Editor's note: Christine Romans hosts CNN's "Your Bottom Line." Ali Velshi is CNN's chief business correspondent and host of CNN's "Your Money." Romans' and Velshi's reports are also featured on CNN's "American Morning." Below is an excerpt from their new book, "How to Speak Money."
(CNN) -- "To buy or not to buy: That is the question."
That's how Shakespeare might have put it if he had considered the housing issue instead of writing Hamlet.
You probably know that the housing market is in the worst shape we've seen in decades. Prices have declined from the record highs they reached in late 2006 to levels last seen in 1998. We've lost 10 years of housing gains.
Vacancies are at an all-time high. Foreclosure rates are stubbornly high. How did this happen and what does it mean for you?
How it happened goes like this. In the early 2000s, our country experienced a housing bubble. Government policies encouraged home ownership and banks gladly lent to almost anyone who could sign a mortgage document. Interest rates were low, and "no money down" became a mantra. With more people looking to buy homes, prices rose. Then people borrowed against the rising value of their properties, putting themselves deeper in debt but figuring it was safe to do so, since property values kept going up, up, and still higher. Developers jumped in with both feet, increasing the available housing stock. Then the economy began to slow down.
The first to feel it were the low folks on the totem pole. They'd had no business buying homes in the first place, and banks had been foolish to lend to them. But the banks didn't own the loans anymore. They'd sold those loans to investment firms that bundled thousands of loans together, sliced them into thin tranches, and sold those tranches to pension funds, foreign countries, and other institutional investors, including other banks. When the marginal individuals at the bottom of the pile began defaulting on their mortgages, it began a cascade of trouble that roared through the entire global economy. Interest rates rose, putting more stable borrowers at risk of default. They'd been comfortable paying an adjustable rate mortgage of x, but when it suddenly became 1.5x, or 2x, the story changed.
And as interest rates climbed and money grew tight, no one wanted those big expensive houses anymore. Home values began to slide. Then they began to plummet. Soon many people found themselves with homes worth less than their mortgages. When this happened, houses were said to be underwater; that is, the paper value of the property, as reflected in the mortgage, was more than anyone would pay for the property now. Faced with this reality, many homeowners simply walked away.
So, today, we have a country filled with unoccupied houses that are worth substantially less than they once were. With unemployment high and the job market wheezing, people are reluctant to commit to buying a home. And even if they were willing to take the plunge, banks have become much more stringent in their lending policies.
Let's look at the pros and cons. The most basic fact is this: You have to live somewhere. Unless you're staying with your parents or crashing on a friend's sofa, that means paying money for a place of your own.
Whether renting is better than buying depends on many factors, particularly how fast prices and rents rise and how long you stay in your home. An article in the May 11, 2011, issue of the New York Times suggested that buying was a more economical decision assuming you stayed in your residence more than five years.
The allure of home ownership is that, in time, the place will be yours. You pay a monthly mortgage (and, if you're living in a condo or co-op, you also pay a maintenance or management fee), but at the end of some finite period, you own it. You can turn around and sell it if you want to, or, once you've paid off your mortgage, you can simply live there without having to pay anything each month.
Given those benefits, why would anyone ever rent? Because, historically, it's been less expensive. Renting is good for people who can't really afford to buy, who don't have sufficient credit history to get a mortgage, or who don't plan to stay in the house or apartment for very long. ALI SAYS:
This is the once-in-a-lifetime opportunity to buy a house. Affordability is incredible. You look across the country and prices are down 30 and 40 percent from their peaks. Interest rates are so low that people are getting mortgages for 4 percent, or 5, or 5 and a quarter for even a big mortgage—that's just unbelievable. Rates won't stay this low. Neither will home prices.
You don't buy a house because mortgage rates are low, and you don't buy a house because prices are low; you buy a house because you need the house to live in, you've got money in the bank, and this is a good opportunity for you. What if you're a young worker who wants to be mobile? Are you going to be able to sell that house when you're offered a promotion in another city?
What's a good rule of thumb for a mortgage? What you pay for housing—be it rent, mortgage, or mortgage plus maintenance—should not exceed 30 percent of your take-home pay (or 36 percent of your gross). Anything above that is dangerous.
When thinking about how much you can afford, it's important to keep in mind not only the rent or mortgage payments but also all the other costs of running a household. These expenses include taxes, insurance, utilities, household operations (cleaning supplies, postage stamps, and the like), home furnishings and equipment, household maintenance and repairs, yard and garden supplies, and expenses related to remodeling or home improvements.
A house or apartment isn't really a liquid asset. You can sell it if you own it, but it could take you a while to do so. According to statistics, 40 percent of homes sell within one month, and an additional 34 percent sell within the next three months. So in four months, almost three out of every four homes for sale get sold.
But that's a national average, and real estate is locality-specific. In some areas of the country—parts of Florida, Nevada, and Arizona, for example—many properties have been on the market for more than a year.
BUYING A HOME
If you do want to buy, though, here are a few pointers to keep in mind.
Start by Sprucing Up Your Credit
Since you most likely will need to get a mortgage to buy a house, make sure your credit history is as clean as possible. A few months before you start house hunting, get copies of your credit report. Certify that the facts are correct, and fix any problems you discover.
Credit reports are kept by the three major credit agencies: Experian, Equifax, and TransUnion. Among other things, they show whether you are habitually late with payments and whether you have run into serious credit problems in the past.
A credit score is a number calculated from a formula created by Fair Isaac based on the information in your credit report. You have three different credit scores, one for each of your credit reports.
A low credit score may hurt your chances for getting the best interest rate, or getting financing at all. So get a copy of your reports and know your credit scores. Try Fair Isaac's MyFICO.com, which charges $15.95 each for reports and scores from Equifax and TransUnion. Experian scores and reports can be accessed from experian.com and cost $15.
Errors are not uncommon. If you find any, you must contact the agencies directly to correct them, which can take two or three months to resolve. If the report is accurate but shows past problems, be prepared to explain them to a loan officer.
Aim for a Home You Can Really Afford
Next, you need to determine how much house you can afford. The rule of thumb is that you can buy housing that runs about two-and-a-half times your annual salary. But you'll do better to use one of many online calculators to get a handle on how your income, debts, and expenses affect what you can afford.
For a more accurate figure, ask to be preapproved by a lender, who will look at your income, debt, and credit to determine the kind of loan that's in your league. If you have significant credit card debt or other financial obligations like alimony or even an expensive hobby, then you may need to set your sights lower.
The size of your down payment will also determine how much you can afford.
If You Can't Put Down the Usual 20 Percent, You May Still Qualify for a Loan
If you haven't already, you'll need to come up with cash for your down payment and closing costs. Lenders like to see 20 percent of the home's price as a down payment. If you can put down more than that, the lender may be willing to approve a larger loan. If you have less, you'll need to find loans that can accommodate you.
Various private and public agencies—including Fannie Mae, Freddie Mac, the Federal Housing Administration, and the Department of Veterans Affairs—provide low down-payment mortgages through banks and mortgage companies. If you qualify, it's possible to pay as little as 3 percent up front. For more, check out www.hud.gov, or www.fha.gov.
A warning: With a down payment under 20 percent, you will probably wind up having to pay for private mortgage insurance (PMI), a safety net protecting the bank in case you fail to make payments. PMI adds about 0.5 percent of the total loan amount to your mortgage payments for the year. So if you finance $200,000, your PMI will cost $1,000 annually.
Once you've considered the down payment, make sure you've got enough to cover fees and closing costs. They can easily add up to more than $10,000—and often run to 5 percent of the mortgage amount.
If your available cash doesn't cover your needs, first-time homebuyers can withdraw up to $10,000 without penalty from an individual retirement account. You can also receive a cash gift of up to $13,000 a year (the limit for 2011) from each of your parents (a total of $26,000) without triggering a gift tax.
Check on whether your employer can help. Some big companies will chip in on the down payment or help you get a low-interest loan from selected lenders. You can also tap a 401(k) or similar retirement plan for a loan from yourself, but do this with extreme caution!
Excerpted from "How to Speak Money" by Ali Velshi and Christine Romans. Copyright 2011 by Ali Velshi and Christine Romans. Published by John Wiley & Sons. Used with permission.