Math Problem

posted on August 2nd, 2008 filed under: Real Estate News

Anyone remember the old conservative lending formula that says a person’s home payments (including principal, interest, taxes and insurance, also known as PITI) should be no more than 28% of their gross income?  What would happen if we went back to those tried and true lending standards?  It’s a question worth asking, because we just might be headed that way.

Here’s the answer: A person’s loan should be no more than about three times their gross income.  That’s a scary concept, because most people have been borrowing way more than that, and a return to old standards could mean continued downward pressure on home prices.

The math is plain.  The old standard says .28 x gross income = PITI.  With interest rates a bit over 6%, the P&I portion is about 7% (gotta pay principal).  Taxes are usually 1% to 2%, and insurance is generally less than 1%.  Figure that T&I add up to another 2%.  Therefore, total payments = 7% + 2% = 9% of the amount borrowed.  Plugging that into the old formula: .28 x gross income = .09 x amount borrowed.  In other words,

.28 / .09 = amount borrowed / gross income = approximately 3.

Consider what that means for places like the Miami suburbs of Coral Gables and Pinecrest, or many of the suburbs around New York City, like Westchester County.  The median home price in all these communities is still about $600,000, and the median household income ranges from about $70,000 to $100,000.  Traditional lending standards would say that the median household should borrow no more than about $210k to $300k.

Where would the other $300k to $390k come from to pay for a $600k home?  Savings?  In a country where the savings rate is near zero?  Think about it: A household with income of $100k would have to save 10% of that income for 30 years to come up with $300k.  (Yes I know, savings appreciate, but over a 30-year period, house prices appreciate too.)

It’s really been a sort of Ponzi scheme in which prices continued rising faster than incomes as long as people were willing to borrow more aggressively.  Inevitably, the time was reached when a greater fool could not be found, and the scheme exhausted itself.  Mr. Ponzi, meet Mr. Minsky.

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posted by // This entry was posted on Saturday, August 2nd, 2008 at 8:22 pm and is filed under Real Estate News. You can follow any responses to this entry through the RSS 2.0 feed.

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