Mortgage interest rates have been steadily falling since the beginning of the 2018 and are now closing in on the previous low record for this century, 3.31% for an average 30-year fixed mortgage in 2012. This makes it very tempting for renters looking to swap a rent check for a mortgage payment and the growing home equity that comes with it.
If only it were that simple.
Yes, mortgage interest rates are nearing historic lows, but housing requires some additional math. Home prices are rising, partially pushed by a shortage of inventory. And owning a home is a much more involved equation than a mortgage. Utilities, maintenance and insurance must all be taken into account, along with a myriad of household expenses. How much does it really cost to own a home? And is now the right time for you to become a homeowner.
Read on to find out—but make sure your pencil is sharpened, because there will be some equations.
Step 1: Your Debt-to-Income Ratio
Renting is simple math. Landlords usually consider little more than your monthly income and employment longevity. Renters largest expenses are rent, insurance and utilities. Homeowners have housing expenses that are much more expansive and include maintenance items that should be considered..
If you stop paying rent, landlords can evict you and bring in a new tenant. Lenders have many more questions as your mortgage is backed by them, and they want to make sure you make your payment every month..
One way lenders gauge your financial situation is through a debt-to-income ratio (DTI) calculation. This formula helps lenders determine if you have the capacity to meet your monthly debt obligations, including home expenses. To get a qualified mortgage, your DTI generally needs to be below 43 percent.. A lender who provides a qualified mortgage makes a good-faith effort to ensure the borrower can repay the loan prior to approving it. You can get a mortgage with a DTI above 43%, but it depends on other factors in your loan profile.
To assess your debt, lenders request a credit report, which includes your credit score and all your monthly debt obligations. These include: credit card payments, school loan payments and car payments. Make note: installment payment of less than 10 months are not included in this calculation unless they significantly affect the borrower’s ability to pay.
To assess your income, lenders look at your gross income from work, any social security income, savings account balances, retirement account balances and any money contributed by family members.
Debt-to-income ratio (DTI)= Total monthly debt/gross monthly income
Step 2: How much house can you afford?
Lenders look to see that borrowers are spending no more than 28 percent of gross monthly income on mortgages and associated housing costs. Sometimes called the front-end ratio, this does not include other housing expenses like utility bills or cable TV services. It does include:
- Principal and Interest (P&I): These are the main components of your monthly mortgage payment. Principal is the amount borrowed that has to be paid back to the lender. Interest is what the lender charges for lending the borrower money.
- Property Taxes: The tax is based on the value of the subject property and is assessed by the local municipality. It is prorated and charged as part of the monthly mortgage payment.
- Homeowner’s Insurance: Insurance coverage for owner-occupied properties to protect against personal liability and physical property damages. It is usually prorated and charged as part of the monthly mortgage payment.
- Mortgage Insurance: Borrowers who put less than a 20 percent down payment must pay additional insurance, called private mortgage insurance (or PMI). Borrowers with FHA loans must pay a mortgage insurance premium (or MIP).
- Flood Insurance: Compensates for physical property damages resulting from flooding. It is required in federally designated Special Flood Hazard Areas. The lender will conduct a flood certification during underwriting to determine whether the property is in a designated flood zone.
- Homeowners’ Association (HOA) Dues: An HOA is an entity formed to manage the day-to-day operation and long term interests of residential dwelling communities, including condos and co-ops. HOA dues are paid monthly.
Everyone’s situation is unique, but U.S. Census data offers a yardstick. The majority of households who own a home and have a mortgage (60.1 percent), have household income over $75,000, according to the 2017 American Community Survey. Of that total population:
- 68 percent spent less than 20 percent of their income on housing costs
- 25.4 percent spent between 20 and 30 percent of their income on housing costs
- 6.6 percent spent over 30 percent of their income on housing costs
When calculating your total housing costs, do not be surprised to find that private mortgage insurance, homeowners’ insurance, and real estate taxes increase the loan amount.
Affordability= Housing costs/Gross monthly income
Step 3: Household Expenses
Let’s face it, life is expensive, and owning a house adds to that expense. How expensive? Well, we’ve already discussed housing expenses. Now you need to factor in living expenses, as your mortgage is one of many bills you pay each month.
Being able to afford your monthly mortgage payment is important, but more important is being able to pay that monthly bill along with all your other bills. These bills can be grouped broadly into two categories: other housing expenses (not included in the debt-to-income ratio) and living expenses.
Other housing expenses beyond those used to calculate housing affordability:
- Maintenance and repairs: There is a landlord to fix a leaky toilet or hire someone to check over the heating system. A good rule of thumb is to put aside 1 percent of your home’s value each year for maintenance and repairs, more if you can afford it. You can use Homebinder to digitally manage your maintenance schedule and keep track of receipts.
- Emergency fund: Let’s face it, emergencies happen. The roof leaks, the water pump dies, someone is laid off. This fund is for big ticket items that will happen, at some time. By knowing the age of your appliances and major systems, and keeping up with maintenance, these repairs should be more manageable. It is suggested that people have three to six months of living expenses in this fund to cover housing, food, transportation, health care, utilities, personal expenses, and any debt payments.
- Savings Fund: This fund, unlike the other funds, are not geared to a specific purpose, but when you want a new kitchen or need a new car, you will be happy it is there.
Household expenses: People tend to forget about the myriad of smaller housing expenses when calculating mortgages, interest and real estate taxes. But they do add up, so knowing what they cost if critical, so you don’t put yourself in a position where you are house poor—meaning you spend a large percentage of your income on house ownership, without much money left over for other costs.
According to the latest data from the Bureau of Labor Statistics, household expenditures are rising. Between 2017 and 2018 household expenses for food, transportation, housing, personal insurance and healthcare all increased. And this increase followed increases in household expenditures between 2016 and 2017.
These monthly expenses include:
- Food, home upkeep and personal care items (even small items like haircuts)
- Health insurance and health care costs
- Utility bills
- Dining and entertainment
- Transportation expenses (public transportation fares and car insurance and maintenance)
- Childcare or daycare
- Life insurance premiums
There are many different apps to plan for household expenses and get a picture of your finances. U.S. News and World Report reviewed its 10 favorites. As a bonus, they are all free.
Step 4: What Housing Choice is Right for You?
The housing choice that is right for you is a combination of your financial picture and your personal comfort level in terms of savings. It is often helpful to meet with a personal advisor to get a better picture of your situation and be able to make the smartest financial decision.
Some people choose to wait a little longer to buy and save more money for a larger down payment and lower interest rate, while others choose to buy sooner. To get a baseline measurement of your situation, consider this rent vs. buy calculator from Fidelity. Beyond this, consider these three factors, which are harder to quantify.
- Your lifestyle and life stage: People with jobs that are likely to change more frequently, or who have the desire to move often, find homeownership more difficult as a home ties you down.
- Your tinker index: If you like being the handyman and having the freedom to remodel as you choose, homeownership is for you. If handyman is a foreign word to you but you want to own a home, be prepared to spend more money.
- Your risk tolerance: Renting comes with risks and uncertainties from year to year. Homeownership does to, but they can be mitigated by planning and saving for surprise repair bills. Which situation suits you better?
Own Up is focused on helping people through the homeownership journey and empowering them to make the best personal decision through education about homeownership. Consider us your co-pilot. Because we streamline the origination process, lenders save money, which means we can pass the savings on to you. The Consumer Financial Protection Bureau estimates that rates can vary among lenders by as much as 0.5%, which can equal tens of thousands of dollars over the life of a mortgage. Why pay more than you have to?
If you are considering buying a home, call us. Our advisors are waiting.