By Mary Umberger
Tribune staff reporter
November 18, 2007
Maybe. Then again ...
It turns out that how much mortgage debt one should carry -- and by extension, how much house they can afford to buy -- falls into that great gray chasm known as "it depends."
The Internet and folk wisdom abound in "rules of thumb" about determining your housing budget. A casual surfing of financial-advice sites, for example, turns up all manner of estimates of how much house one can afford, ranging from 2.5 to 5 times one's annual salary.
And that, of course, isn't necessarily the same thing as how much debt one should assume, a concern that apparently has its own infinite supply of rules of thumb.
Financial planners say, yes, it can be enlightening to plug your personal figures into the online calculators that ostensibly gauge how much you can afford -- just don't believe everything you read.
For one thing, such calculators vary wildly in the number of factors taken into account to come up with "affordability." Among the literally dozens of such devices that turn up on an Internet search, some omit such pesky line items as the cost of homeowners' association dues, homeowners insurance or even property taxes.
Nonetheless, those rules of thumb persist. Mortgage financier Freddie Mac, for example, suggests that a mortgage payment be no more than 25 percent of your monthly income.
"I wish people were at 25," said Lynette Briggs, a housing counselor for the DuPage Homeownership Center in Wheaton.
She said locally variable factors -- particularly property taxes and homeowners insurance -- can throw such guidelines out the window. "In DuPage County, where the median home price in September was $348,000, [the typical proportions of debt are] in the neighborhood of 30 to 40 percent."
But the interesting thing about rules of thumb is that if you look long enough, you'll find one that fits -- or comes close. For example, the Web site for financial services provider Credit Suisse suggests allotting one-third of one's income to housing. Sherry Smith, a counselor for Neighborhood Housing Services of Chicago, says her non-profit group suggests a limit of 40 percent.
"We don't use rules of thumb; we use real circumstances for real people," said Shawn Parker, a financial adviser for Ameriprise Financial in Schaumburg. "What might be appropriate for one person, might be a disaster for another."
But you've got to start somewhere. Mortgage lenders for many years have used a couple of benchmarks to determine how much they'll lend, though industry standards have made them anything but hard-and-fast. Those benchmarks are called "front-end ratios" and "back-end ratios."
The former consists of the total housing payment - loan principal, interest, taxes and insurance/homeowners' fees (or PITI) -- divided by gross monthly income. This tells the lender how much of your income you should be able to devote to housing, and the standard has historically been 28 percent.
Back-end ratios carry more weight. In this calculation, the lender combines PITI with monthly debts (such as credit cards, car payments, student loans, etc.) and divides that sum by gross monthly income. The traditional industry standard on this ratio suggests you should be able to put 36 percent of your income toward housing.
Those ratios bring us back, generally, into the 30 to 40 percent rule-of-thumb territory.
But the problem with relying on the ratios is that the lending industry has changed the rules.
No concrete standards
"There are no standards anymore," said Jack M. Guttentag, professor emeritus of finance at the Wharton School of Business at the University of Pennsylvania and author of a syndicated column called the Mortgage Professor. "It used to be that 28 and 36 were fairly well enshrined, through the standards of Fannie Mae and Freddie Mac," which set guidelines for mortgages that they will buy from banks and other lenders.
Now, he says, the credit-scoring system known as FICO has changed the picture.
"FICO scores have come to be relied upon much more extensively," he said. "Income ratios have receded in importance."
The maximums today depend on a wide variety of characteristics, he said. "If you have a FICO score of 720 or higher [on an 850-point scale], it's unlikely that you're going to be constrained by one of these ratios."
Briggs said that even with standards tightening since the mortgage industry got into deep trouble over defaults this year, lenders' tolerances are still far broader than they used to be.
"They whittled up to 41 percent if you had no debt," in the acceptable proportion of housing expenditures, Briggs said. "That inched up to 43 percent. Under certain circumstances, they will go to 45 percent.
"If you have excellent credit, they might allow 60," she said.
How much debt a borrower is paying plays a large role, as does the size of a down payment, Briggs said.
Financial counselors say the important thing to keep in mind is that even if a lender says you can get a certain loan, it's not necessarily the thing to do.
"That rule of 28 percent on housing and 36 on debt -- I'd never advise my clients to spend that much on either one," said financial planner Parker. "Those old rules were based on the bank believing that the mortgage payment was the only bill that the homeowner had.
"They knew they stood first in line and they knew that they had leverage," she said. "The didn't put enough consideration to the fact that the homeowner had to eat and put gas in the car."
The counselors say that as long as the consumer has a firm grip on his priorities, being house-heavy may not be a mistake. But getting that grip requires sober scrutiny of one's pennies -- and preferences.
Comprehensive budget needed
This means a detailed household budget analysis, which can be done through a financial counselor or independently. An elaborate do-it-yourself budget worksheet is at freddiemac.com (click on "Calculators and Tools" on the home page, and then "Worksheets").
Financial counselors say that in scrutinizing monthly costs, you have to own up to your $25-week-latte habit, think about how much you spend for haircuts and establish what a CTA fare increase will do to your wallet.
Then, they say, you have to look frankly at which other lifestyle expenditures matter to you and whether home ownership might rule them out.
Conversely, decide whether the house itself -- even if it precludes other spending -- is reward enough.
"Is it more important for you to have the three-bedroom, two-bath house, and maybe you won't go out to dinner anymore or have drapes on the windows?" Briggs asked. "Or maybe you could go, instead, with 1 1/2 baths and no garage."
Such quality-of-life issues -- that is, where you want to put your money -- defy formulas, the counselors say.
"I have some clients who are paying $30,000 a year for a nanny," Parker said. "But then, we also have a couple with no children and their idea of a fun time is sitting in a La-Z-Boy with the clicker. Everybody is different."
Parker's clients, Joan Steltmann-Carbon and her husband, David Carbon, said they had to do some hard number-crunching last year when they decided to move from a condo in Chicago to a single-family home.
Location was an issue: Steltmann-Carbon works in Lake Forest and wanted a relatively short commute, which meant they were house-hunting in some of the area's priciest towns.
They also had to assess how their new mortgage payment would affect saving for their daughter's education and their retirement and for improvements to the new house.
"We had to look at this decision on a tactical basis -- looking at the monthly cash flow and fully understanding not just the cost of the house but also the carrying costs, utilities, upkeep," she said.
After determining what they wanted to spend each month, they made a larger down payment than they had expected to reduce the size of the loan.
"It was substantially larger than we started out with, I'd say by 25 percent," Steltmann-Carbon said.
The couple closed on a house in Deerfield about a year ago.
"I'd rate it a big success," she said. "We're happy with the house we ended up with and the affordability."