ratio equates to $6 for every $1,000, the first portion of your total housing payment (there are 3 parts) would equal $600. The remaining two components of your payment include the property taxes and the home insurance (Hazard Insurance). Using that same $100,000 loan and applying these 2 elements will yield your total housing payment. Use this formula:
- Cost per $1000: $6 monthly payment /$1000 borrowed OR $600
- Property Taxes: $1900/year OR $158.33
- Hazard Insurance: $890/year OR $74.17
1 + 2 + 3 = Housing Payment / $600+158.33+74.17 =$832.50
We are using average costs from the Northeast Ohio housing market for this example. We are also assuming a 30-year fixed mortgage at an interest rate of 4.50% with a 10% down payment. Thus, the payment ratio (#1 in the three-part formula) is accounting for principle + interest + mortgage insurance premium (PMI is essentially the same thing). Using this simple formula will assist with more accurate mortgage payments. Greater financial precision promotes easier buying decisions. I can provide borrower specific details for proper payment ratios as needed.
Funds to Close
When buying a home, your down payment is only a part of what is termed Funds to Close – how much one can expect to need to fund the transaction. As previously mentioned, the down payment percentage is dependent on the type of loan program. Typical down payment percentages are as follows:
- FHA loans – 3.5%
- USDA loans– 0%
- Conventional – 5% to 20%, in 5% increments
- Veterans Affairs (VA) – 0%
Bear in mind that your down payment is dictated by the lending agency and loan program guidelines. Credit, income, and the overall cost of the home will also play a role. Additionally, lenders may want to see at least three months worth of mortgage payments in cash reserves (post-closing), and will want to know where your down payment is coming from (the source). Lenders & program guidelines may also limit how much can come from gifts.
The remaining two (2) elements for Funds to Close include Hard Costs, which are your closing costs, and Soft Costs, also known as prepaids.
Think of hard costs as tangible stuff; what you pay for people to do work (service providers). Examples include appraisals, title companies & public records search, underwriting / processing your loan, surveys, and any permits/materials needed for renovation – among other things. A simple (and silly) real life example: if you go to the grocery store and buy three pounds of ground beef at $2.75 per pound, you’re spending $8.25 in hard costs to have that ground beef. However, that beef is simply one component of your total grocery bill.
Soft costs are a little bit different, but still factor into the overall cost of your transaction/loan. These costs typically include setting up an escrow account for your property taxes and home insurance, and paying for prepaid interest until your first house payment is due. Home insurance must also be paid one year in advance (can be paid at the time of settlement).
Thus, when buying a home, Funds to Close is comprised of 3 critical parts:
- Down payment.
- Hard Costs
- Soft Costs
1+2+3 = Funds to Close. This detail is critical to assist with setting proper financial expectations and allowing borrowers to accurately determine their buying power…how much house they can truly afford.
Money, Money, Money
OK…let’s recap everything that has been discussed thus far.
Before applying for a loan, you’ll want to know details about your credit score and your credit profile. Further details about how a mortgage payment will factor into your debt-to-income ratio are also important. These components drive the lending decision.
Next, meet with your mortgage bank/loan officer and review details about monthly housing payments and the necessary funds to close. After adding up all of the numbers and crunching the calculations, don’t forget to ask about Seller Concessions before you sign the purchase agreement.
*Not intended as credit counseling, accounting or investment advice. Contact your financial representative for more information. Down payment and terms shown are for informational purposes only and are not intended as an advertisement or commitment to lend.