Note: In case you’re curious about how we got the total interest amount, we simply subtracted the amount of the loan repaid ($160,000) from the “Total Payments.” Also, the monthly payment numbers previously cited, as well as these total payments and interest numbers, are rounded off, so if you try multiplying 180 or 360 by the monthly payment numbers, you won’t get answers identical to these numbers.
With the 30-year mortgage (compared with the 15-year mortgage), because you’re borrowing the money over 15 additional years, it shouldn’t come as a great surprise that (with a decent-size mortgage loan like this one) you end up paying more than $80,000 additional interest. The 30-year loan isn’t necessarily inferior; for example, its lower payments may better allow you to accomplish other important financial goals, such as saving in a tax-deductible retirement account. (See Chapter 6 for more information about 15-year versus 30-year mortgages.)
In the early years of repaying your mortgage, nearly all your mortgage payment goes toward paying interest on the money that you borrowed. Not until the later years of your mortgage do you begin to rapidly pay down your loan balance, as shown in Figure 3-1.
Lender’s limits
Because we’ve personally seen the financial consequences of people borrowing too much (yet still staying within the boundaries of what mortgage lenders allow), you won’t hear us saying in this section that lenders can tell you the amount you can afford to spend on a home. They can’t. All mortgage lenders can do is tell you their criteria for approving and denying mortgage applications and calculating the maximum that you’re eligible to borrow. (For the inside scoop on lenders and their limits, see the first section of this chapter.)
Mortgage lenders tally up your monthly housing expense, the components of which they consider to be
Mortgage payment (PI for principal and interest) + Property taxes (T for taxes) + Insurance (I for insurance) = Lender’s definition of housing expense (PITI is the common acronym)
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FIGURE 3-1: It takes many years into a mortgage to begin making real progress at repaying the amount originally borrowed. In this case, paying off half the loan balance takes nearly 22 years.
For a given property that you’re considering buying, a mortgage lender calculates the housing expense and normally requires that it not exceed a certain percentage (typically around 40 percent or so) of your monthly before-tax (gross) income. (Some lenders allow the percentage to go a bit higher.) So, for example, if your monthly gross income is $6,000, your lender will not allow your expected monthly housing expense to exceed $2,400 (if the lender is using 40 percent). When you’re self-employed and complete IRS Form 1040, Schedule C, mortgage lenders use your after-tax expenses (net) income, from the bottom line of Schedule C.
About the only other financial considerations a lender takes into account (besides your income) are your other debts. Specifically, mortgage lenders examine the required monthly payments for student loans, an auto loan, credit-card bills, and other debts. In addition to the percentage of your income lenders allow for housing expenses, lenders typically allow an additional 5 percent of your monthly income to go toward other debt repayments. Thus, your monthly housing expense and monthly repayment of nonhousing debts can total up to, but generally be no more than, 45 percent.
STRETCHING MORE THAN LENDERS ALLOW
Sometimes, prospective home buyers feel that they can handle more debt than lenders will allow. Such home buyers may seek to borrow more money from family or fib on their mortgage application about their income. (Self-employed people have the greatest opportunity to do this.) Such behavior isn’t unlike the shenanigans of some teenagers who drive above the speed limit, drink and smoke forbidden things, or stay out past curfew and sneak in the back door.
Although a few of these teenagers get away with such risky behavior, others end up in trouble academically or psychologically (or worse). The same is true of homeowners who stretch themselves financially thin to buy a more costly property. Some survive just fine, but others end up in financial, legal, and emotional trouble.
And, increasingly, home buyers who lie on their mortgage applications are getting caught. How? When you’re ready to close on your loan, lenders can (and often do) ask you to sign a form authorizing them to request a copy of your income tax return from the IRS. This allows the lender to validate your income. (See Chapter 7 for more details.)
So although we say that the lender’s word isn’t the gospel as to how much home you can truly afford, we will go on record as saying that telling the truth on your mortgage application is the only way to go (and prevents you from committing perjury and fraud). Telling the truth is not only honest but also helps keep you from getting in over your head financially. Bankers don’t want you to default on your loan, and you shouldn’t want to take the risk of doing so either.
Figuring the size of your mortgage payments
Calculating the size of your mortgage payment, after you know the amount you want to borrow, is simple. The hard part for most people is determining how much they can afford to borrow. If you already know how large a monthly mortgage payment you can afford, terrific! Go to the head of the class. Suppose you work through your budget in Chapter 2 and calculate that you can afford to spend $1,500 per month on housing. Determining the exact amount of mortgage that allows you to stay within this boundary is a little challenging, because the housing cost you figure that you can afford ($1,500, in our example) is made up of several components. Lucky for you, we cover each of these components in this chapter, including mortgage payments, property taxes, insurance, and maintenance. (Note that although lenders don’t care about maintenance expenses in figuring what you can afford to buy, you shouldn’t overlook this significant expense.)
As you change the amount that you’re willing to spend on a home, the size of the mortgage you choose to take out also usually changes, but so do the other property cost components. So you may have to play with the numbers a bit to get them to work out just right. You may pick a certain home and then figure