In Part 1 of this post we explored some of the concepts and terms you’ll encounter when taking a mortgage. Once you get past the lingo, here comes the real question: how much house can you afford? In the case of a mortgage it is especially important you consider this question carefully, because unlike other personal loans, which are for relatively short periods, a mortgage spans 20-25 years on average and could be your single largest loan.
It’s a tough balance because you want to choose somewhere you’d like to live for many years, while trying to make sure you can afford to pay for it over the long loan term. There are also ancillary costs involved and we’ll identify a few of these as well.
Only your budget matters
What we’ve found is many people rely on a lender to tell them how much loan they qualify for. But as we discussed in both posts, YOU need to determine how much you can afford before approaching a lender. The only way to do this properly is by referring to your budget.
If you used our Cari$ Sample Budget spreadsheet, you would now have your budget laid out in four sections: Income, Fixed expenses, Discretionary expenses, and Savings. If you applied our 33/33/33 approach, you would be trying to keep your Fixed expenses to 33% of your after-tax income. Remember, Fixed expenses do NOT only include loan payments. It includes ANY expenses that you have little control to vary or reduce.
If none of this sounds familiar, you’ll probably have to read the posts we linked to above so you can understand properly.
The idea is, whatever loan size you ultimately decide on, the payments have to fit within the 33% allocation. If it cannot, then either the home you want is too expensive or the loan size is too large for you to comfortably manage.
But please read the last section below, “Varying the 33/33/33 approach”.
Payments under different scenarios
One of the more common mistakes in making a home loan decision is basing that decision solely on your circumstances today. If you take a 3-year personal loan, sure we could understand you’ll only focus on your ability to repay today, but mortgages have two challenges:
- They span the majority of your working life
- Most are variable rate, which you would remember from Part 1 of this post means, the lender has the right to eventually re-set the rate when interest rates move
So you should really work out what your payment range could be under these scenarios:
Firstly, work out how much you can afford based on your current budget – don’t change anything other than including the new loan payment. This means, if your existing income remains unchanged and your lifestyle remains the same (so your expenses are the same), how much house can you afford based on your current circumstances. Don’t forget you can use our Cari$ Loan Calculators to help.
Next, think about the worst realistic event that can happen and change your budget to reflect this event. Then, see how much loan you can afford.
We suspect you may think the worst event could be job loss. If so, be realistic – at least assume you’ll get a replacement job at a lower income. But the “worst” event would depend on individual circumstances e.g. supposed you have elderly parents whom you may have to eventually support, or what would happen if they become ill? We hope you get the point.
While we do not recommend relying on this situation, you should evaluate if there are any favourable events that could arise e.g. salary increases, new job, an expense that would no longer be incurred, etc.
We find it useful to know if lady luck smiles on you, how much additional loan you could take. Of course, only you can decide whether the good luck event is actually possible. If you aren’t convinced, it’s better to leave it out.
We think the fourth scenario is the most important, so let’s discuss it separately: interest rates.
Changes in interest rates
The biggest issue to tackle is, you are dealing with a moving loan target: when interest rates change, your loan payment will eventually change. Of course, it’s fine if it goes down, but as of now, this is not going to happen realistically. The real problem is, therefore, can you afford the loan payment when interest rates go up?
Most home loans in the Caribbean are variable rate mortgages. Yes, you could get a loan that is fixed for a short period, but it is ultimately re-set at some point in time. So Financial Freedom Fighters, you MUST consider what your loan payment would be at different higher rates and then see if your budget can afford it.
Fear not! CariDollarsAndSense is here to help! You can use the loan calculator below.
The first part below should be familiar from the post Learn To Use Cari$ Loan Calculators. It shows you how to estimate your loan payment. Go ahead and make changes to the blue shaded cells and see the loan payments calculated.
The additional part below builds on the above calculator by calculating for you what your payment (etc.) would be under different interest rate scenarios. This is also available in the Tools section.
Just enter the rate you’d like to start with in the blue shaded cell. The green shaded cells give you the results.
Using the example shown, sure, you might be able to afford to pay $3,624 monthly based on an interest rate of 8.5%. But can you afford to pay $4,249 if rates increase to 10.5%?
The point to note here is that it is impossible to predict how or when interest rates can change, so all you can do is, don’t panic, have your eyes wide open, and plan for it as best as you can.
Borrowers are required to make a down-payment toward the purchase, but the amount would vary from lender to lender.
This is an important variable in your home loan because the higher your downpayment, the lower your loan amount, and consequently the less interest you’ll pay over the life of the loan.
While the monthly loan instalment will obviously be the largest payment you need to plan for, there are other costs that new homeowners should be aware of when deciding how much they can afford. Your lender should be able to give you a list. Make sure and ask for it and triple confirm that it is complete. You really need to know what is the all-in cost of your mortgage.
Here are a few examples:
- Lender fees: Application Fee, Commitment Fee, etc. These one-time upfront fees vary by lending institution
- Valuation report. The bank will most likely require an up-to-date valuation report but there is no consensus whether the buyer or seller is required to pay for this
- Title Search Fee. It would depend on the property type and complexity of the search
- Stamp Duty On Deed Of Conveyance – see below
- Stamp Duty On Mortgage Deed
- Legal fees for the deeds
- Owner’s life insurance. Lenders may require that homeowners take out a life insurance policy to ensure that the loan can be repaid in the event of the borrower’s death
- Building insurance. Lenders also require that you fully insure the property
- Prepayment penalty. While this is not a current payment, it is something you need to bear in mind if it applies; make sure you understand the rules
Stamp duty on deed of conveyance
Essentially this is a fancy name for a transfer tax when property ownership changes, and given the potential large outlay, we thought it best to identify it separately.
The buyer is usually responsible for paying the tax but negotiation between buyer/seller is always possible. To make it simpler, we created below a calculator for Trinidad transfer taxes. This is also available in the Tools section.
Go ahead and try it by entering the purchase price for your home in the BLUE shaded cell:
Varying the 33/33/33 approach
As much as we hate to say it, you may need to consider changing our 33/33/33 approach, because the reality is homes are expensive, probably too expensive given the current economic environment. This means, if you are convinced that buying a home is the right approach for you, then you may need to consider temporarily increasing the 33% allocation to Fixed expenses, assuming saving a larger down payment is not an option.
The big BUT is that it entirely depends on your level of discipline. Let’s say you start at 40%. Your goal should be to reduce to 33% as soon as you can in order to meet your targeted level of savings (33%). So it just means you need to continually tweak your budget by not spending any new income you receive or reviewing expenses continuously to reduce them – these tweaks should get you back down to 33%.
You’ll still need to work though the scenarios we described above, but ultimately you may decide you have no choice but to commit temporarily to a higher Fixed expense percentage. Once this is a conscious decision, then no problem. But your number one priority should then be to reduce this to 33% as soon as possible. Why? Because we want to sleep stress free. The only way to do that is to ensure that you can comfortably manage all your Fixed payments.
We hope you now feel empowered to make a good mortgage decision! If you have questions or comments, we’d love to hear from you in the comments below.
Best of luck in your new home search!