This month, the Consumer Financial Protection Board (CFPB) put into effect new rules to protect mortgage borrowers from taking on more debt than they can handle. Despite the good intentions of these new guidelines, you might want to hold yourself to an even higher standard when deciding how much mortgage you can afford.
One of the provisions of the new rules has to do with the relationship between monthly mortgage payments and the borrower's income. The new guideline is that total debt payments, including the mortgage, should not exceed 43 percent of the borrower's income. There are exceptions to this rule which would allow you to take on debt payments even higher than 43 percent of your income, but if anything, you should go the other way. In many cases, it is questionable whether it would be wise to tie up 43 percent of your income in debt payments.
Income Considerations: Be Conservative!
Here are seven things to think about before tying up as much as 43 percent of your monthly income in debt payments:
- Your tax situation. Depending on you tax situation, it may be that 43 percent of your monthly income actually represents well over half of your take-home pay. This is especially true if you live in a city and/or state with especially high local income taxes on top of the federal tax.
- Mortgage rates. While the interest component of mortgage payments is factored into the 43 percent rule, higher payments make more sense in periods of low mortgage rates than when rates are high. Why? Because with low mortgage rates, a greater portion of your monthly payment represents principal instead of income. That means you are getting more value back in the form of home equity, rather than simply losing it to the lender in the form of interest. According to the Federal Reserve, 30-year fixed mortgage rates are currently about 4 percent lower than normal, so this would qualify as a period of relatively low mortgage rates.
- Retirement and other savings. Lenders are allowed to consider the impact of savings on the ability to repay, but you should flip that around and think about how the mortgage payments will affect your future savings. How will you ever be able to save for retirement if a disproportionate mortgage payment dominates your budget? Unless you are well ahead of schedule in accumulating a nest egg, make sure you leave room in your budget for retirement saving.
- Job security. As many people have found out in recent years, when you lose a good-paying job, it is not always easy to find a replacement at the same income level. So, before you take on a mortgage payment that pushes your current income to the maximum, you should think about how certain you are of maintaining that income over the long haul.
- Rent alternatives. If you live in an expensive area where your rent payments are already pushing close to 43 percent of your income, then you would be much better off with mortgage payments at that level so you can build home equity. On the other hand, if rents are much cheaper than a mortgage payment would be, you might be better off continuing to rent for a while so you can save up for a larger down payment. This will give you more home equity right off the bat, and allow you to take on a smaller mortgage payment.
- Other debt. Other debt payments are factored into the 43 percent debt-to-income calculation, but you have to ask yourself what the term of that debt is. If, for example, you are a year away from paying off a car loan, that means you will soon get more breathing space in your budget. On the other hand, if you still face several years of student loan payments, you may want to shoot for a less burdensome mortgage payment.
- Earnings potential. Taking on a mortgage payment that stresses your budget is one thing if you are early in a career with much higher earning potential, but it could be a long-term burden if you are near the peak of your career earnings. Consider your future earnings potential when deciding how much mortgage payment to take on - but in this economy, don't fall prey to being overly optimistic.
The new CFPB rules are designed to address some of the worst lending abuses of the housing boom. The fact that some people took on debt-to-income ratios that were more than 43 percent of income shows just how excessive some of those lending practices were. The further you stay on the low side of that debt-to-income guideline, the further your situation will be from the default epidemic of the mortgage crisis.