In theory, mortgage companies do not want to lend you more money than you can reasonably afford to pay back each month. That seems logical because if you fail to repay your loan, the lender has to go through a costly foreclosure process that takes a lot more effort than simply cashing your check each month.
The problem is that when it comes to lending money there has always been a grey area where lenders use discretion to make loan decisions. In optimistic markets where money flows freely, that grey area expands and lenders are more willingly to accept the borrower's glass half full view of his or her own finances.
In tighter markets, such as what we experienced post-2006 housing crash, that gray area gets very narrow, with lenders adhering more strictly to the 28/36 rule. That's a long-held standard for judging whether people can afford the loan they hope to obtain.
"The '28' refers to the percentage of your gross monthly household income that should be allocated for housing costs each month, including principal, interest, taxes and insurance," according to real estate agency Re/Max's blog. "The '36' represents the total debt that you carry. It shouldn't exceed 36% of your total income."
It's a simple rule -- and one which makes sense for consumers to follow -- but as the economy has improved, and the housing crisis has receded from memory, it's one that banks and other lenders seem to be more willing to ignore. But just because a lender will loan you more money than it should does not mean you have to accept the offer.
How we ended up with too much house
Just before the housing market crashed in 2006 my wife and I upgraded from a roughly $205,000 house, on which we had made a 10% down payment to a $299,000 condo with the same amount down. The new property had higher taxes and a homeowner's association (HOA) fee, pushing our budget a bit but our expenses still fell within the 28/36 rule.
Our housing expense on the first house had been a little under $1,400 each month, including mortgage, escrow for taxes and homeowner's insurance, and private mortgage insurance (PMI). At our new home with the higher amount borrowed, around $240 in HOA, and taxes that nearly doubled (plus still having to pay PMI), our monthly housing expense moved to just under $2,250.
At the time, not only did our builder-financed loan through PulteGroup not require much documentation or income verification, it did not mandate the sale of our previous home. That left us, for a few terrifying months, paying mortgages, taxes, and other expenses on two houses.
Our income at the time could comfortably afford the new home, but certainly not two properties. Paying for both homes pushed the percentage of our income spent on housing to over 40%. That's an uncomfortable place to be, and most lenders would not approve (be it on one home or two).
Until we sold our first home, which we did after a couple scary months, we owned too much house, or in our case too many houses. That's a big part of what caused the housing crash -- people spending too big a percentage of their income on housing, making it much easier to default if anything went wrong.
Why 28/36 is a good idea
At the time we ended up owning two houses my wife and I made roughly the same amount of money. Had one of us lost our job, finances would have been stretched, and we could have easily missed a mortgage payment or even defaulted in favor of paying for food or other immediate needs.
Once we got back inside the 28/36 level, job loss or an unexpected major bill (medical expenses tend to be what sink many people) would put us in less danger of not being able to pay our monthly mortgage. It would have been tight to get by one salary, plus unemployment, but it would have been possible.
Only you can protect you
Once the crash came in 2006, mortgage lenders got much tighter with lending requirements, which for a while stopped people from buying too much house. Now, however, while standards have not returned to the days of stated-income loans (where people told banks how much they made without providing proof) they have loosened somewhat.
That puts the onus of not being tempted into buying too much house back on the borrower. It's an easy mistake to make as in many cases the borrower can easily afford the added payment as long as his or her financial situation remains unchanged or improves. Rainy days happen and even the most steady jobs sometimes go away or a health situation changes your income-earning ability.
The 28/36 rule is a guideline designed to protect banks, but it can also protect homeowners. Staying within those numbers may cost you a few square feet, an extra bathroom, or force you into accepting a city view instead of that ocean view you wanted. Those are sacrifices, but paying less because you overlook the street rather than the water beats being thrown out on the street should you default on your mortgage.