Frequently asked financial questions are questions that I’ve seen pop up over and over again. I thought I’d take the time to answer them in this new Series. So each post will have a short quick answer to these frequently asked financial questions followed by a longer more detailed answer.
Can I afford to buy a house?
I think everyone at least thinks about buying a house at some point. Everyone debates not only if it’s right for them, but also if they can afford to do so.
There are loans available that only require you to have a down-payment of 3.5%. That being said there is a lot more to owning a home than just a mortgage.
There is the upkeep of a home, repairs, and whole responsibility for everything. So it’s smart to make sure you have enough to not only cover a down payment and closing costs but also enough to cover any repairs or changes you might want or need to make to the home.
While you may only be required to put down a small percent, the more you put down the less you have to pay back later. This is particularly important if you want to avoid paying mortgage insurance.
If you have a significant amount of student loans then you might have trouble obtaining a mortgage due to a high Debt to Income Ratio (DTI). Your DTI is the amount of money that has to go towards your debt each month in relation to your income.
For example, if you make $3500 a month and have to put $750 towards debt each month your Debt to Income (DTI) ratio is 21%.
However, if you are on an income-driven repayment plan, your mortgage lender may be required to use a different amount other than your monthly payment when calculating your DTI. Typically, you need your DTI to be less than 41%.
There are different loans and programs out there that can help you to buy a house. But you not only need money, but also a good credit score, and a low debt to income ratio if you plan on getting a mortgage.
Federal Housing Administration loans help first-time homebuyers by providing a low down-payment option of 3.5%. Though you must have a credit score of at least 580, otherwise you may be required to put down a larger percentage.
FHA loans do require mortgage insurance and can be financed as part of the loan. You also cannot have a debt to income ratio that exceeds 31%.
U.S. Department of Agriculture loans aim to help homebuyers interested in buying in more rural areas. With a USDA Loan, you can have 100% of the home financed at a lower than average rate. Though you must take a fixed loan and are required to have mortgage insurance.
If you are interested in learning if a particular area qualifies, you can do so here, 97% of the U.S qualifies.
Traditional mortgages typically require you to make a 20% down payment and have terms of either 15 or 30 years. It might be a fixed rate loan or an adjustable rate mortgage (ARM) meaning your payment might increase with a raised rate later on.
State Sponsored Homebuying Programs
In addition to FHA and USDA programs, your own state might offer additional assistance. For example, where I live, in North Carolina they offer up to 5% down payment assistance for first-time homebuyers. They also offer mortgage credit certificates.
If you’d like to know more about housing assistance programs offered in your state, go to your state’s government website and search for their section on housing.
What is Mortgage Insurance (PMI)?
PMI stands for private mortgage insurance. It can sometimes be required if you put down less than 20% as a down payment or it is required for certain types of home loans. Lenders require it to protect their investment.
If you default on your loan and the lender takes your house and sells it at a loss, the mortgage insurance makes up the difference.
Once your loan balance drops to 78% of the home’s original value then the PMI must be canceled. Though you can ask to have it canceled sooner, typically when your loan balance is at 80% of the home’s original value.
Why You Need a Good Credit Score
The better credit score you have the better interest rate you will get on your loans. Credit scores range from 300-850. Ideally, you want a score above 700. Though the higher your score, the more reliable you appear to lenders. And the lower the interest rate you will qualify for.
There are different reporters for credit scores. You’ve got FICO scores which are the most commonly used credit score. There is also your Experian score, Equifax, and a TransUnion Score.
Debt to Income Ratios and Student Debt
Your DTI is the amount of money has to go towards your debt each month in relation to your income. For example, Let’s say you make $3,000 a month. You have a monthly car payment of $250 and a monthly student loan payment of $550. Then you are paying $800 towards debt each month. Your DTI is 800/3000 = 26%
Where things can get tricky is if you are making student loan payments using an Income-Driven Repayment plan. If you have a large amount of student loan debt *cough*law school loans*cough* then depending on they type of loan you want to get, the lender may be required to use a different amount in calculating your DTI.
For example, for FHA loans when calculating the student loan payment amount for DTI purposes, the lender must use the either the documented payment if that payment will pay off the loan in the current repayment term (Since my payments do not even cover the interest, my monthly payment would not amortize the loan) or the greater of 1% of the outstanding balance or the monthly payment reported on the borrower’s credit report.
If you have private loans or your debt to income ratio allows, consider refinancing with a company like SoFi. I wrote a review about my experience refinancing my bar loan with SoFi. Refinancing with SoFi ended up saving me over $1k. Use one of my links to refinance and you’ll get a $100 bonus.
Wrapping it Up with a Bow on Top
Ultimately, being able to buy a house and affording a house are two different things. You may be able to buy a house under one of the many programs out there, but you might also be biting off more than you can chew. If you are looking at the numbers and can barely afford it, then you should probably wait a while longer to have a bit more of a cushion.
Read more from the Frequently Asked Financial Questions Series.