You may not know this, but this is really two questions in one:
- How much home will my personal budget allow?
- How much home will the lender approve us for?
The first question is a personal one. Even though we may be able to approve you to buy a home for, say, $500,000, the payment might be more than you are comfortable making. In that case, you’d want to decide what payment you want, then work backwards to determine your purchase price “sweet spot.”
If you plan to put 10% down and have determined that you want to pay no more than $2,700 a month including taxes, insurance and mortgage insurance, you would be looking for a home of about $440,000.
The calculations involved are somewhat complicated, but they are routine for your loan officer. They can work the numbers for you in seconds. Just keep in mind that there are ways to increase the amount of house you can get for a certain payment. For example, you might decide to lower the rate by paying discount points. You can expect that making a one-time payment of 1% of your loan amount will lower your interest rate by about .25%. For a loan amount of $450,000, the lower rate will reduce your monthly payment by about $65.
The second question, how much house the lender will approve you for, is a little more involved.
The maximum loan a lender can approve you for in Washington State depends on several factors:
- Your down payment
- Your income
- Your other monthly payments
- Your credit score
The first one, the down payment you make, will determine your loan amount (and therefore your monthly payment) as well as whether you’ll have to pay mortgage insurance.
Lenders are always conscious of risk. One of the ways they limit their risk when they agree to lend you hundreds of thousands of dollars is something called “protective equity.” In most cases, this is your down payment. That is the money that protects their investment—the money they are lending you.
Mortgage lenders secure their loans with a deed of trust. They know they can get their money back if the borrower stops making their payments by pursuing a legal process called foreclosure. This is similar to the way a bank holds the title (the “pink slip”) on a car when they make a loan on the vehicle. They have the right to repossess the car and sell it if the borrower doesn’t make their payments. When they take the car back, they sell it to get their money back. If the sale doesn’t pay off the loan plus the costs of repossessing, storing and selling the car, they have a “deficiency,” which means that they can pursue the borrower for the shortfall. Sometimes they can get it; most times, they can’t so they take a loss.
With real estate in Washington State, the process is more involved and lengthier, but the principle is the same. The lender has the right to look to the equity in the property to get their money if the buyer doesn’t make their payments.
If a property doesn’t bring enough money to pay off the loan and pay the expenses of foreclosure, the lender technically can pursue the foreclosed borrower for the deficiency, but that may be problematic, so the lender has to take a loss.
With a larger down payment, there is more of a “cushion” of equity to lessen the chances that the lender will come up short if the worst case scenario—foreclosure—happens. The cushion that lenders find acceptable protection is 20% of the purchase price.
That amount of cash is out of reach for many hopeful home buyers. So lender can offer loans with much smaller down payments—as low as 3%. Because of the smaller down payment, the lenders look for additional protection. That is where mortgage insurance comes in. It limits the amount of risk for the lender if things were to go bad. Mortgage insurance is an alternative to a large down payment.
When we review your loan application, we calculate an important number called the debt to income ratio (DTI). This is your total house payment (including taxes, insurance and monthly mortgage insurance, if any), plus other monthly payments such as car payments, students loans, credit cards, etc., divided by your gross monthly income (before taxes). We can approve conventional loans with a DTI as high as 50%. Government insured FHA loans allow us to go a bit higher, sometimes as high as 55%.
Finally, there is the matter of your credit score. While we can approve conventional loans with scores as low as 620 and FHA loans as low as 580, the rate will be higher for the lower credit scores. A borrower with a 620 score can expect to pay about .75% more in rate for a loan than someone with a score of 740 or higher.
The credit score determines not only the interest rate, but also the cost of conventional mortgage insurance, if the lender requires it. If today’s rate for a borrower with a 740 score is 4.25%, someone with a 620 score can expect a rate closer to 5.0% for the same kind of loan. For a $450,000 loan, this means a monthly payment about $275.00 higher.
Similarly, the cost of mortgage insurance depends on the borrower’s credit score. With a 10% down payment and a 760 score, monthly mortgage insurance costs about .20% per month. With a 620 score, the cost goes to 1.1%.
A buyer can avoid having to pay monthly mortgage insurance by opting to make a single payment, called single-premium mortgage insurance. The premium may be financed into the loan. For a purchase with 10% down, the single premium can be as low as .87% of the base loan amount—that would be $3,900 for a $450,000 loan. Not having to pay a monthly mortgage insurance premium can increase the price of the home you can afford.
Because of the credit score’s effect on the monthly payment, a buyer with a higher score will qualify to get more home. To put this into perspective, a buyer sporting a score of 760 or higher and monthly income of $6,100 might qualify to buy a home for about $500,000 with a 10% down payment.
A buyer with the same income and a 620 score, however, will get a higher interest rate and a higher cost of mortgage insurance. Because of this, they’ll qualify for about $430,000.
Please note that these examples are somewhat generic—and represent extremes. We present them for illustration purposes only. The only way to determine what your actual purchasing power is—both for your personal comfort zone and the maximum you can qualify for—is to have a conversation with your Sammamish Mortgage loan officer. We can give you answers specific to your unique situation. Contact us today to learn more.