- Your house payment and other debt should be below 36 percent of your gross monthly income.
- Your house payment alone (including principal, interest, taxes, and insurance) should be no more than 28 percent of your gross monthly income. The maximum debt-to-income ratio rises to 42 percent on second mortgages. Some lenders go even higher, though fees and rates get expensive – as will your monthly payment. However, a debt-to-income ratio of 38 percent probably is the highest you should consider carrying.
The less interest you pay, the more loan you can afford
The LTV determines how much you can borrow, and your debt-to-income ratio establishes the monthly payment for which you qualify.
Interest rates. An adjustable-rate mortgage (ARM) is one way to lower that rate, at least temporarily. Because lenders aren’t locked into a fixed rate for 30 years, ARMs start off with much lower rates. But the rates can change every 6, 12, or 24 months thereafter. Most have yearly caps on increases and a ceiling on how high the rate climbs. But if rates climb quickly, so will your payments.
Loan term. The longer the loan, the lower the monthly payment. But total interest is much higher. That’s why you’ll pay far less for a 15-year loan than for a 30-year loan – if you can afford the higher monthly payments.
Points. Each point is an up-front cost equal to 1 percent of the loan. Points are interest paid in advance, and they can lower monthly payments. But if your credit is less than perfect, you’ll probably have to pay points simply to get the loan.
What Are the Options?
Loan shopping often starts with mainstream mortgages from banks, credit unions, and brokers. Like all mortgages, they use your home as collateral and the interest on them is deductible.
Unlike some, however, these loans are insured by the Federal Housing Administration (FHA) or Veterans Administration (VA), or bought from your lender by Fannie Mae and Freddie Mac, two corporations set up by Congress for that purpose. Referred to as A loans from A lenders, they have the lowest interest. The catch: You need A credit to get them. Because you probably have a mortgage on your home, any home improvement mortgage really is a second mortgage. That might sound ominous, but a second mortgage probably costs less than refinancing if the rate on your existing one is low.
Find out by averaging the rates for the first and second mortgages. If the result is lower than current rates, a second mortgage is cheaper. When should you refinance? If your home has appreciated considerably and you can refinance with a lower-interest, 15-year loan. Or, if the rate available on a refinance is less than the average of your first mortgage and a second one. If you’re not refinancing, consider these loan types:
Home-equity loans. These mortgages offer the tax benefits of conventional mortgages without the closing costs. You get the entire loan upfront and pay it off over 15 to 30 years. And because the interest usually is fixed, monthly payments are easy to budget. The drawback: Rates tend to be slightly higher than those for conventional mortgages.
Home-equity lines of credit. These mortgages work kind of like credit cards: Lenders give you a ceiling to which you can borrow; then they charge interest on only the amount used. You can draw funds when you need them – a plus if your project spans many months. Some programs have a minimum withdrawal, while others have a checkbook or credit-card access with no minimum. There are no closing costs. Interest rates are adjustable, with most tied to the prime rate.