- The Washington Times - Friday, June 8, 2007

More than a decade ago, lenders used tried-and-true debt-to-income ratios to determine the maximum amount a potential home buyer could borrow. With the proliferation of loan programs and the introduction of automatic underwriting programs, which evaluate a variety of factors to estimate a potential borrower’s ability to repay, traditional ratios have faded in importance.

Most consumers know to meet with a lender before searching for a home in order to be prequalified for a mortgage, but not everyone realizes that the loan amount for which he or she qualifies should not necessarily be the loan he or she chooses.

As mortgage default rates climb around the country, wise consumers should be sure to evaluate all their financial circumstances before deciding how much to spend on a home.

“It’s easy to let a house purchase drive your financial plan, but it should be the other way around,” says Greg Smith, a certified financial planner with the Wise Investor Group in Reston.

Mr. Smith is heard on WMAL-AM (630) on Sunday mornings from 8 to 10 a.m.

He says consumers should make sure they can afford to continue to save for their retirement rather than rely on their home as their only investment.

A financial plan gives consumers the context in which to determine how much they should pay for their home.

“Remember the motivation of who you are talking with when you meet with a lender,” Mr. Smith says. “The lender wants you to use up every penny of what you are qualified for because their mission is to get buyers into a loan. It takes a wide-angle lens to look at the entirety of your financial situation.”

Mark Atherton, a certified financial planner with Ticknor, Atherton & Associates in Reston, says determining how much to spend on a home is complicated by the many personal circumstances that go into the decision.

“Deciding how large a mortgage to take on is based on an individual’s risk tolerance, just like any other investment,” Mr. Atherton says. “Consumers need to think about the stability of their jobs, and they need to plan for potential changes such as a growing family or a disability.”

Mr. Atherton says some financial planners have advised clients to build wealth over the past half century by moving from one home into a more expensive one and then into another more expensive home, rolling the equity from each home into the next.

Other financial planners suggest that a more balanced portfolio relies on a diversity of investments, including a home that does not consume the majority of the household income.

Jason Klein, president of City Line Mortgage LLC in Bethesda, says that qualifying for a loan depends on the borrowers’ assets, credit scores and debt-to-income ratios but that the ratios have become less of a factor now that so many loan products are available.

“When I prequalify someone for a loan, I suggest several different scenarios of monthly payments depending on the loan program, but I also ask if they are comfortable with those monthly payments,” Mr. Klein says.

Mr. Klein says he makes certain that his borrowers understand that housing costs are not simply the mortgage principal and interest payments, but that they also include taxes, insurance and condominium or homeowner association fees.

“I tell people not to let themselves get emotionally attached to what should be a business decision,” Mr. Klein says. “Becoming emotionally attached to a home can skew someone’s thoughts so they end up buying something that’s not right for them.”

Barbara Miles, a Realtor with Coldwell Banker Residential Brokerage in Bethesda, says two key elements to determining how much to spend on a home are to talk to a lender and to know what the borrower is spending now on housing.

“The starting point should be what the current rent or mortgage payments are and to decide how much more than that they can spend,” Miss Miles says. “They should back into the decision from what the lender says.”

Miss Miles says lenders and online mortgage calculators just take into account taxes, insurance and homeowner association fees but leave out utilities and the possibility of an increase in insurance costs.

“Utilities have doubled in some areas, so it’s incumbent on Realtors to provide a reality check and make sure they know the average utilities of a home they are showing,” Miss Miles says. “Insurance costs often skyrocket in areas like Georgetown or Old Town Alexandria after a flood, and in Calvert County, they went higher after storms damaged properties.”

Miss Miles says debt-to-income ratios were not supposed to rise above 36 percent overall but that ratio is a thing of the past.

Mr. Klein says the ratios depend on a consumer’s credit score, with a higher score allowing some borrowers to have debt payments as high as 45 percent of their gross income.

“It’s kind of a rule of thumb to have the back-end debt-to-income ratio, which includes all the minimum payments on all debts, including the mortgage, at less than 42 percent of the monthly gross income,” Mr. Klein says.

“But these ratios are less of a factor in determining loan approval now,” he says. “A good debt-to-income ratio for consumers is anywhere from 35 [percent] to 42 percent, but, depending on the circumstances, people can be approved for loans with higher debt percentages.”

Mr. Smith says he has heard the number 28 percent tossed around as the percent of the monthly gross income that should be spent just on housing costs.

“That number is basically just picked out of thin air,” Mr. Smith says. “If someone makes $30,000 per year, there would be almost no way they would be able to keep up with housing costs spending just 28 percent. But for someone making $5 million per year, spending 28 percent of their monthly income on a mortgage would be absurd.”

Consumers entering the housing market for the first time often are concerned about the media attention focused on the increasing number of foreclosures occurring as borrowers find they cannot make their monthly payments.

“People really need to understand their loans and make sure they know what it means when they choose an interest-only or an adjustable-rate loan,” Miss Miles says. “People need to review what the payments will be farther out, not just during the first few months or years of the loan. Some consumers assumed they could just refinance the loan, but refinancing usually requires some equity in the home, which isn’t there if they have just been paying the interest.”

Mr. Klein says the rise in mortgage defaults has been caused mostly by lenders approving 100 percent financing loans, which means the homeowners have not built any equity in their home.

“Some of the defaults are also coming from loans made to borrowers with lower credit scores and those made on the basis of ‘stated income,’ which does not have to be documented,” Mr. Klein says. “Some of those ‘stated income’ loans were based on income amounts that were simply not true.”

Home buyers concerned about affording their monthly mortgage payment often rely on the tax benefit of deducting mortgage interest to offset their monthly payments.

Mr. Klein recommends that borrowers talk to an accountant to get a feel for what the tax write-off will be. They can adjust their tax withholdings accordingly so that they keep more of their monthly paycheck rather than waiting for a tax refund.

The National Association of Realtors (NAR) Web site (www.realtor.org) includes a Housing Affordability Index that says a home selling for $337,300 requires a qualifying income of $80,688.

This figure is based on a mortgage interest rate of 6.36 percent, a 20 percent down payment and a qualifying ratio of 25 percent of the monthly gross income going to the monthly housing expense.

Many consumers opt for loan programs that require a lower down payment of just 5 percent or 10 percent, which means they must borrow a higher portion of the sales price than the example.

Loudoun County residents have the nation’s highest median household income, $98,483, but the housing costs in that county are equally high. The average price of a detached single-family home there in March was $623,530.

In the Washington metropolitan area, the average sales price in March for a detached single-family home in Arlington County was $770,503. It was $675,736 in the District, $714,042 in Fairfax County, $478,086 In Prince William County, $594,899 in Montgomery County and $368,666 in Prince George’s County.

Housing costs in the Washington region are among the highest in the nation, which often leads local buyers to purchase a home at the maximum loan amount for which a lender will qualify them.

Though borrowing the highest amount possible may not be the smartest financial move, even this may prevent consumers from affording the home they really want.

“Home buyers need to make compromises,” Miss Miles says. “They either need to pick a different location or a smaller size home or a less expensive home. Sometimes they try to wait for a change in the market to see if prices will drop, but I think prices have basically flattened or are going up slightly.”

Opting for a condominium instead of a single-family home can represent a significant savings because the average sales price in March 2007 for a condominium in the District was $390,036. In Arlington County, it was $384,128, and In Prince George’s County it was $208,770.

Mr. Atherton recommends that consumers focus on the future when making a decision about buying a home.

“People often think ahead for a year or two, but they need to look out past that and think about the next seven to 10 years,” Mr. Atherton says. “Especially during the past five years, people wanted to jump into homeownership because they thought they were missing out on something. But they need to plan for potential changes, and they need a cushion of savings.”

Mr. Atherton says homeownership is not the right choice for everyone.

“If you can’t afford it, then it’s not the right solution,” Mr. Atherton says. “The answer for many people is to rent. People don’t want to do this because they feel they are not building equity, but they can get themselves in big trouble if they take on a mortgage they can’t afford.”

For example, Mr. Atherton points out that a $400,000 condominium with all its carrying costs of insurance and condominium fees may cost $3,000 per month but that a similar rental could cost $1,500 per month.

“Buying a home just doesn’t make sense in all circumstances, especially if you are uncertain about your job,” Mr. Atherton says.

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