There are many different opinions on the percentage of income housing costs should account for in the family budget.  One thing experts agree on, however, is that housing costs encompass more than just mortgage costs for homeowners.  Families should include homeowners’ insurance, property taxes, and maintenance costs in the housing budget. 

Prior to 1981 when the mortgage industry was deregulated, would-be homeowners were required to put 20% down on a home purchase and qualify for a loan based on only one income.  This protected banks from loss in the event one spouse lost their job or left the workforce to raise children.  Consumers were also protected by usury laws that capped interest rates the banks could charge them. 

Now that banks can consider both incomes and charge rates commensurate with risk, they are much more willing to lend whatever amount consumers wish to borrow.  This has allowed families to dig a hole making them more and more likely to face foreclosure and bankruptcy.  HUD reports 12 million families spending more than 50% of household income on housing, renters and homeowners combined.  So what is left for food, clothing, transportation, and medical care?  Even a temporary job loss or illness forces them off the financial cliff all too often.

Banks may approve a mortgage for up to 30 – 35% of your pretax income (without regard for taxes, insurance, and maintenance).  The actual percentage must be considered along with all household debt.  However, financial guru Dave Ramsey recommends not borrowing more than 25% of after-tax earnings, putting at least 10% down, and only taking on a 15-year loan.   Regardless of the philosophy you embrace, borrowing what you are comfortable with rather than what you qualify for is clearly the wise choice.

Steve and Annette Economides recommend housing costs not exceeding 40% of the primary wage-earners take-home pay in their book, Americas’ Cheapest Family Gets You Right on the Money, including homeowners’ insurance, property taxes, and a detailed maintenance plan.  They recommend allocating 10% of the mortgage payment for monthly maintenance and maintaining an emergency fund equal to 1% of the value of your home for large repairs such as furnace, air conditioning, water heater, and roof replacements. 

America’s Cheapest Family Gets You Right on the Money

CNN.com cites the median household income for 2012 at $51,017 (down nearly $5,000 inflation-adjusted from 1999).  Let’s assume the Smith family lives on this median income.  If the bank allows them to borrow with a payment equal to 30% of their income or $1,275 per month, they would qualify for a $254,397 loan.  Assuming monthly take-home pay of $2,884.95, the Economides approach would suggest taking out a mortgage for no more than $80,000 if they put down 20% to avoid additional insurance premiums of $35 to $60 per month. 

These calculations were made on total household income.  For my own calculations, I totaled up our family’s housing costs and divided them by our primary source of monthly take-home pay to calculate the percentage of our income allocated to housing costs.  It would be typical for our family to use secondary income to pay for major repairs.  We also look at improvements that would increase our home’s value as savings/investments when we have extra money as they increase our net worth by increasing the value of our assets. 

So you know your percentage, now what?

Under budget – Way to go!  Save the difference in what you are currently spending and the percentage you would be comfortable with if buying a new home is in your future.  This will speed along the process of getting to that down payment goal.

On budget – Congratulations!  Be sure to fund that maintenance account to prepare for costly replacements.

Over budget – Get down to business.  Consider all of your options to get these fixed costs under control to insulate your family from economic risks.  Look for ways to realize savings from the family’s secondary income, other budget categories, or the sale of other assets to pay down the balance of the loan below 80% of its value to eliminate the PMI requirement.  Then, consider saving an emergency fund that would help your family make payments for three to six months in the event of a job loss.  Selling a home that is more of a nightmare than the American Dream can be a sacrifice that pays off in the long term if you are overburdened with fixed housing expenses.

Next week, we will continue evaluating our spending categories on Finance Friday.

Step 1: Know Your Condition

Step 2: Dream Big

Step 3: Create a Family Spending Plan