How Much is Too Much? - Part 2

Last week I started a discussion of qualifying for a mortgage. The qualifying process is basically one that draws a line between loans that will be approved and those that will be denied. These old rules were strict enough that they restricted the number of homebuyers coming into the system.

With the advent of automated underwriting (AU) systems, there has been a significant change. These underwriting systems use more liberal standards so that people whose loan applications would have been denied a few years ago are now routinely approved.

In fact, that has meant a significant transformation in the role of the lender. In the old days they acted as gatekeepers, making sure that it only made homeowners out of those people who were virtually certain to make all the payments. But now the lender employees’ role as gatekeepers has almost been eliminated. Their job now is to assemble the documentation required by the AU system, because the system already made the decision.

Without that control, you can conclude that our industry has the potential of burying people in debt, not a good thing. I don’t mean to say that it’s doing that on purpose, it’s just that some people who are really going to be stretched are still getting approved, and maybe they shouldn’t buy a home. If you are a potential homeowner, you want to make up your own mind as to how much you can afford before going to see a lender.

First, although many people work out a budget before home shopping, I have met a few people who had, quite literally, no conception of what is involved in owning a home. Their previous experience was paying their rent on the first of the month. You can imagine people like this getting in over their heads. For that reason I would suggest that everyone buy a book to get educated about home ownership. Consider my book too.

Here are some guidelines you can use to develop your own limits. First, calculate your provable gross income from your employment. Things such as overtime and bonuses that haven’t been regular for at least two years won’t be counted by the industry, but if they are going to be ongoing, make a note of it for future reference as it may increase your comfort level. Consider too if a non-working spouse will be able to get a job.

Then calculate the total of your obligatory payments, car loans and credit card payments for example. If you are unclear about the exact numbers, get a credit report so you can use the same monthly payment numbers that your lender will. It’s a good idea to check your credit anyway. Finally, examine what you are now paying for housing, either your current rent or payment on your mortgage plus taxes and insurance. Now you can calculate your own ratios. We’re going to use simple numbers in this example for ease of calculation.

Say your rent is $1,000 per month and your gross income is $3,300 per month. Your housing ratio is $1,000/$3,000 = 33%. Next add your other expenses, say $300 per month. The total expense then is $1,300 and your total expense ratio is $1,300/$3,000 = 43%. Our industry would say that your ratios are 33 over 43. Note that these ratios are higher than traditional 28 over 36, but it would likely get approved by any lender today.

Now make an assessment as to how comfortable you are at this level. Perhaps you are single or have no kids and you are able to save money every month. Then there is still some room in the budget even though the ratios are a little high. Other borrowers with these same numbers but with two children might feel terribly stressed.

Finally I would go to one of the many calculators on the Internet, such as at www.mtgprofessor.com. Take the proposed home value you are considering, subtract the down payment to get the mortgage amount, and then use the calculator to get the mortgage payment. Add the monthly amount of property taxes and insurance to get the new housing expense. You want to come up with similar housing and total expense ratios and compare them with your current situation. Calculate your total expanses ratio too.

The key question is, “Are you still comfortable?” If you are really comfortable with the numbers, then you might want to increase your limit a bit. Importantly, at some level you need to draw the line. There are forces out there that will sell you more home than you can comfortably afford, so even if you can get approved for it, don’t let someone talk you into going past the line you have drawn.

Finally remember that a house isn’t everything. We didn’t talk about this as an obligatory item in the budget, but somewhere along the line you need to be saving for retirement or for your kids’ education. Those are obligations too so don’t trade those for a home.

Good luck!