Can You Really
Afford That House?

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Jan. 9, 2003 -- The housing market's astonishing strength over the past few years has been a boon to homeowners looking to trade up for nicer, newer or bigger homes. We've all heard stories about the couple who bought a two-bedroom condo, say, in the Boston suburbs in early 1997, sold it in early 2002 for a $300,000 profit and promptly moved into their 4,000-square-foot dream home. Membership in the homeowners' club has its advantages.

But for every get-rich-quick success story, there's a corresponding tale of financial woe. The rapid escalation of home prices in the last few years has squeezed first-time homebuyers like never before. Precious few members of this unlucky group have been able to put down the standard 20% as a down payment on their first homes. Instead, with prices soaring, many first-timers have leveraged themselves to the hilt in order to get in while they still can.

The result: crippling mortgage obligations. Housing payments as a percentage of disposable personal income are up 45% since the Federal Reserve began tracking the statistic in 1980. And down-payment percentages for first-time buyers are near their lowest levels ever, averaging just 6% of a home's total value in 2001, according to the National Association of Realtors. That's down from 10% a decade earlier.

With first-time homebuyers stretched so thin, there's little room for even the slightest financial hiccup. That's risky business in a sluggish economy. The latest numbers bear this out: Mortgage-payment delinquencies and foreclosures are more frequent now than at any time since the Mortgage Bankers Association of America began tracking this information in 1972. And experts expect these numbers to rise in 2003.

Two developments in particular have fueled the housing boom: low interest rates and easier credit standards. Major government-sponsored entities like Fannie Mae and Freddie Mac have always allowed homebuyers to put little money down on first-home purchases. But as the housing market began to heat up in the late 1990s, other lenders began relaxing their lending standards to snare more business, offering 105% mortgages and other dangerous products. Financial institutions big and small, reputable and fly-by-night, began allowing consumers' total debt-to-income ratio to exceed the traditional lending guideline of 36% -- and to reach as high as 50% in some cases.

That's all well and good when the economy is hot and jobs are plentiful. But when a job loss slashes a highly leveraged borrower's income, the results can be disastrous.

Consider the case of Catherine, a 52-year-old homeowner living in Robinson, Kan., who asked that we not use her last name. Catherine, struggling under the weight of a too-generous mortgage her lender might not have approved just a decade earlier, is in danger of losing the modest home she bought in 2000.

When Catherine and her husband, who works for a lumber company, applied for their mortgage in 2000, they factored in his overtime income, which totaled $600 to $700 a month. But when the economy faltered last year, his hours were cut, and the overtime income vanished. Without that added income, their housing cost as a percentage of their income ballooned to 52% from 35% -- a heavy burden, to be sure. Add rising gas costs and medical bills into the mix, and it's no wonder Catherine and her husband are now more than three months behind on their mortgage payments.

Catherine has tried to work out a payment plan with her lender, a local bank. But her requests have been rejected. Why? A 90-day delinquency in payments is the standard limit that triggers foreclosure, says Chris Burk of the Consumer Credit Counseling Services of Topeka, Kan. Now, Catherine is considering filing for bankruptcy. "We don't want to do that, but we feel we have no other choice," she says.

What can prospective first-time buyers do to avoid a similar fate? Financial experts recommend taking a step back and thinking more conservatively. "The biggest misconception is that, because you are approved [for a mortgage], you can afford it," says Steve Rhode, president of Myvesta.com, a debt-counseling service. That's especially true in a slumping economy, when job security is virtually nonexistent. Labor market aside, there are a few costly scenarios all prospective buyers need to consider before taking the plunge. For example, because of skyrocketing housing prices, the charming little starter home of years past is now a major fixer-upper. That can eat into a first-timer's savings mighty quickly.

To avoid becoming a casualty of the red-hot housing market, all prospective buyers should do the following:

• Inflate Your Budget

A new house is more expensive than most people realize. Coming up with the money for a down payment and closing costs is just the beginning. Many people don't consider the costs of fixing up a new home. A simple do-it-yourself paint job can easily cost hundreds of dollars once you buy all of the necessary tools. New furniture to fill all of your new rooms can push a struggling young couple over the edge.

So when you determine your housing budget, give yourself a big cushion. Make sure your final number is considerably larger than your mortgage payment and property taxes. "I always tell people that they will never be as broke as when they buy a house," says Diane Wilkman, president of Springboard, a nonprofit credit-counseling service based in Southern California. Believe it.

• Don't Take On Too Much Debt

It makes good sense to borrow less than the maximum amount the bank is willing to give you, and to put down as large a down payment as you can afford. As a guideline, the old-fashioned rule of thumb is that homeowners should put down a 20% down payment and not dole out more than 28% of their monthly pretax income to a mortgage payment and property taxes. Total debt, including credit cards and car payments, shouldn't exceed 36% of one's pretax monthly income.

Higher debt ratios don't scare many loan officers these days, but they do make credit counselors quite nervous. Springboard's Ms. Wilkman says she has clients with debt-to-income ratios of 45%. "You would be skating on thin ice if you had that much debt," she says. If playing the numbers game isn't your thing, consider Myvesta's Mr. Rhode's advice: Make sure you have money left over after you pay all of your living expenses, including debt -- and squirrel away that monthly savings.

• Plan Ahead

If you're planning to start a family, you'll need to inflate your budget even more. Kids are expensive. Not only do you have to feed and clothe them, but you'll also have to figure our your child-care situation and start saving for college. Nannies and day care can be quite pricey, particularly in wealthier areas. And if one of you wants to stay home with Junior, you'd better not buy that new home based on two salaries. Mr. Rhode's suggestion: Make a larger down payment, so your monthly mortgage payments are more manageable.

That's just what Tom Kopczynski, a 31-year-old securities trader from Basking Ridge, N.J., did. When he bought his home in 2001, his wife was already pregnant. Worried that Tom could lose his job during the bear market, and considering the possibility that his wife might want to stay home with the baby, the Kopczynskis made a 50% down payment. "We wanted to maximize our monthly cash flow as much as possible," he says. Smart move.

We understand that most first-time homebuyers can't afford a 50% down payment, or anything close. But the lucky few who can should strongly consider it, particularly if they plan on starting a family soon.

• Rainy-Day Fund

Financial planners advise all people, and especially homeowners, to set aside three to six months' worth of living expenses in case of job loss. "Can you survive changes in your economic situation?" asks Gerri Detweiler, personal-finance author of "Invest in Yourself: Six Secrets to a Rich Life." If not, you should make a rainy-day fund your top priority. For first-time homebuyers, that might mean putting off home repairs until the savings-account balance is repaired first.

Don't forget Murphy's Law: If anything can go wrong, it will. If you're just squeaking by when all the stars are perfectly aligned, you'd better reassess your situation. It isn't just your job you need to worry about. What if you need to replace your furnace in the middle of winter? What if your roof starts to cave in during a snowstorm? "Everyone tells you it's better to own [than to rent], but you shoulder the responsibility of owning that property," says Ms. Detweiler. "One big expense could sock it to you."

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