The Debt-to-Income Ratio: How Much House Can You Afford?
Tuesday, 11th November 2008 (by J.D.)This article is about Budgeting, Debt, House and Home, Planning
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.
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.
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.
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.
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.
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
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.
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!
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?
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.
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.
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.
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!
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.
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.
@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.
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!
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+.
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.
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.
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.
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.
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.
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.
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!
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.
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.
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.
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.
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…
@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?
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.
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
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.
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.
“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
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?
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.
To me it should be 28% and 36% of your after-tax income allowing ample opportunities to save.
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.
…and now you know where the housing bubble came from.
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.
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.
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)
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%?
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.
@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!
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.
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.
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.
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
@Alan Cordle (#30):
If someone is so mentally handicapped that they cannot process numbers and simple mathematical procedures, then they should either have a guardian or some kind of state-assisted guide.
It would be nice if all commissioned salespeople and anyone with a conflict of interest was nice enough and knowledgeable enough to provide the right kind of advice for all their customers. But do you seriously think that would ever happen?
Whatever happened to personal responsibility, wisdom, study, research, etc.? Should we forget about all those because “somebody” should have told us better???
Living in California the debt to income ratios tend to be quite high. I had a really high debt to income ratio when I bought my house, because the loan/purchase was based solely on my income. Mr M works freelance, his income wasn’t any help in qualifying. I had to find a lender willing to do a high ratio, I had great credit so it wasn’t too hard. My lender, a credit union, allows up to 60% debt to income! I was pushing 55% at the time.
Even though we had an additional income, it was a stretch the first two years. House poor is what we call it. I ran up some credit card debt as a result. Finally the only that helped was increasing my income and paying off my car loan. My ratio now (with just my income) is down to about 30%. It’s much more comfortable.
Math is not easy for most people. Critical thinking is not easy. I don’t think I am naturally gifted at math - I was always envious of people in school who seemed to find it so easy. But after a few years of working puzzles and real world problems for practice, I started to recognize patterns, which is all the ‘gifted’ people really do - they just caught on to it sooner than I did. It’s a skill that takes work and practice. In today’s world, it is a critical skill. If you’re bad at math, you’re an easy target for all kinds of scammers. Ours is a finance based society, and math is the language of finance.
RE #13
ARM’s are great in certain situations. In our last house, we had a 30 year mortage at 6.125%. 5 year ARM’s were running around 5.25%. Reminder: A 5 year ARM means the rate doesn’t reset for 5 years. We only stayed in the house 4 years and I don’t want to think about how much extra interest we paid. The last statistic I read was the average American only stays in their house for 7 years. We are currently building a new house and earlier this summer 30 year mortages were at 6.25% and a 5 year ARM from ING was 5.5% along much cheaper closing costs than any bank in my area. I figured that by taking the ARM we would save just over $9000 in interest expense over 5 years. We don’t know how long we’ll stay in this house so I got a 90 day lock at 5.75% on a 30 year but it’s important to understand these are good options for many folks depending on their situations.
I haven’t read all the comments here - so I apologize if this is a repeat. However, I am in the middle of rearding Alan Greenspan’s “Age of Turbulance” and in the book he mentioned that while he thought it was nice that more people were being encouraged to buy houses by the federal governement encouraging relaxing the criteria for mortgages, he was a little concerned about it.
This whole mortgage mess is a case of bad lending practices (banks/mortgage companies denying the reality) and yes, definitely some borrowers that either didn’t take the time to understand their true financial position, or just ignored. It can be hard for a business or potential borrower to say “no, not gonna do it - bad idea!” when you have the fed govenment saying”Lend! Borrower! Everyone should experience the American Dream even if you cannot really afford it!” However, the ultimate responsibility definitely lies with the borrowers and lenders.
I don’t really feel for the person in the example you put here, though. A third grader should be able to figure out that $100 a month doesn’t cut it for expenses for 1 person, forget plus kids! Maybe she had some other plans that didn’t work out, but it wasn’t very smart. And with that much cash she had to put down, she could have gotten something more reasonable with a mortgage she could have really afforded.
Alas, hindsight is 20/20.
Good post - I was in mortgage banking as a closing rep/process back in the 90s and by the time we started talking to mortgage brokers 2 years ago - I was appalled by what they said we could afford and what we actually could afford. We finally bought earlier this year, and stayed clear of all the crazy loans.
I think they should go off of NET not gross. But that’s just me.
Why do people act as though advocating for societal responsibility means abdicating personal responsibility, and as though the only way to advocate personal responsibility is to abdicate societal responsibility? If we want to have any kind of society at all, we need to have BOTH!
Yes, people need to take responsibility for their finances, and yes, we need basic business ethics & light-handed regulation to prevent predatory practices. These are NOT mutually exclusive!
When I started house-hunting in 1996, I had no other debt and a decent annual salary, but I was a single mother. Both my Realtor and my bank told me that I could afford way more than I was comfortable with.
For awhile, the realtor kept trying to show my houses at the level she had decided I could afford, rather than houses that were under my self-imposed limit. When I refused to look at them, she eventually started showing me houses in my price range. Although at first they were fixers in fairly bad shape, eventually she started showing me the type of house that I was looking for.
The banker also tried to push bigger mortgages. And, when I said no, tried pushing ARMs because then my “payments would be smaller at first and who knows if I’d even still be living in the house when they started to go up.”
I eventually purchased a home that cost less than 1/2 of what I was told I “could afford.” I put 1/3 down and insisted on a 30-year fixed. My mortgage payment is less than I could rent an apartment for. When I needed to take on a car payment, it wasn’t an undue stretch.
I’m still perfectly happy in this house — it’s the house I need — and have no intention of moving any time soon.
While I do feel sorry for the Natalie’s of the world, I also believe that one must be responsible for one’s choices. If you don’t understand the math, keep asking until you do and don’t sign the contract until then.
Unethical lending is also not OK, and any lenders who committed fraud should be hung, drawn and quartered (or a legally acceptable alternative.
Someone:
For the most part societal responsibility exists, because people do not take personal responsibility. Address the individual and the former is needless.
To Adam: AMEN Brother!!!!
It’s your signature on the mortgage application. It’s your signature on the property deed.
These are all decisions you make. And all your responsibility. No one else is to blame.
If the total payment was $1873 and her take home was about $100 more than that then she’s making around $30,000 total a year. With that loan, her payment/income ratio would be about 75%. Either we aren’t being told her total income including childcare & alimony or that bank was predatory at worst and negligent at minimum. The article does mention :”And her ex-husband’s small financial contributions had abruptly stopped” so her ex husband was paying her something. We don’t know how much. We also don’t know what other income she might have had.
As is typical with news articles they leave out some specifics and details and the article can come across leaving a different impression than reality.
I think people should lay off attacking the womans math skills. We’re likley missing specifics on her income situation. And in any case half of us are below average in math and thats no cause for the other half to get all condescending about it.
Sam #19 had almost identical situation to myself. I also bought my home in 1999 and I followed the same steps. 1) figure my budget and decide what payment I can afford 2) get preapproved and ignore what max loan they told me (I can’t even remember) 3) work with a realtor with predefined limit on my spending. I never had anyone push a higher loan on me and my realtor was good about showing me houses in my range. I did end up spending a little more than I originally wanted but it was less than 10% difference and I couldn’t find good homes for the price I originally wanted and she didn’t push me to do it. My first loan was about $140k and my income at the time was around $50-60k. So I was in the 2-3 range of mortgage multiples of income. My debt/income came out to about 25-30%. I live in Oregon. The only think I should have done different in hindsight was have a higher downpayment. I only had about 3% down at the time.
@Kevin, #24 said: “For a $200,000 mortgage, nearly $2000 a month seems ridiculous.”
THe payment was $1873 and it included taxes and insurance. The home was worth $385k and property tax in NY is about 1.7% average so her taxes alone are around $500 a month. Insurance could easily run another $100 a month. Principal and interest on a $200k loan at 6% would be $1200. So it would easily add up to $1800 range.
Jim
You really should do your DTI, because you know your expenses to income. Someone can tell you all day long that you can afford x based off of your income, but that definitely doesn’t convey your actual expenses to include your savings goals. I exchanged long emails with another blogger about how I did not feel my wife and I could afford a home, and the blogger was arguing i could afford a home, just not the home that i wanted. i replied that why would i buy something that i didn’t want? I would rather rent, until i could afford the house that i wanted.
@Alan: I echo others, if you shut off in the face of numbers, you need to find someone who doesn’t have a stake in the mortgage to help you out. If you don’t understand, then don’t sign.
@April: you have to consider whole cost of ownership and contingencies. If you could afford the home at the teaser rate, but couldn’t afford it when it adjusted, then you couldn’t afford it to begin with.
@Cathy: I never understood the big deal about the vilification of predatory lenders. What the heck does that mean anyways? sales people, lenders, and marketers all “target” groups based off of income, race, age, etc. All you have to do is say no. If you can’t, then you do reap what you sow.
@seawallrunner
Does the same go for people who sell guns to kids who shoot up schools? No responsibility whatsoever?
We took a homebuyer education class before we ever started looking at houses. These classes are very cheap, sometimes free, and are offered to first-time homebuyers at any income level. The class we took provided general information about the homebuying process, how to shop for an agent and a mortgage, how to figure out what you can afford, how to organize your priorities, etc. etc. They also had listings of partner agents, brokers, banks, etc. whom they had vetted and determined were responsible. As a result, not only were we armed with information, but the agent and broker we worked with only showed us houses and loans we could afford. In addition, we had support every step of the way; someone we could call with questions or concerns, someone to help my boyfriend fix his credit, all kinds of stuff. It was fantastic and everyone should do it. It would prevent all these kinds of problems from happening.
Our first mortgage was a 5-year hybrid loan - 5 years at a fixed rate and then adjustable after that. Our “homebuying coach” made sure we knew exactly what we were getting into with that kind of loan. The fact was, I had never lived anywhere for 5 years in my life, and also we planned to refinance anyway when my boyfriend’s credit improved. We have since refinanced into a 30-yr fixed at a screaming good rate. I never want to move again.
@Tim:
The reason you would buy a home you didn’t want is simple. For profit. People see prices go up, so they want free money and buy. This causes prices to go up more. Rinse and repeat until it all comes crashing down.
The housing market is literally a giant Pyramid Scheme.
Basing the percentage on your total take-home pay seems even too risky, IMO. We based ours on the dollar amount we put towards monthly bills, therefore discounting savings, emergency funds, and so on.
The example you have here may not include information related to child support. The smart single mom’s live VERY frugally so that a skipped child support payment doesn’t equal losing the home.
No one should buy a home without having a monthly budget. No one should buy a home without considering how much they will need to set aside on a monthly basis to maintain the home. I live in a subdivision of homes where many have not been painted in more than 10 years.
I think that we all need to remember that these lender guidelines are predicated on 2 assumptions that are no longer true - rising home values, rising household incomes. Has there ever been a time where it was more reckless to borrow as much money as a lender was willing to lend?
You’re too rough on Natale, whose income was composed of two pieces: take-home pay and child support. It is reasonable to rely on the child-support as income, is it not?
Further down in the article there is a mention of this: “And her ex-husband’s small financial contributions had abruptly stopped.”
Is it rational to assume that both parents will pay for the upkeep of their children?
On a larger note, how much did deadbeat parents (either gender) contribute to the inability of their shafted partners to pay to support their children?
When we purchased our second house four years ago, I had a simple payment guideline: I wanted to keep our monthly payment the same. I figured that with the drop in mortgage rates since we bought our first home (8.25? to 5 3/8) and with all the equity from our previous home that we could apply to a downpayment that this was reasonable. I was right; our new house is roomier but still modest, and we now pay about 10% of my gross income for mortgage, insurance and taxes. We were told that we could afford a mortgage payment (excluding insurance and taxes) of over 30%, which I found shocking.
We’ve refinanced a couple of times to get better rates, and every single time, we were pushed to take cash out. “You can take $100k out and go on a vacation or something!” We always avoided the temptation and kept our mortgage debt at a reasonable level. This has helped us 2 ways - our payments actually went down (we always did this to get lower rates), and more importantly, especially in today’s economy, by keeping the loan amount down, we still have some equity in our house despite the tremendous drop in value. If we had to sell now we wouldn’t clear much, but we are not underwater!
I can’t believe the gal in the story agreed to a loan that would take 95% of her take home pay. I know that some people are bad at math, but how hard is it for even the worst to go “hmmm, I bring home $2000/month, and my payments will be $1900 - that sure doesn’t leave me much!” Even if she failed to recognise the absurdity of the situation, why was the bank willing to take that risk? Any bank that didn’t run away from that situation is NOT one I where I want to deposit MY money.
@Carla - You said you spent time going over the loan papers, and calling to ask questions about the parts you didn’t undersatnd - that seems to me to be strength, not weakness! I don’t think you have anything to feel defensive about. I know that I’ve been pushed to “just sign, it’s just standard boiler-plate”, and have people get upset with me because I insisted on reading everything before I signed. I don’t care - I still sit there and read everything before signing. More power to you!
My husband and I are in the process of pre-approval and are starting to look at homes. We will be buying something that we can afford one 1 income and are assuming one of us will be out of work at some point in the future, either voluntarily or involuntarily. The process is so emotional and many outside forces are telling you what to do. We’re staying true to what we KNOW we can comfortably afford and ignoring all the noise.
Oh, and we left the SF Bay Area primarily because we knew we’d never be able to afford to buy. We haven’t looked back! CA has got to be the most insane RE market in the US.
When we purchased our home in 2003, we pre-approved through our local fiscally conservative credit union. Our loan officer would ONLY qualify us on my husband’s income, not looking at my variable self-employment income or the rental income from my live-in mom. Although we chafed a little at the limits at the time, we’re happy now, especially since rising property values increased our taxes and two hurricanes skyrocketed our insurance.
It isn’t just a problem with people who don’t understand numbers. Many people don’t have the interest or inclination to understand contracts. I am a landlord and the level of apathy and misunderstanding of a lease is mind boggling. These are intelligent people who are capable of understanding, they chose not to. I think that the feeling is: If they don’t know or understand the terms then they are not at fault if things go wrong and they can remain a victim.
People are able to survive in this innocent way because I think we have a very safe society. The level of civilization we have attained makes us think that everyone is civil and every transaction should and will be to our benefit. I do not say that to excuse people who do illegal or unethical things. But they, and people like them, are a fact of life. There will always be opportunists and scammers. If they can’t sell snake oil then they sell knockoffs on a street corner, send email from Nigeria, or push unaffordable loans. It is impossible to make enough laws or regulations to catch them and you wind up inhibiting honest people. For example stated income/”liar” loans are a good tool for a successfully self employed person to buy a house.
People who refuse to take the reigns of their own finances (and sometimes lives) are making a deliberate (if not conscious) decision. Refusing to choose is a choice. Failure to understand a contract does not morally absolve one of the responsibility of that contract if one is ABLE to understand (even if it takes work or study).
My mom has a hard time understanding finance, so she calls me and I go to appointments with her financial planner and mortgage broker because I understand and she trusts me. I don’t understand cars, so I asked my neighbor who works on Toyotas to send me to a good Ford mechanic, and many years later I have been very happy with the result. Not everyone is honest and it is MY responsibility to look out for ME.
Good post. This explains a lot about the current crisis that I just can’t fathom.
I immediately went to Bankrate to see what kind of loan this woman must have had to have such high payments for this loan. She must have had a loan for at least $230,000.00 @9% for a 30 year loan plus escrow payments for taxes. That’s outrageous!
I feel sorry that she obviously wasn’t getting good advice and support in any part of the buying process. I’m sure she felt she was just trusting the experts to help her fulfill this fantasy dream house. I know she must represent a large number of people who have experienced the same.
She was lucky to get help at this end.
Wow - lots of people talking about the buyer having financial responsibility.
Where’s the financial responsibility of the mortgage company or real estate agent? I think these entities need to be sued for negligence - at least to the point of getting your mortgage reduced to an amount that you can afford.
After all, where’s our trillion+ dollar bailout going?
Hello JD,
Curiousity - Perhaps someone can clarify this for me:
—
The “back-end” debt-to-income ratio, which includes all of the above plus other debt payments: auto loans, student loans, credit cards, etc
—
This makes sense if I have fixed payment loans. But how does the “Back-end” DTI get calculated if I carry non-trivial credit-card or line of credit debt, which have `flexible` repayment options (e.g. a minimum payment to cover interest)?
Thanks.
Ignore my previous numbers, I was assumed that was her mortgage payment.
Jim@61 Thank you for pointing out the breakdown of costs that include NY taxes and insurance as part of her mortgage payment. A $1200 mortgage payment plus taxes & insurance seems more conceiveable in reaching her housing payment cost of $1873.
I’ve also heard it said, buy as little house as you can and then pay it off as quickly as you can.
I have sympathy for the woman even if her situation is of her own doing.
Too many people on these boards forget that people who are college educated or even not college educated but at least capable of critical thinking and a general grasp of finances are the MINORITY. Many, many people just see a page of numbers they don’t (and can’t, never will) understand.
People who read self improvement websites on the internet are NOT representative of society as a whole.
I’m not sure some people here understand how expensive housing - even renting - is in major metro areas. Renting is so expensive in some areas that mortgages are cheaper - but either way, a person making the median household income could end up spending 50-60% of her income on housing. Sometimes there’s no alternative, unless you want a three hour commute (where the cost of fuel and car maintenance can make up for the housing savings!).
Moving to a cheaper area doesn’t work because your income falls proportionately, too (in most cases).
That’s no excuse for buying what you can’t afford, but when someone offers you an ARM with a low intro rate and promises you can refi it before the scary unknown rates kick in later, and the monthly mortgage payment for the intro period is way below what you’re already paying in rent, it can get really confusing. You have to be extra savvy to realize no one can “promise” you’ll be able to refi before it hits the fan - yet they all say it.
Great comments today, everyone. As usual, I’d like to point out that things are not black and white. Everyone shares some burden of responsibility in the mortgage crisis. Consumers cannot be expected to be as educated about statistical models as the bankers and mortgage brokers who work with them daily. If these professionals know that the borrower is doing something stupid, they have an ethical obligation to speak up. So, yes, lenders do bear some responsibility.
On the other hand, as others have noted, we’re each ultimately responsible for our choices.
Also, thanks to people who have pointed out aspects of Ms. Natale’s situation, including the child support, etc. I don’t know much about child support, so I don’t know how one would account for it on a loan application. I still think that it should have been obvious to her (and everyone else in the process) that she was asking for too large of a loan.
This isn’t just a US problem, I’m afraid. I live in Australia and have a $470K mortgage, and we pay $3600/month. (Interest rates are generally a bit higher here than the US). We accepted it even though we couldn’t really afford it because we knew we were close to paying down some other debts, and once those were gone we would be able to afford it comfortably. But it was a REALLY tight six months between buying the house and paying the other debts out. There were times when we weren’t sure we could find $1.20 for the kids to do sport at school, and between us we’re in the top 2% family income. Anyway - we got the other debts cleared and it all ended well. But here’s the kicker: the bank knew about our other debts (and didn’t know how close we were to paying them out), and they were willing to lend us $250K more than we borrowed!
After climbing out of 70K in credit card debt (still have 75K in student loans to go), and trying to currently sell a house with 0% equity, I’ve learned my lesson.
My new thing when calculating whether I can afford ANYTHING (house, car, rent, etc.) is whether one income (preferably the lower income) can sustain those expenses. If not, then we have no business buying it. No one needs the stress of constantly worrying what happens if one person loses their job!
I’ve also heard your rent shouldn’t exceed 25% of your take-home pay. Why should a mortgage be any different?
@Mister E: I agree that I feel sympathy for the woman. She made a mistake, and I can relate to the feeling of drowning in debt that was your own stupid fault.
However, I disagree that people see a page of numbers they can’t understand. This is something that frustrates me about the American education system. Why are American math skills so poor compared to our industrialized counterparts? Are eurasians naturally more gifted than Americans? I don’t think so. I think it has more to do with effort. As Shara said, a lot of people don’t want to take the time to understand the contracts. Why put in the ‘A’ or ‘B’ effort when you can get away with a ‘C-’.
Math is hard, and it takes effort to understand. A home mortgage calculator (all you have to do is plug in your principle and interest and be able to comprehend what the monthly payments mean), and a budget spreadsheet is a core competency that everyone who graduates high school should be able to manage.
I think people need to read a little more carefully and stop being victims of sensational stories in the media. Here is a little more of her story:
“Ms. Natale found it a bit unsettling that the interest rate was adjustable but was assured by the broker that she could refinance. More heartening was her $20,000 in savings and sense that things were starting to look up.
…
After she depleted her savings, she refinanced in June 2007, and again in July of this year, taking out another loan … … her ex-husband’s small financial contributions had abruptly stopped. The breaking point came a few months later.”
So she had $20,000 in the bank and income beyond that $100. And she was able to refinance twice.
Its the people here criticizing her basic math skills who can’t do the math.
Had home values continued to appreciate at 5 or 6 per cent per year she would have been making money on the house. Far from a bad investment, she would be coming out ahead.
The problem is that she bought into a speculative bubble. She paid more for the house than it was really worth. Instead of appreciating, it depreciated toward its natural value.
In fact, that “sage advice” that you should buy the most house you can afford? It is based on exactly the same assumption that she had that home prices will always appreciate. It was repeated over and over again by financial planning wizards in advice columns and on the pages of the New York Times. And it was the underlying assumption at AIG as it sold credit default swaps (insurance) on bonds backed by mortgages. These were not people who are mathematically challenged.
In terms of how much house you should buy. The answer right now in most markets is none. You are going to lose a lot of money no matter what house you buy. You are better off renting.
Just listen to those folks from California saying they can’t find an affordable home without going beyond the traditional measures of affordability. Eventually the prices will drop to where people can afford them. Until they do, we are still in a bubble.
There is nothing wrong with this poor lady’s math, she was just drinking the same Koolaid tens of millions of other Americans did that housing prices would continue to zoom, and she could refinance and probably even make a lot of money in the process. However, she took the risk, and now she must be responsible.
The real shame of the American real estate market is that DEBT is for all practical purposes a prerequisite to entering the market. You cannot own your own home in most areas unless you agree to take on $200K in DEBT to finance your air-conditioned dream home. Why aren’t there $35K starter homes (maybe one room, 300 square foot) that an average family can buy without going into DEBT? And slowly work your way up until you can afford to pay for your dream home in cash? Answer: because people are greedy and want as much as they can get without having to pay for it now, so there is no market for frugal housing.
LOL 35k starter homes? Maybe in Oklahoma or one of those other red states. I live in California, and you’ll be hard pressed to find something for less than ten times that value.
It’s not all bankers and bad judgment, of course. You’d be amazed at how much peer pressure I’m under to buy a house. I’m a single university professor in her 40s and friends and coworkers tell me I’m crazy not to buy, especially “now that the prices are going down.” The topic comes up regularly in conversation. When I protest that I can’t comfortably afford a house (condos are 350K+, houses 500K+ in my part of SoCal), I get the same old arguments about tax breaks, equity, etc. It’s hard *not* to give in, especially when apartment noise levels get high. On the other hand, I don’t want to sacrifice my life just to own a house. I wish there were more social support for those of us trying to make rational homebuying decisions.
you’ll be hard pressed to find something for less than ten times that value.
I think you mean, price, not value. The fact is housing is still way over-priced and until then median price is affordable for people with median incomes it is a bad investment.
’m a single university professor in her 40s and friends and coworkers tell me I’m crazy not to buy
Tell them that they are being foolish holding onto a house in this market. The question is why aren’t they selling. Most of them probably think their house is going to be worth more in the future than it is now. But that is unlikely to ever happen in real terms. Its true you don’t have to pay taxes on the interest you pay. But when your house has lost 50% of what you paid for it and you owe more on the mortgage than its worth, that isn’t much consolation.
The best reason to own may be those noise levels. But neighbors can be a problem when you own as well.
Thanks for the nudge. This post made me go back and review my Solvency, Savings and Liquidity ratios. I haven’t done that since the end of last year and I wasn’t certain where I stood. I haven’t made any big purchases this year, but I have been saving more so this was a timely reminder.
I loved this post!
It’s the most clear description of the debt to income ratio I’ve seen, especially as it applies to buying a home. I’ve never purchased a home before, but hope to in the not-so-distant future, so I loved the post!!
This is exactly why one of our MAIN considerations in our job hunt last year was location. We had a few opportunities in large metropolitan areas like NYC, Chicago, Seattle and D.C., but knowing that the costs of living in those places make it almost impossible to own a home as well as save money for other things in life, we passed on all of them.
Sure, we would have been making maybe 20-30k more than we are now, but the difference in the cost of living is so substantial that we can’t even consider a move to a more urban area. We live in rural New England and make only $69k together (gross) but we manage to save anywhere from $1600 to $2400 per month. Sometimes more.
Coincidentally, I realized tonight that our rent is EXACTLY 10% of our gross income. What are the odds of that? I mean, EXACT.
I remember learning the basics about this stuff in my finance class in college! Now my husband and I are on the lookout for our first new home. We’ll probably buy one in the next year or two. It’s a very exciting thing, but it’s good to know the facts!
Thanks for enhancing my knowledge on home buying, debt to income ratios, and personal finance! My husband and I have a finance blog at http://www.financialnut.com! We’d love for you to visit sometime when you get a chance! Happy house hunting!
@Ross Williams: Actually, I did the math and I didn’t buy the kool-aid. It was horrible advice from ‘experts’ who were speculating that house prices were only going up. I had been paying attention during the ‘boom’ and heard the warnings from other experts who were saying this was a bubble. I listened to the unpopular wisdom. House prices do not always go up. Sometimes they go down. If you buy a house to live in, you’ll be fine - it doesn’t matter if your house is worth less. If you buy one to get rich, well, it’s just like any market. Buy low, sell high. At the time I was looking to buy would have been the high. I have an innate distrust of bankers. If they’re excited, then they’re probably ripping me off. If they’re gloomy, I’m probably getting a great bargain.
@Dru Pagliassotti: I hear ya. I’m under pressure from coworkers on why I don’t own a house either. I’ll buy one when I’m ready to settle down. I know that’s not the popular opinion, but personally, I am old fashioned and want to buy a house to live in and raise a family. I’ll get a 30 year fixed with 20% down. I’ll be renting for the foreseeable future, especially with a tight economy. As long as I’m renting, I can move to where the jobs are, if it comes to that.
@MisterE I can tell you that you don’t need a college degree in finance to understand your mortgage papers. CPAs like me are available to sit with you and analyze the settlement statement before you close on your home. Some of us also help with budgets and other personal finance issues.
When we see a stinky deal and tell a client that they are getting ripped off they have to choose between believing us OR believing he real estate and mortgage brokers who SELL the idea that this home/mortgage are doable. I have seen some extremely bad deals signed in spite of my counsel. The truth is that we want what we want and we want it now! Most people would rather hear the real estate agent and the mortgage broker tell them that they can have “it” rather than hear me tell them why “it” will be a curse and not a blessing.
Frugalbachelor - there is no market for affordable housing because it is very difficult for a builder to make money on a home like that.
This is the same reason why the mortgage broker encourages you to take equity out when you refi. The work to write a 100k loan is the same as for a 50k loan. But if you make 1% of the loan balance which loans would you choose to write?
I want to share that it is possible to do this right. The 1700 sq ft colonial in my neighborhood just sold for $155,000. A 25 year old man bought it without a loan. He has been working 2 jobs to save up the cash.
@FrugalBachelor
Those types of starter homes exist - they’re called mobile homes. But most people don’t want to live in them. If you can end the stigma associated with it for so many, then people might be willing. In many parts of the country, particularly those areas with tornadoes and hurricanes, there is also the issue of safety.
I don’t think it’s greedy for a family to want to live in more than 350 sq ft. (only people in the most expensive housing markets - CA, NYC, etc - will put up with that size). It might be unrealistic for some, but certainly not greedy. There’s a vast difference between the tiny one room places you suggest for those who can’t afford it and the sprawling suburban McMansions that are probably what are offending you. There is a middle ground.
Adam wrote: “LOL 35k starter homes? Maybe in Oklahoma or one of those other red states. I live in California, and you’ll be hard pressed to find something for less than ten times that value.”
Wow. I don’t even live in a red state, and that comment annoyed me. Condescending, much? Whatever. Since I don’t live in an inflated market like California (but still live in a big city with big city amenities, mind you) I can own a home by the age of 29 that won’t strain my budget. With a 30 yr fixed, that mortgage payment will seem smaller and smaller as the years go by.
Is there a general guideline for planning purposes as to how much homeowners’ insurance costs (assuming 20% down payment), as a percentage of the value of the house?
Cathy: “If you buy a house to live in, you’ll be fine - it doesn’t matter if your house is worth less. If you buy one to get rich, well, it’s just like any market. Buy low, sell high.”
I think that is right. But that is not the story in the NYT.
It didn’t matter how much house Ms. Natale bought, she was going to be buying high. As the market value dropped she was going to lose her investment. When the support from her ex-husband stopped, she was going to have a hard time making the payments or refinancing.
In a typical real estate market, stretching to the limit makes sense. Its very likely you will make more money as you get older, your kids will start to support themselves, inflation will make your payments easier. And, of course, you will have a nicer home to live in. There will also be appreciation that will keep up with inflation. Then when and if you want to move you can buy a similar house with the same size mortgage. Or a nicer house if you can afford a bigger mortgage.
In the current market, a good part of what you spend on a house is an expense that will never be recovered. When you move it does matter what your house is worth. You are going to have to make up the difference between what you paid and what someone will pay you for it.
The real comparison people should make is to how much it would cost them to rent the same home - assuming they can find it in the rental market. In most places, it is going to be cheaper to rent than to buy.
The real story of Ms. Natale is that, until the market bubble completely deflates, no matter how much money you have to put down on a house you may find yourself under water. And that means if your finances change and you can’t meet the payments, you are not going to have any good options. Just like Ms. Natale.
In addition to the banks having a reluctancy to say no, so does the potenial home buyer. We don’t want to say no for a million different reasons - maybe we don’t want to admit we can’t afford something, maybe we just think it’s the coolest house ever or we get pressured by the real estate agent. Of course they have their own agenda - lots of commission and (as far as I’m aware) suffer no reprecussions if the house is foreclosed.
I see a lot of the same thing when people buy cars. They have a slick salesperson who talks them into more car than they can afford. I understand they have to make a living also, but we have the power to say no and walk away.
When I bought my house, I had the choice of a $135K house that was in nice shape. There was another house that had been a rental property for the past 10 years. It was in terrible shape and needed lots of work. It was $80K. Aftre discussions with some friends and family members, I opted for the cheaper house and yes, it was a lot of work but it still cost less than $55K to make it liveable. I got a 6% fixed rate loan. Needless to say, the mortgage crisis never touched me.
Saying no the the $135K house may very well have saved my future. It’s not easy to say no when you are wrapped up in the emotions of buying a house and it’s easy to forget your math. No matter if you are good at math or not - get someone unbias and trustworthy to help you crunch numbers.
I also have noticed the change in the rules for debt as a percentage of income since I bought my condo in 2001 and now. I was approved using the 28% model and was alarmed that the banks were using 41% now. I don’t think it had anything to do with being competitive, it was a move to sell more loans and make more money by relaxing the requirements and making a larger pool of candidates to sell to. If they would have stayed at 28% the profits would have stopped in about 2002. It was a calculated move motivated by banks’ greedyness for profits and constant high percentage growth.
I don’t understand why these formulas even use “gross” income. My net income is about 50% of my gross. Does anyone do their monthly budget using gross instead of net??? It’s not a real number.
I personally feel that bankers and realtors really went too far in this latest bubble. When I went to refinance to get a lower rate, no one wanted to do it, they wanted to have me refinance with a higher mortgage AND do an adjustable “because the rates so much lower”. It’s hard when you have supposedly knowledgeable people criticizing you, telling you your making a mistake. (I ended sticking to my guns and getting the simple refi through my local bank. Though the rates weren’t as good, they did as I asked with no hard sell). My sister and brother in law when they were selling their house and getting another one. They kept telling the realtor what price range they were looking at, but she would literally roll her eyes and say stuff like c’mon you make more money than that- you don’t want those houses. It was all over after much pestering they told the realtor what they qualified for from the bank. She literally never showed them another house in theire requested price range but all houses far above that. And yes after months of that and that talk they did get desensitized to the price and ended up getting one of those houses.
Anyways I call “bs” in that we had to offer higher mortgages, they were “afraid” to say no. All the pressure I saw was coming from the other way, with both bankers and realtors in collusion.
When it comes to gross income, I know a lot of people don’t even consider taxes let alone other deductions. In addition to taxes, I have a medical flexible spending account that takes out $5K a year, my part of my health insurance is $1K a year, there are commuter checks, 401K and other deductions besides taxes. I have thousands of dollars taken out of my gross salary besides taxes I need to consider. I dont think a lot of people do that.
I live in Columbus, Ohio and there are some stupid cheap houses here. They’re not necessarily structurally unsound, either. My ambition is to get hold of one that is sound and get enough mortgage to buy it, rewire and replumb it (it’ll probably need both), make sure the roof and gutters are in good shape and redo the walls and floor. And that’s it, and I imagine that in this market I won’t have to borrow more than about $50k to $60k.
It won’t be a ritzy neighborhood but I just spent four years living in one of those and a lot of the stress I endured had to do with the state of my apartment and the negligence of my landlords, which amplified the stupid stuff going on in the neighborhood, which mostly occurred in the first place because we had so many vacant houses nearby and no neighborhood watch to speak of.
If you’re willing to take a risk and actually do something for a neighborhood besides complain about it or avoid it, sometimes going for the cheaper house in the not-so-hot neighborhood can work out well in the long run. It shouldn’t take a city initiative and a whole bunch of tax dollars to turn a neighborhood around, and people gradually moving into a “bad” neighborhood and gradually fixing things up is less traumatic in economic terms for the residents already living there, than if the city steps in and gentrifies it all.
And I figured out the mortgage payments all the way up to 10 percent interest. I’d be paying less per month on a $40k house than I did in rent on my crappy apartment in the crappy neighborhood. I qualify for a VA loan, too, so no down payment. Sweet.
It astonishes me how willing people are to stretch to the absolute limit to buy a house, but then I’m probably too conservative about it. I would want several thousand dollars socked away in addition to a regular emergency fund before closing on a house so I could handle any immediate repairs. Everyone I know who’s moved from renting an apartment to owning a home says they go to Home Depot at least weekly for the first couple of months. Coming from an apartment, I’ve never owned a big outdoor garbage can or recycling bin, a hose, a lawn mower, hedge clippers, or any number of other things that may suddenly become necessary, and I would want funds available to make those purchases.
“Coming from an apartment, I’ve never owned a big outdoor garbage can or recycling bin, a hose, a lawn mower, hedge clippers, or any number of other things that may suddenly become necessary”
I remember someone saying they spent 20 minutes in their first house looking for a plunger when the toilet overflowed … and then realized that if they hadn’t brought it with them, there wasn’t one.
Subba @#100 asked: “Is there a general guideline for planning purposes as to how much homeowners’ insurance costs (assuming 20% down payment), as a percentage of the value of the house?”
Insurance rates vary a lot from state to state. For a rough idea of costs for your state this page has median insurance bills:
http://www.iii.org/media/facts/statsbyissue/homeowners/
Of course the bill will depend on the value cost of the house too. Roughly speaking insurance is probably going to run you ballpark of 0.25 to 1% of the value of the house annually.
Jim
Very timely topic in my household.
Right now our mortgage takes up about 12% of our gross income.
That gets us a 1500 square foot house in a St. Paul, MN “neighborhood in transition.”
But lately we’ve been wanting to upgrade. Technically, a $2000 monthly mortgage would fall within the 28%-33% guideline. But given the economy and my uncertain industry (newspaper), we just can’t get comfortable with the idea. If we were to take on a mortgage within this “conservative” range, it would mean hardship if one of us lost our job.
Are we too conservative? Perhaps.
But the debate has been a good reminder that ultimately, rules of thumb are just rules of thumb. The golden rule is knowing yourself and your comfort-level with risk.
Now if I could stop obsessively surfing MLS listings….
Interesting discussion. Being in Australia things are a little different, and where we are is outrageous.
Our family income would make JD weep, and to buy a 3 bedroom home for our family of 3 adults, 3 children and 1 dog would cost over 4.5x our annual income. If we could find one. 5.5x - 6x our annual income is more common.
We have been looking at the next town over and 3x - 3.5x is the average cost there. The next nearest town is over 1hr away and no cheaper.
So for now we rent, paying 36% of our income in rent, 16% in debt (our retirement block of land) and scraping by on the rest.
Neatly compiled article. Will be of great help to me when I am gonna buy a house by February 2009.
Wow! These ratios drop my jaw. Back in the Cretaceous, when I was a young pup, we figured you should spend no more than 30% of your gross income on housing costs — and in those dark ages few people carried credit-card debt.
I don’t understand how most folks can live on half of their income; a normal person’s total net pay barely covers living expenses. I certainly couldn’t live on half my net pay, which is what 30% of my gross would come to.
Guess that’s why both members of a couple have to work these days, and why having one parent stay home to raise the kiddies is a luxury rather than the normal state of affairs. Problem is, if one partner gets sick, leaves, or dies, then suddenly the cost of housing alone is too much for the remaining worker to cover. I would suggest that the debt-to-income ratio should be based on ONE partner’s income, or possibly on a figure representing the average of the partners’ pay (e.g., Jane makes $60,000; Joe makes $55,000; they base their estimate the amount they can afford for a house on their averaged income of $57,500).
An ethical lender will tell you that the amount you can qualify to borrow is different from the amount you can afford to borrow. But pretty clearly “ethical lender” has become an oxymoron.
Caveat borrower!
An ethical lender will tell you that the amount you can qualify to borrow is different from the amount you can afford to borrow. But pretty clearly “ethical lender” has become an oxymoron.
While certainly some lenders trapped people in mortgages they would never be able to afford, I think this is unfair. The facts changed.
If housing values were relatively stable with an annual 5%-6% appreciation, then we wouldn’t be having this discussion. The person who stretched to afford a mortgage would have seen their income increase to make that mortgage affordable. Even people with adjustable mortgages, would be able to refinance into a fixed rate that was affordable as their income increased.
Even if their lives didn’t develop the way they hoped, they would still be able to sell, take their equity out and a purchase a more affordable house.
The problem is that housing went from being a purchase to being a speculative investment. Prices went far beyond the value of the house as a place to live or what was affordable for the typical home owner. If you pay $300,000 for a house that is only worth $150,000 you may not notice as long as you can afford the payments. Its only when you need or want to sell that you know you are in trouble. Because you are going to have to make up that $150,000 difference.
In short, buying a house based solely on whether you can afford the payments is a mistake. You are asking the wrong question.
Hi JD,
I’m curious, why would you ever use gross income to base payments? It’s money you don’t have! Shouldn’t all that matters is the money you take home? If I make $7500 a month, taxes bring me down to close to $5800 a month, I mean that’s about $500/mo difference in what I should be able to afford, but taxes will always be inevitable, so why even bother considering gross income if you’ll never actually have all of that money anyway?
“taxes will always be inevitable”
Your taxes are based on your adjusted income and mortgage interest is deductible. So your “take home” pay depends, in part, on how much you are paying in interest.
How much you can afford obviously depends as much on what your expenses are as it does your income.
I think it ought to be clear banks are not in the business of determining how much someone can or would want to spend on a house. They are trying to determine what is the largest mortgage you will repay. The painful choices that might entail for you are not part of their equation unless they cause you to default.
I think that appropriate D:I ratios are dependent on income levels. For instance, if you make $200,000 a year you can comfortably spend 40% of your income on a mortgage (and taxes and insurance) — that works out to a 4.5 to 5.5 price to income ratio. If you’re at $100,000 income that threshhold drops to 30%, and it drops to 20 - 30% for those making $50,000.
This is because other costs in life are still affordable. The person making $200,000 a year and dropping $80k a year on a home (with ins. and taxes) and $40,000 on taxes is still clearing ~6,700 a month after taxes and a housing bill.
There are other factors as well. For instance, if you are married w/ kids but your wife stays at home, you can handle a higher debt-to-income ratio than if you were both working, since you aren’t paying for child care and household costs get generally contained.
This is why banks are flexible on D:Is. Dave Ramsey is crazy if he thinks you can afford a house on 1/4th of take-home pay. You can’t even rent for that!
Some lenders would give you a loan for 10x your salary if they could get away with it because they’d turn around and sell your loan anyway so the risk wasn’t on them. This caused other lenders to lower their standards to compete. Once the music stopped, the predatory lenders sunk due to the massive amount of bad loans in their pipe that haven’t been sold yet, the competing lenders ran to Congress for help, and the homeowners went bellyup.
Part of the reason the DTI numbers changed is the assumed appreciation of the property that was essentially guaranteed by the government , its monetary policy, its tax policy, and its commitment to “encourage” home ownership. Of course the government cannot guarantee appreciation even if it wanted to — only the market can determine that. And when the bubble burst and the market won over government, people were in bad shape.
This is a great example of the moral hazard idea discussed when it comes to market regulation by the government.
This is a great example of the moral hazard idea discussed when it comes to market regulation by the government.
This had nothing to do with government. Mortgages were a valuable commodity and manufacturing and marketing them were profitable businesses. The reality is that the government had nothing to do with the mortgage-backed Collateralized Debt Obligation’s that created that market. Low interest rates on other investments may have contributed to the amount of money being thrown at those investment vehicles, but that was hardly the Fed’s intended purpose in keeping interest rates low.
Low interest rates certainly made mortgages more affordable and that helped feed the housing bubble. But making mortgages more affordable didn’t encourage people to take out a mortgage they couldn’t afford. Nor did it encourage making loans to people that they couldn’t afford. That was entirely market driven.
“that was hardly the Fed’s intended purpose in keeping interest rates low.”
That’s the point. Unintended consequences plague government intervention in the market because governments are not smart enough to set prices and understand the consequences of mis-setting them. This is why planned economies do not work.
“But making mortgages more affordable didn’t encourage people to take out a mortgage they couldn’t afford.”
This is a bizarre comment, Ross. Making it cheaper to purchase the same properties didn’t encourage people to purchase them? That really makes no sense. The government depressed interest rates, and that made expensive properties affordable by more people who would not have been able to afford them otherwise. Some amount of these people will of course select ARMs over fixed rate mortgages. When interest rates are depressed artificially vs where the market would set them, then this makes ARMs more risky, as interest rates will eventually have to reset closer to the market rate.
I really don’t understand how you can claim that lower interest rates didn’t encourage people to take on additional risk.
“Nor did it encourage making loans to people that they couldn’t afford.”
Demand for mortgage securities skyrocketed, but that is only half of the contract. You can’t explain the situation from only half of the contract.
Unintended consequences plague government intervention
Actually all sorts of unintended consequences “plague” the market in general. I doubt any of the folks putting together CDO’s intended for this to happen. I doubt AIG intended to get in over their head with CDS’s.
My response was to your claim that the federal government was somehow deliberately supporting higher real estate prices. Not that there weren’t unintended consequences to the Fed keeping interest rates low. For instance, economic prosperity also drove up housing prices. There were a lot of intended consequences as well - which caused unintended consequences.
making it cheaper to purchase the same properties didn’t encourage people to purchase them? That really makes no sense.
What makes no sense is to suggest that making a mortgage more affordable will make it more likely the borrower won’t be able to afford it.
In a market where lenders were figuring out how to write mortgages even to people who couldn’t afford an ARM, I doubt low interest rates had much to do with getting more people to take on mortgages they couldn’t afford.
This was a classic market bubble. Expectations of higher prices helped create the higher prices that fed those expectations. In that environment it wasn’t tough to convince people to take the biggest loan they were being offered. Interest rates didn’t have anything to do with it.
Demand for mortgage securities skyrocketed, but that is only half of the contract.
Wasn’t that the half that was setting the DTI? Lowering interest rates lowers the cost cost of a mortgage but it has no effect on the percentage of income someone can spend.
“My response was to your claim that the federal government was somehow deliberately supporting higher real estate prices.”
I will take that as you believing the government did not do this. That is simply not a correct assertion. Here is the most recent example I can find from Bernanke:
For example, some observers have pointed to factors that may create a longer-term drag on the growth in household spending, including high energy costs, the likelihood of slower growth in house prices, and a possible reversal of recent declines in saving rates. If these drags on the growth of spending do materialize, then a lower real interest rate will be needed to sustain aggregate demand and keep the economy near full employment.
http://www.federalreserve.gov/newsevents/speech/Bernanke20060320a.htm
“For instance, economic prosperity also drove up housing prices.”
Economic prosperity drove up housing prices? Ross, Americans have no savings. Where did this prosperity come from? It came from cheap debt. It was not real prosperity.
“This was a classic market bubble. Expectations of higher prices helped create the higher prices that fed those expectations. In that environment it wasn’t tough to convince people to take the biggest loan they were being offered.”
That is the Keynesian or Behavioral Finance view of bubbles. There are other views, so I wouldn’t call your explanation the “classic market bubble” explanation. Personally I find it hard to believe that bubbles are created wholly by psychological factors and there is nothing “real” (like the manipulation of the cost of capital) behind it. Aside from that, you seem to be disagreeing with a well-established link between home values and interest rates. When interest rates go down, buyers can afford more expensive homes. This itself puts upward market pressure on home prices. This pressure is intensified because demand for real estate increases when the cost of capital decreases. Those who are renting can now buy cheap homes. Those in cheap homes can now buy mid-range homes. Those in mid-range homes… etc. This upward force continues each time the cost of capital is decreased.
“Wasn’t that the half that was setting the DTI?”
No. As with any contract, there are two sides of the negotiation. The lender will have its standard, which may be 28%. This means the lender is not willing to assume risk beyond that level. However, the borrower has her own idea of risk she is willing to assume, and may wish only to go as high as 25%.
However, the borrower has her own idea of risk she is willing to assume, and may wish only to go as high as 25%.
I don’t see how the Fed’s policy its lending rate low would cause borrowers to decide they could afford a higher percentage of their income for house payments.
Low interest rates clearly did contribute to increased real estate values by making mortgages more affordable, as I pointed out above. But home values increased way beyond the impact of the lower cost of interest.
The fact is that mortgages were a valuable commodity. Manufacturing them for resale was a profitable business. And the market for CDO’s didn’t much care about the ability of people to repay them. With investors paying little, if any, attention to the underlying quality of the mortgages, a lot of junk got manufactured. That was a failure of the market.
Personally I find it hard to believe that bubbles are created wholly by psychological factors and there is nothing “real” (like the manipulation of the cost of capital) behind it.
That seem to be based on ideology rather than observation. Local real estate bubbles have been a common part of the American experience for a long time. Same problem, same dynamic, smaller scale.
Where did this prosperity come from? It came from cheap debt. It was not real prosperity.
It came from employing a lot of people producing “real” goods and services. Did some people go into debt to buy those goods and services? Sure, but the companies and people who produced them were still producing “real” wealth.
<Here is the most recent example I can find from Bernanke:
Your quote from Bernake says nothing about a strategy to sustain real estate values. It only mentions slower growth in home prices as being a potential drag on the economy.
What is important for people concerned about their personal finance to understand is that lenders are not in the business of evaluating how much you can afford to borrow while still meeting your other life goals. You have to do that.
“Your quote from Bernake [sic] says nothing about a strategy to sustain real estate values.”
Read it again. It says that if home prices fall, he will lower interest rates. And this is exactly what he did.
“What is important for people concerned about their personal finance to understand is that lenders are not in the business of evaluating how much you can afford to borrow while still meeting your other life goals. You have to do that.”
Finally something we can agree on, Ross! A mortgage loan is a contract like anything else, and it is each participant’s responsibility to make sure the terms are suitable to him/her.
It says that if home prices fall, he will lower interest rates.
No. He doesn’t say that. He says he will act to stimulate the economy if any of several factors produce a drag on the economy. He no more says he will act to increase home prices than he says he will act to increase energy costs or lower savings rates. He only mentions all of those as factors that might lead to slower economic growth.
And this is exactly what he did.
In fact, that wasn’t what he did. The growth in home prices was starting to slow at the time that Bernake gave that speech over two years ago. The Fed continued to increase interest rates and didn’t start to reduce them again until a year and a half later. In fact, the Fed started increasing interest rates in 2004 and continued to do so through almost the entire period of the real estate bubble.
“No. He doesn’t say that. … He only mentions all of those as factors that might lead to slower economic growth.”
I don’t want to get into a “no he didn’t, yes he did” with you, but at the same time I don’t think you are paying attention to what he really is saying. He doesn’t say that he will lower rates to handle slower growth. He says he will lower rates to attack a reduction in household spending. Two examples of household spending he cites are energy and housing. To say that one measure of spending is house prices and then to turn around and say that the goal of an interest rate reduction wasn’t to prop up housing prices seems a little odd. Obviously there are multiple goals, as I would hope there are for any government intervention. But Bernanke specifically mentions housing prices, as have his predecessors.
(Interestingly, he also specifically mentions the “threat” of increased savings due to higher savings interest rates as something that may need to be tackled. Again, the economic prosperity we see is spending and debt driven, not savings or infrastructure driven. This is a mainstream idea: http://www.freerepublic.com/focus/f-news/1053684/posts It is not sustainable.)
“In fact, the Fed started increasing interest rates in 2004 and continued to do so through almost the entire period of the real estate bubble.”
You are correct that the Fed attempted to raise rates closer to the market rate. But with regard to the impact on housing, you are missing the point. http://mises.org/story/3130
There is no evidence he was going to prop up real estate prices. In fact he didn’t. Despite slower appreciation, it was over a year later before the Fed started to reduce interest rates. That was long after housing prices not only were “growing more slowly”, but were actually starting to decline. And the reductions in interest rates then were made based on changing economic conditions, to prop up real estate prices.
You are correct that the Fed attempted to raise rates closer to the market rate. But with regard to the impact on housing, you are missing the point.
I think your ideology is blinding you. The Fed was raising interest rates all through the real estate bubble. Far from being below “market rate” they were well above inflation at the bubble’s peak.
If I can piece together your statements, you seem to be suggesting that the housing bubble started after 2004? That must be what you are saying, because you say “The Fed was raising interest rates all through the real estate bubble.”
Adam @88, there are starter homes in CA and prices range from $15-$45K:
http://www.tumbleweedhouses.com/
I saw these homes on a couple different news spots and it got me thinking.
Nick@117 “Dave Ramsey is crazy if he thinks you can afford a house on 1/4th of take-home pay. You can’t even rent for that!”
Dave Ramsey is recommending that you save a larger down payment to achieve the 1/4th of your take home pay scenario, so home ownership is a blessing not an over leveraged curse. Add to that, he also recommends a 15yr loan.
We bought our CA home in late June 08′ with 20% down before discovering Dave Ramsey, and are working his plan now (1/2 way through Baby Step #3, a 6mo E-Fund). Once we get to Baby Step 6…paying off the house…we’ll work towards the 1/4th-15yr scenario, and go from their. We could have stayed with our in-laws another year and get another 15-20% additional down, but wanted to move and get on with our lives, and had already watched desirable properties drop 15%+.
No regrets as we found exactly what we were looking for (2100sqft 4/2 single, built in 2005) after 50-60 home tours later, and many sleepless nights and long discussions. We expect another 10%+ slip, and the few homes that are in our neighborhood are selling for a hair under $600k still. This is a long term investment, with no plans to move, and we are fortunate that we could get by on a single income, and have achieved much financial peace using Dave’s method’s.
More info:
http://www.daveramsey.com/etc/cms/baby_steps_2867.htmlc
Our first home in the SF east bay was a perfect starter home, $250k back in 2001, 1340sqft 3/2 single, and we got very lucky with a excellent realtor (Brian @ http://www.sharphomessell.com) that listed our home for $409k, which was 10% less then everybody in our neighborhood…and it sold in 4 days in June 06′. He said to us as sellers “to throw a ball to someone one on a roller coaster on a downward slope, you have to throw it further down the slope to intercept them, otherwise you’ll be chasing the falling prices.” Now some of those neighbors homes are still on the market at close to their original selling price…we are very blessed indeed!
Great blog btw, learning lots with each visit!!!