The Debt-to-Income Ratio: How Much House Can You Afford?
Published on - November 11th, 2008 (Modified on - August 6th, 2009) (by J.D. Roth) 
Housing is the largest expense in the budget of most families. But how much is too much to spend on shelter? An article in Saturday’s New York Times contains a shocking example of one woman who crossed the line:
What she got was a mortgage she could not afford. Toward the $385,000 cost, [Christina] Natale made a down payment of $185,000, a little less than what she took away from the sale of her grandfather’s home. The loan that made up the difference, with closing costs, broker’s fee, taxes and insurance, meant a monthly bill of $1,873.96, about $100 less than her monthly take-home pay as an administrative assistant.
I am not unsympathetic to tales of financial hardship, but this stretches even my compassion. Ms. Natale (who has three children) took out a housing loan that left her just $100 a month for every other expense in her life. She shouldn’t need an outside voice to tell her that this was an impossible situation. (All the same, where were the outside voices?)
Although this is an extreme example, many other people buy homes only to discover they’re in over their heads, unable to make payments. How can you prevent this from happening to you?
Debt-to-income ratio
Fortunately, decades of financial data have produced computerized models that help to determine how much a person can afford to spend on housing and debt. To learn more about this, I recently spoke with Robb Severdia of Guarantee Mortgage in Portland. I asked him to describe how the process works. (If I have anything wrong here, it’s my fault, not Severdia’s.)
Traditionally, lenders have used the debt-to-income (DTI) ratio to estimate how much a homeowner can afford to borrow. This ratio is computed by comparing your expenses to your gross (pre-tax) income. The lower the number, the better. If you make $3,000 a month before taxes, and you pay $300 toward debt, your debt-to-income ratio is 10%.
Banks and mortgage brokers look at two numbers:
- The “front-end” debt-to-income ratio, which includes total housing expenses: mortgage principal, interest, taxes, and insurance.
- The “back-end” debt-to-income ratio, which includes all of the above plus other debt payments: auto loans, student loans, credit cards, etc.
When a prospective borrower submits her paperwork, the computer evaluates it, applying statistical models to be sure the proposed debt load falls within accepted ranges. After this automated process, the loan proceeds to manual underwriting, where a human screens the application and makes the ultimate determination to approve or deny the loan.
Industry-standard debt-to-income ratios drive this process.
Lending limits
When we bought our first home in 1994, everyone involved in the transaction told us that our front-end debt-to-income ratio should be 28% or less. That is, we should pay no more than 28% of our gross income toward housing expenses. The back-end ratio was 36%, which meant that our housing expenses and debt payments combined should total less than 36% of our income.
Because Kris had student loans and I had credit card debt, we couldn’t get close to the 28% front-end DTI ratio because it would push us over the 36% back-end. Our high debt-load meant we had less to spend on a house. Our eventual payment was $1,086 per month.
When we bought our new home in 2004, the debt-to-income ratios had changed. “That 28% figure is old,” we were told. “Most people can go as high as 33%.” The back-end ratio had been raised to 38% — and even to 41% in some models!
From what I understand, debt-to-income guidelines have gradually become more relaxed over the years. Here’s what I could puzzle together about the history of DTI (I would love to have clarifications or corrections to this list):
- Reportedly, during the 1970s (before credit-card debt became common), DTI wasn’t split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance were less than 25% of your income, it was assumed you could afford the payment.
- In The New Rules of Money, Ric Edelman writes that the lending limits “used to be” 22% and 28%. I’m guessing that this must have been the rule-of-thumb during the 1980s.
- When we bought our first home in the mid-1990s, the front-end ratio was 28% and the back-end ratio was 36%.
- By 2004, those ratios has increased again to 33% and 38%, respectively. (To qualify for an FHA loan, your front-end DTI is limited to 29%, and the back end is capped at 41%.)
A 5% increase may not seem like a big deal, but when you’re talking about a house payment, it’s huge. Remember: 5% of a $60,000 income is $3,000 per year, or $250 a month. Many foreclosures occur because people take on housing payments that are as little as $250 a month more than they can afford.
Afraid to say “no”
During my conversation with Robb Severdia, I asked him about the growing debt-to-income ratios. He acknowledged that he’d seen the numbers rise during his decade in the industry. “Banks feel they need to increase the limits in order to be more competitive,” he explained.
“I think that in most cases, it’s a bad idea for borrowers to push that 41% back end,” Severdia said. “It might make sense in some instances, but it can be a recipe for disaster.” In other words, give yourself a margin for error. Instead of basing your home budget on a 33% front-end debt-to-income ratio, consider dropping that to 28%. You won’t be able to afford as big of a mortgage, but you won’t feel as pinched by the payments, either.
I asked Severdia how people like Christina Natale from the New York Times story were able to get mortgages that amounted to more than half their income. “People are afraid to say ‘no’,” he told me. “They were afraid to lose the deal.” Thus the subprime mortgage crisis.
In The Automatic Millionaire Homeowner, David Bach warns:
You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow. [...] Don’t fool around with this. Do the math. Be realistic about your situation. Don’t pretend you’re in better shape than you really are.
Nobody cares more about your money than you do. Your real-estate agent, your mortgage broker, and the bank all have a vested interest in encouraging you to buy as much house as possible. Their incomes depend upon it. Listen to what they have to say, but make your decisions based on your own knowledge of the situation.
Better safe than sorry
Homeowners are often admonished to “buy as much house as you can afford”. There’s some merit to that statement — in general, housing prices do increase, as does personal income. As a result, your mortgage payments generally become more affordable.
The problem, of course, is that when you buy as much house as you can afford, you’re left without a buffer. What if you lose your job? What if you’re forced to sell your home, but housing prices have dropped? I think it makes more sense to buy as much house as you need, keeping the conventional debt-to-income ratios as ceilings.
Ultimately, it doesn’t matter what the guidelines are. What matters is what you can afford, what you’re comfortable paying. Just because conventional wisdom says you can take out a $1400 monthly housing payment on your $60,000 annual income doesn’t mean you have to do it.
Foreclosure photo by respres.
This article is about Budgeting, Debt, House and Home, Planning
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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“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.
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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
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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….
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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.
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Neatly compiled article. Will be of great help to me when I am gonna buy a house by February 2009.
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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!
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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.
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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?
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“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.
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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!
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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.
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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.
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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.
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“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.
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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.
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“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%.
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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.
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“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.
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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.
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“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
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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.
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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.”
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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.
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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!!!
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Even in a depressed real estate market, Californians still struggle to find homes that are compatible with their incomes.
Debt-To-Income rations are high and banks will lend up to 55%. Consequently, its important to budget all other expenses.
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I took a 30 year loan with required payments = 20% income, but I over-pay equivalent to that of a loan requiring payments = 35% income.
If all goes well, I’ll own the house in 10 years. However, if things do not go well… I have flexibility, and I should be fine for most of the common curve-balls of life.
It boggles my mind to think how low my basic expenses will be once the mortgage is eliminated. I can’t wait!
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” if things do not go well… I have flexibility, and I should be fine for most of the common curve-balls of life.”
This has been a long time and conditions have changed. But for people who bought at the peak of the bubble, this strategy did not provide “flexibility”. Instead, the market value of the house fell faster than their payments and they ended up having tied up a lot of money in a house they can’t sell.
This is the downside to paying off a mortgage early. Until it is paid off, your “savings” are tied up in the house.
At current mortgage rates, it probably makes more sense to invest the money elsewhere. You can use it to pay off the remaining balance on the mortgage when you have enough saved. But if your financial goals change, you will have a lot more flexibility.
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Ross, You make good points and there probably isn’t a pure math case to support my approach. Nevertheless, the motivational/psychological appeal of watching a quickly shrinking mortgage balance cannot be ignored (by me at least). I failed to mention in my previous post that I didn’t start over-payment of the mortgage until I achieved an emergency fund = 6mo take-home pay. At this point, things are going quite well, but if layoff/illness/etc finds me, it would seem that flexibility granted by the ability to revert back to minimum payments and the emergency fund buffer should be a sufficient risk mitigation.
Your comment seems to imply that part of your “flexibility plan” is to stay liquid, and don’t tie up too much in a house that may ultimately be in your best interest to walk-away from. I hate to say ‘never’, but walking away is not at all built into my plans (raising young children here, and living in the place I’d like to stay for life.)
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“don’t tie up too much in a house that may ultimately be in your best interest to walk-away from.”
Walking away from your house isn’t really the issue.
If you plan to stay in the house and can afford the minimum payment, equity isn’t important. But if you need the money you used for extra payments for some other purpose, you can’t take out a home equity loan on a house if the equity there.
So liquidity is important. Suppose you have used up your emergency fund and can’t make even the minimum house payment. You could lose your house no matter how much of your mortgage you have paid off. But if you had that money in an investment account, you could use it to make the current payments.
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I appreciate this conversation. You have me thinking. Maybe there’s a compromise, with the best of both worlds. Actually I think the compromise is exactly your suggestion, just phrased differently.
I could create a brokerage account specifically ear-marked for “house payoff”, and deposit what is currently monthly over-payment amount. When it grows to the right level, pay-off the house.
If life gets ugly, I can use those funds to stay alive.
The funds would need to have some exposure to risk so they earn at a rate near my mortgage rate, but that shouldn’t be too hard.
The only other factor is discipline. There could be temptation to use those funds for some other opportunity. But a well documented goal statement should help avoid a future bad decision.
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