How Much Should You Borrow?

By: Peter Miller
Submitted: 2007-01-17 16:16:08
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There's little doubt that we're borrowing more and there's also little doubt that credit is one of the great conveniences of modern life. That said, like Goldilocks you want to borrow the amount that's just right -- and no more.

So what's the right level of debt?

The loan qualification standards used by mortgage lenders are an important guideline. You can typically get that old standby -- the fixed-rate, 30 year mortgage -- if no more than 28 percent of your gross monthly income goes for mortgage principal and interest, property taxes and property insurance (PITI). In addition, as much as 36 percent of your gross monthly income can go to regular monthly costs -- PITI plus car payments, credit card debt, school costs, etc. In addition, because they have more liberal qualification standards, you can often borrow more with other loan programs such as FHA, VA and adjustable-rate financing.

But no matter what type of mortgage financing you consider, the real question should be not how much can you borrow, but rather how much can you borrow comfortably. In other words, financial sanity counts.

Unfortunately the term "financial sanity" is an expression without a definition. The economics that work for the Webbers plainly may not work for the Johnsons. We each have different incomes as well as different interests, expenses and preferences. Given this background one might ask: What makes financial sense for me?

The answer looks like this: If you're living from paycheck to paycheck, if monthly costs are a burden, if savings are small or non-existent, if you do not have health insurance then it's time to re-think debt burdens.

The richest person I ever met, someone who started with nothing and created jobs for more than 50,000 people, once offered this advice: "The key to financial success is saving, and nothing is harder than saving that first $10,000. After that, it's easy."

In other words, it's entirely possible to have a substantial salary and to fail the financial sanity test. The waiting rooms in every bankruptcy court are filled with people who once had big incomes and bigger debts. One day the numbers didn't work and away went the trophy houses and the big cars.

So how do you begin the savings process?

The first step, literally, is to open a savings account. The very nice people who provide checking accounts and credit cards will also be happy to hold your savings.

The second step is to go after every nickel and dime you can find.

The economics of savings resemble gravity: Little pieces brought together in one place produce big results. Here's an example: Imagine that you usually spend $2.50 per day on little things -- coffee, candy or whatever. Instead, you set the money aside in an account that pays 6 percent interest. The result? After 30 years there's almost $77,000 in your account.

There are any number of strategies to save money, but let me suggest a practical approach. Look at your debts. Pick the one with the lowest balance, say a small credit card that requires monthly payments of $25. Save and pay it off. Then identify the next remaining debt with the smallest balance. You now have $25 a month extra that can be applied to the second obligation. Save and pay off the second debt. Maybe with the second obligation you can save $50 a month. After the second debt is repaid, you have an additional $75 a month to attack the third debt.

During this process there are other steps to take. Bring lunch to work. Have one car (hard in some areas, but not impossible). Collect change at the end of the day and deposit rolls of coins every month or so. Eat out -- but not often. Stay away from credit cards. Avoid late fees and maintain good credit by paying bills in full and on time.

As this process continues you'll notice several interesting results.

First, borrowing for real estate becomes easy as debts decline and qualification scores rise.

Second, better credit results in reduced interest rates that can save you big money. Save a half percent as a result of good credit on a $300,000 mortgage and you'll cut costs in the first year of the loan by nearly $1,500.

Third, there's no tax on "savings."

If you have $1,000 in credit card debt and auto costs each month, that money is available only after taxes are paid. To get that $1,000 in cash you may have to earn $1,300 or $1,400, depending on your tax bracket and location. If you pay off your bills and don't have to pay that $1,000 a month, Uncle Sam does not raise your taxes and you gain the equivalent of a huge raise.

When you speak with lenders about your ability to borrow, consider that with good credit you likely can borrow as much as you need if not more. But also consider that as a matter of financial sanity you have a personal obligation to save. If you can buy a home, pay general expenses and still save 5 or 10 percent of your gross monthly income, the odds are overwhelming that borrowing will not be an undue burden now or in the future.

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Peter G. Miller is a syndicated real estate and personal finance columnist who appears 70 newspapers.

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