Financing Tricks and Calculating What You Can Really Afford in a Home Loan

(Note: the available loan options have shrunk since this was first written, and the rates are significantly lower right now, but the main point is calculating what you can and cannot really afford)

Hi Dan, I am a first time home buyer and a big fan of the advice on your blog. I was wondering if you could offer some advice on my current situation. I apologize for sending you this question but I've had many sleepless nights over this and I really respect your opinion.

I've narrowed my search down to two properties, one is a condo in DELETED (where I work) and the other is a new home in DELETED (closer commute for fiance). As a first time buyer I'm looking to stay in this place 5-7 years and then if possible rent it out as an investment.

The new home builder has a 2-1 buy down plan so the rates on a $519,000 5/1 arm would be Year 1: 3.75%, Year 2: 4.75%, Year 3-5: 5.75% on the first mortgage and 9.375 on the 2nd (which I would try to refinance right away).

The condo is $335,000 (a similar model sold on recently for 400,000) and the rates are 7% on the 1st and 8% on the 2nd. Both loans are with 100% financing.

I really like the house but don't wanted to be lured into a larger loan if it might come back to bite me. I would go for the condo if it would be a better investment in the long run but would be sad without a yard. I my income is 94,000 a year and I have good credit, my fiance will also be contributing to the monthly payments.

Thank you for reading my lengthy email, I'd really appreciate your help!

I am not going to pass judgment on either property and its worthiness as an investment, its comparative value, etcetera. Those are buyer's agent questions. The real question I can deal with here is numbers: What can you afford? If you can afford both, is the more expensive property worth more money to you?

You make $94,000 per year, which equates to $7833 per month. Subprime will allow a fifty percent debt to income ratio, which means that for is total monthly housing and debt service, you can afford $3916. That's got to cover first, second, taxes, insurance, Mello-Roos and HOA, etcetera, as well as your existing debt. A paper fixed rate firsts allow basically 45 percent, while A paper hybrid ARMs are usually lower, and compute based upon the fully indexed payment, not that low initial payment. Matter of fact, what they're trying to sell you on looks like a Temporary Rate Buydown, so they can sell you the property based upon a low initial payment.

Let's look at these two situations.

On a $335,000 condo, that's a first of $268,000 at 7% and a payment of $1783. On the second, that's a $67,000 second at 8%, which is a payment of $492. At 1.25% (standard California rate) your property taxes would be $349 per month. Insurance is not required for condominiums even though it's both cheap and a really good idea, so it doesn't impact debt to income ratio. On the other hand, there will be HOA dues, and may be other monthly expenses such as Mello-Roos. As long as these, plus your other debts do not exceed your remaining $1292, you're likely to be able to afford it. Add in 75% of whatever your fiance will sign a lease for, as standard allowance for rent, in addition to the $1292. Bottom line, based upon the information provided, it looks likely that you can afford that condo.

On a $519,000 property, that's a first of $415,200 and a second of $103,800. The second gives a straightforward payment of $863. The first has an initial payment of $1923, but that's not the real payment. The real payment is $2423 - $500 more. Nor is this the qualifying payment that an A paper lender will use, which is computed based upon what would happen if that loan hit the end of the five year initial fixed period today. That rate would be 7.125, or a payment of $2797. Yes, I like 5/1 ARMs, but they are perversely harder to qualify for than fixed rate loans. I get that basic California property taxes would be $541, I'm guessing insurance would be about $100. Total is $4301, and we haven't considered Mello-Roos, HOA (if any), or your existing debt. On the plus side, we haven't considered your fiance's contribution, either, but it's not looking good as you're nearly $400 over your monthly total payment limit already, and that's without considering possibly lowered debt to income ratio guidelines.

Now, let me point out a couple of tricks going on here: That temporary buydown isn't free, or even cheap. Nor is 5.75 available on a 5/1 without points right now, from any lender I'm aware of. This developer is not going to do your loan for free just to unload the property, and they used the temporary buydown to make it look like the payment is lower. They came close to hooking themselves a sucker fish, too, from your email. The money to do all of this is coming from somewhere, and the only candidate I'm seeing is the pockets of the buyers. It's almost certainly a waste of money as well as defeating the purpose of a hybrid ARM to pay points and temporary buydowns - and you would be paying them. If not explicitly, through being able to negotiate a lower price on the property without the developer paying for all of that. Which would you rather have: slightly lower payments for a while, or a lowered amount of debt in the first place? They pad the price, so they get more money right away, while paying out a part of it to make the payments look lower for a while. If you offer someone a dollar for thirty cents, most of them will take you up on as many dollars as you have, then turn right around and hand you back a portion of the money you just handed them. When you reduce it to the basic mechanics, that's what is apparently happening here. Of course, the average consumer is clueless about this - all they understand is that they're getting a beautiful property that they didn't think they could afford for an initial payment they're happy with. Well, they really can't afford it, but someone who knows a critical bit more of how the game is played persuaded them they could.

All of this is one more argument why everybody should get a good buyer's agent. If you don't have one, especially in dealing with developers and their lenders, nobody has a fiduciary responsibility to you. That and shopping your loan extensively are the best ways to avoid rude awakenings expensive enough to jeopardize your entire future that there are. In fifteen minutes with a calculator and my professional experience, I may have just saved your financial future. The other side has people whose job it is to get that property sold for the most possible money and make money with that loan, too. They're paid to act like your friend while picking your pocket. If you really want to play that game without someone on your side who knows the same tricks they do, you're a foolhardier braver man than I am, Gunga Din.

Caveat Emptor

Original article here