As millennials and other first time home buyers begin their quest of buying a home, they face ever increasing costs of home-ownership. To help combat these increasing costs, lenders may provide some options to consider such as buying points.  A caveat we have to mention (almost by law) – we are not financial advisers or mortgage experts. Any information we provide derives from personal experience and working with families buying a home.  Please obtain counsel from a professional financial adviser to help you determine what option suits you and your family best.

Now that we have done our due diligence for the legal mumbo jumbo (our apologies), we can move on to the point of the article. We want to discuss buying down points. Another option includes a different type of loan which we will discuss in a separate article. Both options require that you have discussed with your significant other and know your family’s future plans.

 

Buying A Home – What Can You Afford

A key factor when applying for a loan when buying a home includes the size of the payment.  From your point of view, you want the payment low because you want to have the option to spoil your family with the additional disposable income, as you should. The banks on the other hand, want to make sure you have the financial capacity to make the payment on the note even in the slowest times with the least income.

Lenders have formulas to help them determine what size of a payment you can afford to maintain.  They also have guidelines they must follow, either their own corporate guidelines, or the guidelines of the financial institution they plan to sell the note to after buying a home.  In most cases, they look at one or two main numbers, both of which indicate a ratio compared to your income. The two ratios include the Total Obligation Ratio (TOR), and Housing Expense Ratio (HER).

 

HER And TOR Ratios Explained

The HER describes the maximum amount of your income the lender can attribute to your housing payment. The Department of Housing and Urban Development (HUD) has stated that for 2017, their limit for FHA loans caps at 31%.  For simplicity, we will assume a $4,000 per month salary, and $1,000 per week.  31% of $4,000 comes out to roughly (4,000 x 0.31) $1,240. So for a household with $52,000 annual income under HUD guidelines, the maximum payment would cap at roughly $1,240. This comes out to somewhere around a $200,000 home after including taxes, mortgage insurance, property insurance, Homeowners Association dues and such.

The next ratio lenders have to consider, TOR, includes all recurring monthly debts. This would include credit cards, car payments, medical payments, student loans, etc. This number can go up to 43% of your monthly income though, which comes out to roughly $1,720. So of the same $4,000, if the mortgage payment were the $1,240 we calculated previously, you could only have $480 worth of recurring monthly bills.  The more you have to pay out every month, the less home you can afford.

For example, if you have a credit card payment of $100, a car payment of $200, and a student loan payment of $250, you have a monthly recurring obligation of $550.  Now take that $1,720 and subtract that $550, and that would provide you the maximum payment with your current monthly obligations – $1170.  This lowers the value of homes you can consider by roughly $15,000. So you are limited to $185,000 with that $550 worth of monthly recurring obligation.

 

Options When Buying A Home

To afford more house, a family’s options include lowering the monthly recurring debt, or lowering the housing payment. A quick explanation on the former before exploring the latter.

 

Lowering Monthly Recurring Debt

This can confuse some folks, so we wanted to touch on this briefly, even though this does not directly impact the topic of this article. When considering this option, you need to understand how a mortgage lender sees the different accounts on your credit report.  Remember, the lender will base the amount you qualify for on the payments in the credit report. We discuss credit reports in more detail Here.

Credit card debt affects the amount as most would expect – as you pay down the debt, the amount you qualify for rises. Buy why?  Notice on a credit card bill how the monthly payment changes every month? The payment you see typically relies on the current balance of the credit card debt – the more you owe the higher the minimum payment.

Automobile payments, student loan payments, and personal loans from any financial institution follow a different format.  Typically, you will find fixed payments that never change with those types of credit lines. That $300 car payment stays the same for the life of the loan, whether you owe $40,000, or $400.

With this in mind, remember that unless you pay down a credit card, the only way to increase the amount of home you can afford includes paying the debt completely off. Even if you only owe $1 – until that loan shows as “Closed/Paid in Full” on the credit report, that $300 payment will count against you. So when you get that income tax return, before you use it to “pay down” that automobile loan, consider carefully.  Make sure you pay it off, or hold on to that money.

 

Lowering The Payment

Of the limited number of ways to lower the payment when buying a home, one includes lowering the interest rate. A family can accomplish lowering the interest rate a number of ways, though we will only focus on one for this article. Buying down points on the interest rate.. As we mentioned in the beginning of the article though, you and your family will want to have a clear plan for how long you plan to live in your new home. You will want to have discussed the options available to you for the property after moving out as well.

 

Buying down points

Buying down points means exactly what it says – you pay the mortgage lender a sum of money up front to lower your interest rate. Typically, the cost of 1 point equals 1% of the loan.  Also typically, 1 point will reduce your interest rate by ⅛ of a percent, or 0.125%. And before we get into some examples to help shed some light on the math, remember the amount relies on the loan amount, not the purchase price of the home.

Now for the math – if your stomach does not agree with numbers, you better get a bag! Seriously though, we will try to make it as simple as we can. You can use this site to help sort your specific situation.

 

Our Fictitious Home

Let us consider a $240,000 home, with an FHA loan at 4%. Under FHA, a potential home-buyer will need to supply 3.5% as a down payment, or roughly $8,400. That leaves $231,600 – the lender will use this amount to determine the cost of a point. In our hypothetical case of a point costing 1%, that comes out to $2,316 per point.

Remember that each point paid lowers the interest rate only ⅛ of a percent, or 0.125% – so paying for one point would lower the interest rate from 4% to 3.875%. Paying 2 points would lower the rate by 0.25% to 3.75%, costing you $4,632. To lower the interest rate an entire percent to 3% (not typically allowed, as most lender have limitations) you would have to purchase 8 points, costing roughly $18,528 up front, on top of your down payment and closing costs.

How does that affect your monthly note payment? On our fictitious $240,000 home, lowering the interest rate from 4% to 3.875% lowers the month payment by $25. So you spend $2,316 to lower your monthly payment by $25 – does not sound worth it right? Remember how we mention the plan?  How long does your family plan to live in that home? Or own it?

 

The Effect Of Buying Down The Rate

$25 per month adds up!. What does that mean? The break even point, the point where the cost of the purchased point equal the savings on your monthly payment, occurs around month 93, or just under 8 years. Every month after that, you begin to save money.  8 years sounds like a long time, except when you compare it to a 30 year mortgage.  $25 a month over the course of the entire 30 years would end up saving you $6,684 over what you paid to lower your interest rate. The caveat here though – you have to keep that mortgage payment for more than 8 years to make buying that point worth it.

Finally, buying down points, while a smart investment if you plan to keep the note for more than 8 years, costs a lot of money up front, for very little growth in home affordability.  That $25 a month only allows for maybe any additional $5,000-$10,000. On top of that, since most families only stay in their homes for an average of 8-10 years, the next option may suit more families. However, as this article has already run longer than we wanted, we saved that for a separate read.

 

Summary

We wanted to discuss an option available to families that wanted to obtain a lower mortgage payment. One option we covered included buying down points. The other will speak to a different loan option in a separate article. Both options require that you have discussed with your significant other and know your families future plans.

• A key factor when buying a home includes the size of the payment
• Two ratios to pay attention to:
  • Total Obligation Ratio – Total Payments on Credit Report versus Total Income
  • Housing Expense Ratio – House Payment versus Total Income
• Lowering Monthly Recurring Debt by:
  • Paying down credit card debt or…
  • Paying off loan debt (remember the difference!)
• Buying down points lowers monthly payments but:
  • Has a high cost up front
  • Only worth it if you keep that mortgage payment for more than 11 years

Even then, some financial analysts would encourage families to take the money intended to buy down the interest rate and invest it. Even with a moderate gain from a lower risk mutual fund would provide a better return over the same length of time.

Stay tuned for our next article, which will discuss another option to lower those monthly house payments and potentially afford more home!

 

Are you ready to find your #dreamhome?