A rule of thumb is a guideline that applies to a specific situation. One example is only marry the girl whose foot fits the glass slipper. A feline rule of thumb or paw, perhaps is never enter a space thats narrower than your whisker span. The mortgage industry also has its own rules of thumb, many of which pertain to buying and refinancing
SEE ALSO: 7 Questions You Must Ask Neighbors Before You Buy
Borrowers and lenders often have different interpretations of how much mortgage
the homebuyer can afford. The rule of thumb is that an affordable mortgage should not be more than two or two-and-a-half times the homebuyers gross income. If your gross income is $50,000 per year, for example, you should be able to afford a property between $100,000 and $125,000.
Two mortgage rules of thumb that banks rely upon to determine mortgage affordability are principal, interest, taxes, and insurance (PITI) and the debt-to-income ratio (DTI). PITI is the front-end ratio, and represents the percentage of your annual gross income thats required to cover your mortgage payment. The rule of thumb is that it should not exceed 28 percent of your annual gross income. If your gross income is $50,000 per year, for example, your PITI should not exceed $14,000 a year, or $1,167 a month
DTI is the back-end ratio, and calculates the percentage of your annual gross income required to cover all of your debt, from PITI to credit cards and loans for college, to cars and child support. The general rule of thumb is that DTI should not exceed 36 percent of annual gross income. Thirty-six percent of an annual gross income of $50,000 is $18,000, so your monthly DTI should not exceed $1,500.
Traditionally, the down payment rule of thumb was a firm 20 percent of a homes price. During the housing boom, that guideline fell by the wayside; five percent, 10 percent, even zero down mortgages existed. But thanks to the 2008 mortgage crisis, 20 percent has picked itself up, dusted itself off, and is now the darling of many lenders once again. If you plan to purchase a home for $125,000, putting down $25,000 will satisfy most lenders, and net you better mortgage terms.
SEE ALSO: Pinging Your Credit Report: The Consequences
When To Refinance
Once upon a time, a rule of thumb for refinancing was to wait until rates drop at least 2 percent. Fees were a lot higher back then, so a larger interest rate difference was required if you were to recoup loan costs in a reasonable amount of time. Closing costs tend to be lower today, as lenders compete for the business of the most qualified homeowners. Nowadays, it often makes sense to refinance if rates are 1 percent lower than your current terms
. If you refinance $100,000 at five percent into a four percent mortgage, for example, your monthly payment will drop from $536.82 to $477.42, for a savings of $59.42 per month. If you spend $1,200 out-of-pocket for closing costs, youll break even in 20 months, and youll save more than $20,000 in interest
over the life of the loan.
The rule of thumb about rules of thumb is that theyre only guidelines. Different lenders and loan products may use different ones. Some lenders will accept a borrower with a PITI of 30 to 40 percent of his annual gross income. FHA loans
allow 31 percent PITI and a 43 percent DTI. You can also get an FHA loan with a mere 3.5 percent down payment.