Financial Tip # 2 - Don't Ask A Barber if You Need A Haircut

Don't Ask A Barber if You Need A Haircut

This cowboy wisdom can be applied throughout your financial life. Don’t ask a realtor how much house you can afford and don’t ask a banker how much of a loan you need.

Don’t get me wrong, good advice is a thing to be treasured, but you always have to consider what someone’s motivation is. Are they working for your benefit or for theirs? When it comes to your realtor and banker, you don’t usually have to wonder.

This housing boom and the following bust came largely because people trusted their banker and real estate agent on what they could afford instead of educating themselves and proceeding with caution.

The biggest issue is that they base what you need on what they think that you can afford.

Let’s look at a little banking term called DTI (Debt to Income). This is a ratio of how much money you have going out the door compared to how much you have coming in the door each month. It seems like an easy concept until you consider that different banks, mortgage companies, finance companies, credit card companies and other lenders look at this amount differently and NONE of them look at it realistically.

Here is our example today:

Mr. Jones has a job where he makes $50,000 a year. After taxes, 401k, insurance, and other payroll deductions, he actually brings home about $37,000 a year. Divide that by 12 and you get a monthly income of $3083.

Let’s say that Mr. Jones is a normal guy and has a car payment of $420 (average American car payment) and car insurance payment of $145 (average American car insurance payment). He also has a home phone bill, cell phone bill, gas, water, and electric bills totaling $600 per month. Let’s not forget cable television and internet of $120 per month. Groceries are about $300 a month and he eats out a few times a week totaling another $200 a month. He also has credit cards with a total minimum payment due of $115. His rent at this time is $1000 a month. That brings him to a total of $3083 coming in each month and $2780 accounted for in spending each month. This doesn’t take into consideration that cup of coffee at Starbucks every morning, his medicine and clothes as well as other extraneous impulse buys.

To calculate his Debt to Income ratio, you divide his debt ($2780) into his income ($3083) to get 90.2%. That’s very high. Of course the rent would come out when he buys the house, but then he’ll have a house payment, plus property taxes and mortgage insurance, so that will likely be higher. Let’s say that totals $1200 a month. His DTI is now 94.1% He’ll have no cushion in case of emergency. Kind of scary, Huh? No lender in their right mind would offer this guy a loan. Except…

Different types of lenders and banks look at his DTI differently. Most don’t count utilities. So that automatically knocks off the $600 a month from their calculation. They also don’t think about groceries and payment history as well as that cup of starbucks every day, medical expenses, etc. So that knocks off another $500 a month from their calculation.

Then, the kicker: Most of them use Gross income, not Net income. So they take the $50,000 per year and divide by 12. Now the calculation works like this:

$50,000 divide by 12 = $4167. Total expenses used in calculation: $1880. $1880 divide by $4167 = 45.1% DTI!!! Now he’s looking good. Heck, he can afford way more than a $1200 a month payment now. Let’s get him into a bigger home. Incidentally, I think that politicians use this same methodology for balancing the budget.

As a consumer, it is YOUR job to be brutally realistic about your finances. Look at your real budget. Include those cups of coffee from starbucks. Don’t forget medical expenses, cell phones, and utilities. Groceries really do cost money and so does eating out all the time.

Calculate your own DTI before deciding what you can afford and don’t trust your banker or realtor on this. You don’t need as big of a house as you think you do.

I’m not telling you that your banker or realtor is dishonest, only that they are working in their interest too and you need to be aware of that. Don’t shut off your brain and blindly accept what they say.

Think for yourself and do the math for yourself.

And be careful where you get a haircut.

Disclaimer: I am not a trained financial advisor, I just play one on this blog. Seriously. Get good financial advice in life. My information comes primarily from personal experience, working in consumer lending in the banking industry, and watching friends, family, and parishioners struggle. But, much of this is common sense, most people just don't use their common sense when it comes to financial matters.