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For most of us, the purchase of a house is a particularly important financial transaction. But the recent crisis in the banking industry, centered around homeowners who couldn't afford to make their mortgage payments, highlights the fact that real estate isn't the best investment for everyone. Buyers who spend more than they can afford on a house can easily find themselves without a home and with a damaged credit report.

Worst Case Scenario

Consider the following scenario, which was common a few years ago:

Chase and Christine decided to purchase their first home. Their friend, a real estate agent, suggested that they pre-qualify for a mortgage in order to determine the amount they should spend on a house. Chase and Chris were shocked to learn that they pre-qualified for an exceptionally large mortgage - for an amount much larger than they expected. In fact, they couldn't believe that their income would support the mortgage payments on such a loan.

Chase and Christine take advantage of the pre-qualification and buy a much larger house than they would have otherwise purchased. Their monthly payments are big, but they manage to scrape by for many months. Then Chase got laid off from his job, and the interest rate on their adjustable-rate mortgage (ARM) increased, thus increasing their monthly mortgage payments.

Suddenly, Chase and Christine could no longer afford their mortgage payments. They tried to sell their home, but the real estate market had slowed down, and they were unable to find a buyer. They stopped making payments and their bank foreclosed on the home. Today they live in a rental apartment, the foreclosure has damaged their credit reports and they can't imagine being able to get approved for a new mortgage and buy a new home anytime in the foreseeable future.

Unfortunately, millions of homebuyers have found themselves in this situation, or one similar to it.

A Better Approach

A far more prudent course of action is for a home buyer to make an independent determination of how much they can afford to spend on a house. Numerous budget calculators are available on the Internet. In determining the amount to spend on a house, a home buyer should calculate how much he or she can afford to spend on several types of costs.

Upfront Costs

How much cash does the home buyer have saved to invest in a home? Most buyers save some money for a down payment, but it's easy to incur thousands of dollars of additional out-of-pocket expense while buying a new home. The following costs are incurred before closing, at closing or immediately following closing:

• Down payment
• Closing costs (these may be rolled into your mortgage)
• The cost of any immediate repairs necessary on the new house
• The cost of moving expenses
• The cost of furnishing the new house with the basic necessities

Monthly Expenses

In addition, you need to analyze how much you can reasonably afford to spend on your home on a monthly basis. One measure of this is to calculate how much money you're currently spending on housing-related costs. Can you afford your current payments? How much more could you afford to spend on a monthly basis, and are you prepared to sacrifice spending money on other discretionary expenses, such as clothing, dining out, entertainment and vacations? On a monthly basis, homeowners can expect to spend money on the following expenses:

• Mortgage payments
• Homeowner's insurance and PMI insurance
• Utilities
• Homeowners' association dues
• Maintenance costs
• Property and other real estate taxes

Changes in the Mortgage Industry

In response to the recent mortgage crisis, banks have tightened their lending rules. Consequently, banks are approving fewer mortgages, pre-qualifying buyers for smaller mortgages and charging higher rates to potential borrowers who are potential more likely to default on their loans.

Although some potential home buyers may be frustrated to find that they can't borrow as much as they would have liked on a new home, these changes are designed for protect home buyers. After all, no home buyer wants to lose his home to foreclosure and damage his credit rating because he was unable to make mortgage payments.

Related Resources on Lawyers.com^sm

- Home Purchase Worksheet
- Home Evaluation Worksheet
- Intent to Purchase Real Estate form
- Home Loans and Mortgages
- Bankruptcy, Foreclosure, or Both?
- Financing a House FAQ
- Real Estate: Selecting a Good Lawyer
- Find a Residential Real Estate Attorney in your area
- Visit our Real Estate message board for more help

Related Web Links

- How Much Home Can You Afford?
- Loan Estimator