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?
This 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.