Suppose you work through your budget and determine that you can afford to spend $2,000 per month on housing. Determining the exact size of a mortgage that allows you to stay within this boundary may seem daunting, because your overall housing cost is comprised of several components: mortgage payments, property taxes, insurance, and maintenance (and association dues if the property is a condominium or has community assets like a swimming pool).
Using Appendix A, you can calculate the size of your mortgage payments based on the amount you want to borrow, the loan’s interest rate, and whether you want a 15- or 30-year mortgage. Alternatively, you can do the same calculations by using many of the best financial calculators available for less than $50 from companies like HP and Texas Instruments. (In Chapter 8, we discuss the ubiquitous online mortgage calculators, which are often highly simplistic.)
Some people we know believe they can handle more mortgage debt than lenders allow using their handy-dandy ratios. Such borrowers may seek to borrow additional money from family, or they may fib about their income when filling out their mortgage applications.
Although some homeowners who stretch themselves financially do just fine, others end up in financial and emotional trouble. You should also know that because lenders usually cross-check the information on your mortgage application with IRS Form 4506T (the lender receives your actual tax return you filed, which certainly didn’t overstate your income), borrowers who fib on their mortgage applications are caught and their applications denied.
So although we say that the lender’s word isn’t the gospel as to how much home you can truly afford, telling the truth on your mortgage application is the only way to go. It may be painful to learn that you don’t qualify for the loan you need to purchase that home of your dreams, but you’re likely better off in the long run not overextending yourself with mortgage debt.
We should also note that telling the truth prevents you from committing perjury and fraud, troubles that catch even officials elected to high office. Bankers don’t want you to get in over your head financially and default on your loan, and we don’t want you to either.
As you’re already painfully aware if you’re a homeowner now, you must pay property taxes to your local government. The taxes are generally paid to a division typically called the County or Town Tax Collector.
Property taxes are typically based on the value of a property. Because property taxes vary from one locality to another, call the relevant local tax collector’s office to determine the exact rate in your area. (Check the government section of your local phone directory to find the phone number or search for the name of the municipality and “property tax” online.) In addition to inquiring about the property tax rate in the town where you’re contemplating buying a home, also ask what additional fees and assessments may apply. In California, many recently developed areas have special assessments (such as Mello-Roos districts), which are additional property taxes to pay for enhanced infrastructure and amenities, such as parks, police/fire stations, golf courses, and landscaped medians.
If you make a smaller down payment – less than 20 percent of the home’s purchase price – your lender is likely to require you to have an impound account (also called an escrow account or reserve account). Such an account requires you to pay a monthly pro-rata portion of your annual property taxes, and often your homeowners insurance, to the lender each month along with your mortgage payment. The lender is responsible for making the necessary property tax and insurance payments to the appropriate agencies on your behalf. An impound account keeps the homeowner from getting hit with a large annual property tax bill.
Now is a good point to pause, recognize, and give thanks for the tax benefits of homeownership. The federal tax authorities at the Internal Revenue Service (IRS) and most state governments allow you to deduct, within certain limits, mortgage interest and property taxes when you file your annual income tax return.
You may deduct the interest on the first $1 million of mortgage debt as well as all the property taxes. (This mortgage interest deductibility covers debt on both your primary residence and a second residence.) The IRS also allows you to deduct the interest costs on additional borrowing known as home equity loans or home equity lines of credit (HELOCs, see Chapter 6) to a maximum of $100,000 borrowed.
To keep things simple and get a reliable estimate of the tax savings from your mortgage interest and property tax write-off, multiply your mortgage payment and property taxes by your federal income tax rate in Table 1-1. This approximation method works fine as long as you’re in the earlier years of paying off your mortgage, because the small portion of your mortgage payment that isn’t deductible (because it’s for the repayment of the principal amount of your loan) approximately offsets the overlooked state tax savings.
TABLE 1-1 2017 Federal Income Tax Brackets and Rates
When you own a home with a mortgage, your mortgage lender will insist as a condition of funding your loan that you have adequate homeowners insurance, which includes both casualty and liability coverage. The cost of your insurance policy is largely derived from the estimated cost of rebuilding your home. Although land has value, it doesn’t need to be insured, because it wouldn’t be destroyed in a fire. Buy the most comprehensive homeowners insurance coverage you can and take the highest deductible you can afford, to help minimize the cost.
In years past, various lenders learned the hard way that some homeowners with little financial stake in the property and insufficient insurance coverage simply walked away from homes that were total losses and left the lender with the loss. Thus, in addition to sufficient casualty and liability insurance, lenders require you to purchase private mortgage insurance if you put down less than 20 percent of the purchase price when you buy. This is risk insurance that protects the lender by making the mortgage payments to the lender if you’re unable to. This could be because you have a loss of income whether from a job loss or an injury/illness.
As you budget for a given home purchase, don’t forget to budget for the inevitable laundry list of one-time closing costs. In a typical home