Money & Credit
All real estate transactions have some kind of consideration to bind the contract. The most common consideration component is money. Where the money comes from can be important to both buyer and seller. When a seller is looking at an offer to purchase contract, they would like to be reassured that the buyer can perform before agreeing to the terms and taking the property off the market. This assurance usually is presented with an offer in the form of a pre-qualification or pre-approval letter from a lending institution. Even a 'cash buyer' will make their position known to a seller by indication on a purchase contract their ability to move forward without the need for lender approval or some sort of mortgage contingency.
If you have not purchased real estate before, this process can seem very complicated leaving the question, "Where do I start?" The best place to start is by understanding where you fit in to the process as it relates to the real estate market and your goals. It makes no sense to go house hunting and engage the process only to find out later that you can not find the money to complete the purchase. The basic ability to borrow money for a home purchase is related to your income to debt ratio and your credit score.
Credit simplified, is your reputation as a borrower. Lenders evaluate this reputation by review of credit reports and other information to see how likely you are to repay a loan. Various credit reporting companies have computer programs that look for characteristics, patterns, and 'red flags' belong to your history resulting in credit scores. Many consumers are familiar with the "FICO credit score" from the Fair Isaac Corporation, but other credit modeling and scoring agencies may come to different conclusions and scores. Although these numbers do not determine whether or not a loan is approved, they can have an affect on the 'cost' of borrowing and lenders do make decisions based on set standards, which include credit scores.
Anyone can request through AnnualCreditReport.com their free "credit file disclosure" (credit report) once every 12 months from each of the nationwide consumer credit reporting companies. Equifax, Experian and TransUnion all will charge you a fee for the actual "credit score" number, but often lenders (i.e. banks, credit unions etc) will give you your credit score when working through the pre-approval process or discussing with you how much you might be able to borrow.
"How much can I afford?" can usually be determined by a formula called the 'debt to income ratio'. Lenders work with their version of this ratio when they are deciding whether or not to lend money for a home or other purchase. Calculating the ratio is done in 2 parts; the 'front-end' which is the housing expense (principal, interest, taxes and insurance) and the 'back-end' which is the total long-term debt (fixed monthly expenses i.e. car payments, credit card payments, etc, together with the proposed housing expense). A general rule is for the back-end ratio to be no higher than 36 percent; above that level could cause a denial of credit or a higher interest rate on a loan. Additionally most lenders also like the front-end not exceed 28 percent of your monthly gross income.
An example of this calculation might work like this:
- Buyer earns $3,000 per month gross (before taxes)
- Buyer has a car payment of $200 per month and no credit card debt
- Lender uses a 28/36 debt to income ratio
- Front-end calculation 3000 x .28 = 840
- Back-end calculation 3000 x .36 = 1080
- Lender would want a total spending cap of $840.00 per month for the front end housing expense.
- Lender would want a total spending cap of $1,080.00 per month for the back end total debt expense.
When looking for a home in a 4% 30 year fixed lending environment, $200,000.00 might be comfortable target for you home search. Regardless of what you may qualify for, it is always a good idea to stay within your fiscal comfort zone.
There can be many other 'money' related issues that come into play when purchasing a home.
- Debt to income ratio and the affects on a mortgage
- Calculating mortgage payments
- Home mortgage interest deductions
- How points work
- Paying points vs. bigger down payment
- Mortgage choices - fixed vs. variable
- Understanding and comparing the APR
- High-risk mortgages
- Low documentation loans
- First time homebuyer loans
- Down payment assistance
- Appraisal and loan to value ratio
- Second mortgages
- Seller participation
Many books have been written on the subject of lending, mortgages and other money related issues surrounding the real estate industry. We at New England Contract Realty strongly advise you seek out a reputable professional to satisfy your needs in this area. Building a team with good up-front planning can not only save you time and money, but can also give you piece of mind.
