How Much Should You Be Mortgaged?

“Beware of little expenses. A small leak will sink a great ship.”  – Benjamin Franklin

In April, May, and June of this year, 640,000 mortgages were in foreclosure. On a percentage basis, that’s 1.23% — the highest, by far, in the 30 years that the Mortgage Bankers Association has been tracking. The stock market deflation and the sagging economy are certainly a cause of it, but the real problem is people.

Bankers, on the one hand, are giving out loans to customers who aren’t creditworthy and encouraging those who are into buying homes that are simply too expensive. Homebuyers, on the other hand, are giving in to the vain indulgence of wanting to live in houses they can’t afford.

When I was first in the market for a house, my father gave me some very conservative advice. He told me to make sure my total house payments, including mortgage, taxes, insurance, and upkeep, were no more than 25% of my gross income. I’ve heard this advice from other people since, although the number seems to have grown. Thirty percent is a number that was popular about 10 years ago, and today, according to my brother, many banks are happy with 33% to 38%. (That’s 33% to 38% of pretax income, including property taxes and other debt — credit cards, car loans, etc.)

I don’t know whether my dad got it wrong, I misheard him, or he was purposefully being conservative, but I took his advice and — when it came time to move into my first house — bought a $62,000 home instead of the $75,000 home my wife and I preferred.

We quickly began to like our starter home, fixing it up and making it special, and I never had to stretch to make payments. So, let’s apply this conservative estimation and see how it works.

Say your household income is $90,000. My dad’s rule of thumb would indicate that you can’t spend more than $22,500 a year on housing. Remember, though, that I’m talking about total housing expenses — including insurance, taxes, and upkeep. As a rule, those three additional housing costs generally amount to about a third of total housing expense or about half of the raw mortgage fees (principal plus interest on a loan with a 30-year amortization schedule).

total housing budget: $22,500

principle and interest: about $15,000

taxes, insurance, upkeep: about $7,500

That seems roughly correct to me. A mortgage of $15,000 would buy you, in today’s good interest climate, a $150,000 to $180,000 house. On that, you’d have to pay about $3,500 a year in taxes, $1,500 on insurance, and another $2,580 ($210 a month) on upkeep. (That last number may seem high — but if you track what you spend, you’ll see that it’s fair.)

How many families in the USA with a $90,000 income settle for a $180,000 house?

Too few, I’m afraid.

As is suggested by my brother’s research, banks have become very liberal in their lending policies. They not only let you spend too much on your mortgage but also have invented all sorts of mortgages that make it easier for you to eventually go bankrupt.

There are all sorts of ways you can buy a home that is, by this standard, too costly for you. There are interest-only loans, low-down-payment mortgages, negative-amortization schemes, balloon payments, and so on.

CF, my sister-in-law, told me yesterday that one of the homes she and her husband are selling is being financed by a loan that requires no down payment. “That’s impossible,” was my first thought. But then she explained that the buyer is a single, pregnant mother of three who doesn’t have a job but gets welfare and food stamps. “Oh, then that makes sense,” I said.

These sorts of loans are very irresponsible. The bankers who make them are happily and stupidly taking the short-term money (in interest payments) while ignoring the economic fundamentals and eventual costs of foreclosures.

“Many of these products are being stress-tested for the first time in a recession,” MBA chief economist Doug Duncan told USA Today. I’ll say! When it comes to building wealth, it is a great mistake to get into a mortgage you can’t support. Not only will you be working most of your work week for the bank and the government, paying the two of them an absurdly high portion of what you make, but you also risk having your home taken away from you one day, with any appreciating value eaten up by all the unnecessary financing and foreclosure expenses.

Figure out how much you are spending. If the figure is more than a point or two over my dad’s 25% recommendation, do yourself a favor: Make a change. Start by figuring out what refinancing might do. With interest rates as low as they are likely to be in your lifetime, it’s a great time to lock in a long-term fixed mortgage. And if you haven’t refinanced recently, you may be able to reduce your monthly payments considerably — down to where they should be.

If refinancing won’t do it, consider moving into a less-expensive house. It will take a bit of gumption and courage to do so, but once you are settled and friendly with your new neighbors (and feeling relaxed about your mortgage payments), you’ll be glad you did.

As I mentioned to a group of AWAI students in a recent conversation about wealth, the cost of the house you live in is the biggest factor in the amount of money you spend each year. I’m not talking just about insurance, taxes, and upkeep. I’m talking about entertainment, vacations, cars, and so on. Your house — which means your neighborhood and friends — more or less determines these things.

“Don’t be house poor,” my mother told me. How can you enjoy your home if it means spending sleepless nights worrying about bouncing checks and new expenses? Much better to live in a nice home in a modest neighborhood in the company of good friends and with the peace of mind that comes from knowing there is extra money each month being put away for your retirement.

[Ed. Note.  Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]