Can You Really Buy
That Pricier Home?
Obscure pronouncements from Alan Greenspan usually leave me scratching my head, but last week's declaration from the Federal Reserve chairman on home loans had me fuming.
Mr. Greenspan noted in a speech last Monday that homeowners "might have saved tens of thousands of dollars had they held adjustable-rate mortgages [ARMs] rather than fixed-rate mortgages during the past decade."
What's frustrating about what he said isn't just the Monday morning quarterbacking. (Gee, thanks Al. Where were you when I took out my first mortgage a decade ago?) It's the introduction of yet another one-size-fits-all home-financing nugget: If Mr. Greenspan says ARMs are better than fixed-rate mortgages, it must be so.
Who's going to suffer for it? Home buyers who fall in love with homes they really can't afford.
Mr. Greenspan's suggestion that mortgages with interest rates that fluctuate are a better deal than fixed-rate mortgages -- particularly at a time when >rates are at record lows -- could be a recipe for disaster for home buyers who may be considering using ARMs to borrow more than they should in order to get that nicer home. As this article explains, when rates start to rise, those loans may end up wrecking already precarious household finances.
Mr. Greenspan isn't the first expert to make an observation on what's right for home buyers. Mortgage brokers, lenders and real-estate agents do it all the time. And understandably so: In general, the more you borrow, the more you buy, the more they earn. But that doesn't mean their advice is right for you.
An old chestnut in the financial-services industry says that to be considered "affordable," the cost of a home, including insurance and real-estate taxes, should come to no more than 28% of a homeowner's annual gross income. But how much home you can afford really depends on your own individual circumstances.
To make sure you don't get in over your head, find out what you can really afford before the hunt begins -- and stick to it. In the last of a continuing series on "Dealing With Debt," here's a look at why shoppers end up buying above their means, and what they can do to avoid it.
The Buck Stops With the Buyer
Despite what consumers hear from lenders and agents, in the end it's up to buyers to figure out what they can afford. Unfortunately, few do the math on their own.
Typically, after lenders indicate how much they're willing to lend based on the financial documents provided, buyers begin looking at homes near the top of that range. Then the stress and emotion involved with home shopping -- and the desire to have a certain type of home, in a certain neighborhood, with a certain school system -- drive some to buy more home than they should.
"If there's a couple involved, usually one spouse is more aggressive and wants to buy more house than they can afford," says Bert Langdon, a certified financial planner in Houston. "They usually 'compromise' … and end up getting more house."
Kimberlee Peters can relate. The 27-year-old mortgage broker and her fiancé, Jason Dworczyk, originally set their own price target for buying a home on Long Island, N.Y., at $200,000. But they're now willing to stretch their already tight budget to $250,000.
"After seeing so many homes and going through the bidding process you get all excited and tied up in it, and before you know it you're making higher bids than you had planned," she says.
What's Affordable for You
Ideally, a first-time homebuyer should consult an independent financial adviser to determine a sensible price range and borrowing option, says Mari McQueen, associate editor of Consumer Reports Money Adviser. "Don't let the mortgage brokers tell you what you can afford before you go out house hunting."
You can also do the math yourself with the aid of software or online calculators. One thorough software program is "Home Ownership: Can You Afford It," developed by the University of Illinois Extension in Urbana. (The cost is $25, plus shipping and handling.) Users enter their income and all their regular expenses, as well as all the costs related to a particular house, and then receive an analysis of how much home they can comfortably afford.
Online calculators will give you a rough estimate of how much home you can afford, but they key word is rough. "How Much Home Can You Afford?" calculators typically exclude important costs that must be considered when figuring your earnings, debts and bills. Here are a few points to consider:
When Your AGI Isn't. Home-affordability tools typically don't account for fixed savings. For example, a person making $75,000 a year who deposits 10% of his annual gross income into a 401(k) in practice has pretax earnings of just $67,500 for purposes of the calculator. Homeownership also intensifies the need to build an emergency-savings account -- when the roof leaks there's no landlord to call to pay for pricey maintenance calls. If you don't already have a rainy-day savings account in place, set aside a portion of your income to fund one and deduct that amount from your AGI for purposes of the calculator.
Redefine Your "Debt." Affordability calculators also don't consider other significant fixed costs that, like debt, simply must be paid each month. One major fixed cost for families is child-care expenses. On average, a working mother of a preschooler paid $4,888 a year for child care, or nearly one-tenth of her annual income, according to 1999 Census data (the latest data available). But parents who live in and around major metropolitan areas may pay sharply higher rates. A government report released this month found that the average family in Alameda, Calif., a suburb of San Francisco, with children ages 0-13 spends $8,320 a year on child care.
Health care is another wildcard. More workers are being asked by their employers to pay for some or all of their health insurance, and out-of-pocket costs are rising in the form of higher co-pays. (If you're not insured, or don't have disability insurance, one major medical problem can prove financially devastating to a household, especially if you're carrying a big mortgage.)
So when using home-affordability calculators, include these and other types of fixed monthly costs in the field provided for "other debts."
Do Family Planning. Mortgage brokers and lenders are apt to say, "You'll earn more over time so eventually your budget won't be so tight." While that might be true, it doesn't mean you'll earn more in the near term. Indeed, chances are, due to children or even layoffs, you may earn less.
A young working couple, for example, needs to consider whether they're planning on having one of the two stay home for a few years to raise kids, says Paul Fein, a senior vice president at GMAC Mortgage in Horsham, Pa. In this case, you may need to stick to a more conservative borrowing range. Or, if there's only one working spouse today, but it's likely the other will return to the work force in a few years, stretching a bit for a home may make more sense.
Choose the Right Loan. Figuring out what you can afford is easier if you plan on ignoring Mr. Greenspan's comments and financing with a fixed-rate loan. But with adjustable-rate mortgages or no-interest loans -- where your monthly mortgage payment may increase over time -- the calculus gets tricky.
"You should look at a worst-case scenario and then stress-test your budget to see how it holds up," says John Bitner, chief economist for Eastern Investment Advisors, the wealth-management division of Eastern Bank in Boston.
Run the numbers using the highest percentage rate you could be charged to see whether the loans you're considering may be a budget buster.
Your Assumptions May Prove Wrong. My own experience in borrowing for my first home played out in the fashion most first-time homebuyers assume will happen to them. In the years after we took out a big mortgage, my husband and I started earning more and the monthly payments became more manageable. Then interest rates tumbled, allowing us to refinance at a much shorter term and lower rate, and we were able to funnel that extra cash into long-term savings.
But how likely is it that this same scenario will play out for homebuyers who are capitalizing on record low mortgage rates to borrow heavily using ARMs? Consider the fact that, despite these exceedingly attractive rates, mortgage foreclosures and personal bankruptcies both are currently running at highest rate in history. To ensure you aren't setting your finances up for a fall, give the decision-making process on how much home you can reasonably afford the respect it deserves.
-- Ms. Cullen writes the Fiscally Fit column for The Wall Street Journal Online. WSJ.com subscribers can view past columns in the Fiscally Fit archives.
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