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Can Use Don't bite off too much house
The classic formulas for mortgage affordability could lead you to disaster. Here's
how to get a better handle on what you really can afford.
By Liz Pulliam
Weston
Thirty years ago, first-time home buyers were often encouraged
to stretch as far as they possibly could to buy a house. Back then, that advice
made some sense.
Today, it can be a recipe for disaster.
A
too-big house payment can, at the very least, leave you with too little money
for other goals: retirement, vacations, college funds for the kids. At worst,
it can leave you vulnerable to foreclosure and bankruptcy.
What's more,
you can't count on your real estate agent, a mortgage loan officer, your friends
and family or an Internet calculator to know what you can really afford. That's
a decision you have to make yourself after reviewing your finances, your future
obligations, your goals and your gut.
Yet many first-time buyers are
still being pushed into mortgages that are bigger than they can handle, based
on old-fashioned advice.
Here's what's changed in the 30 years (or more)
since your parents bought their first house:
- Inflation.
Rapidly rising prices in the 1970s and early 1980s meant you could count
on hefty annual raises. Today, you can't rely on double-digit income boosts to
make your mortgage payment less of a burden each year.
- Two-income
couples. A generation ago, single-income families were more common.
If the breadwinner lost a job, the other spouse could go to work to save the house.
With more two-income families needing both paychecks to make the mortgage payment,
there's no one on the sidelines to take up the slack -- unless you put the kids
to work.
- The lending industry. Thirty years ago,
it was pretty tough to get a mortgage for more than you could really afford. Today,
it's fairly commonplace. More lenders have loosened their criteria, knowing that
the vast majority of their borrowers will do whatever it takes to pay their mortgage
-- even if it means trashing the rest of their financial lives.
- Retirement.
A much bigger proportion of the workforce was covered by traditional,
defined-benefit pensions 30 years ago -- which means they didn't have to save
massive amounts of money on their own to have a decent retirement. Today, the
onus is typically on you to carve enough out of your budget to fund 401(k)s and
IRAs.
Let's get real
So how much should you spend on a house?
The traditional way to calculate that is to add up all your income and make sure
that your housing expenses -- mortgage payment, homeowners insurance and property
taxes -- don't exceed a certain amount of that total. The traditional limit, still
used by many lenders, is 28% of gross monthly income. Some financial advisers
recommend capping your outlay at 25%; others suggest stretching to 33% or more.
These limits, by the way, apply only if you don't have a lot of other
debt. Most lenders don't want more than 36% of your total income to go toward
mortgage and other debt payments. If your total debt would push you over that
figure, most lenders will reduce the size of the mortgage for which you qualify.
Here's how the varying limits translate. The figures assume you earn
$45,000 a year and that you would pay $480 in homeowners insurance and $2,000
in property taxes annually. (In reality, those figures would fluctuate with the
value of the home you buy.) This also assumes a 30-year loan at 5.5% interest
and a big enough down payment that you'll avoid private mortgage insurance, or
PMI.
| How
large a mortgage can $45,000 a year get you |
| If share of income devoted to housing is: | The
monthly cash requirement is: | Less: taxes and insurance
… | … leaves cash needed to pay the mortgage … | …
and translates into this loan amount | | 25%
| $938 | $207 | $731
| $128,745 | | 28%
| $1,050 | $207 | $843
| $148,470 | | 31%
| $1,163 | $207 | $956
| $168,372 | | 33%
| $1,238 | $207 | $1,031
| $181,582 | | *If
gross income is $45,000 a year. **$480 a year for insurance, $2,000 for taxes.
*** Assumes a 30-year, fixed-rate loan at 5.5% interest.
As you can
see, the percentage of income used has a huge effect on how much house you can
buy.
Fixing a glitch in the calculators
Most Internet mortgage
calculators use the 28%-of-total-income figure. If you want to see how much mortgage
you could afford under other scenarios, adjust your income by using the following
multipliers:
| Income
converter to make online calculators work better |
If you want the share of your income*
devoted
to housing to be: | Multiply your income by |
| 25% | 0.9 |
| 28% | 1 | | 31%
| 1.11 | | 33%
| 1.18 | | * Gross
income
Then, use the calculators.
Your own math is more important
The best way to figure out how much house you can afford is to do your own
math.
- Figure out how much money you need to contribute to various
goals, such as your retirement and your kids' college educations.
- Estimate
how much your house is going to cost you in maintenance and repairs each year
(figure about 1% to 3% of the home's total value annually, depending on its age
and condition -- see “ The
hidden costs of homeownership ” for more details). Then see how much of your
remaining income is eaten up by your housing costs (including insurance and taxes),
and see how you feel about that.
All that math making your head hurt?
Here's the short version: You'll probably be most comfortable using the 25% lid.
You may want to go even lower if: - You plan to have children.
Kids can be expensive, and many couples discover they want to have the
option of one partner staying home, or working part-time, once kids arrive. That's
tough to do if you need every penny of both incomes to make ends meet. If you
really want to be conservative, do your calculations based on the income you think
you'll have post-baby.
- You have an expensive hobby, like
travel. Most homeowners are willing to put their wanderlust on the backburner
to buy more house. If that's not you, buy less house.
- Your
income varies considerably. Most American workers have variable incomes,
thanks to the prevalence of overtime pay and bonuses. If yours swings wildly from
year to year, though, consider basing your calculations on your average earnings
over several years or (even more conservative) on the minimum you expect to make.
You may think you can't possibly limit your housing expenses by that
much, especially if homes cost a lot where you live. You do, in fact, have plenty
of alternatives, as I pointed out in “ Find
a bargain in a hot housing market .”
However, you can stretch further
if:
- You're absolutely debt-free. No credit
card debt, student loans or car payments -- and none anticipated in the near future?
You probably can handle a bigger nut.
- You don't have to
worry about retirement. Many teachers and civil servants have terrific
pensions -- so good that to be sure they'll be fine, they just have to throw a
few bucks each year into an IRA or deferred-compensation plan.
- You're
pretty sure your income will climb steeply in coming years. Fresh out
of law school and doing a few years in the public defenders' office? If private
practice is your goal and you don't want to wait to buy a home with the bigger
income that's coming, stretching now can work out okay.
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