Every financial ‘expert’ has their favorite calculations, based on their favorite books, influences and advice. Stick with these magic figures, they imply, and you — and your budget — are automatically safe.
I could use any number of areas to test my point, but will focus on something that many people debate about: buying real estate. How much of your income can you afford to pay for buying a house? This is called a “front-end ratio,” by the way…unless you’re including all debts in the figure. Then it’s called a “back-end ratio.” (Vacation homes and rentals have even more interesting complications to deal with.)
*Dave Ramsey says 25% of your income can be used for a house…after you’ve paid at least 10% down of the purchase price, that is, and only because you couldn’t pay 100% down. (He also recommends a 15-year fixed loan, rather than a 30-year plan.) But he also cautions, “There is no magic dollar amount for the ‘perfect home.’ How much house you can afford is as unique as you are and is based on many factors—your location, income, savings, personal preferences, and most importantly, the house-buying plan you have in place.”
*Suze Orman isn’t big on a specific number. Nor does she specify 15-year versus 30-year…or fixed rate versus variable…or a down payment. (Though she recommends the latter.) She’ll use a basic mortgage calculator like Bankrate.com — with a safeguard. Instead of just slotting in the basic house price, Suze pads it by 30%, in order to cover items like home insurance, property tax, and “all the joys of home maintenance.” (More of Suze’s homeowner’s advice here.)
She adds: “It wasn’t too long ago (early 1990?s) that your monthly mortgage payments and other recurring debt payments needed to clock in at no more than 36 percent. By the height of the bubble, some lenders were writing deals at 50 percent. And you know how those loans are performing right now.So please don’t let lenders tell you how much you can qualify for.”
*Money Magazine‘s numbers have varied all over the map over the years. One thing about this venerable publication: it can change numbers at a monthly flip of the page — and often does. Lately, its writers have been more cautious: “For wealth building, smaller is better.” (Tell that to previous issues, who recommended extensive remodeling and expansions.) “Less space, resulting in a lower mortgage, improves the odds your lender will green-light the deal, and you’ll be left with more cash to invest. Standard rule: Mortgage payments (including taxes and insurance) should be no more than 28% of your gross income. A better gauge: 22%, the average for borrowers lately, says data provider Ellie Mae.” (“101 Ways to Build Wealth”, May 2013)
*The FHA says 31% (but suggests you should think about paying less). It’s specific on a back-end ratio, as well: no more than 43-45% of your income should go toward debts, including your mortgage.
Poll more experts, and you’ll have even more numbers to play with, although most are currently hovering around the 25-30% area. (Few, by the way, have concrete action plans for dealing with an income which is suddenly decreased — or disappears altogether, although they’re willing to mention that possibility.)
What should you do — 22%, 25%, 28%, 31%…or in the case of Money, just make a guess?
*Are you willing to stake your — and your family’s well-being on someone else’s calculations?Their past advice may have been reasonably trustworthy. Will it continue to stay that way? (Although I’ve noted with amusement that with every setback in the market, they often suddenly change. Suze Orman, for example, is no longer big on paying credit card debt off quickly — though Dave Ramsey hasn’t changed his mind on the subject.)
*Do the experts take regional differences into account? Often they’ll make statements based on national averages. Is the situation in Las Vegas, NV or Detroit, MI the same as your St. Paul, MN home? Can you trust that Los Angeles will act the same as Buffalo, NY? Of course not. Every place is different.
*Do they know your specific situation? Do they know that solid household income has only been there for a few months, since you were unemployed for a year before that? They may not factor in items like a new deck and landscaping, leaky pipes, or a sudden flight home because of a relative’s sickness or death. But you’ll need to. Numbers are straightforward, which feels reassuring. Reality is much more fickle.
*Are they suggesting you commit to less, instead of more? If you’re laid off, a smaller mortgage payment will be easier to scrape up than a large one. Not only that, as Money Magazine points out, “You’ll be left with more cash to invest.” (Or pay your bills. Build an emergency fund. Pay for your kid’s orthodontics. Things like that.)
*Now, more than ever, the ‘experts’ are hedging their bets. They may give a number, but they’ll also hem and haw, and use two words: “Yes, but…” Besides, there are other factors besides current income. “Before you consider buying a home, you should be debt-free and have three to six months of expenses saved in addition to your down payment,” Dave Ramsey says. “…You want your new home to be a blessing, not a curse.”
There’s no harm in listening what people and publications have to say — provided you get the most complete picture possible. Advice is helpful — but so is common sense. Remember: you’re going to be the one paying the bills. Like Suze says:
“The question you should be asking yourself is: ‘what can we comfortably afford?’ That’s what you want to borrow. Not a penny more.”