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In the home-buying process, the first question you must answer is “how much house can I afford?” And in an effort to determine that amount responsibly, you may have googled for a calculator like this one on CNNMoney.com, which will tell you that you can spend between 28% and 36% of your gross income on a mortgage.

But just how realistic is that advice? Let’s run some numbers.

Say the Smith family earns $52,029, the median household income (in 2008, the most recent year for which data is available). They have saved a 20% down payment on the median home price – which currently rests at $140,000 – for a down payment of $28,000. The national average interest rate for a 30 year fixed mortgage is 5.01% right now, so we plug that in as well. And we’ll also assume the Smiths are making $300 monthly payments on student loans, car notes, and credit-card debt.

The calculator reports the Smiths can buy a house valued between $192,162 and $217,016. That’s up to 55% more than the average home is selling for right now.

Surprised? We are. The lending guidelines on which this calculator and its copycats are based tell people they can afford to spend more on housing than they really can.

For example, if you’re spending 36% of your gross income on a mortgage, another 25% or more on taxes, and then you’re responsible for other monthly expenses like debt repayment, groceries, utilities, healthcare, home maintenance, and transportation, what exactly is left over for a rainy day? If you followed that advice, saving anything would be basically impossible for the average household. It’s a recipe for falling behind.

At Econ4U, we often talk about “living within your means.” But to figure out what that really means for your household, you may have to ignore commonly accepted rules of thumb and use your head instead. After all, that’s where your brain resides.

The article follows the Pemberton family in St. Petersburg, Fla., who have stopped paying their mortgage so they can put their money to more fun use, such as trips to a casino and joyrides in an airboat:

“Instead of the house dragging us down, it’s become a life raft,” said Mr. Pemberton, who stopped paying the mortgage on their house here last summer. “It’s really been a blessing.”

Because of the glut of homes in default in Florida, foreclosure proceedings last an average of 518 days. The Pembertons have yet to be evicted — meaning they will continue to live there rent-free until the bank collects its due.

The people interviewed for the article make the case that the banks should pay the price for the naïve decision to grant them mortgages in the first place, but the justification seems to originate from an ethics-free zone.

And it’s a short-sighted game, to say the least. Once the bank gets around to completing its paperwork, not only will these borrowers lose their homes, but their FICO scores will plummet by up to 280 points. And the foreclosure will stay on their credit reports for 7 years —almost as long as a bankruptcy.

Considering what their credit history means for their future job, housing, and credit prospects, these homeowners need to reconsider whether scamming the bank is worth it in the long run.

Imagine you’re buying a house, and borrowing $200,000 to do it. What is the total cost of the loan? Well 6% of $200,000 is $12,000. But that’s just for the first year. Under a standard payment plan, you’ll end up paying $231,676 in interest – 116% of the original loan amount.

Let’s look at student loans next: The standard interest rate for a PLUS Loan is 8.5% APR. If you borrow $40,000 for college and are on a 20-year repayment plan, you’ll end up paying $43,311 in interest – 108% of the original loan amount.

Do you carry a balance on your credit card? Among American households with credit card debt, the average amount is about $11,000. At a typical 18% APR, if you start paying down your balance with $300 per month, it will take about 4 years, and you’ll pay $5,090 in interest – 46% of the original loan amount.

One more example: two-week “payday” loans usually cost about $15 for every $100 borrowed. So if you get a payday loan for $400, you’ll pay $60 in interest – 15% of the original loan amount.

See the pattern here? Long-term loans generally have lower annual interest rates. But over a few decades, even a low rate can really add up. The best strategy is to pay cash when you can, and only borrow when you need to. And if you have a little spare money at the end of the month, use it to get ahead on your bills and you’ll save big in the long run.

This chart compares the total costs of these different loan types:

In line with that topic, there’s good news on the horizon for consumers concerned about the effect credit scores have on the terms they’re offered from a lender. Starting in January of 2011, the federal government will require lenders to give notice when a poor credit score results in a higher interest rate. From the Washington Post:

The rules require lenders to alert consumers whenever derogatory credit data cause them to be charged higher rates, higher down payments or less than optimal terms on a “risk-based pricing” system.

It used to be that a bad credit score didn’t mean a high interest rate – it meant you didn’t receive a loan at all. Consumers would then have the opportunity to find out why they were denied, and could appeal the decision to the lender – especially if the decision was due to an error on your credit report.

Modern credit technology changed all of that:

But with the rapid spread of risk-based pricing systems, fewer applicants were formally declined for loans; lenders simply raised rates to handle the perceived higher risk.

Though this expanded the availability of credit to those who may not have received it previously, it also meant you were less likely to find out if your credit score resulted in a higher rate until well after the paperwork was signed.

The Fair and Accurate Credit Transactions Act of 2003 set out to change that. Because of this law, you can access your credit score once a year from each of the three major credit agencies (Experian, Equifax, and Trans Union). And, starting in 2011, this new provision will ensure you know what effect your credit score has had on a loan’s interest rate before you‘re committed.

Of course, if you’re interested in improving your credit score, or in understanding your credit report, Econ4U has many resources available.

The deadline for that juicy $8,000 new homebuyer’s credit is rapidly approaching, but how do you know if you’re ready to own a home? Ask yourself the following five questions to help make that decision:

And as everyone knows by now, if you qualify only for a subprime mortgage, you cannot afford to buy — no matter how attractive that $8,000 credit looks.

The government offers several financial incentives to homeownership. From tax credits to deductible interest, buying a home and having a mortgage can reduce your tax burden significantly.

But renting makes a lot more sense if you aren’t tied to a geographical area — say by industry or family — because you have the freedom to move to where the jobs are without having to go through the process of selling your house.

Also, if you live in an area where housing prices are exorbitant, your monthly rent payment might be half what a mortgage would be on an identical property. (This article from TIME magazine explains the concept of price-rent ratios well.)

In areas with rent control, you would probably end up financially on the same footing or better as homeowners by renting long term.

A friend of mine from college grew up in a spacious Manhattan loft that his family has been living in since the 1970s. They pay a shocking $400 per month in rent. Even though they have built no equity in their housing, assuming they’ve invested the extra money they’ve saved by not paying a mortgage, they could be in a very rosy financial picture indeed. (Especially considering how much better the stock market has performed over the past 30 years than the housing market.)

Houses do have emotional value that apartments do not, but as far as finances go, there are several sound reasons to rent. The $8,000 home buyers credit that expires soon is tempting, but as always, consider all angles and read the fine print before you commit to a life-changing financial decision.

A secured loan, if you’re unfamiliar, is one backed by collateral, such as your car or your house. If you don’t pay your bills, someone comes and takes your collateral. And right now, more and more people are choosing to forfeit their possessions rather than sinking more money into their depreciating assets.

In McArdle’s words, here’s why that’s a bad thing:

If you have sizeable assets or stong income, the bank isn’t going to let you do a short sale just because your house has lost value and you don’t want to waste any more money on it. The second mortgage holder you’ve decided to stop paying will probably block the sale. If you let the house go into foreclosure while you still have assets, unless you live in a non-recourse state, the lender will come after you. As will the lender that repo’d your car. The borrowers always seem sort of shocked to find out that yes, lenders have legal recourse if you decide to stop paying them.

I wonder if they haven’t gotten this notion from all the articles about jingle mail and desperate families trying to short-sell. What seems to have sunk in is that you can stiff the bank. Yes, you can, but often only if it’s not worth suing you.

She wonders whether this unhealthy relationship with credit is just “part of the American soul” — I’d like to hope it isn’t. What does it say about our society when refusing to pay our debts on agreed-upon terms isn’t an ethical issue?

We had a great group for the presentation (check out the presentation here).

For those that were interested and unable to attend we will be hosting a make-up session on Tuesday, September 1, 2009 at 10:30am.

Have a question you want answered on the financial crisis? Post it in the comments!

Former Mets and Phillies slugger Dykstra filed for bankruptcy last week with reported assets totaling $50,000, despite claiming in April that he was worth $60 million.

According to the Los Angeles Times:

In the bankruptcy petition he said he owes JPMorgan Chase & Co. $12.9 million and Bank of America Corp.’s Countrywide and credit-card units a combined $4.2 million, according to Bloomberg News.

Dykstra also owes almost $1 million to jet charter services, about $342,000 to celebrity lawyer Daniel Petrocelli and $229,000 to literary agent David Vigliano, Bloomberg said.

Dykstra may have played an instrumental role in the Mets’ 1986 World Series win, but his financial endeavors have yielded few home runs. ESPN.com profiled his “business acumen” just three months ago. Television finance personality Jim Cramer has repeatedly hyped him as an investment savant: Dykstra will even sell you his stock picks on a website for a subscription fee of $999.95 per year.

But after years of living high on the hog, Dykstra has nothing to show for it. He purchased Wayne Gretzky’s mansion in Thousand Oaks, Calif., for $18.5 million in 2007, but his bankruptcy filing shows a combined $17.2 million in borrowing against it. He claims to own a Gulfstream II private jet, yet owes $1 million to a jet-chartering service.

Like Michael Vick, Lenny Dykstra serves as a grim reminder of how easily a fool and his money are parted — and how financial education is just as important for the filthy rich as it is for people of lesser means.

Econ4U wanted to go a step further, so we went exploring and found 12 of the most prolific personal finance gurus (both big and small) on the popular social networking website:

• OnTheMoney — from CNBC’s personal finance program of the same name, updated throughout the day
• TND_DebtCons — debt consolidation advice from TopNewsDigest.com
• GHCommunity — family budgeting tips sponsored by insurance giant Allstate
• GettingFunded — an entrepreneur shares tales from his journey of attracting investments to his business ideas
• DaveRamseyLIVE — the Twitter page for personal finance guru Dave Ramsey
• FrugalToRich — daily tips on how to save money on hotel rooms, gas, groceries, and more
• RealEstateUS — the latest in mortgage refinancing, ways to prevent foreclosure, and other real estate news
• CramerTV — hour-by-hour stock advice from Mad Money‘s Jim Cramer
• OnlineResume — a good one to follow if you’re in need of job-hunting tips
• ColumbiaEntprog — news stories and tips for building your own start-up from Columbia Business School’s Eugene Lang Entrepreneurship Center
• MJHel — small-business development ideas from market researcher Mark Helgestad
• TransformMoney — personal finance coach Melanie Fine shares ways to make your budget stretch and savings grow