OCTOBER 2007 :: COVER STORY : PERSONAL FINANCE

Loan, Sweet Loan
Understanding These Mortgage Basics May Keep You Out of Trouble

For most Americans, buying a house is the largest purchase they'll ever make; the price of an average home in the U.S. is about $250,000. Moreover, they'll be paying off this purchase for as many as 30 years, more than one-third of the average life expectancy.

›Adapted from "The Wall Street Journal Complete Personal Finance Guidebook," by Jeff D. Opdyke. Copyright 2006 by Dow Jones & Co. Published by Three Rivers Press, an imprint of the Crown Publishing Group, a division of Random House.

For many people, this asset will turn out to be one of the best investments ever, because land prices historically rise over time and because the government essentially helps you pay for your house by offering tax breaks on the interest you pay and on the profits you earn when you sell.

Not everyone wants to or should be a homeowner. For short periods of time, renting can make much more sense than buying because buying and owning a house involves a long list of expenses, from loan origination and legal fees to title insurance and private mortgage insurance if you can't come up with at least a 20% down payment. Then when you go to sell, you have more fees to pay. All those fees can diminish, or even wipe out, any profit you might have earned by selling your house.

Over the long haul, however, it's hard to argue against buying a place. While rent is spent money, homeownership creates wealth over time even if you buy at the top of the market. Prices might fall or stagnate at some point, but over a long stretch of time, your house is almost certain to rise in value simply because of inflation.

Here are some basic concepts you should understand before taking on such a large purchase:

WHAT CAN I AFFORD?

Before digging into the question of what you can afford, let's step back to understand what a mortgage is, how it works, and the two basic types that exist. After all, the real question isn't how much house you can afford, it's how much mortgage you can comfortably pay each month.

Every mortgage has three traits: size, term and rate.

Size refers to the amount of dollars you need to borrow to buy the house you want.

Term is how many years you will take to repay those dollars. The most common fixed-rate mortgages are for terms of 15 and 30 years. Adjustable-rate mortgages, meanwhile, are fixed for anywhere from one to seven years, before their rate begins to float for the remainder of the mortgage term.

Rate represents the annual interest rate the lender charges you for borrowing the money. Fixed-rate mortgages maintain the same interest rate over the term of the loan; adjustable-rate mortgages fluctuate annually, generally, though some adjust as frequently as every 30 days. (Which is better? See sidebar.)

This is how size, term, and rate come together to determine how much the house will cost you, and how much borrowing you can afford: Let's say you want to buy the average American house for $250,000 at a time when interest rates on 15-year and 30-year fixed-rate loans are 4.9% and 5.4%, respectively. With the 15-year loan, your monthly payment is $1,963.99. With the 30-year, your monthly payment is $1,403.83. The 30-year is cheaper, right?

Not so fast. You're paying that $1,403.83 over 360 months. Thus, you'll spend a total of $505,378 to buy a house with a price tag of $250,000. In contrast, you'll pay just $353,518 over the life of the 15-year loan, a savings of $151,860. In short, a shorter-term loan costs more per month, but saves you money over the long haul; a longer-term loan means you have a smaller payment, and you can afford more house, since $1,964 over 30 years would buy you a $350,000 home instead.

WHAT WILL A LENDER LEND ME?

Mortgage companies examine two particular ratios in calculating how much house they think you can afford:

Front-end ratio is your total monthly mortgage payment divided by your monthly gross income. In general, the industry figures that no more than 29% of your gross income can be allocated to mortgage expenses, which include payments for principal, interest, taxes and insurance, or "PITI"-since those expenses constitute the ongoing cost to keep the home. If you earn $60,000 a year, or $5,000 a month, your PITI shouldn't exceed $1,450 ($5,000 x 0.29 = $1,450).

Back-end ratio is your total monthly debt payments divided by your gross monthly income. The industry guideline is generally in the 41% range. Total debt includes the PITI you're looking to assume as well as monthly credit-card payments, car loans, student loans and such. With $5,000 in monthly gross income, your back-end total cannot exceed $2,050 ($5,000 x 0.41 = $2,050).

Now, just because a lender or a real-estate agent says you can afford the Taj Mahal based on your income, that doesn't mean you should buy that much house. Lenders and real-estate agents have a vested interest in your buying as much house as possible, because their fees are based on the price of the house and the size of the loan. But only you know how truly comfortable you will be with the larger mortgage payment every month.

CLOSING COSTS

Buyers sometimes are so consumed by the purchase price that they don't think about all the extras they're responsible for when buying a home. Those costs can add up. Here are a few:

• Points or loan-origination fees. These are fees you owe the lender for providing the loan. Points are actually percentages, so "two points" means 2% of the loan amount. The fewer points you pay, the higher the interest rate you're charged.
• Property taxes. No matter what time of year you buy a home, you're going to owe some amount of property taxes to keep yourself current until the next set of municipal tax bills go out. Note that property taxes are generally wrapped into your monthly mortgage payment and are paid for you by the company that services your loan.
• Escrow fees. These will cost anywhere from a few hundred to a few thousand dollars. Escrow is simply an account where all the money you put down on a home is kept while you and the seller negotiate terms of the home sale.
• Homeowner's insurance. Your lender typically will require that you pay for an entire year's worth of insurance coverage upfront. After that, your insurance premium will be wrapped into the monthly mortgage payment, and the loan-servicing company will renew your policy each year. Both the insurance and tax portions of your mortgage payment go into a separate account that is used to pay the taxes and premiums.
• Title insurance. This is another lender-mandated cost. This type of insurance policy ensures that the house you're buying can legally be bought. Title companies search various city and county records to make sure no one else has any ownership claim to your house; the insurance protects the lender just in case.
• Notary fees, courier fees, overnight fees, copy fees and so on. You'll be surprised at how many little fees pop up on the final sale documents, ranging from $25 to a few hundred dollars. People want to be paid for their small part of your homeownership dream.