The Old Mortgage Rules
October, 1 2008
At the heart of the US financial crisis is that many financial institutions are holding large numbers of “sub-prime” mortgages. In real talk, a sub-prime mortgage is one that was made to someone who couldn’t afford to pay it back. Yes, the banks were wrong to make so many of these marginal loans, but it takes two to tango, and the homeowners have to bear some responsibility for buying a house they couldn’t afford.
OK, I have to admit that when we bought our home, we borrowed every penny the bank would lend us, and it is hard to criticize others for doing the same, but back then banks used sensible rules to decide what the limits were.
If the old rules for home loans had been followed, the current mortgage meltdown never would have happened. Those rules protected both the banker and borrower. Neither is well served by a default and ensuing bankruptcy. The old rules were the product of hard experience. They did disqualify some from buying the house they wanted, but in disqualifying them they were protecting people from buying a house they couldn’t afford.
We are now in a new era, where the bank telling you that you can’t afford to pay back the home loan you are asking for is discrimination against the poor, and rather than face discrimination charges in court, the banks removed the barriers preventing foolish home buying decisions. That means you now have to make this decision for yourself. Politicians can repeal the rules, but they can’t change the hard reality the rules were based upon. If you violate the traditional rules of home buying, the penalty will be that you find yourself with house payments you cannot afford to meet.
Buying a home is the largest and single most important financial transaction you will ever make. Do it right, and it will help you to build a solid financial foundation that will make the rest of your life better. Do it wrong, and you are in for a world of pain, humiliation, and poverty that could have been avoided.
The best guide for today is what worked in the past. The bankers may have thrown out the old rules, but I am old enough to have bought a house under them and still remember. The rules are simple, but designed to limit home loans to those who have the ability to pay them back. If you plan to buy a house, you would be well advised to follow these rules, no matter what your banker says. They are simple and you will easily be able to understand them. You will end up with a lower price home or perhaps no home following them, but they are designed to keep you from deluding yourself into thinking you can afford that which you cannot.
Following are the old financial rules of thumb regarding the financing of your first home.
Down payment: You should have at least a 10% down payment, preferably one you saved yourself, so the money really means something to you. If mom & dad give you the down payment, it is just Monopoly money, and the amount of work and sacrifice that the down payment represents is not clear to you. Saving the money yourself demonstrates that you can forego current gratification for a greater long term benefit. The down payment says that you are a serious person, doing a serious thing, and covers you in case there is a downturn in housing values, to prevent you from going into negative equity. (You owe more than the house is worth, a bad position to be in.)
Closing Costs: You will need to pay an additional 2% of the amount financed up front for various documents and fees, plus “Points”, which are up front profit for the bank and a commission for the loan officer who sold you the mortgage.
This adds up to about 12% of the price of the house. If you can’t put that much money on the table, you can’t afford that house. The corollary of this is, the most expensive house you can afford is eight times the amount of money you are willing and able to withdraw from savings.
Repairs and first month purchases: If the house is not new, you need additional money for any repairs that are needed now, and a reserve for stuff that will break soon after you move in. An old house is like an old car, there is always another repair just around the corner, usually at the worst possible time. If the house doesn’t have a functional stove, refrigerator, washing machine, furnace, and water heater, you will have to buy or repair them the first few days. You will need to have extra money set aside to cover stuff like this.
Monthly Payment: Your monthly house payment is comprised of P.I.T.I.; banker jargon for Principal (Paying off the loan), Interest, Taxes, and Insurance. Your monthly payment should not be more than 28% of your income. Your combined payments for mortgage, other loans like car loans, and credit card payments should not be more than 35% of your income. If you run the numbers, based on a 6% mortgage and 3% property tax, it works out that the most expensive house you can afford is about three times your annual income if you have no outstanding consumer debt. Higher taxes or interest rates, and outstanding consumer debt reduce that ratio.
The numbers above are based on long experience loaning people money. People who can meet these standards usually are successful at paying back their mortgage. Those who do not meet these standards are likely to default. These standards exist to protect both you and the bank; neither of you benefits from a default.
Adjustable Rate Mortgages (ARM): Do not take an ARM. If you need the slightly lower rate of an ARM to be able to afford the house you want, you cannot afford that house. It is not smart money management. If the rates go up, which can happen unexpectedly, your payments will go way up and you will be screwed.
Refinancing: If you are refinancing your home it should only be to shorten the mortgage, or pay for major improvements to the property. If rates go down, or your ability to pay off the mortgage improves, it is wise to refinance. Lower rates and/or a larger payment will reduce the number of years required to pay off the mortgage and can save you very large amounts of money.
If you refinance your home to get cash to pay off consumer debt, buy luxury items, or reduce your monthly payment, it is a major danger sign. It means you are living beyond your means and are literally mortgaging your future to cover excessive spending today.
Second Mortgages: Also called home equity loans, are taking out a new mortgage using the accrued equity in your home as collateral. The money is not free, and you will end up with a larger mortgage payment for many years. Unless the money is to finance major improvements to the property, they are a bad idea. If the money is for buying a car, boat, or some luxury item like a super-size TV, or to take an expensive vacation, or paying off consumer debt run up buying such items, you are literally mortgaging your future to pay for a lifestyle you cannot afford, and you will be poorer in the future to pay for today’s pleasures.
If you have to refinance or take out a second mortgage to pay off your credit card debt, you should cut up the cards, close the accounts, and live on your current income. You have just demonstrated that you can not handle having a credit card responsibly.
I know that much of this may seem obvious to many, but if it seems obvious, you are not the person this message is aimed at. Judging from the current situation, there are many who never heard these truths, or ignored them, thinking that if the banker is willing to loan me the money, it must be OK. Well, once upon a time, when bankers made loans with their own money, that was true. Today, your mortgage is simply an investment vehicle, and the mortgage broker, who is really just a salesman, sells it the same day to an investment firm who will then bundle it up with a lot of other mortgages and sell the bundle on an exchange. The person making the loan gets their money that afternoon and never has to worry about it again. This leaves you as the only person looking out for your best interests. Ignore this responsibility at great peril.
Never forget; the only person who cares what happens to you is you.