We’ve been mulling over a move and it’s been a balance of fiscal restraint vs. getting the actual home we want in a more expensive school district that makes a move even worthwhile.  There’s no sense in moving into a smaller home or having a yard we don’t enjoy, so to get the home we want in the area we’re targeting, we’d definitely be looking at a higher mortgage/tax payment than what we have now.  Now, there’s a difference between what you CAN do and what you SHOULD do.  In talking to a mortgage broker I’ve used before, he said lenders will generally give someone with our top credit rating (FICO Score of 760 and up) a loan that totals 45% (possibly as high as 50%) debt to income ratio (What is a Good Credit Score to Buy a Home).

There are some interesting factors built in there which definitely shows that’s a little too “cookie-cutter” to meet all needs.  While we may be allowed to borrow for a mortgage that will ultimately result in a debt load of up to 45% for all consumer debt combined, here are some reasons it may not make sense to assume this generice number is appropriate for all borrowers:

  • Tax Bracket – Aside from the fact that your tax bracket increases the more you make, taxes are also likely to increase in 2011 for the top couple tax brackets.  If 45% total debt to income was appropriate today, it probably won’t be tomorrow.  High earners are going to lose 3-5% of their earnings starting next year if the administration gets its way.
  • Increased Heating/Cooling Costs – Movers have a tendancy to trade up, not down.  So, chances are you’re going to be moving into a larger home which is going to cost more to heat and cool.  This may account for over $1000 per year easily.
  • Other Extras at the New Home – Throw in a pool and a new Homeowner’s Association fee and now you’re looking at another $1,000-$2,500 that weren’t accounted for.  These fees can add up and when a lender blindly quotes you a debt to income limit, they have no idea that you may be incurring these larger fees into the future, and they don’t show up on the “debt” ledger per se, but they are future debts nonetheless.
  • Children – Kids confer a huge variance into family finances that this generic model doesn’t take into account.  On the positive side, if you fall within the appropriate income limits, you can get a $1000 tax credit for each child.  In our case, that’s $3000 BACK each year, which helps.  However, kids cost WAY more than $1000 per year to raise.  So, how would a bank not consider this in the ratio requirements?
  • Commuting Costs – This may seem minor, but if you live 3 miles from work now and you’re moving to the exurbs 30 miles away to get that monster house in the country, think about what those increased commuting costs are going to do to your monthly budget.  With even conservative assumptions on depreciation and gas, that move would end up costing you over $5000 more in after-tax dollars annually than if you didn’t move.  That’s a lot of money!  The model didn’t account for that.
  • Lifestyle Inflation – Let’s face it, if you’re moving to a newer neighborhood in a more expensive area, you’re probably going to spend more money than you do now for everyday living.  Even if you’re not in the “keeping up with the Joneses” crowd, things just cost more money in more affluent areas.  And if you have kids, they tend to get more expensive the older they get.  They get involved in more activities, their clothes are more expensive, they eat more and so on.  Models don’t account for that.

This exercise is meant to reinforce that while lenders rely on this rather generic formula to set a limit on how much they’ll lend you, chances are, you shouldn’t be borrowing the maximum amount allowable just because you “can”.  You should actually set up a moderately detailed spreadsheet yourself and build in some conservative assumptions to see if taking on a larger loan makes sense for your family.  The way I structured my model was to factor in all new assumptions like increased taxes, mortgage payments, heating/cooling costs (in a larger home), etc., and look at the NET increase in monthly spending.  So, if for instance, my all-in expenditures on housing total $3000 and the new home would be $3500, we’ve gotta ask ourselves if our budget can really allow for $500 less each month.  And we also need to think about whether we can still fund our retirement and our childrens’ 529 plans without that $500 each month.  Meanwhile, our lender has already communicated the ability to borrow way more than that $3500 total monthly expenditure, but that doesn’t necessarily mean it makes sense for us.

I’d recommend you use the lender’s limit simply to know what your upper limit is with the full realization that you probably shouldn’t be anywhere near that, and from there, set up your own spreadsheet from scratch to confirm how your new financial situation will look.