real estate

Save for a House

How much you’ll need and what to expect when you apply for a mortgage.

Before lenders will approve you for a mortgage, they want some assurance that you aren’t going to default on the loan—that you have enough income to pay your mortgage, enough savings for a down payment and closing costs, and a good credit history. The better your credit profile and the bigger your down payment, the lower the interest rate for which you’ll qualify. (In early April, the average 30-year fixed rate was 4.3%.)

Lenders size up your “three c’s”—credit history (your credit score and your record of debt repayment), capacity (income, savings and investments) and collateral (your down payment and the value of the home you want to buy, after an appraisal). They verify employment for the past two years and try to predict how likely it is that you’ll keep your job. If you’re weak in one area, strength in the other two or in a spouse’s profile may compensate.

To figure out how big a mortgage you can afford, lenders apply payment-to-income ratios. (The majority of banks and credit unions sell the mortgages they originate to Fannie Mae or Freddie Mac—agencies that guarantee the loans made by lenders—and follow their rules.) Your monthly mortgage payment shouldn’t exceed 28% of your monthly gross income (before taxes and other deductions). That 28% limit covers principal and interest, real estate taxes, homeowners (hazard) insurance, and homeowners or condo association dues.

Recurring monthly payments for all debts (including student loans, even if they’re deferred) shouldn’t exceed 36% of your monthly gross income. The Federal Housing Administration (FHA), another loan guarantor, bumps up the ratios for mortgages and all debts to 31% and 43%, respectively (it doesn’t include student-loan payments that are deferred for a year or more).

Probably the greatest challenge for would-be home buyers is saving for the down payment. Fannie Mae and Freddie Mac require a minimum down payment of 5% to 10% of a home’s purchase price. In early 2014, 10% down on a median-priced home in the U.S. would have required nearly $19,000. Put down less than 20%, though, and you must pay for private mortgage insurance. The FHA allows down payments as low as 3.5% but requires that you pay upfront and annual insurance premiums.

If you’ve been stashing money in a traditional IRA, you can withdraw up to $10,000 penalty-free for a first-time home purchase (you’ll owe taxes on 100% of the withdrawal unless you’ve made nondeductible contributions). You can always withdraw your contributions to a Roth IRA without penalty or taxes, and you can take up to $10,000 of earnings penalty-free for a first-time home purchase. If your Roth has been open for at least five years, those earnings are tax-free, too.

Or you can generally borrow up to half of the balance of a 401(k), up to a maximum of $50,000, for any reason. The interest you pay on the loan goes back into your account. Your employer may give you up to 15 years to repay the loan if you use the money to buy a home, and the loan doesn’t count in the debt-to-income ratio.

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