Please note this article is a reproduction of a blog posting from www.anawise.com dated June 27th, 2007.
Buy a house on its inherent economics. Do not buy a house based on your ability to qualify for a mortgage. This article identifies the folly of the latter approach.
Lenders determine a home buyer’s affordability based on lending ratios. The two most commonly used ratios defined as the ‘front end’ and the ‘back end’ ratio determine the ratio of monthly housing payments to gross monthly income and ratio of total debt (mortgage, credit card, tuition etc) to the gross monthly income respectively. If homebuyers fall under these qualifying ratios guidelines, they may qualify for a mortgage. Most lending institutions adopt their own lending guidelines based on their goals, credit ratings, target customers (prime, sub-prime etc), and today, with the softness in the housing market, it may seem that you can always find a lender who is willing to offer you a mortgage. A few years ago, when ARMs and option ARMs were a much smaller percentage of total mortgage originations, a 36% debt to income ratio was accepted as the defacto industry standard, however, with the run-up in housing prices over the last few years, lenders have relaxed such qualifying ratios to capitalize on the housing boom.
As a homebuyer, it is important that you determine your affordability based on the inherent economics of your home purchase and not on your ability to qualify for a mortgage. Economists often site a high mortgage payment to income ratio as a sign of a ‘bubble’. In certain hot metro markets like the San Francisco Bay Area, such ratios have gotten out of whack. In such areas, with surging home prices, and an increase in the mortgage interest rate (30 year FRM) from 2005- mid 2006, homebuyers are ‘stretching’ to qualify by opting for more exotic mortgages on the ‘mortgage totem pole’. You start with a 30 year fixed rate mortgage that typically carries the highest interest rate (Some lenders are also offering 40 year and 50 year mortgages, but they are excluded from this article as these loan programs are relatively new and comprise a miniscule % of total mortgage originations), and if you don’t qualify for it you slither down the ‘totem pole’ : 30 year fixed rate mortgage with interest only option, ARMs, ARMs with interest only options and option ARM with negative amortization until you find a program you qualify for. By doing so, you have bought a home not on the inherent economics (we will discuss that below), but on your ability to qualify for a loan program.
As a homebuyer, it’s important to determine affordability based on your pocketbook. Can you make the mortgage payments without compromising on your quality of life? Can you balance your checkbook? Do you believe your home will appreciate over a 3, 5 year period? Can you ride out a decline in home prices ? The hype from the realtor aside, how much would you ‘really’ pay for this house?
The bottom line: Affordability calculators are useful, but use them only as a guideline. Start with your net income (gross income less taxes, social security, Medicare, retirement and other deductions), back out your mortgage payments, other debt payments and expenditures and stare at the balance. Are you comfortable with it? Are you saving enough to meet the needs of your family? If so, go ahead and buy.
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