For those of you just joining the “Buying a House in 2008″ series, I have recently been going through the process of purchasing a house for my wife, daughter and myself. It is our first house so instead of hoarding all of our newly acquired knowledge it made sense to share the lessons I have learned with the readers of Schaefer’s Blog, many of whom I know are getting ready to purchase their first homes soon as well.

The point of Schaefer’s Blog is to share lessons in skilled living. Since buying a house is the single largest purchase most of us will ever make, knowing how to do it well is a great skill to have. A couple weeks ago I wrote about what I had learned in determining how much of a house you can afford. Today, I present a quick and dirty guide to the most common types of home loans and the pros and cons of each.

A home loan, also called “mortgage” is simply the money you get from a bank or lender to bridge the gap between the amount of money you can pay for the house and the amount the house actually costs. There are endless types of mortgages from the basic to exotic. Much of the current mortgage crisis has to do with people choosing unusual home loans that they didn’t really understand or couldn’t afford. The loans I cover are the basics, by no means a comprehensive guide, but a good starting place for those looking to finance a home purchase.

VA Loan - I throw this in because I’m in the military as are many of my friends. The VA (Veteran’s Affairs) loan is designed for qualified veterans, reservists and active-duty members and their eligible spouses. Many lenders like USAA make this option available and the benefits can be quite helpful. Here’s the official site.

Pros: No down payment needed to qualify and no mortgage insurance premiums. Also, the government limits the closing costs and origination fees lenders can charge.

Cons: VA loans have a funding fee, typically around 2% (can be lower if borrower puts 5% down). The maximum amount guaranteed by a VA loan is $240,000. While this is enough for many, in more expensive parts of the country it may not be enough.

Who Should Consider It: Any military member or spouse that qualifies who does not have money to put down on a house, or wants to use that money elsewhere and will be able to purchase their home without going over the $240,000 maximum.

Fixed Rate - A fixed rate mortgage is one in which the interest rate and monthly payments stay the same for the entire term of the loan. The most common terms are 30 years and 15 years, but many others also exist.

Pros: You never have to worry about your interest rate going up unexpectedly or your monthly payment changing in any way. No matter what the markets are doing your rate is locked in so you have peace of mind.

Cons: Peace of mind has a price. Interest rates on fixed rate mortgages are generally higher than the initial rates on an adjustable rate mortgage. Plus, if interest rates happen to go down significantly after locking in your rate you will lose money, either in opportunity costs or in paying the fees associated with refinancing your mortgage to get a lower interest rate.

Who Should Consider It: Anyone who like stability and is looking at living in their home for a longer period of time like 10 years or more.

Adjustable Rate (ARM) - An adjustable rate mortgage is one where the interest rate is initially fixed for a set term and is then allowed to float (follow the market rate) after the initial term is up. Every ARM has an adjustment margin which is the amount the lender adds to whatever index they follow for the market rate, so the market rate plus the margin is actually what you will end up paying in interest after the initial fixed term is up.

Pros: Lower initial monthly payments than a fixed rate mortgage.

Cons: Once the initial fixed term is up you must either refinance or risk paying higher payments if interest rates go up, both costing more money.

Who Should Consider It: Someone that plans on reselling their home within a short time after purchase. For example, if you are in the military and know that you’ll move every four years, a 5/1 ARM may make sense. The “5″ is the number of years the mortgage is fixed initially and the “1″ is the adjustment interval thereafter. A 5/1 would give you a lower monthly payment than that of a fixed rate.

Resources:
Mortgage New & Advice - Bankrate.com
Pick the Right Mortgage - Kiplinger.com
Mortgages - USAA.com
Which Mortgage is Right for You? - Interest.com
…and before you get too excited about the possibility of making loads of money off real estate check out my man Ramit Sethi’s posts on real estate…I’m not saying don’t buy a house, just don’t be stupid.

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Today marked the beginning of an exciting new adventure for the Schaefer family, buying our first house. We will be moving to Washington this summer where I will be flying C-17’s for the Air Force. We should be stationed there for at least 4 years, just long enough where buying actually makes sense.

For the past several months I have been studying home buying (trying to be one of Ramit’s other friends), reading books, blogs and asking questions to people who have some experience in the area. I’ve learned quite a bit, but realize there’s still much I don’t know. In an effort to share with my readers the info and advice that I pick up along the way, I present a new series of posts called Buying a House in 2008. The goal of this series is to share the lessons I learn as I go through the long and sometimes turbulent process of buying a house.

Figuring Out How Much You Can Afford

Trying to buy a house without knowing how much you can afford reminds me of the episode of Seinfeld where Kramer decides to see how far he can test drive a car on an empty gas tank…neither him nor the car salesman knew how far was too far. So, earlier today I decided to call up my bank and talk to someone about getting pre-approved for a loan. By doing this I would be better equipped to search for prospective properties. This call was absolutely free and did not place me under any obligations to the lender. What I learned was, aside from the basic information (estimated price range, where we’d be buying the house, etc.) the first thing the lender must determine is your debt to income ratio. This ratio shows what percentage of your income is available for a mortgage payment after all other obligations are met.

A commonly used guide is that the total amount you pay toward your mortgage should not exceed 28% of your gross income. This number is simply a rule of thumb and the percentage is often times much higher depending on circumstances. To calculate your debt to income ratio you must know your total income. This includes your salary and any other monthly payments you receive like dividends, interest, alimony or child support payments, etc. If you are married pool your spouse’s income with your own.

After adding up your annual income, divide this amount by 12 to determine your monthly income. Next multiply your monthly income by .28 which will give you the maximum monthly payment allowed for housing expenses (mortgage payment, insurance, taxes…known as PITI). The next number used by many lenders is 36%, the maximum percent of your monthly gross income the lender allows for your housing expenses plus additional recurring debt. To find this divide your monthly income by .36. As you navigate the loan process these amounts should help you understand how much you can afford and what to expect when you talk with your lender. **A note to my fellow USAFA grads that took “the loan” - this debt alone significantly effected this ratio, so be prepared.

Example:

Annual Gross Income = $50,000 / 12 = $4,167 monthly income

$4,167 Monthly Income x .28 = $1,167 allowed for housing expenses

$4,167 Monthly Income x .36 = $1,500 allowed for housing expenses plus recurring debt.

On the phone with my lender I was told that this ratio, along with a few other factors like additional liquid assets, job security and credit score help the lender determine the amount of money they are willing to loan you. This aspect of our conversation took up the first 30 minutes and was extremely informative and beneficial. The second 30 minutes included the various types of loans available to me such as VA, conventional, 5/1 ARM, etc., as well as the actual pre-approval of the loan. More on what I learned on this topic in the next post.