A Real-world Scenario

Let’s take all the information we presented in the previous section and connect it to a real-world scenario to see how someone gets prepared to take on a mortgage for a house.

Meet Johnny Smith. He is 25 years old, single, and his S.M.A.R.T. goal is to:

Buy a 3 Bedroom 1 Bath house for $200,000 with about a ¼ acre of land, within a 10 mile radius of where he works that is close to outdoor recreational activities, in 2 years with a mortgage of no more than $1320 a month. 

Johnny has his first job out of college making $40,000/year, and:

• Currently lives at home
• Has a credit score of 590
• Owes $2,000 in credit card debt
• Has a $20,000 student loan
• Owns his car outright
• Has $1,000 in a savings account

He schedules a meeting with a Mortgage Officer to see if he can buy a house he likes in town.

The Mortgage Officer evaluates the information he submitted including his credit report and suggests that Johnny:

• maintain or increase his income for 2 years
• increase his down payment to at least $10,000
• increase his credit score to 700
• lower his debt it income (DTI) ratio below 40%

He told Johnny to pretend he was looking over his shoulder with every financial decision he made for the next 2 years. If Johnny could make progress in these areas, the Mortgage Officer said he could buy a house for $200,000 on his own in two years.

Johnny needs to set a budget with his new goal in mind, but first he needs to analyze his situation and specifically tell his money where to go.

Income 

A lender will look at the Gross Income for the Debt to Income Ratio (DTI), but Johnny will need to use the Net Income to prepare his budget:

Gross Income =  $3333.33/month ($40,000/12 months)

Net Income = $2933.04/month (12% tax deducted from the gross income)

If Johnny likes his job and the company he works for, he should work to increase his value at the company and increase his income. He could also add in a part time job or side hustle to increase his income.

Expenses 

Housing is typically the largest expense, and since Johnny currently lives at home – he has a major advantage. His parents don’t charge him rent, which will allow him to save the majority of his income. His other monthly expenses include:

$70 Cell phone

$100 Gas

$75 Car Insurance

$200 Student Loan Payment

$60 Credit Card Payment

$200 Contribution towards food at the house

$200 entertainment.

Total Monthly Expenses = $905

 

Monthly Cash Flow = $2028.04 ($2933.04 Monthly Net Income – $905 Monthly Expenses). This means after Johnny’s monthly expenses, he has $2028.04 extra dollars that he can use to pay down debt and save for his down payment.

 

Debt & Saving

Johnny’s current debt includes:

• $2,000 on a credit card at a 14.99% APR
• $20,000 student loan at 3.99% APR

He was paying the minimum payment of $60 per month on his credit card, and since his student loan is in deferment for 1 year he is making no monthly payment.

Based on the Monthly Cash Flow of $2028.04 that Johnny calculated in the previous section, he could pay his credit card off within one or two months. He could also save some more money for his down payment since his student loan is deferred. Once his credit card is paid off, he will likely want to start making payments on his student loan.

 

Debt to Income Ratio

One of the criteria for obtaining a home loan was to get Johnny’s Debt to Income Ratio (DTI) below 40%. If Johnny pays off his credit credit, is making $200 per month student loan payment, and adds a mortgage payment of $1320 his monthly debt payment will be $1520:

• Monthly Debt: $200 + $1320 = $1520

In the Preparing a Budget section, we learned that Johnny’s monthly Gross Income was $3333.33, and the Loan Officer had asked Johnny to see if he could increase that amount. Let’s assume that Johnny has taken on a part-time job that brings in an additional $516.57 per month that brings his monthly gross income to  $3850. These two things will change Johnny’s DTI:

• Debt-to-Income Ratio: Monthly Debt Payment $1520/$3850 Monthly Gross Income= 39.5%

This brings Johnny’s DTI Ratio to below the 40% threshold that the Mortgage Officer requested.

 

Down Payment

The Mortgage Officer recommended that Johnny save at least $10,000 toward the down payment, and that works out to be $416.66 a month:

$10,000/24 months = $416.66 saved per month

At the onset of this goal, Johnny had $1,000 saved. He should keep that in place in case of an emergency and begin saving $416.66/month (or more) so that he will have $10,000 saved for down payment in two years.

With maximum potential cash flow of $2,028.04/month – he could save the $10,000 in only 5 months. At that pace for 2 years – he could save $48,000 for a down payment!

TIP: The more Johnny can save, the less money he will need to borrow from the bank, the less interest he will pay on the loan, and the lower his payment will be for the home.

 

Credit Score Change

To increase his credit score, Johnny should consistently:

• Make on-time payments on any debt
• Have low credit usage
• Maintain credit accounts long term to show established credit relationships
• Check his Credit Score periodically

He also doesn’t want to take out any new debt or have too many recent credit inquiries. By paying down his credit card, Johnny could increase his credit score and keep the account open.

He could also call his credit card company and request an extension of credit limit. This will further reduce his percentage of used credit.

 

Wrap Up

We just worked through a lot of numbers, formulas, and definitions! Please go back through the content so that you really understand the process and the criteria. Buying a house is one of the biggest financial decisions you’ll make.

Take what you learned from this section and look at your situation. Look at a house you’d like to buy and plug in the numbers into a mortgage calculator such as the DTI Ratio Calculator or Mortgage Calculator. Are you in a good financial position to buy a house? If a Loan Officer looked at your income, expenses, debt, and credit score – what would he or she recommend?

If you are looking to become a homeowner, and apply what you learned in this section, chances are you will be in good shape to finance a mortgage!

 

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