Housing is the largest expense in the budget of most families. But how much is too much to spend on shelter? An article in Saturday’s New York Times contains a shocking example of one woman who crossed the line:

What she got was a mortgage she could not afford. Toward the $385,000 cost, [Christina] Natale made a down payment of $185,000, a little less than what she took away from the sale of her grandfather’s home. The loan that made up the difference, with closing costs, broker’s fee, taxes and insurance, meant a monthly bill of $1,873.96, about $100 less than her monthly take-home pay as an administrative assistant.

I am not unsympathetic to tales of financial hardship, but this stretches even my compassion. Ms. Natale (who has three children) took out a housing loan that left her just $100 a month for every other expense in her life. She shouldn’t need an outside voice to tell her that this was an impossible situation. (All the same, where were the outside voices?)

Although this is an extreme example, many other people buy homes only to discover they’re in over their heads, unable to make payments. How can you prevent this from happening to you?

Debt-to-income ratio
Fortunately, decades of financial data have produced computerized models that help to determine how much a person can afford to spend on housing and debt. To learn more about this, I recently spoke with Robb Severdia of Guarantee Mortgage in Portland. I asked him to describe how the process works. (If I have anything wrong here, it’s my fault, not Severdia’s.)

Traditionally, lenders have used the debt-to-income (DTI) ratio to estimate how much a homeowner can afford to borrow. This ratio is computed by comparing your expenses to your gross (pre-tax) income. The lower the number, the better. If you make $3,000 a month before taxes, and you pay $300 toward debt, your debt-to-income ratio is 10%.

Banks and mortgage brokers look at two numbers:

  • The “front-end” debt-to-income ratio, which includes total housing expenses: mortgage principal, interest, taxes, and insurance.
  • The “back-end” debt-to-income ratio, which includes all of the above plus other debt payments: auto loans, student loans, credit cards, etc.

When a prospective borrower submits her paperwork, the computer evaluates it, applying statistical models to be sure the proposed debt load falls within accepted ranges. After this automated process, the loan proceeds to manual underwriting, where a human screens the application and makes the ultimate determination to approve or deny the loan.

Industry-standard debt-to-income ratios drive this process.

Lending limits
When we bought our first home in 1994, everyone involved in the transaction told us that our front-end debt-to-income ratio should be 28% or less. That is, we should pay no more than 28% of our gross income toward housing expenses. The back-end ratio was 36%, which meant that our housing expenses and debt payments combined should total less than 36% of our income.

Example: Our gross (pre-tax) income in 1994 was roughly $60,000, or about $5,000 per month. To stay under the 28% front-end debt-to-income guideline, we could afford housing expenses of no more than $1,400 per month, including insurance and taxes.

Because Kris had student loans and I had credit card debt, we couldn’t get close to the 28% front-end DTI ratio because it would push us over the 36% back-end. Our high debt-load meant we had less to spend on a house. Our eventual payment was $1,086 per month.

When we bought our new home in 2004, the debt-to-income ratios had changed. “That 28% figure is old,” we were told. “Most people can go as high as 33%.” The back-end ratio had been raised to 38% — and even to 41% in some models!

From what I understand, debt-to-income guidelines have gradually become more relaxed over the years. Here’s what I could puzzle together about the history of DTI (I would love to have clarifications or corrections to this list):

  • Reportedly, during the 1970s (before credit-card debt became common), DTI wasn’t split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance were less than 25% of your income, it was assumed you could afford the payment.
  • In The New Rules of Money, Ric Edelman writes that the lending limits “used to be” 22% and 28%. I’m guessing that this must have been the rule-of-thumb during the 1980s.
  • When we bought our first home in the mid-1990s, the front-end ratio was 28% and the back-end ratio was 36%.
  • By 2004, those ratios has increased again to 33% and 38%, respectively. (To qualify for an FHA loan, your front-end DTI is limited to 29%, and the back end is capped at 41%.)

A 5% increase may not seem like a big deal, but when you’re talking about a house payment, it’s huge. Remember: 5% of a $60,000 income is $3,000 per year, or $250 a month. Many foreclosures occur because people take on housing payments that are as little as $250 a month more than they can afford.

Afraid to say “no”
During my conversation with Robb Severdia, I asked him about the growing debt-to-income ratios. He acknowledged that he’d seen the numbers rise during his decade in the industry. “Banks feel they need to increase the limits in order to be more competitive,” he explained.

“I think that in most cases, it’s a bad idea for borrowers to push that 41% back end,” Severdia said. “It might make sense in some instances, but it can be a recipe for disaster.” In other words, give yourself a margin for error. Instead of basing your home budget on a 33% front-end debt-to-income ratio, consider dropping that to 28%. You won’t be able to afford as big of a mortgage, but you won’t feel as pinched by the payments, either.

I asked Severdia how people like Christina Natale from the New York Times story were able to get mortgages that amounted to more than half their income. “People are afraid to say ‘no’,” he told me. “They were afraid to lose the deal.” Thus the subprime mortgage crisis.

In The Automatic Millionaire Homeowner, David Bach warns:

You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow. [...] Don’t fool around with this. Do the math. Be realistic about your situation. Don’t pretend you’re in better shape than you really are.

Nobody cares more about your money than you do. Your real-estate agent, your mortgage broker, and the bank all have a vested interest in encouraging you to buy as much house as possible. Their incomes depend upon it. Listen to what they have to say, but make your decisions based on your own knowledge of the situation.

Better safe than sorry
Homeowners are often admonished to “buy as much house as you can afford”. There’s some merit to that statement — in general, housing prices do increase, as does personal income. As a result, your mortgage payments generally become more affordable.

The problem, of course, is that when you buy as much house as you can afford, you’re left without a buffer. What if you lose your job? What if you’re forced to sell your home, but housing prices have dropped? I think it makes more sense to buy as much house as you need, keeping the conventional debt-to-income ratios as ceilings.

Ultimately, it doesn’t matter what the guidelines are. What matters is what you can afford, what you’re comfortable paying. Just because conventional wisdom says you can take out a $1400 monthly housing payment on your $60,000 annual income doesn’t mean you have to do it.

Foreclosure photo by respres.