Housing Intuition: home prices should generally rise in line with local income growth. If prices grow too fast, then homes are less affordable and price growth should slow while incomes catch up. Frank Nothaft, Chief Economist, CoreLogic
Measuring the Box
If you are considering buying a home —whether its for the first time or you’re “moving up” or downsizing— that move won’t happen overnight. Typically it is an evolution, one that often begins with four questions;
- Should I buy a house?
- Can I buy a house?
- How much house con I buy?
- How much house do I want to buy?
The first question is probably the most complicated. It is a little bit about money and a lot about personal and emotional choices. Do you understand the process? Are you aware of the pitfalls? Are you comfortable with the changes required to become a homeowner?
There is a lot of responsibility. Maintenance involves more than a call to the super and can cost time (and money) you might prefer to spend elsewhere. Defaulting on a mortgage has far worse outcomes than failing to pay rent.
It can be disruptive. It may mean moving away from family, friends, services, and amenities that are important and accessible in your current setting. Your lifestyle might have to change. It could stir conflict if a major player in your life doesn’t agree with the where, when, and how of your buying plans.
Timing could be an issue. Are you ready to become a homeowner? Might you be better prepared or find the market friendlier in a year or in five years?
These are choices that can only be made by the people involved, and some might require a leap of faith. But the answers to the other three questions are primarily driven by…
Money, Money, Money
It is totally true that buying a home is the biggest financial decision most people will ever make. Therefore, what questions 2, 3, and 4 are really asking is;
Can I qualify for a mortgage?
How large a mortgage can I get?
What size mortgage do I really want?
Before the market crashed in 2008, almost anyone could get a mortgage. There were loan programs for borrowers with terrible credit, no down payment, limited income, or income that could not be documented. When it all came crashing down, two things happened. 1) Lenders and their government regulators tightened underwriting rules, a lot, and 2) those who watched family or friends struggle to pay their mortgage or even lose their homes were spooked. The effects of both still linger, a decade after the crisis.
Analyses by CoreLogic and Freddie Mac have found that many potential homebuyers overestimate the difficulty of getting a mortgage or underestimate their ability to qualify so they don’t even try. CoreLogic calls this “self-sidelining.” And, while there is a lot written about tight mortgage credit, the “credit box,” the term describing the width of a lenders’ parameters for granting a mortgage and determining its price, has been slowly but steadily growing.
Boxed In—or Out
The image of a “credit box” is useful in some respects, but misleading in others. We think of a box as a physical space – a square or rectangle – an immovable one. Stuff either fits inside or it doesn’t. However, credit boxes are considerably less rigid, their sides composed of credit risk factors which can adjust, within limits of course, and accommodate many borrower shapes and sizes. These credit factors include borrower attributes like credit, income, and debt; and loan and property characteristics, including the size and length of the loan, the property’s value, and the down payment. In fact, it may be more accurate to view the credit box as
The entities that guarantee mortgage loans, the VA, FHA, and the GSEs Fannie Mae and Freddie Mac each have an audience they seek to serve and credit boxes that reflect those needs. The loans they accept are governed more by guidelines than hard and fast rules. That said, they all do have outside limits on the credit factors, how much they will loan, and the leverage they allow.
GSE, VA, and FHA loans, all have maximum loan sizes of $484,350 for a single family home. In high cost areas however, that box will expand to accept a loan as large as $726,525, a jumbo conforming loan. As to leverage, except for VA qualified loans, every loan must have a down payment of at least 20% or must carry private mortgage insurance (PMI.) With this insurance the down payment can be as low as 3%.
Because most loans are sold on the secondary market, efficiency and consistency are a necessity, so most credit factors are reduced to a score or scores. Borrowers who understand how those scores are computed will have a clearer picture of how likely they are to obtain a mortgage and an approximation of how large it might be.
Let’s construct a profile for Jane, a more-or-less typical first-time home- buyer, and see if she will fit into a more- or-less typical credit box.
Jane’s credit risk is assessed by way of a credit or FICO score which reduces an individual’s credit profile to a single number between 300 and 850. The score weighs the length of the borrower’s credit history, number and type of open credit accounts, and payment history. The score also weighs the percentage of available credit the borrower has used, and whether there has been a recent flurry of new accounts. For the sake of discussion, we are going to assign Jane a credit score of 775. The GSEs will accept scores down to 620, but the current average for their newly originated loans is 752; Jane’s score looks good.
WHO’S THE BOSS?
A recent survey found that 55% of U.S. homeowners with a child under age 18 said they considered their child’s opinion when they bought their home. Among Millennial parents 74% admitted their kids’ opinions were a factor in their choice. Among renters who plan to buy in the future, 83% said their children’s opinion will be a factor in the home they choose.
So what do kids lobby for? No surprise, the top request (57%) is a bedroom of their own. They also want a big back yard (34%), proximity to a park (25%), close to schools and friends (each at 24%) and near a swimming pool (21%). Michele Lerner, Washington Post
Front and Back
The second credit risk factor is Jane’s capacity to pay the mortgage. Rather than simply considering her income, it is combined with her outstanding debt to create two scores; front-end and back-end debt-to-income (DTI) ratios. The front-end is based on the sum of required monthly payments on existing revolving and installment debt. The calculation includes credit cards, student loan debt, auto loans, personal lines of credit, store credit cards, and any court mandated payments such as child support. It does not include Jane’s utility or cell phone bills, medical or insurance costs, or amounts she might spend on clothing, groceries, or travel. If her credit report says she has a minimum monthly VISA card payment of the $25 that goes into the front-end calculation. The total is then divided by her verified gross monthly income.
Jane has an annual income (and that would include wages, dividends, rental income, child support (with some restrictions), provable and consistent overtime or income from “gig” type work) of $85,000 or $7,083 per month. Her car payment is $450, and she has a $100 minimum VISA payment, giving her a front-end DTI of 7.8%. However, in two months a deferred student loan payment will kick in, and that $325 payment raises her total debt payments to $875 and her ratio to 12.4%.
Jane has saved enough cash for a 20% down payment on a $450,000 home, so the $360,000 loan she seeks will both fit into conforming loan limits and give her a loan-to-value (LTV) ratio of 80%. Assuming a 4.5% interest rate, her monthly principle and interest payment will be $1824.07. With property taxes and insurance the payment becomes $2124.07. Added to the front end debt, her required monthly payments will be $2999.07, a back-end ratio of 42.3%. If she were buying a condo or had less than 20% to put down, the association fees and/or PMI premium would be included in the back-end calculation.
FIRE DISASTER RELIEF
The October 2017 disastrous Tubbs Fire left Santa Rosa, California, short thousands of units of housing. The catastrophic fire season of 2018, which devastated Paradise, Mendocino and other areas only added to the statewide losses. The Sonoma County affiliate of Habitat for Humanity, the well-known housing non-profit, is picking up the challenge with a push to sharply increase its output of workforce housing, focusing on housing for families displaced by the fires. To find out more or to make a donation, go to www.habitat/ca.org.
Jane’s DTI is low on the front end, but barely slips under the recommended maximum for a conventional loan. Still, her excellent credit score and the 80% LTV both fit well within the conforming loan credit box. Here we can begin to see the fluidity involved. Jane’s lender can consider what are called “compensating factors.” If a borrower has a DTI that is a little too high, but an extremely strong credit score, or a borderline credit score but a large down payment, a lender may move the sides of the credit boxes a bit, allowing one credit risk factor to compensate for another. A credit score that is simply too low for a GSE loan might fit beautifully into an FHA loan, with a much wider credit box which allows scores down to 620 although borrowing costs (and thus DTI) will be higher.
This push and pull also affects the interest rate a borrower will be offered. A borrower who fits neatly into the credit box with a little room to wiggle around is likely to get the “golden” rate, the lowest one available, while a higher rate (called a Loan Level Price Adjustment by the GSEs) may apply to one who is viewed as riskier. Of course, even a slightly higher rate will again affect the DTI and could bump the borrower out of the box.
With a little tugging and trimming, Jane’s lender fits her into an appropriate credit box and approves her for a loan. Knowing exactly how much house she can buy, and the costs gives her the tools to revisit Question 4. How much home does she want to buy? Or, put another way, can she live comfortably with this loan?
OUT OF FOCUS
Fannie Mae researchers recently followed a small group of prospective homeowners through the entire buying process and found a lack of focus on the details of getting a mortgage unnecessarily complicated and delayed their search. Participants concentrated on home shopping, had negative feelings about getting a mortgage and considered it a hurdle to overcome, neglecting financing details until late in the game. Then, time pressure and the host of other buying-related tasks led them to forego negotiating terms or shopping around. They frequently selected the lender, sometimes the only one they contacted, who could get the mortgage closed in time. Mark Palim, Chief Economist, Fannie Mae
This assessment could start with Jane’s back-end DTI. With 42.3% of her income committed, what can she do with the remaining 57.7%? The lender’s calculation does not include the amounts taken out of her gross income before she sees a paycheck; employment and withholding taxes, health and other insurance premiums, or contributions to a 401 (k). Then there are other more-or-less fixed expenses; transportation, child care; utilities and other housing costs not included in the DTI.
The remainder is discretionary income. Money that she can choose to spend where she wants – sort of. But does that include food and clothing? Is there enough to continue her current level of spending there, or on entertainment, travel, charitable giving, or contributions to savings?
If not, then what gives? Can she shave anything from the non-DTI fixed costs? Maybe, but probably only on the margins. It will be in the discretionary part of the budget that hard choices must be made. Only Jane can decide if the house is worth giving up her Netflix subscription or highest speed Wi-Fi. Should she wait another year to buy, hoping for a raise, paying down debt, saving more toward a down payment? Perhaps she can take a second job or lower her expectations and look for a less expensive home.
Hard decisions, but smart ones to make up front. Credit boxes, it turns out, are rather flexible. A borrower’s budget may be less so.
Considering a home purchase? There is much to consider. Call soon!