How Much is Too Much? – Part 1

For most of my career the rules for qualifying for a mortgage were pretty strict. People frequently seemed to want more house than our industry was prepared to finance, which is one of the main reasons why getting a mortgage was difficult. It wasn’t that they weren’t qualified; it’s just that they weren’t qualified for the more expensive home they wanted.

They could afford a 2-bedroom home, but they wanted a 3-bedroom home that was $25,000 more expensive. It is human nature, I suppose, to want to stretch. The fact is that in our consumer oriented society, there are a lot of forces telling you to buy a bigger, or faster, or better thing than what you need, or started out thinking that you wanted.

People buy a slightly more home than they start out looking for so frequently that when people tell me they are looking in the $200,000 to $250,000 range, we start out getting them pre-approved for a loan on a $275,000 or $300,000 home. They should still tell their real estate agent the original range, but I’ve put in a safety valve. I cannot tell how miserable people get when they put a home in escrow and then find out that they just can’t qualify for the loan necessary for its purchase. I don’t want to go through that, and you don’t either.

That’s why it is really important to get pre-approved – not just pre-qualified - for a loan before you start home shopping. And be sure that you build in a little safety margin for yourself to avoid the problem of stretching too far.

Traditionally, our industry has drawn the line as to approval based upon comparing the proposed housing expense as a percentage of gross income, which is income before deducting for Social Security, Medicare, and taxes. The goal was 28%, so if your salary is $4,000 per month, a lender would approve you if your housing expense – mortgage payment, fire insurance, and property taxes – were less than $1,120 per month.

An additional limiting factor was that your total expenses, the above housing expense plus the total of your fixed monthly obligations could not exceed 36% of your gross income. In other words in our example, if you had total payments on your bills of more than $320, your total expenses would exceed $1,440 per month and the lender would not approve the loan.

The rules are much, much less severe these days. We routinely get loans approved where the total expense ratio is in excess of 50%. That means if you make $4,000, our industry would lend you money even if your recurring obligations were over $2,000 per month. If you figure out what the actual paycheck is for someone making $4,000 per month, then subtract $2,000 for fixed expenses, you can see that there isn’t much left over. Perhaps a skinny, single person who doesn’t like to have fun would be OK on that, but a family? Pretty tough!

Another relevant question you might ask here is, “Aren’t those loans risky?” Well they may be more risky than those underwritten using the old rules, and maybe not. Those same underwriting rules may not count someone’s real income. In addition to the $4,000 of income they would count, perhaps the borrower works overtime, but doesn’t have a two-year history of it. Perhaps there is a second job, or a part-time job. The real income might be $5,000, not the $4,000 they would count, and then the ratio is back to 40%. It is also possible that in a world of potential two-income households, a non-working spouse could go back to work if the budget were to get strained.

You can also talk all day about socially desirable objectives, like “Expanding Homeownership Opportunities,” and I am certainly for that. And the fact is that when you take a family that never thought that they could buy a home and arrange one for them, they will do everything in their power to keep it. They may have their brother-in-law’s family renting and living in the garage, but they will make those mortgage payments!

Finally, FannieMae and FreddieMac, the organizations who buy these loans do have data on the REAL performance of million of families who are making payments today, so they have an idea about what works and what doesn’t. I have an idea that they finally sat down and said, “Gosh, with these rigid underwriting criteria we only get a default rate of about 1 percent. Why don’t we loosen this up a bit and see what happens?” And I guess we will.

Remember too, that they are selling interests in these loans to investors, and those are the people who are really taking the risk, not the guys making the rules. So if FanneMae and FreddieMac can sell a loan and make money on it and someone else takes the risk, what are they going to do? They’ll do the loan.

There is another issue which presents itself here. You can no longer rely upon a lender to be reasonable about curbing your enthusiasm for homeownership. If your credit is good it is possible, even likely, that our industry will bury you in mortgage debt! You don’t want that to happen. It isn’t just the likelihood of foreclosure and losing your equity; it’s just that being house poor and having no money for anything else is NOT a fun way to run your life.

I don’t want you to be unhappy, so in the next article, we’ll discuss some rules that you can follow to establish your own limits, to make sure that homeownership is a joy for you.