Manage Debt Wisely - Follow Basic Mortgage Rules

Yesterday’s blog about exotic mortgages and the high estimated rate of defaults is a great lead in to today’s column. This is my second installment of my Rules of the Road. Last week, I wrote about credit card debt and car loans (See my December 12th blog listing). This week’s rule:

Rule #2:
Never borrow more money than you can afford to pay back on your current income.

Many people justify taking on unsustainable debt based on the premise that they will earn more in the future or the asset will appreciate. They are borrowing from their future to sustain their current lifestyle. This is a dangerous strategy. What if you don’t earn more in the future? What if you get sick and can’t work or lose your job? Always live within your means, in case tomorrow doesn’t pan out like you expected.

This includes borrowing to buy a house. Do not buy more of a home than you can afford. You may be able to initially side step this problem by using some of the new exotic mortgages discussed in yesterdays blog but it is a risky strategy.

Your monthly debt payments should not exceed 36% of your gross income. So if you are loaded down with credit card debt or a car loan this will reduce the amount of monthly income you have available for your mortgage, property taxes and insurance obligations.

Here is an example: If you wanted to borrow $500,000 to purchase a house with less than 20% down. You decide not to use an exotic mortgage product but to go with a standard 30 fixed rate loan and buy the mortgage insurance (instead of getting the newer riskier piggy back loans usually in the form of a variable line of credit).

The monthly payment for a $500,000 at 6% is $2,998. To do the standard qualifying calculation, you have to add on your monthly costs for Real Estate taxes (approximately 1.1% in California that’s $460), Property Insurance ($100), Homeowner’s Fee ($30) and of course the Mortgage Insurance ($150). In this scenario these total $739. Added to the monthly mortgage payment, your obligation totals $3,737. If you are using the 36% rule then your annual gross income should be at least $125,000 a year.

To circumvent these rules borrowers are reducing payments only initially by signing up for interest-only loans so their payments are lower. These loans may offer a very low initial teaser interest rate of only 3% so monthly payments are $1,250 versus $2,998 for a few months. The buyer initially qualifies based on the reduced monthly payment. After the initial period, the interest rate resets and the payments escalate. The borrower finds themselves trapped with a mortgage that is devouring more than 60% of their gross income. It doesn’t take much for the borrower to fall behind in his mortgage payments and lose the house.

So here is the moral. Don’t overextend yourself by taking on too much debt. You risk losing the house you’ve bought and your credit rating. It is better to wait then over extend.

Libby Mihalka