No home is worth drowning in debt

THE BALTIMORE SUN

Two years ago, Andrea Eaton had just finished studying financial planning at Texas Tech University and was tempted to buy a home as she started her first job in Minneapolis.

After college apartment living, the last thing she wanted to do was to rent again. The apartments she found were discouraging - cramped and drab for the price. So she considered buying a townhouse, and a mortgage broker assured her she could handle the payments.

By the time she heard what he had in mind, however, she dropped the house idea and was satisfied paying rent. Buying a home then would have meant spending almost half her income on house payments - a risky proposition for anyone, and especially a person just starting out in a new job. If she ended up disliking her job or the community, she might have had to stay there anyway just to satisfy the mortgage payments.

"I wanted to feel comfortable, knowing I could swing it," she said, so she decided to wait.

With house prices soaring last year at the fastest rate in 40 years, many renters jumped into a home anyway - afraid a delay would make a home less affordable later on. Some reasoned that if a house didn't work out, they would sell it.

For many people, buying meant using exotic mortgage products such as adjustable-rate mortgages, with low initial rates that typically increase after a few years, which can raise payments by thousands of dollars. As interest rates rise, experts say potential buyers should be cautious before agreeing to one of these loans. For some, renting may be the better option.

A person can lose money on a home - especially if the housing market cools, as many analysts predict. People in over their head with mortgage payments who made a low down payment might have to sell a house for thousands less than they have to pay their lender.

In Eaton's case, home prices are higher than when she first thought about buying two years ago. On a national level they were up 9.4 percent in 2005, adjusted for inflation, according to the Joint Center for Housing Studies of Harvard University.

But Eaton has saved some money, and with her husband, Michael, she is buying a townhouse - using less than 28 percent of their income for payments on a 30-year fixed-rate mortgage.

That puts her purchase within the parameters financial planners recommend and gives the couple the leeway to take trips and perhaps buy a boat.

Historically, financial planners and mortgage lenders have insisted that individuals are stretching too far if they commit more than 28 percent of their gross income toward house payments, association fees, insurance and property taxes.

And that was applied to traditional fixed-rate mortgages - not the adjustable or interest-only types that let naive buyers secure affordable payments at first, delaying potentially crippling payments until later.

Now the mortgage industry no longer enforces the 28 percent cutoff. Some lenders allow borrowers to go as high as 64 percent.

For people struggling to get into homes, lenders entice them with short-term teaser rates that play havoc with household budgets when higher payments come due.

It's up to buyers to make sure they aren't stretching too far.

"Frequently, people say the lender was willing to loan to them, so that must mean they can afford the home," said William Apgar, a lecturer in Harvard's housing studies program.

But lenders make money if they provide loans, and "there is all this capacity chasing fewer borrowers" as rising interest rates discourage refinancing and home purchases.

Former mortgage lender Terry Sullivan of Minneapolis said the pressure is on brokers to do the deal. "Whatever they can get a customer to qualify for fast, they will sell," Sullivan said.

So it's a buyer-beware market, in which potential homebuyers have to examine whether they should rent or buy.

As a start, borrowers have to look beyond introductory short-term low rates.

When adjustable rates are involved, homeowners must play out scenarios. For example, they may intend to move from a home before the payments on a three-year adjustable-rate mortgage (ARM) rise to an unaffordable level.

But what if they can't move or refinance then because new houses are too expensive or interest rates are soaring? What if they lose a job or they can't sell their original home because high interest payments are deterring potential buyers? Then their $1,231 a month payment on a $200,000 loan could become $2,074 in six years.

Even worse, if they get sucked into a dangerous "option ARM," or "negative amortization loan," an initial $643 payment on a $200,000 loan would last only a month, and interest payments would keep climbing and could reach $1,448 in five years, and continue to grow. Meanwhile, the original $200,000 loan also grows.

If you have one of these loans, you should discipline yourself to pay extra each month, which gives you equity and insulates you from higher costs later.

Since these exotic loans are complicated - changing from year to year - individuals have to ask brokers to show them the worst-case scenarios for the period of time related to the loan.

Buyers also can analyze it themselves with calculators at www.mtgprofessor.com. Then, before buying a home, people need to ask themselves how they'd juggle expenses given the most troubling possibilities.

"We will never do interest-only or option ARMs," said Matthew Murphy, a financial planner in Buckeye, Ariz. "I've seen thirtysomething couples with no children and two good jobs figure they can afford payments; then they have a child and are in a precarious position if one spouse stays home."

Instead, he advises clients to save up for a down payment, and "buy what you can afford."

Besides the mortgage, homebuyers must add to their monthly payments insurance and property taxes and consider expenses such as lawn mowers, snow blowers - or new roofs - that renters wouldn't need.

Often people look at mortgage payments and think they are about the same as rent. But that can be misleading without calculating the extra costs.

Randy Gardner, a financial planner and tax professor at the University of Missouri at Kansas City, thinks people buying homes should save $150 every month in an account reserved for unexpected home repairs. On top of that, financial planners suggest people keep an emergency stash for other expenses - maybe a car breaking down or a job loss. Saving three months of pay is a rule of thumb.

Gardner also recommends delaying a home purchase if a family must spend so much for a home they cannot save for retirement or for their children's college education.

Saving for retirement is one of the reasons Eaton decided recently to forgo the $300,000 single-family home she wanted and accepted a $185,000 townhouse instead. While she's just two years out of college, she knows homeownership requires good financial planning.

Eaton, like many financial planners, discounts a common belief that people should buy a home as an investment.

"The whole investment thing is overplayed," she said.

And so are the tax benefits, said Cathy Gordon, a financial planner with CCH Inc., which designs tax guides and offers a free calculator on the Internet to help people choose between buying or renting. Find it at www.finance.cch.com/sohoApplets/MortgageRentvsBuy.asp.

Without owning a home, a person can claim the standard deduction on his tax return - $5,000 for singles and $10,000 for married people.

Gordon said that deduction can be as beneficial as deducting mortgage interest payments because a person gets the standard deduction without incurring the extra costs.

Not only are the tax benefits and investment prospects overrated, she said, but people should not expect to recover closing costs unless they stay in a home for five years.

There are signs that the extraordinary recent growth in home prices is starting to slow in some markets, said Yale economist Robert Shiller.

That could be good news for people delaying a home purchase until they are in better financial condition to buy. Still, Shiller's recent findings aren't all good news for renters. More people are starting to forgo homes and stay in rentals. As a result, rents are rising.

Gail MarksJarvis writes for Tribune Media Services.

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