You, not the lender, should set size of mortgage

Dear Dollar Diva,
How do I figure out how much of a mortgage payment I can comfortably afford, including taxes and homeowners insurance? I’d like to know what monthly mortgage payments I can afford with a 30-year mortgage vs. a 15-year mortgage.
Janet

Dear Janet,
The first question is the one that needs to be answered. Once you figure out how much of a mortgage payment you can afford, the next question is how much house will it buy? If you want to pay the mortgage off in 15 years, you’ll have to settle for less house than if you’re willing to stretch the payments out over 30 years.

You may have to settle for less house with a 15-year mortgage, but not that much less. Given a $25,000 down payment and an 8 percent rate, the same mortgage payment buys a $255,000 home over 30 years or a $200,000 home over 15 years.

But you have another option: Buy the $200,000 home with a 30-year mortgage and pump up the monthly payments to get it paid off in 15. Why would you want to do that?

  • It gives you some wiggle room if you run into a cash flow problem down the road.
  • If inflation rears its ugly head, as it did in the early ’80s, instead of adding extra cash to the low-interest mortgage debt, you could sock that money away in a safe, tax-deferred investment that’s indexed for inflation, such as U.S. Treasury Series I savings bonds.

The debt-to-income ratio
Mortgage lenders use a debt-to-income ratio to determine how much of a mortgage folks can afford. PITI is the term lenders use for a mortgage payment that includes principal, interest, taxes and insurance. The rule of thumb is: your total monthly debt payments (PITI, credit cards, bank loans, and all other debt) divided by your gross income should not be more than 36 percent. Bankrate.com’s ” How much house can you afford?” calculator has this formula built into it. Plug in your numbers to get an idea of what a mortgage lender will say you can afford.

You’re in charge
Lenders are in the business of lending money, but you’re the one who has to cough up the monthly payments, rain or shine. You, not your banker, should decide how much mortgage you can really afford.

Let’s take a look at two potential homeowners with the same income and debt burden:

  • A single mother, who makes maximum payments to her 401(k) plan, lives in a state with a hefty income tax, tithes her church 10 percent and sends her two kids to private school.
  • A single computer geek who lives in Florida, has no 401(k) plan and no life.

The Diva doesn’t think the debt-to-income ratio would cut it for either of them.

To determine what you can afford for a mortgage, you need to know what your monthly net income and expenses are. Separate the non-negotiable expenses (debt payments, school tuition, tithes) from the negotiable (clothing, vacations, recreation) so you know where you can cut if you have to. The National Foundation for Credit Counseling Web site has some excellent budget tools to help you with this task.

Don’t forget the other costs
If you can’t afford to put 20 percent down, you’ll also have private mortgage insurance (PMI) added to your monthly payments. And don’t forget the closing costs and other expenses, such as moving, homeowner’s association fees and making the new place livable. If you know you’re going to be earning more money in the future, the Diva thinks it’s OK to stretch when buying a home; just don’t stretch so far that you break.