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Week of 2.6.09

Coping with the Mortgage Mess
By Manisha Thakor

Manisha Thakor Manisha Thakor is a financial guru and co-author of the book "On My Own Two Feet: A Modern Girl's Guide to Personal Finance". Here she breaks down the mortgage mess and offers advice to those "held hostage by their homes."

As you may have noticed, the airwaves are filled with bleak, sad stories of foreclosures and bankruptcies. It may seem hard to believe, but the national average home price is off nearly 25% from its peak. And that's just the average. There are parts of the U.S. (California, Nevada, Florida, and wide swaths of the Midwest) that are seeing even more dramatic declines, according to the widely quoted Case-Shiller index of home prices. The headline is this: Millions of Americans are literally being held hostage by their homes. Inquiring minds want to know:

How the Heck Did This Happen??

This is a vital question because if we do not understand the roots of this debacle the odds of it repeating down the road (albeit in a different asset class... perhaps with student loans or reverse mortgages) is high indeed.

Have a question about your housing situation? Email us. Manisha will answer selected questions online next week.
With the increasing complexity of the American financial landscape, the old structural safeguards have crumbled. In plain English, years ago if you wanted to buy a home you had to put down 20% and your choices for a mortgage were two: a 15-year or a 30-year fixed rate loan. These limited options helped you save yourself from yourself. In other words, these "institutional" safe guards limited how much house you could buy. The similarities with food and body weight are striking. Think about this: In your parents' generation, people were essentially forced to eat healthier because there weren't as many pre-packaged, processed foods available. Then came the proliferation of unhealthy food choices and 24/7 fast food chains and our nation became physically obese.

The past two decades have been the financial equivalent of super-sized fries. Up until the freezing of the credit markets in the fall of 2008, you had almost unlimited options for financing your home—low money down, no money down, adjustable rate mortgages, option-ARMs, etc.

The scope of choice was breathtaking. Now, to carry the analogy a bit further, would you ever walk into a fast food restaurant and say, hmmm... let me see how much of the stuff they sell that I can eat in one sitting, would you? Hopefully not! But that's exactly what so many of us did—often unwittingly—when it came to shopping for a home and a mortgage. We asked the sellers of the loans how much we could afford and they said the financial equivalent of "well, sit down at the buffet table and see how much you can pile in, we have so many options for you to choose from."

Most Americans don't have a solid understanding of how much housing costs they can easily digest. It would have been one thing if we Americans had walked into the financial smorgasbord as fully informed consumers. But we didn't. Most Americans do not know the answer to this simple but powerful question: How much house can I afford? Had we known this, we may have stopped ourselves from biting off more home than we could chew.

How Much House Can I Afford?

The rough rule of thumb is that a family can comfortably afford a home that is up to 3 times their average annual household income. Where did this number come from? Well, think of your annual income as a pie. It has 4 slices: taxes, savings, needs, and wants. For most people taxes chew up about 25% of their gross income. In an ideal world you are saving 15% of your gross income. So that leaves you with 60% of your gross (or pre-tax) income for everything else. Your housing costs, your transportation costs, your health care, your childcare, your food, your entertainment, etc.

If you buy a house with a 20% down payment and a 30-year fixed rate mortgage—in an average interest rate environment the way the math works out is that you will end up spending about 30% on your total, all in housing costs (think: mortgage, insurance, property tax, maintenance, upkeep). That leaves you with 30% for everything else in your life. If you buy a house for significantly more than 3x your annual income, the bite that housing costs take out of your budget pie grows—and that's when the financial trouble starts. You will either have to cut back on your wants, or what happens more often—is you end up cutting back on your savings. The way housing prices got so out of control is that we all collectively bid them up WAY past the point of 3x the national average income by thinking we could keep eating at the financial buffet without getting financially obese.

What to Do Now?

If you are being forced to sell your home (you have to move for a new job, you are being foreclosed upon, etc.), the picture isn't as pretty. You will either have to take a loss and/or see your credit score suffer mightily. For all the rest of us, well, it's like waking up one day and realizing you gained 30 pounds, seemingly "overnight."

What can you do about it? Eat less and/or exercise more. If your house is holding you hostage the recipe is similar, spend less and/or earn more. This no doubt is the last thing you wanted to hear. But the good news is that if you are in a position to refinance, and you plan to stay in your home for a while, you can turn this situation to your advantage. Interest rates are low, low, low—for those with good enough credit to qualify. Go to www.bankrate.com to get a sense of current interest rates across the nation. Additionally, at present there is some talk about a possible government subsidized loan program to help existing and new homeowners lower their monthly payments through lower interest rates. However, for you (and our country!) to move forward it is vital that we all make wiser spending choices when it comes to buying a home.

Here are three rules of thumb that can help:

  • Only buy a house when you can afford to make a 20% down payment.
  • Only use a 15-year or 30-year fixed rate mortgage.
  • Only buy a house if you think you will live there for at least 5 years (because otherwise the costs associated with buying and selling your home have high odds of exceeding any gains you might make from price appreciation).

Finding the right home is like finding the right diet, there are many nuances that are particular to your specific situation. The above thoughts are meant to serve as broad, general framework, not a one-size-fits-all answer. The key point to take away from this discussion is that for a free-market economy to function efficiently, we must have informed participants.

When it came to buying homes, lenders often did not disclose enough about their terms and buyers did not ask enough questions. There are many parties to blame and likewise, it will take all hands on deck to right this ship. Each of us as Americans can do our part by taking personal responsibility for learning how much home is right for our personal circumstances. You want your home to be your haven, not hold you hostage!

 
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