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Thursday, February 15, 2007

Let's talk Financing: Gross Income outdated?

Bonus Picture Day (billboard next to Everett Events Center): Looks like the banking industry is aware of the debt picture.

Gross Income outdated?

For years the lending industry has utilized gross income as the yardstick by which consumers are qualified to obtain mortgages. Let's say the median priced home in King County is $465,000. What would the gross income need to be to qualify for this mortgage?

Here's the generic scenario: Specifically, let's use a 100% financed program as our sample; not to ridicule the program, but because it is used so often. Property Taxes are presumed to be $5000/yr. Homeowner Insurance is presumed to be $600 per year. We won't worry about Mortgage Insurance for this illustration. This is just to make you think, so don't pull out your calculators.

A single 1st Deed of Trust loan is $465,000 @ 6% fixed for 30 yrs: Using the Bankrate.com Mortgage Calculator, the Principle & Interest is $2787.91 Now add $466 per month for taxes/insurance, so your total monthly payment is: $3253.91.

If a rule of thumb is to not exceed, say, 33% of your gross income, then what should my income be to qualify for this loan? If your payment is $3253.91, roughly a third of what you make, then you would need gross income to be roughly $9900.00/month. That is a lot of dough.

But, hey! Meet Bob. After tax income for Bob the borrower is actually around $7,000/mo. That's his net income. But, hey! Wait! Bob spends at least $500 per month on utilities and he needs cable to watch pay per view specials like the UFC Championships. And he spends hours blogging, so Bob needs a high speed internet service at $50/mo. He also drives that sweet Acura TL, so his payments are around $600 mo., including insurance--which would have been less, but that's another story. He loves the Sonics and attends at least 2-3 games per season. Bob and his close friends eat out at least once a week and dang it, he wants to go to REI and buy that Thule car roof rack for his new boards that he purchased last year. Up to a few weeks ago (conditions have been horrible recently) Bob was skiing at Crystal Mountain every weekend. That's a hundred dollar day, just to ski and play. When Bob really thinks about it, he's spending about $2000.00 month on food, utilities, car payments, and other stuff. Once in a while he likes to travel.

What I'm illustrating is probably not terribly far off from reality. After tax income on this borrower does not leave very much left for a housing payment, provided the income stated was a full doc loan---full employment and income verified loan. If the borrower did not actually make $9900 mo/ gross (went Stated Income or NINA--no income or asset verified) but ACTUALLY brings home $5000.00 per month, NET, this borrower is on borrowed time.

Fortunately for Bob, his co-worker is also a part-time loan officer! Bob went with an 5 yr. Interest-only ARM, amortized over a 30 yr term. Bob is paying interest only, $2325 plus taxes and insurance, so his payment is about $2791/mo. That is about $500 less than the previously mentioned loan program. He could take that difference and invest it or have more fun. Is this scenario plausible to readers? It should be. It works well with those who use it wisely.

Should the lenders stick with gross income? I'm probably old fashioned, but when I look at my monthly obligations, my decision making (usually) is based upon take home pay, not gross income. Borrowers should know what they actually bring home and use that figure as the real number to stay within their comfort level.

13 comments:

Eric said...

As you state, I never really understood why lending institutions base the qualification amount on Gross and not Net income. I use the same 'conservative' estimate as you and only see home prices under $350k as feasible. If a person like Bob throws a wife and kids into that mix, the results would be unpleasant.

Even though the government gives you a nice gift at tax time (mortgage interest deduction) that helps make up for some of the outlay, it seems imprudent [to me] for a person to rely on what is basically a government subsidy to afford housing. That subsidy has come under fire recently and could at another point in time as well...

stephen said...

Yeah, my wife's 700 month (including insurance) Rover turned into a 10 year old SUV in favor of a house.

I would think Bob can afford 360-400 on a 30 year fixed, if he trades down on the car and cuts back on the spending. If he keeps renting he still should consider those things and start putting more money aside for retirement ;-)

rubyfan said...

33% of gross is a fairly new qual level. It wasn't that long ago that it was 25% of gross income.

BTW: in regards to interest only loans you say: "It works well with those who use it wisely." How does one use these wisely? I would guess that you could use them wisely if you pay extra every month (the equivilent of a payment for a regular 30 year fixed) - however, wouldn't there always be the temptation to pay the interest only?

DebtFree said...

I don't think you should ever rely on what a banking institution will lend you, they will make you a slave for the rest of your life. People need to make that decision for themselves.

My families decision:

1) Debt Free (of course)
2) 6 month emergency fund
3) Down payment big enough so that my mortgage + taxes + insurance is less than 25% of my take home pay.

This will leave us with enough money for retirement (15%), kids education, and doing the things we love to do! I call that FREEDOM!

simple simon said...

debtfree...

I'm with you. Debt is no way to live. "Live well below your means" - thats my practice. Holding a big mortgage for that tax write-off is way over-rated. I cashed in on my rentals (too soon I might add) and burned my mortgage at 32. With two new cars and no car payments, along with no credit card bills, the money just piles up. Some say I'm way to conservative, but I sleep really well. 1,400 square feet is all we need. Forget impressing your friends; I say impress yourself. When your free to leave that corporate job at 50 (or sooner), while your impressive friends are still chained to that desk, who will be impressive then??

The Bruce said...

Doesn't make sense to me either.

I just moved up to Puget, and am renting a newer 2200sq' home on a nice lot for $1700/mo. It would cost me all of my savings (around 50k) just to get INTO this home at its appraised $480k value, and STILL have to carry a 2nd 10%, which would make my payment with escrowed taxes almost double my rent payment. I'd love to say "we own the home" but it just isn't worth the disposable income to me as I enjoy the same things Bob does - 2-3 NBA games, UFC Championships, taking my family out to dinner 2-3 times a week. I find I'm lucky to save $500 a month in my budget- WITH the $1700 payment. I'd be underwater despite a low 6 figure income if I actually had to make a full 30 year mortgage payment (family of 5, single income). Sometimes I need reinforcement on my decision to rent instead of getting into a 'creative' mortgage I could afford, which I find here. :)

Tony1790 said...

Debt free,

I can see that you are a Dave Ramsey fan, me too.

Bob the buyer (know many like him) is NOT using a interest only ARM, he is most likely using the Option ARM......which gives you the Option to pay full payments, interest only or minimum......guess which one people choose to do, yeah the minimum. The min payment will allow him an additional $500 to "invest" or more likely to spend. These are dangerous and VERY common type loans.

I just sold all of my rental homes and my primary home and moving to TN to pay cash for a house, I'm already debt free, paid off the credit cards and paid cash for a new truck.

The great unwinding will be ugly and horrendous for those involved and there are more people involved than you realize. The realtors and banks have been pushing the concept of interest or Neg-am loans, while saying you can always refi or sell the home. That's true unless the values go down or no one is buying.

Smart investors know the housing prices are too high and are waiting like vultures to pick up foreclosures, the weak buyers are on the way out with the current subprime lender implosion (22 lenders kaput since dec 06), credit standards are on the increase, hello 25% gross income. Who's left to buy that hasn't already bought?? CA market is imploding as we speak, their absence will be felt in the Seattle market, good luck boys and girls.

Congrats to the poster who makes low $100k and is currently renting, save that money and buy after the fall, it's coming.

Tony in Port Orchard

Herb Wright said...

For most Americans, 1/3 of you income is a workable number. The official numbers lenders used when I started in real estate was 36% and 41% (36% of income allowed for house payment, 41% for the total of all regular monthly bills.) My parents did advise me to use 1/4. But even using 1/3 of your income on house payment requires some budgeting, a skill that I have seen decrease significantly over time. The solution...........marry a foreigner. My wife was able to get her first house with a 50% ! payment to income ratio, but some lenders know that certain immigrant borrowers have much better spending habits than Americans and will make that loan. She not only paid the house off, but paid it off early.

Richard said...

I know too many people that qualified for 50% of gross, and one that actually pays 90% of gross income on PITI.

The key here is they have multiple income households where one (or more) of the people paying the mortgage each month are not on the loan.

What has happened is the people with good credit or cosigners are acting as the anchor for a 4-8X annual income loan, and using the income from people with bad credit to pay it off.

SeattleMoose said...

In the early-mid 1990's the banks I used required a ton of documentation and a ratio of anywhere from .28 to .33 of monthly housing costs/gross monthly salary.

I had spotless credit and a good salary and I still had to go thru the 3rd degree just to get loan in the .28 range.

What the @#$% happened in the last 10 years?

Eleua said...
This comment has been removed by the author.
Eleua said...

Is this the same "Smiling Bob" from the Enzyte commercials?

Matt said...

Yes, it could be a problem for Bob (or whatever his name was, btw, property taxes on a $460k house wouldn't be $5k a year, and the interest deduction on having a mortgage that large would make his net income probably at least $8k a month), but instead of changing the way that people qualify for a mortgage, why not change the way they spend?

I bought at $540,000 house and don't make anywhere near $9,900 a month. But you know what, I didn't get an ARM either. If you are smart about spending, you can get a fixed rate, get the house you want, and still have money left. I have cable, high-speed, an appetite for skiing, an Acura RL (which I bought three years old and saved $30,000), automatic investments into an IRA, and do it all for less than $8,000 a month.

It is all about priorities. Know how much that latte costs a year? That bottle of wine at a meal out? Or all the other places where money disappears...