Don't underestimate your debts

Payment due marked on calendar

What you owe is as important as how much you make when deciding how much to spend on a new home.

Underestimating, or flat out ignoring, debts and inescapable monthly expenses is one of the biggest mistakes home buyers make. They wind up with a more expensive house or condo than they can afford -- and suffering for it.

All too often they assume that they can't be overspending just because the bank approved their mortgage, and that is definitely not the case.

Part of the problem is that it's easy to figure out how much you make. You collect your pay stubs and the records from any other sources of income you might have and add them all up.

Figuring out how much you owe can be a bit trickier since there are different types of debt. Mortgage lenders are mainly interested in long-term debt such as car payments, loans, alimony or child support, credit cards -- any debts that will still be around six months from now and beyond.

Your housing costs and long-term debt are used to determine your debt-to-income ratio. Federal Housing Administration guidelines say that your housing costs should be less than 31% of your income, but they add -- and this is the important part -- that when you combine your housing costs and your long-term debt, the two should add up to less than 43% of your gross, or pretax, income.

We asked Eric Tyson, co-author of "Mortgages for Dummies" and "Home Buying for Dummies" to explain the math. Here's his example:

If your gross pay is $4,000 a month and you're spending $1,000 a month on housing -- either in rent or mortgage payments -- you're spending 25% of your income on housing. Under the FHA guidelines, you could spend 31%, or $1,240. Some lenders, however, will approve loans that would let you spend 40%. That would be $1,600. The difference between that 25% and 40% -- $1,000 and $1,600 -- is $600 a month or $7,200 a year.

It's when you add in your long-term debt that people start to get confused. Is that 5% of your income? Is it 10%? Does it include utilities? A child's braces? College tuition? Regardless of what your lender looks at, you have to look at your own total regular debt -- all of it.

Take two seemingly identical families. They have the same income and want the same size loan with the same size mortgage payment. One, however, has three times the long-term debt as the other. The one with less debt will qualify for a bigger loan.

"Many people don't really understand what the numbers are saying, so they allow lenders and real estate agents to tell them what they can borrow," adds Tyson, whose most recent book is "Mind Over Money: Your Path to Wealth and Happiness."

"They leap to the conclusion that if the lender tells them they can borrow that much, they can really afford to do so. People need to take a good hard look at their current spending and budget, and examine how that is going to change with the proposed home purchase. How will the increased expenses of buying a home affect their ability to save money?"

The question really boils down to how much money do you have after paying off all your bills, including your housing costs, and how well can you live on it? That is not a question that a lender can answer. Lenders are trying to lend you as much money as they can.

That's why Tyson says there really are no hard-and-fast rules about debt-to-income ratios.

"Some people might be able to have 50% of their income go to housing expenses,'' he says. "Maybe they don't have children. Perhaps they are good savers and don't spend money on anything else."

For many people, having a home is their primary goal and all their available income goes into making it as beautiful and perfect as possible. Someone else, however, might not be able to afford to earmark even 30% of his or her income to housing costs. They might have to limit themselves to 25% because of -- what are for them -- normal expenses that the lender doesn't measure: food or clothing, educational costs or expensive hobbies.

"Maybe they have lots of kids, or they like to travel a lot, or they might have elderly parents they are caring for."

It would be easier to figure out all of this if buying a home were a cut-and-dried and dispassionate process. It isn't.

"There is so much emotion caught up in the process of buying a house," Tyson says.

People can be blinded by the idea of buying a house and so fixated on having one particular house that they will do whatever they can to qualify for the loan, even though they know that they can't really afford it. Having a house means more than merely owning a building. It is a matter of ambitions, dreams, self-image and identity.

"The house represents so many other things to them," Tyson says. "It becomes a status symbol. They just have to live in that neighborhood because once they are there ... their lives will be perfect. It can be so emotional."

Some people also hide debt.

Lenders look at your credit report and at what you tell them. However, if you have off-the-book debt, to a family member for example, or to anyone else who hasn't filed the information with a credit-reporting agency, the lender will not know about it unless you mention it.

With housing prices at record or near-record highs in many parts of the nation, it is getting more difficult for many to qualify for a home loan, especially their first one. Many people will hide debts, try to figure out ways to lie about their income, or do anything to get into a home.

This can leave them house poor -- unable to afford anything else except the house. When unexpected expenses turn up -- and they will -- the owners can find themselves in serious trouble, maybe even in foreclosure.

No matter what the debt-to-income ratio -- or your lender -- says you qualify for, only you can really determine what you can actually afford. If you can't really afford the house you want, your best bet is to learn to want a less expensive home - one that you can afford to both buy and keep.

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