Monmi Barua

 Homeownership – the American dream America has always been the land of opportunity and home ownership or possessing one's own home has always been considered an important part of the modern American dream. Home ownership is not merely about a home, it connotes security & pride, control, stability and an achievement. It is an embodiment of the American belief that if you work hard, your dreams can come true. Over a period of time, the market value of the home surges which results in creation of equity. Homeownership not only provides financial security, it is provides us with social security too. Homeowners are actively involved in volunteer work, community drives and engagements. This provides a sense of belongingness. Studies have revealed that children of homeowners are less likely to be involved in crime and drug abuse and they excel at school too. Although achieving the American dream is not a daunting task, it is not a cakewalk either. The complexities of understanding the dynamic mortgage industry, the amount of paperwork involved and the innumerable programs offered makes it a challenging task. With the national homeownership rate falling to 63.4% in 2016 which is the lowest yearly average in 50 years, the American dream seems like an elusive affair. Homeownership calls for meticulous planning and patience. In the preceding chapters, we will try to understand the various components that will help us to achieve homeownership. 1) Income There are some important milestones to be achieved on the road to homeownership. The most primal one being income – the source from which we would be paying off our mortgage payments. Income can be from any source provided it has a document trail, not paid in cash & most importantly, should be from a steady source. For example, a lawn mower’s income may not seem lucrative enough for a lender as compared to a librarian’s for the obvious reason that the income is not steady. A steady income promises a steady inflow of dollars in to our bank account. It also acts as an assurance to the lender the borrower’s ability to repay the mortgage on time. The primary step towards preparing for homeownership is to list down all the possible avenues of income and then check whether they are steady or not. It is typical for every lender to check for the employment history of the last two years, either employed or self-employed. Supposedly, you had worked as an accountant at a law firm for the first six months and then moved on to work as an accountant for a marketing company, it will be considered as an acceptable career move. However, if you had worked as a physical trainer at a health club for one year, worked as a bartender for another and currently working as an accountant, it will be unacceptable. To cut things short, the lender is checking whether you have a reliable source of income or not. The lender also tries to ascertain that you will be having a steady flow of income to keeping paying your mortgage debts. From how long should one be employed? The tenure of the employment is of utmost importance, one of the many items which have to pass through the microscopic lens of the underwriter. An underwriter is a person who will check your credit eligibility and provide decision on the loan application. Typically, an underwriter will require minimum two years’ of employment history to make you eligible in any of the loan program. Most of the loan programs – conventional, FHA, VA or USDA have a requirement of at least two years of verified employment history. When we say verified history, it wipes out any income which does not have any paper trail. The income should have been reported to the IRS, payment should not be received in cash and above all, it should be steady. Lenders would seek the W2s along with the pay slips to authenticate the income mentioned in the loan application. Furthermore, the borrower will contact the current and previous employer to confirm the length of employment, income and also position held. Next question is a bit tricky, how much of income is required to be eligible for mortgage? A wee bit of logical bent is required to understand this aspect. Lenders typically use the Debt to Income (DTI) calculation as a yardstick while determining mortgage eligibility. Debt includes everything from liability payments, utility bill payments, judgements, open & revolving credits, instalment payments etc. plus the proposed PITI (Principal, Interest, Taxes and Insurance) for the proposed mortgage debt. The combined debt when divided by the income should be within the bracket of 35% - 40%. Let us go through the below table to elucidate it further.   Mr. ABC Ms. XYZ Income $10000 $10000 Student loan $600 $400 Instalment loan $1200 $700 Proposed PITI $2300 $2300 Total $4100 $3400 DTI 41% 34% Let us accept the ugly fact that no lender provides 100% mortgage. The maximum mortgage is 95% which very few lenders provide that too under some special loan programs. There are certain special requirements to be met to be eligible for such programs. One component which is the first check for any underwriter is Loan to Value (LTV) ratio. LTV, as the term implies, is the proposed loan amount versus the actual value of the property to be financed. The appraisal is an important document in this aspect. Underwriter requires the appraisal report of the property to ascertain the current market value. The appraised value should always be higher than the loan amount else it will be marked as underwater mortgage. The formula to calculate the LTV is loan amount/market value of the property. For example, if the market value of the property per the appraisal report is $100000 and the loan amount is $85000, then the LTV would be $(85000/100000) = 85% LTV. This brings up an interesting subject which is down payment or the amount of payment the borrower is willing to pay from his end towards the mortgage. Down payment in mortgage term is also known as borrower’s contribution. The borrower’s contribution can typically consist of down payment, financing costs, closing costs and prepaid/escrow. One easy way to understand borrower’s contribution is the difference amount that needs to be paid to make the mortgage hundred percent (100%) Typically, the higher the LTV, the higher is the chance of the borrower defaulting on his payments. On the contrary, historically, loans with lesser LTV stand a less chance of being in default. Let us now return to our original discussion about how much of income is required. Loans with lesser LTVs mean that the loan amount will be less as compared to higher LTV loans. Hence, a borrower with an LTV of 60% for a property value of $100000 would require loan amount of $60000 while an LTV of 90% on the same property signifies a spike in the loan to $90000. The combined DTI is also an important aspect for the lender in calculating the risk associated with lending the respective loan amounts. Let us look at the table below. ­   Borr A Borr B Down payment $40000 $10000 Property Value $100000 $100000 Loan Amount $60000 $90000 LTV 60% 90% PITI $900 $2300 Other payments $2600 $2200 DTI 35% 45% Both Borr A & Borr B have applied for mortgage. Borr A with an LTV of 60% is obligated to PITI of $900. He stands at a decent DTI of 35%. From lender’s perspective, he is a good bet as his combined DTI% of 35% still leaves room for additional expenses. On the other hand, Borr B with a combined DTI % of 45% does not leave any room for any additional expenses. Borr B stands at a higher chance of default in the near future. Since Borr A has made a down payment of $40000, his loan amount requirement is less than Borr B. Borr A would require less income to qualify for the loan than Borr B. 2) Saving – starting it early and its affects In the previous chapter, we had discussed about the borrower’s contribution and how it affects the overall loan amount. The down payment is not the only contribution the borrower needs to pay during the mortgage. There are certain hidden costs like appraisal fee, closing costs etc. which the borrower is not aware of. As the borrower trudges the weary road ahead, he comes face to face with these unseen costs. Imagine a situation when after having meticulously planned your home ownership you finally apply for the loan with documented income from the past two years and your lender being kind enough to provide you an LTV of 90%, one fine day, you are informed that there are certain additional costs of about $4000 – $5000 which you will have to make from your pocket. Your dream of owning a house would be shattered to pieces and you will join the tribe of people who believes that mortgage lenders exists only to fleece borrowers out of every single penny from their pocket. This is a hard fact and it is true. There will be certain costs which the borrower has to make amends from his end. Costs like attorney costs, appraisal costs and certain closing costs are clearly stated by the lender at the time of application. For the additional cost, you cannot take another loan as it will mean recalculating your mortgage eligibility and chances are there that you might not be eligible for the same loan amount that was initially agreed upon. So, how do you offset this situation? Won’t you wish that there were a few extra dollar bills in your bank account as cash reserves? The answer to this lies in saving. We got to believe in the power of saving. When I was a kid, I remember once my dad brought a cute pink piggy bank where I used to save coins which dad used to give every now and then. When I completed my high school, he opened a current account for me at the local bank. He instilled the habit of regular saving which in my later part of life helped me a lot during my financial crunch days. Saving is a great habit which not helps us in our bad days but also provides a sense of comfort and confidence to the lender. A borrower whose PITI is $2000 monthly and has a saving of $24000 in his bank account provides an instant sense of relief to the lender as he can comfortably pay his monthly PITI up to 12 months in case of any unforeseen calamity. When income supersedes spending, saving is a very practical approach, but in recent years there has been less income for most and thus less opportunity to save. A decade ago, the worth of $1000 was lot more than it does today. The main problem lies in inflation. There has been a marked 40-45% hike in goods and services taxes. Combine lower incomes with higher costs and the decline in savings becomes inevitable. It is not surprising that the number of first time home buyers have declined from 40% to 29% in the last decade for the simple fact that it is tough to save enough money for down payment. So, does it mean that first time home buyers will be bereft from the chance of owing a house? The answer is NO. Unless we have inherited a fortune or maybe if we get lucky, win $100000 in the lottery, things will not change. Our expenses will forever keep on changing and our habit of procrastinating things will not help anyway. Unfortunately, like it or not, the onus lies on us. Saving requires a meticulous planning. It has to form like a habit which slowly becomes a part of our life. Saving sends out positive signal to the lender that the borrower has the habit of saving. The lender is assured that the borrower will set aside a part of his pay check towards his saving. Below are some simple steps which will help in imbibing the art of saving Preparing a budget: We all have the habit of planning to save only after we are done with our expenses. We should do it the other way round. The first thing is to prepare a monthly budget. Write down the monthly net income, the income which were receive in hand after all the taxes and other costs are deducted from our pay stubs. Next, list down all the utility payments, rent, student loans, credit cards, food expenses, traveling expenses and any other monthly recurring expenses. Deduct the sum from the net monthly income. Additionally, look for ways by which unnecessary expenses can be reduced. Whatever residual income is left in hand is the income from which you can set aside for a monthly recurring saving. Saving is a calculated approach. There is a tight match between income and expenses in many households. The only way income can get ahead of expenses is to bring in more money or change your spending habits and avidly look for new savings sources. Find out how much you need to save: Saving for down payment is not like saving for a retirement account where you can make small contributions over a longer period of time. We need to save more at a lesser time. To fully understand how much we need to save, we will need the assistance of a professional mortgage broker. Generally speaking, your combined debt to income ratio which includes the proposed PITI and all other expenses should not exceed 35%. We have earlier discussed that lender’s mostly provide an LTV of about 80% - 85% which means that down payment will be around 15% - 20%. In today’s tight lending market, you should generally expect to make a 20 percent down payment on a house. It is just the minimum down payment to get the best-priced deals. You can surely put down less of down payment, however, you will have to compensate with a higher interest rate. Set a realistic time frame: Buying own house is a long cherished dream for all. It requires a lot of planning. Now that our mortgage broker has provided us with the required down payment, we should plan on how we want to buy the house. If the total down payment is $40000 in 4 years, you need to save $10000 every year which when further broken down into months, we arrive at $833.33 per month. Once we start saving $833.33 per month for next 4 years, we will be able to build a corpus which we can utilize in our down payment. Cash reserves:  Another very important factor to keep in mind is cash reserves. A robust cash reserve acts as a cushion during times of surprise expenditures. It is recommended to every homebuyer to have at least 12 months of cash in reserves once down payment and closing costs are paid.  For example, if you are buying a home with a monthly payment of $1,000, it would be a terrific idea if you have at least $12,000 as cash in hand or cash reserve.  There is a reason behind this logic.  Home ownership can often lead to unexpected expenses for maintenance and repair of the property. These are the expenses for which you are not forewarned. One can defend this argument by stating that the home warranty protects a home owner from any surprise maintenance and repair costs of owning a home, however, the fact remains that home warranty does not cover everything.   Household & foundation repairs, cost of insurance deductibles for major losses which are not covered by home warranties can definitely leave one poorer by a few thousand dollars.  ­Additionally, setting up a direct deposit with the employer is another great way to start saving. The money will be automatically deducted by your employer. Another way is getting the family involved. Family members can provide better insights and can also contribute in curtailing expenses. 3) Establishing credit Before we discuss how to establish credit, let us first understand what credit is. Credit is the ability of a customer to obtain goods or services before payment, based on the trust that timely payment will be made in the foreseeable future. Trust is not something which can be built overnight. One has to establish a history of good credits. Let us look at how the credit industry works in the United States of America. Any credit that is lent to an individual has to be reported to the credit repositories. Credit repositories are the storehouse of credit data. These repositories are also known as credit bureau. Currently, there are 3 primary credit bureaus namely Equifax, Experian and Trans Union. Whenever someone procures a credit card or any instalment debt or any credit for that matter, it is immediately reported to anyone of the 3 credit bureaus. These credit bureaus are notified of every transactional activity. Any late payment, any bankruptcy or any foreclosure is automatically captured and stored in the bureaus. All the transactional activity and history stored in the 3 credit bureaus are merged together and a report is generated which is known tri-merged credit report. Basis on the repayment track record, every credit report is given a score which is known as FICO score. The better the repayment track had been, the higher the FICO score will be. If you fail to make payments on your credit on time, it negatively affects your FICO score. A FICO score ascertains the payment character of the borrower. A FICO score of 700 or higher is generally considered to be a good credit score. Whenever someone applies a mortgage application, the lender will pull the credit report of the borrower from the credit bureaus by referring to his SSN number, address and name. Once the lender receives the credit report, the FICO score will determine how much of credit will be made available to the borrower along with the allowable limit for Debt to Income calculation. FICO score of the credit report plays a pivotal role in determining the fate of your home ownership dream. Hence, it becomes very pertinent for us to maintain a good FICO score. There are several methods to establish and maintain credit. Credit card – For a first timer, it is always advisable to apply for a student credit card or a secured credit card exclusively for people with little or no credit. Timely & full payments – Always make full payment of your credit card bills. Paying the minimum amount due is always tempting but the lender will charge compound interest on the remaining due amount. Lest to say, make your payments on or before the due date. Even a day late is reported by the lender to the credit bureaus. Minimal utilization – Every now and then, we might have the tendency to utilize all the available credits which is strictly a no-no. We should make minimal use of our credit limit. A good use will be between to 10% to 30% of the available credit. Credit inquiries – One thing about which not many are aware of is the credit inquiries. Whenever we seek credit, an inquiry is generated and it hits the credit bureaus. Any inquiry which did not result in lending credit is considered a hard inquiry. Excessive inquiries project a bad image about the borrower. It means that the borrower had been shopping for credit but he has been rejected. Bad debts – Last but not the least, if at all you are unable to pay your credit payments on time better contact the lender and work on a repayment plan rather than stopping to make any payment. A repayment plan provides with a breather to the borrower to start credit anew. 4) Creating and maintaining a budget It is a common practise for all to plan to save at the start of a month; however, when we reconcile our savings at the end, we find that all our savings have been superseded by our expenses. Most often, professionals who make a decent salary cannot get out of the vicious cycle of living from pay check to pay check. So, where are their monies going? The main problem is people are not tracking where all the money is going. So, how do we get out of this tricky situation? The solution is creating and maintaining a detailed budget, an itemized description of income and expenses. No matter how noble our intentions are, without a creating and maintaining a proper budget, we will never be able to save. We will discuss a few effective steps which will help immensely in creating and maintaining an effective budget tailored as per our requirement. Identifying income The first step is identifying and listing down all income that you receive from various sources. For example, salaries and wages, social security benefit, royalties, child support, rental income etc. It would be wise to be conservative and not consider sporadic income, income which is not regular and stable. Remember, the golden rule that any income which has a paper trail is worth considering. Classifying expenses The next step will be classifying all your expenses. We all have expenses which are fixed expenses like mortgage payments, taxes, insurance, instalment loans, student loans and we also have variable expenses. Utilities, credit card bills, medical bills etc. are some of the variable expenses. Then we have expenses which are neither fixed nor variable. Expenses like vacations, movies, gifts, dining out are all expenses which can be categorized under miscellaneous expenses. Comparison of income v/s expenses Next step would be to sum up all the expenses and income and make a comparison between both. Ideally, the expenses should be less than the income so that a certain amount of the income can be siphoned as saving. If the expenses are higher than the income, it is a matter of concern and it calls out for reworking on the budget. The damage control plan The third step would to implement a damage control plan. There is no way we can have an immediate change in the income, the only component that can be changed is the expense. Among the expenses, the fixed expenses like taxes, insurance, instalment loans cannot be altered. The focus should be on the variable and miscellaneous expenses. Look for items that are luxuries in the guise of needs. If your mission is to save every dollar, it would be wise to skip the weekly dining out with the family at your favorite restaurant. Start enjoying a family dinner in the confines of the house. There has to be sacrifices made like doing the household work on your own rather than hiring someone for it. Set realistic goals Once you have made a comparison and made a robust plan of curtailing your expenses, set a goal which you want to achieve. Keeping a target of bringing down the expense by 90% at the first go would be too adventurous. Rather, you should keep realistic achievable goals which can be achieved and slowly raise the bar. Monitor your progress Time to time, you should analyse the performance of the damage control plan to find whether it is yielding results or not. The real motive in implementing the plan is to curtail the expenses and bring it lower than the income which should eventually result in savings. A paradigm shift in the expense income ratio reflects a successful planning. However, if you observe that your situation is still the same since the time the plan was put into effect, you should reflect back and reconsider and redo all the calculations. You will need to complete a root cause analysis and identify the loopholes through which the dollar amounts are trickling. You will have to do further more adjustments on your variable and miscellaneous expenses and forgo the trivial ones.