Trends in the real estate market combine rapidly escalating home prices with an eagerness on the part of buyers to own property. With historically low interest rates over the past decade, competition for a limited supply of houses has driven prices through the ceiling.
These factors — and others — lead some consumers to become overburdened by their mortgage.
Struggling with mortgage payments is not limited to those on limited incomes or first-time home buyers. Seemingly wealthy buyers and those who have upgraded their real estate holdings many times also can find it hard to keep up.
The reasons for an imbalance in the family budget are many — illness, unemployment, divorce, or a spouse choosing to shorten work hours or eliminate a job after having a child.
For some homeowners, though, the problem begins when they sign the loan documents committing themselves to a mortgage that is larger than they can handle.
Although most lenders are careful to work with their clients to find a loan appropriate for their needs, some lenders will qualify buyers based on their income and good credit without focusing enough on other expenses and life changes that can affect their ability to make the required payments.
“To be fair to mortgage companies, they are trying to help people get into a home so they can begin building equity and wealth,” says Phyllis Westall, housing and education manager for the Credit Counseling Network in the Washington region.
“They will use your gross income and look at different types of ratios depending on the individual circumstances of the buyers,” she says. “But people need to be aware that the amount they will qualify you for will always be more than you will be comfortable with.”
Although Ms. Westall warns consumers of the danger of jumping in to buy a home without understanding the costs, she also recognizes the value of homeownership.
“Housing prices rose 22.7 percent in Washington, D.C., from the end of the first quarter of 2004 to the end of the first quarter of 2005,” she says. “Potential buyers can’t possibly save that much from one year to the next, so they are eager to get into the market so they can begin earning that kind of return on their money.”
“A home is a great long-term investment and equity builder, plus the tax break is always a factor,” Ms. Westall says.
“Making the stretch to own a home is usually worth it, especially if it can be done with a fixed-rate loan so the buyers are not continually making a higher payment,” she says. “Making the stretch now and budgeting to make the payments will be worth it because later the property becomes an asset.”
Consumers have a hard time knowing how much they can afford to borrow, particularly first-time buyers, who might be less financially savvy. The experts interviewed for this article differ over whether current rent is an accurate gauge, considering the tax implications of ownership. Yet home prices have zoomed upward much faster than people’s paychecks.
“I’m very conservative, and I think the automated underwriting system often approves people for a loan that is larger than they can handle,” says Phil Drew, branch manager of the McLean office of Carteret Mortgage Corp. “I recommend that the old ratios should actually be followed, which means that 28 percent of the gross monthly income should be spent on housing payments, including principal, interest, taxes, insurance and homeowner association fees.”
“Thirty-six percent of the gross income should be the total debt amount,” he says. “In other words, only 8 percent of the income should be spent on consumer debt. I realize that’s pretty difficult, since anyone with a car payment could go over that limit pretty quickly.”
Recognizing that housing costs, especially in the Washington area, have skyrocketed in recent years, financial planners and lenders are developing a variety of ways to help consumers put a roof over their heads without getting over their heads in debt.
“The majority of lenders are not overqualifying people, and very few will go above 50 percent of the income going toward a house payment,” says Rick Eul, assistant vice president of Bank of America.
“For anyone to qualify to spend that much on a mortgage, they would have to have a high down payment, great credit and a great income. Usually, housing payments don’t go above 40 to 45 percent of income,” Mr. Eul says.
Mr. Eul says he believes consumers need to avoid comparing a rental payment and a mortgage payment side by side.
“People need to remember that the tax benefits of owning a home mean that they will net more income,” Mr. Eul says. “If they want to change the amount of income withheld from their paychecks to reflect this income, a lender or their employer can give them some idea of how much should be withheld.”
“But this is a very individual decision, and the best place to determine an accurate amount to have withheld is to go to www.irs.gov, where there are formulas to figure this out,” he says.
Other financial experts say the tax issue is less important.
“The tax tail shouldn’t wag the dog,” says Greg Smith, certified financial planner with the Malone Financial Group in Reston, also heard on “The Wise Investor” radio program on WTNT-AM (570) on Saturdays from 10 a.m. to noon and on WMAL-AM (630) on Sundays from 9 to 11 a.m.
“People shouldn’t just look at a mortgage as a tax break, because having a mortgage doesn’t necessarily give as big a break as some people anticipate,” he says.
Financial planners are experts in creating budgets for families, so they recommend that consumers start their decision-making about a home loan with a financial plan in order to avoid accepting a too-large loan.
“The first thing people should do is make a list of their expenses in their current circumstances and track them for a few weeks to make sure they are accurate,” Ms. Westall says. “I actually did this myself a few years ago and discovered I was spending $700 a year on Diet Coke.”
After verifying the expenses, she says, consumers need to compare the figure with their income.
“The difference between the two is what they have to apply to a monthly mortgage,” Ms. Westall says. “People should try to live with that increased expense for a few months to see if they can handle it. Unfortunately, many, many people find that they are overextended, with their expenses adding up to more than their income.”
Mr. Smith agrees with this assessment.
“We live in a leveraged society at the moment, with nearly everyone up to their eyeballs in debt,” he says, “but people need to realize that just because they qualify for a certain loan amount doesn’t mean they should spend it.”
Consumers need to start with a financial plan, he says.
Buyers should “figure out their savings for the future and then get a good idea of what’s left over and add that together with their current rent to determine a mortgage payment they can be comfortable with,” Mr. Smith says. “Renters also need to be aware that there will be extra costs associated with owning a home, including utilities and maintenance.”
After developing an estimate of an appropriate monthly payment, consumers can begin discussing loan options with a lender.
To help buyers qualify for the high-priced homes in the Washington area, lenders have developed a variety of loan packages, including adjustable-rate loans, interest-only loans and option adjustable-rate mortgages, which give the homeowner the option to make a range of payments — interest-only, minimum or full principal and interest.
Consumers need to understand the risks associated with such loan programs before they sign the documents.
Financial experts share the concern that anticipated interest-rate increases can create difficulties in future years for borrowers who are unprepared for higher monthly payments.
“Today’s buyers are trying to get their monthly payments down, so they take out adjustable-rate mortgages. But choosing an ARM right now is like holding a cocked gun to your head,” Mr. Eul says.
Carteret Mortgage’s Mr. Drew says consumers need to take several steps to make sure they make the right decision about a mortgage.
“First, consumers need to plan for their housing costs to be 28 percent of their gross income, and then they need to look carefully at their debt,” Mr. Drew says. “Households with two wage earners need to think about buying a house on just one salary in case one spouse loses a job or has a baby and needs to cut back or stop working.”
Understanding the loan program is just as important, he says.
“There are a vast number of programs out there that buyers can find to get them into the house, but the real question is: Can they stay in it?” Mr. Drew says.
The financial-industry insiders interviewed for this article say many borrowers don’t understand what happens after five years, when the interest-only portion of a loan term ends.
Borrowers need to be prepared to pay the significantly higher monthly payments or sell their property before the loan terms are adjusted.
Interest-only loans and loans that allow borrowers to adjust their monthly payments should be considered only for the short term or for financially astute families who will voluntarily make extra payments toward the principal of the loan, the experts say.
Also, they say, choosing the appropriate loan to avoid financial straits depends in part on anticipating life changes.
“Lenders look at what the monthly payment will be, monthly income and expenses,” Mr. Eul says, “but they don’t always take into consideration the fact that many husbands and wives decide to take out a mortgage based on their joint income.”
Younger couples might decide to have a baby, which would cause their income to shrink when a spouse stops working, he says. Expenses go up because of day care costs or a new, larger car.
“Then,” Mr. Eul says, “they can’t afford to make ends meet.”
Mr. Smith recommends that borrowers choose a fixed-rate loan because it is easier to plan for the future when the only changes in the housing cost will be taxes and insurance.
Although ARMs are tempting for borrowers who want to buy a more expensive home, Mr. Smith says such borrowers invite financial stress into their lives when they are forced to refinance or sell the home when the adjustable-rate period ends.
Mr. Smith says he recommends an adjustable-rate loan only when borrowers know they will be leaving the area within five years or if they plan to sell the home in that time.
Many families struggle to pay their mortgages, sometimes because of illness or job loss or sometimes because of the addition of children to the household.
Sometimes, the loan burden has been too big from the start.
Financial advisers have several suggestions for borrowers in this situation.
“The first thing people need to do is to see if there are things they can change in their lifestyle to make the mortgage more affordable,” Ms. Westall says, providing examples such as adding a part-time or full-time job, changing a hobby into a business, and finding ways to cut expenses.
“The two dynamics are cutting back on expenses and increasing income,” she says. “Visiting a trained counselor who can look at the family’s assets and options and advise them on things like refinancing a car can be helpful.”
To find a financial consultant, visit www.nfcc.org. Consultants are listed by ZIP code.
“If someone is behind on their payments, they definitely need to contact the lender and see a counselor as soon as possible,” Ms. Westall says. “If credit card debt is the issue, a debt management program might be necessary.”
Mr. Eul warns consumers that there can be unanticipated repercussions to getting involved with a debt-management program and recommends that they avoid credit counseling unless it is necessary.
“Consumer counseling can be nothing more than a glorified collection agency, although it is a nonprofit one,” Mr. Eul says. “I had one client recently who wanted to pay off his debts and signed up with a debt-management program even though he didn’t really need it, but then he was turned down for a loan because the debt-management program showed up negatively on his credit report.”
Mr. Eul says consumers with difficulty making their mortgage payments can see if they can lower the payments through refinancing, or they can sell the house and downsize into a less expensive home.
They also can restructure their debt, paying off other debts with a home-equity loan.
“The only problem is that many people pay off their debt this way and then turn around and build up their debt again. They need to be re-educated on money management,” Mr. Eul says.
“I always go over what I call the ‘two-latte discussion’ with my clients, talking to them about how much money gets spent on things like going out to dinner, going out to lunch every day, and even each spouse having a latte on every workday,” Mr. Eul says. “Two lattes five times a week can add up to over $1,500 a year.”
Mr. Smith recommends that consumers start by finding out where in their budget they can cut spending and find extra money, and then look into refinancing or even selling the property.
“A loan officer should be a problem-solver who can work with a customer to identify financial solutions and anticipate problems,” Mr. Drew says.
“For example, one woman I am working with now has had the same job for 12 years at almost the same salary, so she will definitely be better off with a fixed-rate loan because she doesn’t have a lot of growth potential,” he says.
Another client is working to raise her credit score “because she is struggling with an 8.5 percent subprime loan,” Mr. Drew says.
“Once her credit score improves a little, we can refinance her home at a better rate and lower the payments that way, but the main thing is that consumers need to avoid getting into debt again once they have found a way out.”