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Financial Literacy: Mortgages

This guide discusses topics related to financial literacy

What Can You Afford?

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According to the U.S. Census Bureau, the average cost of a new home (including land) in December 2013 was $311,400 and the median cost was $270,200. Not many people have that much money on hand, which makes a mortgage essential. You must first ask yourself what you can afford. How does a mortgage fit into your budget? One tool that lenders use to determine how much individuals can afford is called the debt-to-income ratio. Lenders will look at both your front-end ratio and your back-end ratio.

The front-end ratio tells them what percentage of your income will go toward mortgage payments each year; this includes the principal, interest, insurance and taxes. A good rule of thumb is that the front-end ratio should not exceed 28%. For example, if you make $40,000 a year, your monthly mortgage payments should not exceed $933: (40,000 * 0.28) / 12 months = $933.33

The back-end ratio tells investors how much of your total income is needed to fulfill all of your debt obligations. This includes your mortgage, car loans, student loans, credit card bills, etc. This ratio should not exceed 36%. Using the example from above, your total debt payments should not exceed $1,200: (40,000 * 0.36) / 12 months = $1,200

A lender will also look at a potential buyer’s credit score. The higher the score, the easier it is to get a mortgage.

 

Check out the Census Housing Survey data in American FactFinder or City-Data.com to determine average housing costs for the city in which you’ll be living.

What's a 30-Year Fixed Rate Mortgage?

The most common type of mortgage is a 30 year fixed rate mortgage. This means that a homebuyer makes monthly payments to the bank for 30 years before they actually own the home. “Fixed rate” means that the interest rate will never change during the 30 year period. Because the homebuyer does not own the house, should he or she fail to make payments the bank can reclaim the property and sell it in an effort to make back the money it loaned the homebuyer. This is known as foreclosure.