Declining incomes have more people paying a higher percentage of their income in rent than in the past. I blame the recession. And what caused the recession? People getting in over their heads, buying more house than they can afford. I blame the big banks for that, because I personally experienced it. If I’d bought the kind of house loan officers were telling me to buy in 2002, I’d have been foreclosed on, too.
Here’s a very easy way to figure out whether you can afford a particular place.
Step 1: Find out the monthly rent or mortgage payment
If the house is for rent, the rent payment may very well be on the sign or in the ad. If not, call the phone number listed and ask how much the rent will be.
If the house is for sale, use a mortgage calculator to get an estimate on the monthly payment. Use a conventional 30- or, better yet, 15-year mortgage to figure the calculation. Do not use an interest-only loan or an ARM. Playing games like that to get into more house was part of the problem that caused the recession. The mortgage calculator will just be an estimate, but an educated guess is much better than a wild one.
Step 2: Figure out what you can afford
Finding out what you can afford is easy. The Federal Government has a cut-and-dry guideline for you to follow. You shouldn’t spend more than 30% of your income on housing if you can possibly avoid it.
So, take your gross (pre-tax) monthly income and multiply it by .3 to get a number. If that number is smaller than what you got in step 1, you can’t afford it. Look somewhere else.
If you want to play it safer, take your net monthly income, after taxes and other expenses are taken out, and multiply that smaller number by .3. You’ll end up with less house, but you’ll also be considerably less likely to find yourself in a bad situation down the road.
If you don’t want to do the math, look at your weekly paycheck. If the rent is substantially higher than your weekly paycheck, find something else. If it’s less, you can afford it with a little room to spare.
The more margin you give yourself, the more protection you give yourself against future pay cuts or other unforeseen circumstances wrecking your financial life. And, if things go well, you can use that margin to pay off the mortgage faster, or if you’re renting, to build up savings so that you can potentially buy a house in the future.
If you’re renting, taking this step can save you a lot of time and, potentially, money. What you want to avoid is filling out an application, paying an application fee, and having your potential landlord run your credit and then come back to you and say you can’t afford that house. Now you’ve spent $50 and you’ve taken a hit on your credit rating. A good landlord can tell you before running your credit whether you can afford it or not, but will every landlord do that? I don’t know.
Step 3: Get some precision
If you’re purchasing, this is the time to make your estimate more precise. Find out from your bank just what kind of mortgage you’ll be able to get, and an estimate from them of what the monthly payment would be. Often you can do this just by visiting your bank’s web site. Just because you hear interest rates are in the fours doesn’t mean a bank near you is necessarily offering that. And your credit history might keep you from getting a particular rate. Plus your bank can give you a much better estimate of what your escrow payment is going to be. This is the time to find out your mortgage payment is going to be $100 more than the initial estimate. Not at the time of closing.
Speaking from my own experience
When I first moved out on my own, I paid 19 percent of my gross income in rent. I didn’t really know what I could afford, so I set my sights relatively low. There was an apartment complex nearby that offered comparable apartments for even less, but had problems with crime. So I got a modest 1-bedroom apartment in a complex with a better record, and I found that I had a surplus every month. And the economy was good my first couple of years out, so my salary increased at a higher rate than my rent did. I lived in that apartment for three years, but after the third year, they wanted to raise my rent by about 10 percent. That’s a lot, especially because they weren’t doing a good job of maintaining the apartment. My air conditioner broke down every summer, and they kept bubblegumming it back together. My hot water heater was leaking onto my neighbor below me, and they never fixed that properly, either. So I told the manager I either wanted to stay with a lower rent increase, or I wanted a six-month lease, after which I would leave. They said the least they would give me was a seven-month lease. So I signed that and started watching the market. After a few months, I got a pretty good idea of where I wanted to live and what I could get, and I called a realtor.
The loan officers I spoke with gave me a ridiculously high upper limit of what I could afford. I ignored that, looked at my budget, looked at what I was paying in rent, added what I generally had left over at the end of the month after paying my bills, and used that figure as a basis of what I could afford. Using the 30% figure would have been a lot easier, but I didn’t know that trick yet.
What I found was that the houses at the lower end of what I was comfortable paying tended to be 2-bedroom houses. They’d be fine for a while, but not exactly optimal for raising a family when that time came. At the upper end of my range, I could get a three-bedroom house with an unfinished basement and, potentially, never have to move again for my entire life because it would be big enough to raise a family, but not so large as to be too much to take care of in my twilight years. I found a three-bedroom house that I liked a lot, and I bought it. I recommend you skip the home warranty.
My initial mortgage payment was a shade over 25% of my gross income. Typically, I paid an extra $100-$150 each month, which brought the check I was writing every month closer to 30%. That was manageable, but I had to make some sacrifices to do it. I ate meals out less often, and it limited the kind of car I could afford to drive. That was fine; houses are much more important than cars. There were months that I was glad I wasn’t obligated to pay 30%, because I needed that hundred dollars for something else. Having that cushion kept me from going further into debt, even short term.
Had I been pushing myself to 35%, I would have had problems. Especially when hard times came, and if they hadn’t gotten better.
A lot of people did push themselves beyond the recommended 30%. Hard times did come for some of them, and some ran out of money and options. Others survived, then times got worse, and they ran out of money and options. That’s why we ended up with so many foreclosures.