Stretching Old Formulas Can Take You to the Edge

For most people, a home is the most expensive purchase they will ever make. Figuring out how much they should spend can be overwhelming.

Online calculators can give a ballpark idea of how much you can afford, but you shouldn't rely on them to make your final decision, said Paul Cocozza, a certified financial planner in Arlington. "To me, that's taking too much of a shortcut for such a large commitment."

So how do you decide what you can spend? Your budget for a house is a function of your income, your household expenses, your credit and your savings.

Traditionally, the guideline was that no more than 28 percent of gross income should go toward housing expenses, which include the mortgage payment, homeowner's insurance, homeowners or condo association fees, and real estate taxes. Likewise, no more than 36 percent of your gross income would go toward those housing costs plus all other debt expenses, including car notes, school loans and credit card payments. Many lenders have stretched those requirements, though, and allow up to 39 percent of gross income to go toward housing and other debt.

But just because a lender says you can afford a loan doesn't mean you have to spend that much.

Peter Hebert, mortgage broker at Allied Home Mortgage Capital in Ellicott City, said buyers should be cautious about the mortgage payment they take on. "If you're going up to 50 percent -- which we will do -- you're going to be living paycheck to paycheck. You're only a broken leg away from going bankrupt."

The issue is that those ratios (and the online calculators based on them) don't cover every possible expense a prospective buyer is responsible for, including some substantial ones such as child care.

"Most buyers have a reasonable idea of what they can afford," said Deborah Knuckey, author of "The Ms. Spent Money Guide: Get More of What You Want With What You Earn" and a real estate agent with Continental Properties in the District. If they don't know where their money goes in a year, she suggests that they use budgeting software such as Quicken or Microsoft Money to track spending.

Buyers should not depend on the lender or mortgage broker to remind them of those other bills, Hebert said. "I don't know if they're paying for a boat slip, or have a child at a private school."

Lenders' ratios don't even cover all the costs associated with owning, such as maintenance.

"How much a lender is willing to lend you is not a useful number," said Elizabeth Warren, co-author of "All Your Worth" and "The Two-Income Trap" and a law professor at Harvard University. "That's a little like asking the clothing salesman how many sweaters you should own." She recommends that people keep their fixed expenses, including mortgage payment, at or below 50 percent of their after-tax income.

People often use the rent they have been paying as a guideline for the mortgage they can afford. But that doesn't always work, Knuckey said, because owning a house is much more expensive than renting, even taking into account the tax break for mortgage interest. "I think people generally underestimate how much they're going to want to do, between the decorating and the maintenance."

Cocozza agrees, especially because without savings on hand, owners will often pay those expenses by credit card. "The last thing you want to do when you buy a place is to increase your consumer debt. It's hard to get out of that."

Another key factor in what you can afford is your credit. Your FICO credit score, in particular, determines how much the mortgage is going to cost you. Lenders base their interest rates and fees on the risk that you could default. With all other factors being equal, the higher the interest rate you have to pay, the less you will ultimately be able to afford for a house.

Finally, buyers must consider their savings. At minimum, buyers need enough cash for their down payment and closing costs. A 20 percent down payment is still the gold standard, even if it's not common for first-time buyers in the Washington area. More modest percentages are possible, but making a smaller one means a bigger monthly payment and will drive up the long-term cost of the loan. It could also mean paying private mortgage insurance, depending on how the loan is structured. Closing costs run about 3 to 5 percent of the price of the house, though many buyers ask the sellers to pick up all or part of the tab.

Buyers should also plan to keep something in reserve after closing, Knuckey said. Indeed, many lenders will require buyers to show that they aren't completely depleting their savings to buy the house, Hebert said. Assets in a retirement account can meet this minimum requirement, which is generally two months' worth of mortgage payments.

"The last thing you want to do is buy a house and have no cash cushion in case something goes wrong early on," Knuckey said.