We decided to sit down with a mortgage broker and get officially pre-qualified for a mortgage. Actually “officially pre-qualified” is an oxymoron because the whole process only involved a legal pad and a calculator. The following is just our experience, yours might vary significantly, I really don’t know.
If you’re not familiar with the terms, “pre-qualified” is just a very rough estimation of what kind of loan you can get from a lender. You tell them your credit score (roughly), your income, your debts, and your current assets. They don’t verify any of this, or run a credit check. It’s basically means nothing to a seller. On the other hand, a “pre-approval” is based on your actual credit score and verification of all your numbers (at least for a full-documentation loan). You need to submit tax returns, old W-2 forms, bank statements, paystubs – basically your entire financial life laid bare. This may offer an edge if a seller is comparing offers between you and another seller without a pre-approval.
But for me, the main reason for doing this is to find out what their lender ratios were. Also called the debt-to-income ratio, this is all your monthly liabilities (housing payments, car notes, credit card payments, student loan payments) divided by your gross income. This gives you the maximum debt load that the lender will accept and still lend you money. By housing payments, this usually means PITI, or principal + interest + taxes + insurance, so it’s a little more than just the straight payment from a mortgage calculator.
Also, historically, there were two lender ratios, at “top” and “bottom” value (Example: 28%/36%). The bottom (lower) number was the max ratio allowed for [housing] divided by [gross income]. The top (higher) number was the max ratio for [housing + other debt] divided by [gross income]. You had to be below both ratios to qualify for the loan. But I was told that if you have no other debt, that we can bump right up to the top value. I guess before they figured you had a good chance of adding on more “other debt” later in life, but now they just care about total debt load. So really there is only one ratio in many instances – the top one.
Historically, the top lending ratios were somewhere in the neighborhood of 38%. But I was surprised to hear that it’s more like 45-50% now in expensive areas like California, and he has seen as high as 60%! Keep in mind this is a percent of gross income before income taxes!
A 5.75X Income Multiplier!?
Let’s say your gross income is $100,000/year ($8,333/month) and you manage to be clear of any other debts. (This is just for a round number.) Using this Mortgage Qualification Calculator, I plugged in zero down payment, the default property tax (1%) and insurance (0.5%) rate estimates, a 6% mortgage rate, and a 50/50 lender’s ratio. Here are my results:
I used zero down payment because I wanted to find out what the “income multiplier” was for lenders. In this case, I could theoretically get a loan for $575,000 based on a gross income of $100,000… 5.75 times gross income! And this doesn’t even take into account any down payment. If you had $100,000 to put down, you could technically buy a $675,000 house while earning $100,000 per year. And you wonder why housing prices went nuts…
Viewed another way, they would let me spend a total monthly payment of $4,166.67 towards housing. Using this paycheck estimator and using a Single person with one exemption living in California, the net monthly take-home pay each month would be $5,364.50. First, I’ll ignore the potential deductibility of mortgage interest, although it can be significant. That means $4,167 out of $5,364, or 78% of take-home pay, would be going towards housing. This leaves just 12% ($1,197) for everything else – food, utilities, gas, emergencies, retirement savings, whatever. Ouch!
2/3rds of Take-Home Going To The House
Now let’s try to estimate the benefit of deducting mortgage interest. On a $575,000 loan, the amortization schedule says that $34,308 of interest will be paid during the first year (it will be less each subsequent year). Everyone already gets the standard deduction of $5,350, leaving us with a net benefit of $28,958. With marginal tax rates of 28% federal and 9.3% for California, that is a savings of $10,801/year ($900/mo). Adding that back into the net pay, that leaves us with 67% of net take-home pay going towards housing costs alone. Still pretty tight, but I suppose a person could still manage if they were very careful. As the wise folks say, just because a bank lets you borrow something, doesn’t mean you necessarily should…