Rob Carrick

A reality test for would-be home buyers

The Globe and Mail

(J.P. MOCZULSKI)

Never ask anyone who lends money if you can afford a house.

Lenders care about their own money. Not yours. So while you’re thinking about how you’ll manage the cost of a mortgage and all your other living expenses, lenders seek the answer to one single question: How much risk is there that this person will not repay our money on time?

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Not that lenders are oppressively picky. The more they lend, the more they make in interest. So there are no high hurdles in deciding who gets a mortgage. Partly, that’s because lenders know they have human nature working for them. If a family is having trouble paying its bills, you can be sure the mortgage will come first.

There are plenty of mortgage affordability calculators online, but they use the lender’s criteria for the most part. So let’s see what we can do to develop some simple rules that will help you understand how well you can manage the cost of owning a home.

Helping us out is Jeff Schwartz, executive director of the non-profit Consolidated Credit Counseling Services of Canada. His agency helps people overwhelmed by their debts, and he knows how problems start. “We see the remnants of people who haven’t kept their financial house in order.”

Where lenders base their analysis on gross income, Mr. Schwartz suggested using take-home pay because it corresponds to what people actually have to spend.

His basic guideline: The monthly cost of your mortgage and property taxes, plus the monthly portion of your annual home insurance bill, should not eat up more than 25 to 30 per cent of your monthly net pay.

Sure, you could push it higher. In fact, Mr. Schwartz said some clients of his agency have housing costs as high as 50 per cent of their take-home pay. “That means they’re eating Kraft Dinner to be able to afford the house they’re living in. They’re making sacrifices somewhere else.”

Capping housing costs at 30 per cent will keep some people out of the housing market, which is fine. They can rent and keep saving to build a bigger down payment. In the housing market, fools rush in.

Those who follow this guideline in buying a home will enjoy three major benefits, the first being that they’ll have room to save for retirement and for their kids’ post-secondary education. Mr. Schwartz figures a goal of saving 10 per cent of your take-home pay is realistic if you cap your housing costs at 30 per cent.

Another benefit of the 30-per-cent ceiling for housing is that it gives you enough financial slack to absorb higher costs in the future. Higher interest rates could push up the cost of your mortgage on renewal, for example. Mr. Schwartz said rising household utility bills are also an issue.

A final benefit of the 30-per-cent rule is that it leaves you with enough money to cover all the usual living costs, as well as a reasonable level of additional debt.

For some perspective on the 30-per-cent rule, let’s check with David Larock, a banker turned mortgage broker. He found this a tough standard and notes that young adults buying homes should find the costs more manageable as time passes and they move into their peak earning years.

Mr. Larock also said that people who buy a smaller, more affordable home may find they have to move in a few years. “Moving is bloody expensive – you have to pay real-estate commissions and land-transfer taxes, you’ve got to move everything. Being ultra-conservative can sometimes end up causing more harm than good.”

The problem with buying a larger home is that it will cost you more, and that means you’ll either have to save a larger down payment or stretch yourself and pay more in mortgage costs. Very likely, lenders will accommodate you on that.

The lender’s key metric for deciding how much you can borrow is the total debt service ratio, which measures your pre-tax pay against the cost of your mortgage, property taxes, heating and any other debts you have. The maximum mortgage payment is supposed to take up to 40 per cent of your gross pay, but Mr. Larock said people with solid but not outstanding credit scores may be allowed to go up to 42 or even 44 per cent.

The first casualty of being over-mortgaged is savings. “Your lender doesn’t care if you have enough money to save for retirement,” Mr. Larock said. “That doesn’t enter their thinking.”

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Can You Afford To Buy A House?

Let's say a young couple want to buy a house in a community where the average price of a detached home is $400,000. Here's how they might assess their ability to carry the cost of buying a home. This analysis was done using guidelines suggested by Jeff Schwartz, executive director of Consolidated Credit Counselling Services of Canada. To keep things simple, it's assumed here that both spouses have cleared all their debts in preparation to buy a home.

After-tax-income (using Ontario rates) *

One spouse makes $50,000

$41,113

The other spouse makes $40,000

$34,038

Total household income

$75,151

Household after-tax income per month

$6,263

The recommended ceiling for spending on a house is 25 to 30 per cent of net household income (covers mortgage + property taxes + insurance)

$6,263

x 30%

$1,879

Monthly payment on a $400,000 home bought with a 5% downpayment

$1,706

five-year fixed mortage rate of 3.29%, 30-year amortization, includes mortgage insurance costs

Estimated monthly house insurance cost

$66

based on a $800 annual premium

Estimated monthly property tax bill

$333

based on a $4,000 annual bill

$2,105

Total monthly housing cost

Verdict: Unaffordable

Suggestion: Save a larger downpayment and borrow less, or find a cheaper home

The Bank's View On Mortgage Lending

Banks use the total debt service ratio, which says the cost of housing plus carrying costs for other debts should not exceed 40% of your pre-tax income

Gross monthly household income for the couple in our example

$7,500

($90,000/12)

x 40%

Maximum a lender would let them spend on a house per month, assuming no other debts.

$3,000

* Source: Ernst & Young 2012 personal tax calculator (http://bit.ly/AbA7uH)





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Further budgeting guidelines for first-time home buyers

Assumption: Family of four

(Data supplied by Consolidated Credit Counseling Services of Canada)

If you borrowed as much as the bank would lend you ($)

If you stuck to the 30% ceiling on housing costs ($)

Net monthly income

6,263.00

6,263.00

Monthly expenses

Mortgage

3,000.00

1,706.00

Home insurance

66.00

66.00

Property Taxes

333.00

333.00

Savings

626.00

626.00

10% of net income - a suggested guideline

Other Debt

626.00

626.00

10% of net income - a suggested ceiling

Utilities

313.15

313.15

5% of net income

Food

626.30

626.30

10% of net income

Transportation

1,565.75

1,565.75

25% of net income (auto payments, auto insurance, gas, maintenance, licensing, parking)

Clothing

125.26

125.26

2% of net income

Dining Out/Personal/Pets/Smoking/Misc

313.15

313.15

5% of net income

Total Expenses:

7,594.61

6,300.61

Surplus/Deficit

-1,331.61

-37.61

based on monthly takehome pay of $6,263

Verdict

Unaffordable

Affordable with modest adjustments, like cutting non-mortgage debt