Homebuyer Basics Part 1: Counseling and Determining Affordability
Are you looking to buy a house and don’t know where to begin? LSS offers free homebuyer counseling! Homebuyer counseling can help prepare you no matter where you are in the home buying process. Starting with a non-profit organization, such as LSS, can help you get unbiased information without any agenda to sell you a particular product or point you in a certain direction. I will go over some basic yet very informative items that may be covered in a home buyer counseling appointment.
Getting Started: The Qualifying Worksheet
At your appointment, a great way to start exploring the home-buying process with your counselor is by helping to determine what monthly Principal, Interest, [Property] Taxes, and [Homeowner’s] Insurance or “PITI” payment you are able to afford. It is also helpful to get an estimate of how much of a mortgage you could qualify to purchase.
One tool that can help determine the PITI you could pay is known as the Qualifying Worksheet, from the Minnesota Homeownership Center. The Qualifying Worksheet a very important tool as it helps to determine viability of homebuying using a number of different factors.
The first item on the worksheet is Monthly Gross Income, which is your pay before deductions. You’ll use this to calculate what is known as the “Front-End Ratio” or “Housing Ratio.” This number will, in part, help determine a payment amount that you could afford.
After that is “Total Monthly Debt Payment.” This is the monthly dollar figure that you are paying towards revolving debt or existing loans. This calculation will help determine what is known as your “Back-End Ratio” or “Debt-to-Income Ratio” (aka “DTI”).
The following info on the worksheet will then give you the results of what a bank/mortgage company sees as your “Maximum Mortgage Payment.” This is the maximum payment that you, on paper, would be able to afford on a monthly basis. This figure is the lower amount of the above calculated Front-End and Back-End Ratios. A very good thing to remember, is that this is the maximum affordable payment; it does not mean it is the actual amount that you will have to pay!
At this juncture, you can now glean a few important aspects of your financial situation:
- If your Front-End Ratio is the lower of the two above calculations, then the amount of debt that you pay on a monthly basis is not affecting your qualified maximum mortgage payment.
- If your Back-End Ratio is the lower of the two, it shows that monthly debt payments are in fact interfering with how much you can afford. The impact of this interference may not be much if your Back-End Ratio is only minimally lower, however, if it is substantially lower it may be more of a barrier.
The final section of the worksheet gives you the total loan amount that you may qualify for. This figure partially ties in with the above mentioned Front and Back-End ratio determination, but also ties in, for the first time, your credit score. The particular credit score that is used is often the middle score from a “tri-merge” credit report from the 3 major credit bureaus: Equifax, Experian, and Trans Union.
In general, the better the credit score that you have, the lower the interest rate that you could qualify to pay. This means that the bank likely sees you as a lower risk of default on the mortgage. As interest rates increase on the chart, it is likely that you have a lower credit score and therefore are considered to be more of a risk to the bank for default.
This variation in lower or higher interest rates therefore illustrates that the lower the interest, the more of a total mortgage you could afford and vice versa. It should be noted that the interest rate range in this worksheet and subsequent dollar figures are determined using a calculation via a set “factor” scale, but not something that you will have to think or be concerned about during your counseling session.
After completing the worksheet with your counselor, you may wonder, “can I actually afford as much as the bank thinks I can? Why is my gross income being used as opposed to my actual take-home or ‘net’ income?” Definitely good questions that should not be ignored! The answer mostly entails the need for a standardized scale for calculation. For example, if you are a wage-earning individual, your gross income is typically going to be a steady amount from paycheck to paycheck without much fluctuation. However, if you factor in periodic health insurance, retirement contributions, and any other potential withholdings, your net income can start to show sometimes even considerable variation between paychecks.
Broadly speaking, deductions can vary greatly from potential buyer to potential buyer, so using gross income for all applicants also helps develop a more even playing field for anyone trying to qualify for a mortgage. It allows for an “apples to apples” comparison.
The Importance of a Budget
Since you now know that your gross income is the figure that will be used, this would be the perfect time to put together your budget. A budget is a very good way to see your net income in relation to either your current expenses, or future expenses using estimated expenses after you may have post-purchase of a house, in order to gain a much truer assessment of what you can or cannot afford.
Keep in mind that banks often do not incorporate budgets into the home buying process, so it is up to you as a homebuyer, with the help of your counselor, to determine. The benefit of getting this monthly budget figured out prior to homeownership is crucial to help avoid future issues of becoming “house poor,” which is where all of your money seems to be going towards your house and you have little to nothing leftover, or worse yet, missing mortgage payments.
In our next blog, we’ll cover finding a loan officer and give a general overview of how the purchase process could go.
If you’re considering buying a home in the future, schedule a meeting with a certified housing counselor with LSS Financial Counseling. We work with Minnesota home buyers long term to get financially ready and informed about resources and options before purchasing a home. Call 888.577.2227 to schedule your free appointment today or visit our website for more information.
Author Dan Park is a Certified Financial Counselor with LSS Financial Counseling.