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A Qualified look at Affordability
Kevin J. Daum
This article was originally published in a 2007
edition of Log Homes Illustrated magazine.
Easily one of the most common questions I hear being in the mortgage business is “ How much house can I afford?” It should be a relatively easy question to answer and I suppose back in the old days it was. Back when loan programs were simple fixed rates and your local bank knew your finances, one could easily figure out the payment that would make sense for the long haul. With today’s complex array of loan programs and additional factors such as tax deductibility, the question of affordability requires a little more investigation and planning.
It wasn’t so long ago that the banks could be your guide for figuring out how much house you could afford. Today banks are focused on selling loans that meet Wall Street criteria. By using computers to analyze your credit history and payment patterns they now determine risk on a percentage basis. Often this results in qualifying you for a payment that may be much more or less than you are comfortable paying.
While the banking approach may not assure you of being able to happily make the payment on your log home each and every month, looking at their approach will give you a basis from which to assess your own comfort level not to mention insure you are prepared when ready to apply for your loan.
Loan to Value – (LTV)
Since mortgage lenders secure their loans against your real estate, the ratio of how much they will loan you relative to value is their primary consideration when establishing the right loan amount for you. Regardless of your income, credit or any other personal factor, the lender will establish a maximum percentage they are willing to loan against the value of the property. This percentage can vary depending upon the size of the loan and other risk factors such as large acreage and whether or not you intend to occupy the home as a primary or secondary residence.
Lenders will typically lend up to 80 percent of value so that their risk is mitigated should they have to take the property back from you and resell it. For those occasions when the lender allows more than 80 percent, they generally look to share the risk either through Private Mortgage Insurance or often with a second lender securing a second mortgage at a higher interest rate to offset the risk.
While the lenders LTV may limit the amount you can borrow due to the value or price of your home, the LTV does little to establish your ability to pay on the mortgage regularly with ease. However the lender does factor in that if you have a large amount of equity and you have financial hardship, you will be motivated to find alternative means of protecting against the loss of your home and its equity.
Credit
Lenders look for two things when examining your credit report. First they check to see if you are credit worthy. In their perfect world you have paid all of your bills on time without ever gone into bankruptcy or foreclosure. If you did have any sort of late payments or collection accounts they occurred well over two years ago. The banks also like people who don’t apply for a lot of credit and don’t carry high balances on their credit cards. If you fit this profile you have likely been rewarded with a credit score over 700. This is your ticket to a higher LTV and more flexibility from the lender when considering other aspects of your loan. While this score may accurately reflect your willingness to pay your bills on time and manage your credit, it doesn’t automatically have an impact on your ability to pay out more money each and every month.
After establishing your creditworthiness the lender will use your credit report to total up your monthly payments aside from your housing expense. The lender will be able to list any car and/or additional house payments you may have for use in your qualification. The lender will also list your minimum payments on any credit card balances you may have. If the report does not list the minimum payments the lender will use 3 percent of the balance as a monthly payment. All of these payments together are totaled the equal your Total Monthly Debt.
Income
Over the last 15 years lenders have made income less of a focus for qualifying loans then other criteria such as LTV and credit. After reviewing historical data going back to the 50s, the lending community realized that people with good credit and strong equity tend to make their payments on time in order to stay that way.
Many Lending institutions recognized that reducing the amount of taxable income one reports is a national pastime and wanted to loan money to these people who were having difficulty producing tax returns worthy of home financing. To accomplish this they created the No Income Qualifier. (NIQ)
There are several types of NIQs. Some require you to state and income that more accurately reflects the money you take in before taxes. This is helpful for Self Employed or commission types. Others allow you to simply state your assets as well. Since no one verifies the information many people are optimistic regarding the stated amounts. For excellent credit with a low LTV some banks may even offer a loan that does not require you to state an income at all. An appraisal, credit report and signature are all that are required.
If you do provide tax returns or state an income, the lender will compare the Total Monthly Debt against the Gross Monthly income. This is called the Debt to Income Ratio (DTI). For example;
If John is looking at monthly payments of $2500 and has credit card payments of $250 and a car payment of $250, his Total Monthly Debt is $3000.
If John shows or states $7500 Gross Monthly Income, his DTI ratio would be calculated as follows; $3000 divided by $7500 equals .40 or 40 percent.
The required DTI varies among lenders and programs but most lenders are comfortable with a DTI around 38 to 42 percent for stated income. Providing full income documentation may make a lender comfortable with DTI as high as 60 percent.
Of course all this depends upon the credit and LTV. Additionally the more money you make the more comfortable the lender is with a high DTI. If you are spending 60 percent of your income which equals $15,000 monthly, your disposable income of $6000 is much easier to live on then the $2000 left over from someone making only $5000 a month.
While looking at a DTI can be helpful, it doesn’t take into account cost of living variations in different communities as well as lifestyle choices which may be the reason lenders put more stock into the data they receive from the credit history.
Liquid Assets
Often overlooked by consumers as an important lending issue is the amount of money they have readily available. Since many Americans today have most of their nest egg tied up in real estate equity they mistakenly believe they look good on paper for the lenders. In actuality equity only plays a positive role in the LTV issue discussed earlier. Even if you have ready access to your equity through a Home Equity Line Of Credit (HELOC) the lender does not consider those funds to be at all liquid.
The lender is interested in your ability to save. They want to see liquid assets meaning cash, stocks, bonds, 401K funds that are in line with the income you are showing or perhaps simply claiming. The lender wants to feel comfortable that you can manage to make at least a few payments should you encounter a loss of work or some other financial catastrophe. For most loans these days 3 – 6 months times your payments is a minimum acceptable amount to make a lender comfortable. Of course the more you have the more the lender will flex their guidelines. Having plenty of ready cash should also make you feel more comfortable stretching for a bigger payment knowing you can make up the difference out of pocket until you can increase your income or change your situation should your struggle financially.
Finding Your Comfort Zone
Just because you fit all the guidelines to make the lenders happy doesn’t necessarily mean you can afford the home. Other factors need to be considered including your tax situation and your lifestyle. One way to assess how much payment you can manage is to calculate a rough cash flow analysis. Here’s how.
First you need to calculate your monthly income after taxes. Start by including everything like salary, commissions, interest and dividends. If your Ebay hobby is generating extra cash make sure you include that as well. We will call the total Gross monthly Income or GMI.
Next subtract any tax deductions for example your monthly mortgage interest and property taxes as well as any deferred retirement contributions. The remaining total is your Monthly Taxable Income or TMI.
For example; John and Mary make $8,500 in salary and john has a wood working business that makes him an extra $500 monthly. Their GMI is $9,000.
They are looking to see if they can afford an Interest Only house payment of $3500 monthly plus property taxes of $450 per month. They defer $750 monthly into their 401k.
GMI $9000 - $4700 in tax deduction = $4300 TMI
Next, contact your CPA or tax preparer and find out what your tax and social security would be on your TMI. This is your monthly income tax or MIT. For John and Mary in California it would be roughly 29 percent or $1230.
Now we can begin the cash flow analysis. Start again with your GMI and subtract all expenses including the MIT and house payment. Remember to include, insurance utilities, car payments, daycare, 401k contribution, etc. After you have subtracted all of your expenses, the remainder is your Net Disposable Income. This is the amount of money you have left to save and live on after making all of your payments. See John and Mary’s example below.
$9,000 Gross Monthly Income minus
$1,230 Monthly Income Tax
$ 750 401K Contribution
$3,500 House payment
$ 450 Property tax
$ 200 Home Insurance
$ 350 Car Payment and Insurance
$ 150 Credit Card Payment
$ 750 Day care
$ 300 Utilities
$1,320 Net Disposable Income for John and Mary
Looking at this example, after making all of their payments including taxes and saving $750 a month in their retirement, John and Mary would have roughly $44 per day to spend on groceries, clothes and entertainment. For some people who thrive on haute cuisine and designer outfits this may not be enough to support their current lifestyle, however each family and each geographic location is unique and people are often able to adapt when looking at acquiring the log home of their dreams.
Using this exercise as a guide will give you good information to discuss with your tax advisor and Loan Officer when finding your comfort zone for affordability. You will put in a great deal of time and effort into designing the perfect Log Home. It’s worth a little effort to design the perfect payment to go along with it.
Kevin Daum is the Founder and CEO of Stratford Financial
Services, a Real Estate finance and education company, founded
in 1989. Stratford specializes in Purchase loans, Refinance
loans and Custom Home Construction finance and has successfully
financed thousands of clients. He is the author of "Building
Your Own Home for Dummies" (Wiley), as well as "What
the Banks Won’t Tell You." Mr. Daum was an Underwriter
for Plaza Savings and Loan and Key Bank of New York. He is
an INC 500 CEO and has been listed as one the 40 Most Influential
People Under 40 in the San Francisco Bay Area. He is the Global
Chair for the Edison Innovation Program with the Young Entrepreneurs'
Organization (YEO) and is a founding Board member of the Bay
Area Chapter of YEO.
Mr. Daum is a frequent contributor to numerous business
publications on the subjects of Real Estate and Small Business
leadership and speaks regularly on both subjects. He can be
contacted at kevin@stratfordfinancial.com.
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