HOMEOWNERSHIP: Understanding What You Can Afford, Mortgages, and Closing Costs. Illinois Association of REALTORS. Springfield, IL 62701

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1 Illinois Association of REALTORS 522 S. Fifth Street Springfield, IL HOMEOWNERSHIP: Understanding What You Can Afford, Mortgages, and Closing Costs

2 WHAT CAN I REALLY AFFORD? When applying for a mortgage, these are the five factors that count the most in qualifying for a loan: This guide is intended to help you determine whether you can qualify and ultimately be approved for a mortgage loan to purchase a home. This guide will help you to understand what you need to know about: What you can afford. Mortgages, closing costs and other costs associated with owning a home. When you carefully choose a home that you can afford, the payoff can be great. Homeownership is a sound investment. But the choices that you make at the very beginning of the process prior to getting a mortgage and selecting a home will help determine whether you get in over your head or whether your investment Your income Your debts Your employment history Your credit history Value of the property A strong loan application will have these features: The homebuyer has a good credit. (To learn more about credit scores and how to obtain your set of scores, go to ) The homebuyer has a steady job (ideally the same job for two years or longer) A housing expense ratio no greater than 28% (the lower the ratio the better) A debt-to-income ratio no greater than 36% (the lower the ratio the better) The last two items here, the two ratios, can be calculated in the next section which will show you exactly how much of a monthly payment you can afford. Estimating What You Can Afford To estimate the most you can afford to pay each month for your mortgage, there are only two basic things you need to know: 1 Your gross income - This is the income before any taxes are paid. 2 Your monthly debts - This includes payments on credit/debit cards, car payments, alimony, child support, student loans and any other loans. Do not include your present rent or house payment. pays off in the long run. 1 2

3 The Monthly Payment You Can Afford Estimate 1 Housing expense as a percentage of monthly income A When you calculate your affordable house payment, you will work on two separate estimates. The first estimate is based on your housing expense. The second estimate is based on your total monthly debts. Gross (before taxes) income each year: The lower of the two estimates is the one you should keep in mind as you select and buy your home. This amount (the lower of the two estimates) represents the upper limit of what you can reasonably expect to spend on a house payment. A house payment includes the principal and interest on the mortgage, property taxes and insurance. (Read more about these in a subsequent section of this brochure.) Keep in mind that this estimate does not take into account all other factors in your life that might affect your financial situation. You should consider other factors such as future employment and life changes such as having children, or future large expenditures like a new car or tuition payments. These factors should be considered when determining the monthly amount for housing with which you are truly comfortable. B Divide by 12 (to calculate monthly income) C Multiply monthly income by 28% (.28) Estimate 2 Debt payments as a percentage of monthly income A Gross monthly income: (from B above) B Multiply by 36% (.36): $ C Total monthly debts: $ D Now subtract C from B and write the answer: 3 4

4 WHAT ARE THE UPFRONT COSTS OF GETTING A MORTGAGE AND OWNING A HOME? Now that you know how much you can afford, you re ready to learn more about mortgage loans. The following items are the upfront costs of securing a mortgage and finalizing the purchase of the home. Down Payment This is your contribution to the sales price of the home. You borrow the rest of the sales price with your mortgage loan. Closing Costs The cost of getting a mortgage loan and completing the home purchase transaction. This includes several items (discussed below). Down Payment When you borrow money to purchase a home, the lender will require you to contribute some of your own money for the purchase. A lender usually requires a down payment of 20 percent. Many conventional loan products and government-insured loans (such as FHA) do not require a 20% downpayment. To learn more about FHA go to If it is lower than 20%, there will be a premium for mortgage insurance. The mortgage insurance payment will be a part of your monthly payment. Discuss these options with your REALTOR or a lender. Closing Costs Closing, or settlement, is the formal process of transferring the property title from the seller to you, the buyer. When you apply for a loan, the lender will give you an estimate of closing costs, which can be estimated to be about 3% to 4% of the amount of the mortgage. These costs include the following items: Lender Fees: Your lender will charge certain fees for the processing and procurement of your loan. Examples of costs include your appraisal, credit check, interest rate buy-downs (also called, points), origination fees, etc. These examples are not an exhaustive list; fees and costs will vary by lender and loan product. Make sure your lender goes over these in detail and you are clear on each fee. Items Paid in Advance (Prepaid Escrows): Most lenders require you to pay for some items that will be due after the closing. These usually include escrow reserves for property taxes and mortgage insurance. This can also include pre-paid interest on the loan which reflects the interest of the first month s payment. Title Charges: A title is the document that shows you own the property. It is necessary for an attorney to examine the title to make sure there are no problems that would prevent you from having clear (legal) title. It is also necessary to get title insurance in case someone else should try to claim title to your property. Recording and Transfer Charges: A record of your home purchase will be on file with the county recorder of deeds and there will be a fee to cover the cost. There may also be a real estate transfer tax assessed on the buyer by the municipality. Attorney s Fee: This fee is to pay the attorney for preparing and reviewing all the documents needed to close your loan. 5 6

5 WHAT TYPE OF MORTGAGE SHOULD I GET?I It is very important to compare the different mortgage offers that you may get when buying a home. The decisions you make will determine the size of your monthly payments, how much you pay upfront, and how much you ll pay over the life of the loan. Here are a set of questions which you should ask when applying for a mortgage: What is the loan s interest rate? Will I be charged points? (It may be best to avoid paying any points.) What are the closing costs and all other fees? What is the annual percentage rate, or APR the rate you ll pay per year for all the costs associated with the loan? Is there a pre-payment penalty? How is the loan amortized? In other words what is the period over which the loan payments are scheduled? Find out the answers to these questions no matter what type of loan you re considering. Each can affect the overall cost of the loan. There are many types of mortgages products available and it is important to understand yours. Here are a few of the most popular types of mortgages as defined on the Web site of the Illinois State Treasurer. 1 Fixed Rate Mortgages - One of the most popular and highly recommended types of mortgage, this mortgage offers fixed interest rates to consumers throughout the life of the loan. With fixed rate mortgages, there will be no fluctuation in monthly payments, making it easier to budget and eliminating the risk of resetting interest rates. 2 Adjustable Rate Mortgages - Also known as ARMs, these mortgages offer a lower introductory interest rate, which can appear far more affordable for those with limited funds or those looking for great value. Consumers must understand that ARMs are not ideal products if you are planning to stay in your home over a longer period of time. When your introductory rate expires, your reset rate could be several percentage points higher, which could increase your mortgage payment by hundreds of dollars a month. 3 Two-Step and Balloon Mortgages - These mortgages contain various repayment options, the most popular in recent years being interest only payments. The loan payments are lower because payment covers only interest and doesn t reduce your principal amount owed. Either at the end of the loan or the interest only period, you will be required to settle the remaining balance. In a real estate market where home values actually decline, you may not only owe the entire balance of the loan after making interest only payments, you could actually owe more than your home is worth! Calculating a monthly payment. To help you find out what the monthly payment would be with a specific mortgage amount, there are several mortgage calculators that can be found on the Internet. One such calculator can be found on the Web site of the Illinois State Treasurer Click on the Finally Home link. 7 8

6 WHAT COMPRISES A MORTGAGE PAYMENT? When you make a mortgage payment, what exactly are you paying for? Lenders often refer to the Principal, Interest, Taxes and Insurance as PITI. Generally, the PITI is the amount you will pay each month for your mortgage. All of these items are considered by the lender to determine your qualification for a specific loan amount. Here is a breakdown of all the costs included in your mortgage payment: Principal The amount of money you borrowed. Each month when you make your mortgage payment, you are paying back a small portion of the principal. Over time, the portion of your payment that goes to the principal gets larger. Interest This is the cost of borrowing money. The lender makes money on the portion of your payments that goes to interest. The interest on a loan is expressed as an annual percentage of the loan amount. (example: 6% on a 30-year loan) Property Taxes These are the taxes paid to local units of government (school district, municipality, etc.). The annual property tax amount is based on the value of your property. Your lender collects the taxes through your monthly payments and holds the amount in an escrow account from which the tax payment is made by the lender to the County Treasurer. Property/Hazard Insurance Your lender will require that you take out an insurance policy a policy that protects you from any financial losses on your property that may result because of a fire, flood or other hazards. Mortgage Insurance This may be required if you buy a home with a low down payment. This insurance policy helps the lender recover some of the losses incurred if a borrower fails to fully repay a loan. [If you purchase a condominium, another part of your monthly housing expense will be the condominium (condo) assessment which is paid by the condo owner to the condo association. This payment is used to maintain and operate the building of which the condo is a part. This monthly amount is also factored into your monthly obligations that help determine your qualification for a mortgage.] PRE-APPROVAL FOR A MORTGAGE SHOULD I GET PRE-APPROVED? If you are a first-time homebuyer, it is recommended that you get pre-approved by a lender even before you begin your search for a home. That means sitting down with a loan officer and working toward a loan commitment. This commitment shows that the lender has already reviewed and verified such items as your credit report, employment, bank balances, etc. and is willing to proceed with the loan. The loan commitment will give you the clearest idea of how much home you can buy. It may also strengthen your negotiating position as a buyer because the transaction has a better chance of going through since the loan commitment is already in place. The transaction can close more quickly. This brochure is intended to give you a condensed review of the financial pre-purchase process. It is not meant to be the sole source of information nor replace professional advice from your REALTOR, lender or attorney. Use this brochure as a starting point for your home purchase and your discussions with those professionals. 9 10

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