Monday, March 3, 2014

Mortgage Math

Back when I bought my first home the world was a simpler though not necessarily better place. When you bought a home the universal rule of thumb was a house that cost less than 3 times your annual salary. You always needed to have a 10% down payment in hand plus something like another 7% of the selling price of the home for fees, points, inspections, taxes, and lawyers. There weren’t very many options when it came to finding a mortgage. The banks and the mortgage companies had the upper hand. The going rate was pretty much the going rate.

Today the new rule of thumb seems to be 2.5 times your annual salary. After the subprime loan debacle of 2006 everyone seems to be running scared. During the glory years of the housing bubble the rule of thumb went up to 4-5 times annual salary! Washington Mutual, the bank that made this suggestion is now deservedly bankrupt. Down payments can range from 0% in special cases or 3% in first time home buyer programs to the customary 10% to the new customary 20% down payment that allows the buyer to avoid the dreaded Private Mortgage Insurance (PMI). The Internet gives the home buyer more information and options than in the past. Since banks no longer have a tight control on information, they are trying to make the information that is available less useful to the average consumer.

How do the banks decide how much house you can afford? Of course they will consider your credit score in deciding how much money to lend you and more importantly at what rate, but they also use two ratios that you can calculate in advance of shopping for a new home.

A Front End Ratio of less than 28%: This number is the mortgage payment (principal + interest), plus taxes, plus all required insurance costs divided by your gross monthly salary.

Example:

Gross monthly salary of \$5,000 (\$60,000 a year) X 0.28 = \$1,400 a month or less in a total payment to the bank or mortgage company. Just for grins let’s say \$140 a month will go into escrow to pay your taxes, PMI of \$150 a month, and your homeowners insurance runs \$50 a month. That would leave you with \$1,060 a month for principal and interest. A \$200,000 loan for 30 years at 5% would require a monthly payment (principal + interest) of \$1,073.64.

Maybe if this family was looking at buying a \$225,000 home with a 10% down payment, they ought to lower their sights a bit, but they are in the right ballpark.

A Back End Ratio of less than 36%: This number is the mortgage payment (principal + interest), plus taxes, plus all required insurance costs, plus all other reoccurring payments such as car payments, student loan payments, and alimony or child support payments divided by your gross monthly salary.

Example:

Gross monthly salary of \$5,000 (\$60,000 a year) X 0.36 = \$1,800 a month or less in a total payment to the bank or mortgage company. Let’s say \$140 a month will go into escrow to pay your taxes and your homeowners insurance runs \$50 a month, PMI will takes \$150 a month since you don’t have enough to put 20% down; in addition you have a \$300 a month car payment and student loans take another \$150 a month. This calculation allows the family \$1,010 a month for principal and interest.

The bank will prefer the smaller number generated by these two ratios. In this case they would go with the Back End Ratio.

In a world filled with different mortgage rates, points, and upfront fees how can a person without a financial calculator and an understanding of the Present Value of Money make an informed decision? Marcie Geffner of bankrate.com suggests comparing the break even point. All this method requires is the monthly mortgage payment (principal + interest) and the upfront fees in order to make an informed decision.

Consider these two options:

\$200,000 conventional 30 year mortgage at 6% with no points or fees Monthly mortgage payment of \$1,199.10

Or

\$200,000 conventional 30 year mortgage at 5.75% with 1 point and a \$1,500 upfront fee Monthly mortgage payment of \$1,167.15

A point is 1% of the cost of the home, in this case \$2,000. Adding \$1,500 in fees brings the upfront cost to \$3,500.

Divide that number by the difference between the two mortgage payments. \$3,500/\$31.95 = 109.5 months to break even or a little over 9 years.

If you are planning to stay in the home for longer than 9 years paying the up front fees to get the better rate make sense. This is not the textbook perfect method, but it is simple and it does provide the buyer with a useful method to compare different offerings.