The classic lending guideline says your principal, interest, property tax, and insurance (PITI) should amount to no more than 28% of your gross income. Obviously, that’s an arbitrary number. Your financial world won’t explode if you stretch a little above 28%. Although, an out sized mortgage payment is going to catch up to you sooner than later. As we’ve seen again and again over the last four years, lenders aren’t cuddly and understanding. They just want you to make your payments, month after month.
It’s not 2006 anymore, and banks are a lot more scrupulous about checking to see if you have any income before shoveling a house load of money in your direction, but it’s still your responsibility to make sure you or your partner has a steady paycheck to go with the steady mortgage payment.
A reasonably sized mortgage quickly becomes an unreasonable burden when you mix it with student loans, car loans, and credit card debt. The traditional lending guideline says that your mortgage payment (yes, including interest, tax, and insurance) and all your other debts should add up to 36% of your income or less.
On top of debt repayment, you have other non-negotiable bills every month: utilities, insurance, basic living, and maybe a tuition payment. Then there are discretionary expenses: saving, dining out, entertainment, travel, etc. In their book, All Your Worth, Elizabeth Warren and Amelia Warren Tyagi recommend that you keep your non-discretionary expenses to less than 50% of your take-home income. When too much of your income gets sucked into required expenses, you lose flexibility. A brief period of unemployment, a medical emergency, or a car repair can turn into a financial disaster that can ultimately cost you your home.
If you have a well-stocked emergency fund now, don’t drain it to fund a down payment. If you don’t have one, you’re not ready for a mortgage, plain and simple.
If you’re uninsured or underinsured, you’re in no position to buy a house, unless you’re sitting on a giant pile of money. Are you?
Small down payments lead to big problems. Reuters’ Felix Salmon crunched the numbers last year and found that mortgages with a 15%-20% down payment were more than twice as likely to become delinquent as mortgages with a 20% down payment for most years before the financial crisis. Lower down payments did much worse. His conclusion: “So, let’s all remember this chart the next time anybody claims that you can have a safe mortgage with a low down payment. Because the fact is that you can’t.”
Home equity is great—that’s why you should bring a big down payment. But it’s also undiversified, subject to the ups and downs of the real estate market, and hard to quickly turn into cash. It’s fine to have your retirement savings plan reflect the fact that your mortgage will be paid off in retirement and your ongoing housing costs will be low.
Unless you’re prepared to stay in your house for seven to ten years, the costs of buying and selling are likely to swamp any price appreciation. Put more simply: If you move a lot, you’re better off renting. And most people underestimate how soon they’ll want to (or need to) move. Look at your past behavior and be realistic.