Why a House or Mortgage Payment Should NEVER Own You

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in Mortgage

I’m a strong proponent of buying beneath your means when buying a home, but never more so than right now. A few days ago we were hit with the stunning news that existing housing sales plunged 27% in July, a huge hit to a market that’s been reeling from weakness for the past three years. When will the housing market improve? Who knows, but hopefully we’re all learning a few things from the fall.

One of the lessons we should be taking from this is that it’s no longer wise to overreach when it comes to buying a home. Over the past few decades it’s become customary for people to buy more house than they can afford based on the notion that they’ll make it up in tax savings, rising property values and increasing incomes.

We’re now coming face-to-face with the outcome of that thinking.

The rules that weren’t being followed

In my early days in the mortgage business, one of the most universal rules was “28/36”—the new monthly house payment couldn’t exceed 28% of your stable, monthly income, while the new payment plus all non-housing debt payments couldn’t exceed 36%.

That wasn’t a guideline, it was a rule. It could only be exceeded if the borrower had tangible compensating factors. Those factors included a down payment of at least 20%, large savings reserves after closing, a small increase in housing, exceptional credit or being engaged in a career with a predictable pattern of increasing income (doctors, lawyers, etc.). More often than not, you needed several of these in order to be allowed to exceed the ratios.

During the 1990s, the industry used automated underwriting systems, credit scoring and computer models to undermine rules that had existed for decades and the end result of that effort was the near total elimination of income restrictions of any sort.

Falling sales, declining property values, rising foreclosures and people being trapped in homes with payments they can’t afford—do you think there’s a connection between the housing crisis and the elimination of income ratio guidelines?

A house payment is the “most fixed” of all fixed expenses

Perhaps the biggest problem with a house payment is that it’s a fixture in your financial life. Once you close on your mortgage there’s no turning back, you’re in it for the long haul. The only ways out are to sell the house or to pay off the loan; one is massively disruptive while the other is prohibitively expensive!

The fact that you can (barely) afford a payment now doesn’t mean you’ll be able to afford it comfortably for the next 15 or 30 years. The possibilities of job loss or income reduction need to be factored into your loan qualification, and the best way to do this is by buying a home that is beneath your means. Being less optimistic in your planning could keep you out of major problems later.

Forget about what the “experts” say

No matter what a lender may say or allow, if you’re buying or refinancing a home, keep your income ratios at not more than 28/36. There was no foreclosure crisis when it was being followed.

I’ll take it a step farther and say that you should keep it at no more than 20-25%. Think that’s too conservative?

Consider the following:

  • Your basic house payment is your PITI (principal, interest, taxes and insurance), but as every home owner knows, PITI is just the beginning. There are also utilities, maintenance, repairs and over time, replacement. When these are added your income ratios will get you well beyond 28/36. Because an expense isn’t recognized by lenders doesn’t mean it doesn’t exist.
  • Higher housing values combined with a quick sale can no longer be counted on to bail you out of a tight situation.
  • If the loss of your job were to force you to accept a replacement one for less money, 28/36 could turn into 42/54 or 50/65 in just a few months. If you limit your housing payment to 20%, the impact of a reduced income would be commensurately less.
  • Have you noticed how energy prices have been bouncing around in the past few years? When they spike, utility costs rise quickly and that has an affect on how much of your income goes to housing expense.
  • Carrying too large a payment on a home could render you house poor, with a disproportionate amount of your income going to keep up the house.

As joyous an occasion as buying a home is, never forget that after you buy it you’ll still need to live your life. Having enough money to buy food, clothing and other necessities will still exist, as will the desire to take vacations, go to the movies and buy extras for your family. While projecting a budget that will enable you to buy the home of your dreams, be sure to keep all of these other expenses and desires in mind, as well as generous room for unexpected contingencies.

In the final analysis, your dream home may need to be scaled back a bit and that may be the best financial move you ever make.

Are you among the millions who are struggling under the weight of an outsized house payment?

Kevin At Out of Your RutThis post is from FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog OutOfYourRut.com.

{ 8 comments… read them below or add one }

Tracy 2010/08/31 at 10:08 pm

The American dream….own your own home. Achieving that is pretty hard now days but it can be done. Good credit is hard to believe and there is almost no credit available nowadays.

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Kevin 2010/09/04 at 4:10 pm

Tracy – There’s loan money available, but it’s a good bit harder to qualify than it was just 3-4 years ago.

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Spedie 2010/09/01 at 3:33 am

This post makes a lot of sense. To add to it, I might add that I was talking to a coworker of mine about 2 years ago. His wife has been working in the lending industry in regards to homes for over 30 years.

He told me that his wife would routinely see job status and income not checked when loans were made. Lenders were running on the FICO score and the truth the person buying the home put down on the loan application. His wife told him about 6 years ago that this was going to be a problem in the years to come – and she was right.

Selfishness, greed…these were also major factors in what caused our housing crisis.

I also think, that somewhere along the way, American home buyers began to see that home ownership became a RIGHT, not a priviledge.

I have read astonishing statistics about how most Americans live paycheck to paycheck. Many Americans have no concept of a budget. Many Americans have no emergency fund.

I was reading a couple of months ago, on the internet, about the causes of the Great Depression. I read that 97% of Americans at that tiime had no emergency fund. When things started to get tight they had no cushion at all. It is amazing to me how history keeps repeating itself.

For me and mine…we have a plan..as long as my high income is in place. I am putting my only debt, the house, up for sale. I will take my losses, if necessary. I am moving into an apartment after the house sell. Then, I will live way below my means for about 4 years and go buy a modest home for CASH.

I lost money on my first home, right before the housing bubble peak, because of the area I lived in. I have now lost significant value in this home. Both homes cost a lot to maintain (first house was bought NEW, second home was 34 years old). Both have been nothing but money pits.

I refuse to play this game any longer. I can only make so much money in my life, and I am sick and tired of giving money to bankers and wasting money on assets.

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Kevin 2010/09/04 at 4:18 pm

Spedie – I think that in general, owning a house is a net plus. But that being said, that’s under normal circumstances! When loans were being granted with zero down payemnts and/or with no income verification, prices got too high and it no longer made sense. Some of us in the industry did realize this, but it was swimming against the tide of the time.

As painful as the price decline may be, it’s totally necessary to get back to price levels that can be sustained on real incomes, not the inflated declared but unverified ones being used to qualify.

In regard to history repeating itself–it always will because human nature is always the same. We learn, we forget, we repeat.

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Margot 2010/09/01 at 7:19 am

Technical Question. The 28/36 rule. Traditionally, was the net or gross income used for this calculation? Using the net would be more conservative than using the gross, but I find that my net has varied a lot more than my gross due to changing deductions, health care expenses and retirement (not all directly under my control). Looking at the net I take home less than I did 5 years ago, though I make more according to my gross.

Just curious. Thanks!

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Kevin 2010/09/04 at 4:12 pm

Margot – 28/36 is based off the gross. Which raises another issue: income ratios ignore income taxes!

What that means is that even if you stay within 28/36 you may find your income stretched even tighter than surface factors might indicate.

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philip 2010/10/13 at 9:36 am

I couldn’t agree more with this article. After I retired from the military, my wife wanted a nice big house. I on the other hand wanted to buy something smaller with a big down payment and keeping the mortgage payment well below my retirement check amount. That way, even if I lost my job, the house payment would still be taken care of. I told her after 3 years, if she didn’t agree, we would start looking for a bigger house. We compromised and got the little one. 2 years later as we all know, the construction biz was belly up. Guess what? I still have my house even though I had to take a job making substantially less income. We know many folks who are struggling to keep their large, luxurious, and expensive homes while we are living quite comfortably in our “little” one

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Kevin 2010/10/13 at 10:55 am

Philip – My guess is that a lot more people are seeing things your way now. Since a house is such a large part of the typical household budget, and since it is a long term commitment in the truest sense, leaning toward conservatism is usually the best path.

For the most part, the people struggling today are the ones who over-bought a few years ago. The ones who didn’t over-buy, and who weren’t serial refinancers have been largely unaffected.

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