Housing is the largest expense in the budget of most families. But how much is too much to spend on shelter? An article in Saturday’s New York Times contains a shocking example of one woman who crossed the line:
What she got was a mortgage she could not afford. Toward the $385,000 cost, [Christina] Natale made a down payment of $185,000, a little less than what she took away from the sale of her grandfather’s home. The loan that made up the difference, with closing costs, broker’s fee, taxes and insurance, meant a monthly bill of $1,873.96, about $100 less than her monthly take-home pay as an administrative assistant.
I am not unsympathetic to tales of financial hardship, but this stretches even my compassion. Ms. Natale (who has three children) took out a housing loan that left her just $100 a month for every other expense in her life. She shouldn’t need an outside voice to tell her that this was an impossible situation. (All the same, where were the outside voices?)
Although this is an extreme example, many other people buy homes only to discover they’re in over their heads, unable to make payments. How can you prevent this from happening to you?
Debt-to-income ratio
Fortunately, decades of financial data have produced computerized models that help to determine how much a person can afford to spend on housing and debt. To learn more about this, I recently spoke with Robb Severdia of Guarantee Mortgage in Portland. I asked him to describe how the process works. (If I have anything wrong here, it’s my fault, not Severdia’s.)
Traditionally, lenders have used the debt-to-income (DTI) ratio to estimate how much a homeowner can afford to borrow. This ratio is computed by comparing your expenses to your gross (pre-tax) income. The lower the number, the better. If you make $3,000 a month before taxes, and you pay $300 toward debt, your debt-to-income ratio is 10%.
Banks and mortgage brokers look at two numbers:
- The “front-end” debt-to-income ratio, which includes total housing expenses: mortgage principal, interest, taxes, and insurance.
- The “back-end” debt-to-income ratio, which includes all of the above plus other debt payments: auto loans, student loans, credit cards, etc.
When a prospective borrower submits her paperwork, the computer evaluates it, applying statistical models to be sure the proposed debt load falls within accepted ranges. After this automated process, the loan proceeds to manual underwriting, where a human screens the application and makes the ultimate determination to approve or deny the loan.
Industry-standard debt-to-income ratios drive this process.
Lending limits
When we bought our first home in 1994, everyone involved in the transaction told us that our front-end debt-to-income ratio should be 28% or less. That is, we should pay no more than 28% of our gross income toward housing expenses. The back-end ratio was 36%, which meant that our housing expenses and debt payments combined should total less than 36% of our income.
Because Kris had student loans and I had credit card debt, we couldn’t get close to the 28% front-end DTI ratio because it would push us over the 36% back-end. Our high debt-load meant we had less to spend on a house. Our eventual payment was $1,086 per month.
When we bought our new home in 2004, the debt-to-income ratios had changed. “That 28% figure is old,” we were told. “Most people can go as high as 33%.” The back-end ratio had been raised to 38% — and even to 41% in some models!
From what I understand, debt-to-income guidelines have gradually become more relaxed over the years. Here’s what I could puzzle together about the history of DTI (I would love to have clarifications or corrections to this list):
- Reportedly, during the 1970s (before credit-card debt became common), DTI wasn’t split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance were less than 25% of your income, it was assumed you could afford the payment.
- In The New Rules of Money, Ric Edelman writes that the lending limits “used to be” 22% and 28%. I’m guessing that this must have been the rule-of-thumb during the 1980s.
- When we bought our first home in the mid-1990s, the front-end ratio was 28% and the back-end ratio was 36%.
- By 2004, those ratios has increased again to 33% and 38%, respectively. (To qualify for an FHA loan, your front-end DTI is limited to 29%, and the back end is capped at 41%.)
A 5% increase may not seem like a big deal, but when you’re talking about a house payment, it’s huge. Remember: 5% of a $60,000 income is $3,000 per year, or $250 a month. Many foreclosures occur because people take on housing payments that are as little as $250 a month more than they can afford.
Afraid to say “no”
During my conversation with Robb Severdia, I asked him about the growing debt-to-income ratios. He acknowledged that he’d seen the numbers rise during his decade in the industry. “Banks feel they need to increase the limits in order to be more competitive,” he explained.
“I think that in most cases, it’s a bad idea for borrowers to push that 41% back end,” Severdia said. “It might make sense in some instances, but it can be a recipe for disaster.” In other words, give yourself a margin for error. Instead of basing your home budget on a 33% front-end debt-to-income ratio, consider dropping that to 28%. You won’t be able to afford as big of a mortgage, but you won’t feel as pinched by the payments, either.
I asked Severdia how people like Christina Natale from the New York Times story were able to get mortgages that amounted to more than half their income. “People are afraid to say ‘no’,” he told me. “They were afraid to lose the deal.” Thus the subprime mortgage crisis.
In The Automatic Millionaire Homeowner, David Bach warns:
You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow. [...] Don’t fool around with this. Do the math. Be realistic about your situation. Don’t pretend you’re in better shape than you really are.
Nobody cares more about your money than you do. Your real-estate agent, your mortgage broker, and the bank all have a vested interest in encouraging you to buy as much house as possible. Their incomes depend upon it. Listen to what they have to say, but make your decisions based on your own knowledge of the situation.
Better safe than sorry
Homeowners are often admonished to “buy as much house as you can afford”. There’s some merit to that statement — in general, housing prices do increase, as does personal income. As a result, your mortgage payments generally become more affordable.
The problem, of course, is that when you buy as much house as you can afford, you’re left without a buffer. What if you lose your job? What if you’re forced to sell your home, but housing prices have dropped? I think it makes more sense to buy as much house as you need, keeping the conventional debt-to-income ratios as ceilings.
Ultimately, it doesn’t matter what the guidelines are. What matters is what you can afford, what you’re comfortable paying. Just because conventional wisdom says you can take out a $1400 monthly housing payment on your $60,000 annual income doesn’t mean you have to do it.
Foreclosure photo by respres.
This article is about Budgeting, Debt, House and Home, Planning
When we bought our home two years ago, we were prequalified to purchase a house costing over $600K and our realtor kept encouraging us to look at expensive homes. Looking at a realistic budget and doing my own Realtor.com research, I set $350K as our ceiling and we eventually purchased a lovely home for $330K.
We could have purchased a small mansion with the loan the bank urged on us. And when our other home didn’t sell, and housing prices crashed, and traveling every week for my job became a huge strain, we would have been trapped and in a desperate situation. Who would have been to blame? We simply followed the rules of the lender!
Nonsense. Personal finance means personal responsibility. It really doesn’t take a masters degree in mathematics to figure out mortgage payments and approximate other bills.
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I don’t want to defend Natalie other than to say there are some people — for a variety of reasons — who are so bad at math, that I can understand how that happened. I work with some students who appear to shut down when confronted with anything connected to numbers. And so ultimately, the lenders (your outside voices) are responsible for setting limits — and I blame them for the mess the U.S. is in now.
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We are in a mess right now and our mortgage is part of it. It sucks. We bought a house we could afford and then our payments went up about a year after we bought it…so now we are scraping month to month to be able to make the payment. Sometimes even when you stick to the budget in the beginning things can get out of your control.
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My Mum used to be a Building Society manager in the UK before she changed careers (of her own choosing).
Based on her experience, she told me that I’d be able to get a mortgage for 3x my annual salary when I applied for my first mortgage (1998). I was actually told I could get a mortgage (by myself, no spouse at that time) of 3.5x my annual salary.
A few years ago I couldn’t believe that banks were reportedly offering mortgages of 5x annual salary. In my opinion the banks got greedy – as mentioned in the article they were afraid to say no. Better that they got the profits than another bank, right? Never mind the problems of customers having repayments they couldn’t afford and negative equity.
What an absolute mess. The accountability of banks world-wide seems to be frighteningly absent.
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Great Post J.D. its nice to see some information on the basics for new home buyers. As for Natale boo who she was either greedy or just plain dumb when it came to the deal on her home. People need to start taking ownership for their decisions and look at the impact of the choices they make clearly Natale did not take this time
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Around 2000, we applied for a HELOC and I was a bit concerned that our debt to income ratio would be close to the 36% level. They told me “no problem.” A HELOC ratio could be up to 50%. Even in my spending days, I was shocked by that.
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The lower your mortgage payment, the more money you have for other things, including paying down debt! I agree, it doesn’t matter what is “suggested” as an affordable mortgage… do yourself a favor and get a cheaper house with a lower payment. It’s been a lifesaver for us, and has allowed me to be at home/work out of the home part-time!
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Kind of an aside to Tony Dobson’s comment, how does the debt to income ratio calculate in to the rule of thumb of “You should spend between 2-3 times your income on a house” or “You should spend 2.5-3.5 times your income on a house” depending on who you ask. For instance, if you spend 2 times your income on your house, at current mortgage rates, what does that equate to in the debt to income ratio?
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The shame in the Staten Island woman’s case is that she seems to have had a nice lump sum of savings to hand. That could have helped her transition somewhat comfortably to life as a single woman – and a renter.
I wanted to spend $300k on my house, but the real estate agent kept showing us places listed way beyond that. It can be tough, even for someone with the smarts and pigheadedness that I have, to maneuver through the home buying process. Everyone else involved are such vultures.
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When I started in banking the dti ratio was 28 front 36 or maybe 38 back depending on variables such as credit score, amount of reserves, amount of down payment, etc. When I left banking the back ratio was 55. (This will differ by lender) I am not joking. The ratios are done on gross income (not net) and the back ratio is only using debts, not food, gas, child care, car insurance, co-pays for medicine or Doctors.
The front ratio includes your PITI= principle, interest, taxes and insurance. The back ratio includes this plus the debts that show up on your credit report. Lenders also offered all kinds of other loans. No point in typing a long response including all of them. I do enjoy your blog. I do not want to get into a debate over who is at fault or who needs to take responsibility. My suggestion is that when you are considering buying a home you have a high level of awareness of what it costs you to live on a monthly basis. Then you look at the additional cost of the home. Having a working spending plan and savings. Savings for a down payment and savings for an emergency. Again I enjoy reading your blog. I lurk. But I would be happy to help anyone who has questions. And before you ask no I do not work in banking anymore.
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In the last paragraph of this article, it states the woman wants to study accounting. If she is really this bad at math, she should save her money. Although I guess she could be an accountant for the government since they use the same fuzzy math.
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I too have a bit of sympathy for Natale for a couple of reasons.
1. Many of us were brought up to believe that bankers were “important people” “smart people” and so you would assume that you can afford the payment if they said you could, especially if you were very dependent and poor with numbers.
2. Years ago we were very young and buying our first house, we asked THE banker (my mind – “important person”) how much we could afford to pay for a house since I am not a “numbers” person. I began telling him that we had 3 children all in private school which was very important to us and started listing a few priorities that would not show on the credit report. He cut me off and told me that he just goes by what is on the credit report and not what we actually spend in a month. Fortunately my instincts knew that he no longer could hold status with me with a statement like that because I knew right there he was greedy and knew he did not care about our life’s priorities because he figured we would pull our kids from private school before we foreclosed. He did not care that I had just told him our children’s education was THE #1 most important thing to us (it was faith based, nothing against public education)It was a harsh reality because I wanted to believe the “experts” had our best interest in mind.
3. Then years later we had become fairly successful and wanted to buy a house that would double as a home and a business, very expensive, but we almost owned all of our other house, just had 3 years left on the payment. We would use all of our equity as a down payment and spread the payments over 30 years to help get the business off the ground. Everything about it was my dream. Then before we sold our house a non contingent offer came in and we tried to step down. Our banker called us non stop for the next 3 days (you get 3 days to sell your house before you lose the first place spot) and begged us to double mortgage, we could not have afforded both house payments with no money down for a week much less the months it probably would have taken for the sale of our home. It was a rude reminder how little the banks care about you as a person and that you must ALWAYS be vigilant with your own money!
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I bought my first home this summer, amid warnings that lenders had “tightened up a lot” and that it was now “very, very difficult” to get a mortgage. Yet, not one lender I talked to had the slightest hesitation in their willingness to pre-approve me for the absolute maximum amount that I felt I could afford to borrow.
It makes me kind of frightened about what they were “tightening up a lot” from.
I never understood the ARM mortgages. Why on earth would someone take out a mortgage where they don’t even know what the rate will be in a few years? If I can’t afford it with a fixed-rate mortgage, then it’s pretty clear to me that I can’t afford it. Why would someone take a crazy risk on an ARM that could potentially jump up above what they could afford to pay? I never understood that, even during the heat of the boom.
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J.D., I totally agree with your advice. We should only buy as much house as we need. What are you going to do with the extra if you buy the most you can afford? It just means more maintenance and upkeep.
@Alan Cordle (#2):
I’m sorry, but it doesn’t matter if you don’t like numbers. You are responsible for your own situation, and you can’t blame others for not telling you any better. I totally agree with what Penny said in the first comment. “Personal finance means personal responsibility.” And J.D.’s maxim of “Nobody cares more about your money than you do.”.
The bottom line is that in any transaction (especially major ones) you have to ask yourself if there’s a conflict of interest for the person giving you advice or selling you the product. If there is, proceed with extreme caution and do lots of research (if it’s important enough). This is true in every area of life – not just personal finance.
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@Traciatim:
Assuming taxes/insurance on the house cost about 2.5% of the value of the home annually (A bit high but I’m being conservative), given that interest rates are 6.06% currently, yields a 29.2% DTI ratio on a house 3*Income assuming no other debts.
To get an idea of where that 38% DTI number really is, with a 15 year mortgage (5.71% interest rate currently) the house being 3*Income still only brings us to a 37.4% DTI ratio.
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I actually did a little math based on a 50K salary and a mortgage of 100K – 175K @ 6.25% over 25 years (Normal for Canada), and it looks like this with estimated taxes, and insurance based on my own rates:
100K Mortgage, 21%
125K Mortgage, 27%
150K Mortgage, 32%
175K Mortgage, 37%
Looks like the 2 – 3 times range is pretty solid for affordable housing. Rules of Thumb FTW!
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This is such a timely post for me. I’m currently looking to buy my first home in Washington, DC, and even though this purchase is a long-term investment, the temptation to “stretch” my budget is something I’m valiantly trying to avoid.
I also second what #13 says. I haven’t noticed a lot of tightening by lenders from my end — but that may have to do with how attractive your credit score is. Mortgage lenders I’ve talked to are very excited to see scores that are 720+.
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I was shocked when my fiance and I bought our first home several years ago. We were pre-qualified for a mortgage nearly 5 times our annual income. I had initially assumed that the figure was so unreal because my fiance is an attorney, but it now sounds like this was standard practice.
We laughed out loud when they told us the mortgage we could “afford” and refused to look at any homes over 1.5x our annual salaries. (Our realtor was rather shocked herself!) It was hard; there was at least one home over our budget that we strongly considered, but in the end common sense won out. We bought a lovely, cozy 2 bedroom bungalow that we can comfortably afford when times are good and when times are…well…like they are today.
Some of his fellow attorneys bought into mega-mansions and expensive cars and all the toys. Now they’re essentially indentured servants, and it’s their own making.
Sad. The only thing that saddens me more is that we’ll end up paying the price for acting responsibly, and the only lesson folks will learn is that the government is there to bail them out of whatever problems they have.
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When I bought my first home, back in 1999, and didn’t know much about real estate I got some great advice.
First, figure out how much house I could afford on my own (using an online calculator) and making sure to include insurance and taxes and my other debt (at the time student loans/personal loan and credit card). Second, shop around for a mortgage and get preapproved. Of course when I did that I already knew how much I could afford and ignored the huge numbers I was preapproved for. Third, I worked we a good real estate agent and told him how much house I could afford and that I only wanted to see houses in my price range. He agreed and so I only saw homes that were in my price range so I didn’t fall in love with a house that was outside my range.
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These kinds of articles remind me why I think it’s important to teach my kids the ways of capitalism. We have to think for ourselves and remember that the motives of banks and retailers and manufacturers and corporations is NOT to make my life better. It’s to make money.
Sometimes I feel like an evil mother raising jaded and cynical children. Every time I take my kids to a store, we review the idea that commercials aren’t aimed at their best interest, and anyone who tries to sell them something is doing it to earn money, not because they care about my kids. I’ve even started pointing out how smart the retailers and marketers are to draw our attention to their products: Tinkerbell pictures on the Bobuli display and Kung Fu Panda pictures on the canned pasta. I talk about it as a game, where the smartest player wins: we win when we pay less for something we truly need and don’t waste money; they win when we impulsively purchase something extra or for too much money and if we don’t enjoy the purchase.
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I must be ultra-conservative. Our first home (we currently live in) was expensive to us at the time, but quickly became very affordable. Now 9 years later its only 14% of our income. I love the flexibility it gives us.
Now we are moving to a different state and buying our “forever” home – which is much larger. I’m concerned over the increse in our mortgage payment, but its still only going to be 20% of our income. Everyone is different, but I know if I have an extremely affordable home I can afford other things. I can fix my home up exactly as I want it. I can get a nicer car or afford a maid or yardman, if I need one. I can take nicer vacations or simply work less cause I can afford it! There are a lot of benefits to having less house than you can afford.
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My husband and I just bought a house last month. Our lender told us we could afford up to $350,000 with a 33% DTI. The payment would have been about $1,700 total, I think.
We bought a house for $190,000 and although it needs some work, we have the money each month to spend on it and our payment is a little less than $1,100.
I left the mortgage industry a couple of years ago and saw ratios go up as high as 45%. These brorrowers were expecting to own the house for a couple of years and then sell it for a Big profit. Then the bubble burst.
Always look at the payment before you decide how much house to buy.
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JD – This post should be mandatory reading for all loan underwriter trainees and first time homebuyers. Everyone should practice saying “no” to numbers that don’t fit. Also, Fannie Mae, Freddie Mac, and FHA should have strict ratio requirements than cannot be waived or circumvented under any circumstances. We need to take those decisions out of the hands of realtors and lenders who cannot think beyond making the sale.
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Am I the only one shocked by how much the monthly payments were on the loan mentioned from the NYT article? For a $200,000 mortgage, nearly $2000 a month seems ridiculous. I could be off base since I’ve been looking at mortgage rates in today’s market, but maybe Ms. Natale’s biggest problem wasn’t a house she couldn’t afford, but that she didn’t shop around for better mortgage rates and broker fees!
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I have to admit, we got a little wrapped up in the subprime enthusiasm. Mostly because we live in Southern CA and none of the rules you have described apply here if you ever want to own a home in a reasonable area of LA (although things are shifting quickly). Once the rules loosened it seemed like we could finally own something and stop giving money away to landlords; flawed logic I know, but there’s a lot of propaganda in this country about house owning. And a LOT of tax incentives for property owners.
Luckily nothing worked out and we continue to rent and watch prices drop and drop all around us.
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I did not know about the mortgage being 36% of take home pay. I am more used to the rule that your mortgage or total mortgage payments should not be more than 2,5 times what you earn in a year. Although this rule seems to have crept up to 3 times what you earn these last years. This probably comes from the fact that in Norway almost all have variable rate loans, not fixed rate.
I was fortunate that I could make a sizable down payment on my house, but still I must have been close to the 36% rule in the beginning, that was tough. It is better now.
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I agree that the rates seem outrageous. What is even more disturbing is that the employees in the industry worked on commission. So for every person that they sold a larger loan to they got a larger paycheck. In my opinion this is criminal and they should be prosecuted – not bailed out!
Every person is responsible for their own finances – but it doesn’t change the fact the government is currently rewarding what I view as criminal behavior.
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I want to have compassion for this Natale woman as well, but it’s hard. She now receives money from the New York Times’s Neediest Cases Fund, a charitable fund which they urge me and other solvent readers to contribute to. I’m sorry that this woman lost her down payment, but the NY Times needs to find more clear cut charitable cases for me to want to give. I feel most for her children who suffer because of adult stupidity.
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wow, that’s an amazing story. hard to believe Natale got such a loan.
In France, you cannot have a loan that’s more that 33% of your net income. to have a bigger loan, you can get more years. So we can get loan from ten years long to 30 years long. It seems moere logical for me. I can’t really understand the 3 times your annual income thingy, as it doesn’t show any concrete view of your day-to-day financial budget.
and the tip about trying to get more into the 28% range is so good. you can even try to save the 5% difference for house purpose : from the boiler that need to get changed to early repayment, or the first sum for the next house.
Do this simple 28-33% maths before going to the bank, you’ll feel better when he gives you numbers…
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@Paul Williams (#14): I did not say, “doesn’t like numbers.”
There are people who simply cannot process — mentally — numbers. Should those people never be able to purchase a home? Or should a responsible lender realize there are all kinds of people applying for loans and that as lenders THEY should follow simple codes of ethics?
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Natale’s problem was not a financial one, but a psychological one. Mentally, she was relying on other people (the ex, the “Prince Charming”) to support her. Reality? Women these days have to be prepared to live and support a family solely on what they themselves earn. In making long term financial decisions one should not rely at all on child support, alimony or any other type of ex support. What happens if the ex loses his/her job? Best to make financial decisions based solely on what you bring to the financial table — treat the rest as gravy and put it in a separate account and buy snow boots, school supplies, and other kid related stuff with it, but NEVER rely on it to prop up your housing expense.
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Two thoughts:
First, outside voices don’t intervene often because we, as a society, discourage it. That is, for some reason, it’s not okay to discuss how much one’s house costs (despite it being public information, see zillow.com). It’s also taboo to ask how much someone makes per year, although many of us are in the same price ranges as our friends. Add to those the fact that we idolize those who live big and rich, often encouraging each other to live that way, and you have a recipe for a lot of debt and nobody wanting to talk about it.
Secondly, I thought I’d throw in Dave Ramsey’s recommended housing ratio. In his cash flow planning sheet, he has 25% – 35% of your take-home pay as the amount that goes to housing. Any more than that is too much to gain traction. Listeners of his radio show will know that he admonishes 25% as the rule of thumb, which makes it easier to remember and calculate (it also plays it safe). Dave’s always been quick to tell people that they’ve got too much house (or car, or whatever) and that they’ll just tread water for years until they sell that anchor off.
-Wayne
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I don’t care what a mortgage lender wants to lend me, I do not want a mortgage payment that is more than 25% of my TAKE HOME income. This is especially important to remember if you have kids and all the expenses related to raising them. If your mortgage payment is only 25% of monthly TAKE HOME pay, then you will have plenty left over for child care, emergency savings, groceries, home maintenance, car expenses, vacation, pet care, etc. etc., etc. If it is more than that, you will feel very pinched each month. When we bought our first house in 1984, that’s what we did, then had a child, with accompanying daycare expenses, not much in savings. Just watch the credit card bills explode in a situation like that. I would not recommend that anyone go above 25% of monthly TAKE HOME (i.e., after taxes)pay.
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I’m one more who had the lenders and the real estate agents trying desperately to push me to a house I knew I couldn’t afford. My numbers came up with something like $275k for a mortgage, but my numbers said I could afford something in the $130k range. I ended up stretching a bit for $135k because we found a house with just the right layout and school district, but much smaller than the real estate agent was pushing us toward. They thought I was nuts. I also wouldn’t consider anything but a fixed rate mortgage.
But when my husband’s business (real estate appraisals) absolutely dried up to nothing and I ended up supporting him and our two children while he goes back to school full time, and we are tight on my salary but not hurting, I am vindicated in holding my ground.
People need to take responsibility for their own finances, but there also needs to be more regulation about what these unscrupulous lenders can push on people. If I hadn’t been so determined, they would have swayed me into a house that would have been disastrous for my finances and I could easily have ended up foreclosed on.
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“There’s some merit to that statement — in general, housing prices do increase, as does personal income.”
As I understand it, housing prices only increase if the average personal income of that geographic area increases. Housing prices are only a reflection of how productive its residents are. If the residents become less productive (economic contraction, health problems, working less), then house prices of that area will drop. If real (after-inflation) personal incomes drop in a particular area, so will housing prices.
squished
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The comments here, taken altogether, are a reminder that personal finance blogs attract readers who understand personal finance to some degree. Even if you’re just beginning to pay attention, you *are* paying attention and that makes all the difference.
I work with people who absolutely could not calculate the DTI ratio without being led through it. These same people probably don’t know how much they gross and don’t understand their paycheck stubs. They don’t know how to find a percentage and they don’t know how to gather the data from their own records to start the problem. They aren’t stupid, many are college graduates and all are at least high school grads, but they are abysmally ignorant about numbers.
I don’t agree with Alan Cordle, above, that these folks cannot process numbers (with the very few exceptions of dyslexic-style problems). They could learn, but society doesn’t require them to do so. They depend on car makers to tell them their mileage because they don’t know how to calculate based on gallons purchased and miles driven. They depend on the grocery store to tell them which size is a better deal because they can’t calculate price per ounce themselves. They don’t choose to buy a car based on the purchase price, instead they negotiate payments because they don’t know how to determine which is the better deal for them. In short, they depend on others for the small items so how do we expect them to be able to muddle through the big things?
I believe to a fault that I am responsible for my own choices, but that doesn’t stop me from having empathy for those who don’t know how to make better ones. Rather than blaming people, how do we tackle the problem of adults who can’t do math? How does society start valuing math and how do I, as someone who can do basic math, fit into the solution?
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I prefer the n x income method (between 2 and 3.5 depending on who you talk to). The difference in this is that it takes into account possible changes in interest rates (they were well into double figures when my parents bought, and could go there again). Of course, ideally, you’d work out what your outgoings would be at different interest rates (be pessimistic), and figure it out from there.
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To me it should be 28% and 36% of your after-tax income allowing ample opportunities to save.
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Bad with numbers? Are you serious? No way. No way, no how. If you are so bad with numbers that you seriously cannot manage a simple subtraction problem (my salary minus my mortgage leaves how much?) then no, you should not ever buy a house. At that point, you really shouldn’t have kids, either. (They require quite a bit of math as they grow older.) Frankly, I’m not sure how you’re holding down a job, managing your other bills, or going to the grocery store to buy food. I have absolutely no sympathy whatsoever.
I had a subprime loan in 2005. At the time, my husband and I were in the process of rebuilding our credit. We qualified for a traditional fixed rate 30-year loan, but the interest rate was pretty yucky. So, we took out a 2-year ARM (for a third of the amount we were approved for!) and wound up refinancing on the 2 year anniversary of that loan. When we sat down with the lender before closing on the original ARM, I asked “what is the highest possible payment I would ever have to pay on this mortgage if I was not able to refinance?” If we did not feel that we could pay that amount, then we were not going to close. Period. Then, I looked through the million-plus pages of our loan documentation and spent hours calling the lender to clarify anything I did not understand. If you can not do this, then no, you do NOT need to purchase property. You don’t need to purchase a car, a piece of furniture, or a bag of grapefruit if you cannot understand how the purchase will work and what your commitment is at the time and what it can be in the future.
Bad with numbers? I can barely add 2 and 2 in my head. I’m horrible with numbers. But somehow, I still managed to find out how much my mortgage payment was going to be. I seriously cannot image telling someone I was losing my house because I was so bad with numbers that I couldn’t figure out how much money I had to send each month to own my house.
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…and now you know where the housing bubble came from.
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Where we live (rent) now, the average home is still around $800,000. We just saw a two bedroom, two bath home listed for $900,000 in our neighborhood that probably will be sold in the next month.
Because of this and the fact that we don’t want to live in a cheaper, less safe, less aesthetically pleasing area where we can buy a “short sell” home and at the same time worry about getting shot by a stray bullet while we are sleeping, we are packing up and moving north (northwest – OUT of California) where we can find a place to buy that’s cheaper than our current monthly rent. We have a substantial down payment so that will help. If it turns out we can’t buy for whatever reason, we will continue to rent where we will end up (which is again, cheaper than what we pay here).
Right now, we are able to learn from the mistakes of others not to get in over our heads.
In terms of numbers, that is something I constantly battle with in my personal life. Numbers, math, algebra, and arithmetic are like Greek to me. I work at it though. I have web tools, calculators, books, pen and paper in order to understand something as simple (to the rest of you) my checkbook, or my take home pay, etc. Its not easy and its very time consuming.
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I am saddened by the people honestly defending full-grown adults who lack the ability to do math at a third grade level. Even people with learning disabilities can manage this. Hell, even first graders understand how to take apples out of their pile, and when they will run out.
This is nothing more than another case of someone using money they didn’t have.
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I am single and make 60k and live in the Bay Area and refuse to have a long commute. Ergo, I will likely never own! Or, I’ll have to leave this area (and believe me, I’d be fine with that).
I lived in Portland from 1996-2006 (yeah, missed a housing rocket, but wasn’t ready to purchase) and have been waiting for this crash for a long time. What kills me is that whole industries are acting shocked that this run-up is having major consequences.
I’m actually really angry about the state of the housing market, and being priced out so thoroughly in so many places. What are average incomes? what is 3x the average income? and HOW MUCH are houses going for? it just doesn’t compute.
(as an aside, I would love it if commenters would post their general location when talking about housing prices.. it would add a lot of meaning to the information)
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I rent, and my rent costs are about the same as 28% of my gross. Does that mean that it’d be more economical for me to look at owning if I can find housing that would also be in that 28%?
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I know what you mean Beth(h?). I live in Monterey, California, and when I hear the two to three rule I almost laugh out loud. You can not buy a cardboard box for that much around here, much less the lot for the box to sit upon.
I think, more than likely, this rule of thumb was invented back when it was much more feasible. Back before we had well over 300 million Americans. Back before everyone ran their lives on credit.
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@bethh – I am posting from the SF Bay Area; Berkeley/Kensington area.
@everyone – After reading the comments here, I have just learned NEVER to admit to my weakness, vulnerability, and struggles when it comes to math to anyone ever again – on or off line. Thanks for that lesson!
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Carla,
I am a high school math teacher. You should not be made to feel badly about a weakness in math….we are all gifted in different areas!! To those who have trouble with math, get a trusted friend to help you.
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While Natale is ultimately responsible for her mistake, under no circumstances should predatory lenders be excused. Unethical behavior should not be rewarded.
A couple of years ago I was looking at buying a condo. In the end, I decided I could not afford it. However, the lender was very persuasive and tried several times to convince me that I could actually afford it, and there would be absolutely no problems with refinancing later. As the past year has shown, this was false. I don’t think the lender was deliberately misleading – she could not have known she would have been setting me up for disaster. Fortunately, I trusted my own math and judgment and I said no thank you.
I know there are lots of people who think they are bad at math, and they make excuses for it. Putting together a simple mortgage calculator does not require an advanced math degree (you can download one where someone else has done the equation for you). Putting together a budget does not require an advanced math degree (can you add and subtract?). If you do not possess math skills at a high school competency, then you are putting yourself at risk of being scammed, whether buying a house or a can of coke at the convenience store. I would never trust a financial advisor or banker’s advice implicitly. I always counter their math with my own to make sure they understand they cannot bully or take advantage of me. I drive car salesmen nuts because their math is always fuzzy.
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I can see how she justified taking the leap, as I did something similar.
Notice that her apartment rents for $1400/mo. For just $400/mo more, she could be putting that money towards something she owned. (She probably didn’t fully calculating the property taxes & other home owner expenses.) Natale inherited a lump sum of cash, enough for a downpayment. If she moved into a rental, she might never have a chance to afford a downpayment again. The article said she was hoping for a 2nd job or something to stop the gap. Surely her grandparents (who left her the $) would want her & her kids to be in a house. She leaped, hoping the cash shortfall was temporary–but it wasn’t.
In the area where I lived, rents for 2 bedroom apartments were going for around $1800. Upon getting a small inheritance, I also leaped and bought a home a couple hours away in a lower-income area, so my mortgage is around what I would have paid for rent. Meanwhile, my self-employed income has dropped instead of increased. 2.5 years ago, it seemed do-able, but in today’s economy it’s not. I’ve got to ride it out as best I can, though foreclosure is a possibility.
Granted, part of Natale’s drive was having the granite counter tops and so forth that made her feel successful. My own place is a bit of a fixer. She might have found something less expensive. But for some of us (I’m in CA) there IS no “less expensive.” When rents & mortgages are similar in price, it seems stupid not to leap if you’ve got the downpayment money.
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The bank probably didn’t walk her through all the numbers. They may have even said, “Well, that $1800 a month is better than paying rent, because you’re getting equity. You’re essentially paying your rent, but you’re getting $400 or $500 a month in equity. And, at 3% annual inflation, that $1400 a month rent will be $1625 a month in five years. If you get a mortgage, you can just refinance for another 25 year term (or 40 years or whatever).” Note that her new apartment is $1400 a month. She’s still going to have to pay out utilities and so on. She’s still going to be in a tough spot. Especially in five years when her rent is $1625 a month…oh, but with no rent control, it could be even higher.
Not everyone has an education or fluency with numbers. Not everyone has an IQ of 100 (in fact, I believe the average US IQ is 98). There is a huge difference between a college-educated single man being in debt and a single mother of limited means who sees the banker as a guide, not a peer.
The major debt crisis in the US (and in much of the G7) stems from deregulation and a desire to let the invisible hand rule. Well, fair enough. But the problem is that the way these financial contractions play out is in human costs. And one of those human costs is a single mom with three kids, limited resources and a desire to probably keep her rent from going up and up while having some sort of equity.
Not only that, the bank may have included child support payments in her income calculations. Yes, she might have been $100 short on her income, but they might has assumed $600-$1800 a month in child support.
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About 2 years ago, I was in the market to buy my first home. I was looking to get a 1 or 2 bedroom condo. In the DC area this meant, I was planning on purchasing at least $230,000 worth of home. My income at the time was a little over $50,000 a year. My payments would have been around $1700 to 1800, because I had no money to put down on a house. Luckily, some strong influences in my life suggested that I wait a couple of years for 3 reasons. (1) I could save up a down payment, (2) I could maybe get a raise, and (3) the market was about to crash. Who knows how much those payments would be, considering the loans agencies were offering were all ARMs. $1700 would’ve have been pushing it. The sad thing is loan agencies were more than willing, and sometimes pushy, to give me the loan.
Caleb
http://www.mefinanciallyfree.blogspot.com
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