I have been writing this month on what has gone wrong in the mortgage industry and mistakes lenders and homebuyers have made. Here are some tips about mortgage numbers that consumers should know to protect themselves.
Home Prices: Speculation abounds in the media on when the mortgage market will bottom. My research suggests that the magic number for a fair sustainable housing market is 3. That number is the ratio of the median home price to the median household income in the United States. An examination of census data shows that from 1987 to 2002 that ratio remained unchanged at 3, even though home prices and income rose steadily during that time period. In 2002 home prices began increasing much faster than household income causing the ratio to shoot up to nearly 5 at the peak of the housing market in 2006.
The fact is home prices cannot rise substantially faster than household income or soon everyone will be priced out of the housing market and there will be no more buyers. At the beginning of 2008, the U. S. median home price—$195,900—divided by the median household income—$50,233—was equal to 3.9. That means more time is needed for income to rise and/or home prices to fall for that ratio to go back to its historical average of 3.
Monthly Payments: The number 3 is important in another way. Total monthly payments for principal and interest should not exceed 1/3 of after-tax household income. Many people think that at higher income levels a greater fraction of income can be allocated toward the mortgage. My last post profiled people who were willing to allocate more than half of their take-home pay to monthly mortgage payments. I imagine they thought that their income was so large that all additional living expenses could be funded with 30% - 40% of take-home pay.
But, ownership costs scale with the price of the home. The more square footage bought, the more it costs to heat, cool, maintain, insure, furnish and pay property taxes. All of those additional costs rise with inflation. If you take out a 30-year fixed-rate mortgage and live in the house a long time, there will come a day when the monthly cost of owning the home will exceed the monthly mortgage payment. That will be true for just about any size home.
Mortgage Options: Creative financing has risks. Recent years have seen an explosion of exotic mortgages. You can choose ARMs, interest-only mortgages, 40-year mortgages, mortgages with balloon payments and many other combinations and payment structures. But, the common element in all of these financing schemes is to make the initial monthly payments as small as possible by postponing actual debt reduction. That’s not a problem in a rising market, but it can be a disaster in a falling market. When prices fall it’s easy to find yourself “upside down” meaning that you owe more than the house is worth, while payments adjust upward to level that you can’t afford. If you are considering a mortgage without a fixed rate, figure out what the monthly payment will be in a few years after the interest rate adjusts. If you can’t afford to make that higher payment now, chances are you won’t be able to afford to make it in the future.
Plan for maintenance: Set aside money equal to about 1% – 1.5 % of the value of the home each year for maintenance, repairs and improvements. It’s easy to be optimistic, but the fact is things will break on a regular basis. When you think of all the things in a house with finite lifetimes that are essential—furnace, water heater, air conditioner, refrigerator, roof, plumbing—you realize that repair and replacement will be an on going expense. It is better to budget ahead of time those expenses with money set aside in a separate bank account. Repairs should not be a financial emergency requiring borrowed money every time they happen.
Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy