Avoiding the subprime downfall

Consumers can turn the American Dream into a credit nightmare when they fall prey to the dangerous habit of borrowing more money than they can reasonably afford to repay. To avoid this trap, it’s important to have a practical and reliable understanding of how much you can actually handle in monthly payments. Then you can borrow responsibly and enjoy the success and peace of mind that comes from appropriate financial planning.

How much is too much?

Figuring out how much debt you can handle doesn’t require a degree in economics. You can easily determine your mortgage comfort zone by using a simple equation and then applying it to your overall budget. Years ago—before the current era of loose lending practices and high rates of foreclosure—mortgage companies normally let you devote a maximum of 25 percent of your monthly budget to housing expenses. If your monthly income was $4,000, you could reasonably afford to spend $1,000 on your residence, including property taxes, mortgage payment, and homeowners insurance.

In recent years, to keep up with the rising price of homes, lenders have expanded that ratio and will now allow up to 40 percent of a borrower’s gross income for housing. That’s how borrowers get in trouble. If you want to be conservative, use the old rule of thumb and don’t spend more than 25 percent. If that’s too rigid, and you’d like to keep your payments within a manageable range, shoot for somewhere in between—perhaps a moderate 30 to 35 percent—and you should be perfectly safe.

The hidden costs of subprime

When calculating your budget, keep in mind that if you borrow using a subprime versus a conventional loan, you’ll incur a more expensive monthly payment, since interest rates on subprime loans are higher. Avoid the temptation to use a subprime loan because it involves less paperwork or lets you borrow more money. In the past, lenders have allowed unqualified borrowers to state their income without any verification. (Industry research has found that the majority of applicants exaggerated their incomes by at least 50 percent.)

This strategy, which is based more on wishful thinking than reality, will only set you up for a more difficult road ahead. Stay within your comfort zone when you apply for your mortgage, and you’ll be paid back time and again with lower payments, less stress, and an improved credit rating.