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Tuesday, August 26, 2008

How much house can I afford?

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. Yet many first-time buyers are still being pushed into mortgages that are bigger than they can handle, based on old-fashioned advice. The old school thinking was that you should buy as much house as you could stretch to afford, since real estate was always increasing in value and so were incomes.

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.

* Medical Insurance. Many more would-be home owners are strapped by the need to pay their own medical bills or to self-fund high-cost medical insurance.

It's time to 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.

As an example, let's look at how large a mortgage a person earning $45,000 a year should take on. Factoring in taxes and insurance, which decrease the amount left for paying the actual mortgage, if you are willing to spend 29% of your income on housing, you can afford a house that casts $121,745. It jumps up to $169,370 of you are willing to kick in 31% of your disposable income and tops out at $181,582 for those willing to put in 33% of their monthly take. It would get closer to the $200K mark if you went all the way to the max allowable level of 36%, but then you'd be sitting on folding chairs eating your dinner of hot dogs and baked beans at a card table.

As you can see, the percentage of income used has a huge effect on how much house you can buy. It also has a huge impact on what kind of life yo can lead, after providing for shelter, food, health care and other necessities. The term "house poor" was invented to describe those who have reached too far to buy a bigger house and now find that they are essentially a prisoner to the house (payments).

As a Realtor I try to advise my clients to stay within their means, but I have to be careful about doing that, so that I don't offend them. I usually ask if they have a financial advisor and if they have consulted with them about what they can afford. If they don't have a financial advisor, I try to direct them to a trusted mortgage agent who will help them find the answer to that question. It's also important in the modern two-earner scenario to have some understanding or plan for what would happen if one of the two incomes were lost, due to job actions or illness or for whatever reason. Could the mortgage be met on only one partner's income?

The other issue that I'm seeing results from the high taxes that are still attached to many of the "great deal" foreclosed homes. Often the buyers get so zoned-in on the purchase price that they forget that they will be responsible for the taxes on that $300K house that they got for $180K. Often the first time that they appreciate the consequences of that is on the HUD documents at closing and then it's a little late to back out. The taxes alone on a $300K house in this area will run over $500/mo.

So what's my advice - get good advice! I'm not a financial advisor and neither are most lending agents, so seek help from someone who is trained to look at your situation and advise you about how much you can afford to spend on a house. I can find you the house and I can recommend a good lending agent. I can even point you towards a good finalcial advisor, but you'll have to work out what you can afford with that advisor and then come back and see me.

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