Announcement

Collapse
No announcement yet.

How much house should you finance? Follow the 20/28/36 rule.

Collapse
X
 
  • Filter
  • Time
  • Show
Clear All
new posts

  • How much house should you finance? Follow the 20/28/36 rule.

    How much house should you finance? Follow the 20/28/36 rule.

    A few months ago I wrote How Much of Your Car Should You Finance? Zero percent. I criticized an article in another publication advising readers to finance 100% of a new car, a depreciating asset, with debt. I advised you to buy the smallest, safest used car you can afford to buy with cash–a "shitbox"–rather than a new car you need to borrow money to buy. If you don't have the cash to buy a car that meets your safety standards, then finance as little of a more expensive, safer car as possible.

    Taking on debt that does not increase your net worth long term is self-inflicted slavery. You are putting a lien on your future income. Mortgage debt–debt secured by the value of your home–is a better form of debt because as of 1986 tax on mortgage interest is deductible. Still, there is a limit to how much mortgage debt is financially good for you, and the name of the game is still: get rid of the debt.


    The new symbol of wealth: cars you can buy with cash, like this.


    The old symbol of wealth: cars you cannot buy without debt.


    In case you're curious, my politically incorrect car. If you stick to buying cars with cash,
    with the money you save by not paying interest, eventually you can buy new with cash.

    Today I received a note from an iTulip reader who is a lender based in Chicago (thanks, Andrew). He points me to an article that really got me going. Typical advice on how to purchase too much house, way too much. Today's column by Jack M. Guttentag, The Mortgage Professor, says:
    Facts are facts: Sometimes, you’ve got less cash on-hand than you’d like. Should you use your cash to pay points – or utilize it to make a larger down payment? Let's discuss this thorny question.

    A reader writes: "I’ve been shopping on-line for a 30-year fixed-rate mortgage. All the sites ask you how much you want to put down, and all offer different combinations of interest rate and points. I have cash of only $15,000 to apply to either down payment or points on my $500,000 purchase, but obviously I can’t use it for both. Where do I get the biggest bang for my buck?"

    The Dilemma of Down Payment vs. Points

    Using your cash to pay points lowers the interest rate. (Points are upfront payments expressed as a percent of the loan). Using your cash for down payment reduces the amount you must borrow, and might or might not reduce the rate on the second mortgage if there is one, or reduce the mortgage insurance premium if there isn’t.

    Whoa. Hold on a minute, professor. Let's start by asking whether someone with only $15,000 available for a down payment can afford a $500,000 mortgage. That $15,000 represents a 3% down payment. It should be 20% or $100,000 for a $500,000 home. If your reader only has $15,000, he can afford a $75,000 condo.

    How do I know? Let's go back in time to the days before the Frankenstein Economy, when accountability between lender and borrower was personal versus "transaction based." If you're looking for a "New Era" catch phrase to justify today's credit bubble the way "public venture capital" was thrown around toward the end of the technology stock bubble in the late 1990s, "transaction based lending" is it. What nonsense, as if "transactions" didn't occur when loans were made before the era of indiscriminate securitization. Lenders ran out of credit-worthy borrowers in the Frankenstein Economy and started to lend $500,000 to people with only $15,000, or $500, or nothing saved for a down payment. The banks, in the process of hedging the added default risk they took on when making these loans, versus the pre-securitization era when they lent money only to borrowers with sufficient savings and income, crudded up the financial markets with Risk Pollution.

    Here's how a HomeStrength loan is sold on the GMAC Mortgage site:
    Have you been putting off homeownership because you haven’t saved enough for a down payment and closing costs? Thanks to the HomeStrength plan, you can stop saving and start shopping today.

    The program provides a second loan for up to 4% of the property value, which you can use for the down payment and closing costs. All you need to contribute is $500 — your financing covers the rest. And the best part? The second loan requires no monthly payments and is completely forgiven after 10 years of on-time mortgage payments.
    I don't have anything against poor people owning homes. I was too poor to own a home when I got out of college, but it did not occur to me to try to buy a home with 3% down, even if lenders existed in those days who were been stupid enough to lend me the money to buy it. Why? Because that would have exposed me to unnecessary financial risk. It's fun to think the laws of finance have been repealed and that, as in 1999, "it's different this time." But it isn't.

    Here's the time-tested, it's not "different this time," standard 20/28/36 rule for mortgage affordability:
    • Down payment 20%
    • Monthly mortgage payments will not exceed 28% of your gross annual income
    • Your total monthly payments for all debt including your mortgage payments will not exceed 36% of your gross annual income
    Here's a handy calculator.

    The name of the game is not to maximize how much home you can buy with the most money you can borrow as carelessly as a bank will lend it. Just because a lender is stupid doesn't mean you have to be. The lender doesn't care how stressed out you get trying to make a bigger mortgage work, just as a used car salesman doesn't care if he sells you up to a tricked out version of the car you went into the dealership to buy so he can earn a bigger commission. They don't care about you. So don't listen to them. The name of the game is to build as much equity as quickly, comfortably, and safely as possible.
    Home equity as the primary source of wealth in the U.S. However, when asked to rank sources of wealth for affluent households by the June 2001 ORCI survey, only four in ten Americans (40%) correctly identified equity in one's home as the most important source. "Contrary to the belief of many, those with modest incomes can, over time, build wealth," noted Stephen Brobeck, CFA's Executive Director. "The easiest way to do so is to buy a home, faithfully make the mortgage payments, and be cautious about borrowing against the accumulating home equity," he added.

    Americans Underestimate Household Wealth (PDF)

    Affordable first house. Buy with pride.


    Unaffordable first house. Your lender loves it.

    Step 1: Buying your first home*.
    Buy a modest house as soon as you can. That means a house that's not as nice as the one you grew up in, and one that needs some work. But you're young and smart. Swing a hammer. Slop some paint. It's one that you can afford using the 20/28/36 mortgage rule. Park your shitbox proudly in the driveway. Consider a variable rate mortgage that doesn't adjust for seven years. You may find it cheaper than a fixed rate 30 year mortgatge. You're going to move in four to six years anyway–this house is just a way to get to the house you want but can't afford yet. No, not some suicide loan with a teaser rate that adjusts after the second full moon in the first year of the dog or whatever. If you are smart enough to be reading this but can't understand a loan you're offered then it's garbage. Don't buy it. Good loans are easy to understand.

    Buy in a town with a good school system if you can because the price will tend to hold up better during inevitable real estate downturns. Don't buy a house at the top of the market in a lousy neighborhood. During the mid-1990s housing downturn in Massachusetts, for example, homes in towns with good school systems declined 10% versus as much as 80% in towns with a weaker tax (income) base. You'll find yourself waiting ten years or more to break even. If you buy in a higher average income town at the top of the market, as occurred in most areas of the US in the middle of 2005, you will find yourself underwater–that is, your mortgage is greater than the value of the house–but you won't have to wait as long for the price to recover than if you buy a bigger house in a lower average income town. If you don't mind the minor inconvenience of managing a tenant or two, I recommend a two or three family house as a first home because your tenants will pay between 50% and 80% of your mortgage. That means you earn equity and save for your next home faster and can live in a better home than you can if you have to cover the whole mortgage yourself.

    Step 2: Buying your second home. Four to six years later, sell the modest house and use the profit as a down-payment on your first good house. Again, look into an adjustable mortgage that stays fixed for seven years.

    Step 3: Buying your third home. Four to six years later, sell the good house and use the profit as a down-payment on a great house. Take out a 15 year fixed rate mortgage and pay if off in ten years.

    Using this method, by age 50 you'll own a great home free and clear, while riding the real estate cycle up and down and without having to win the lottery.

    What not to do:
    • Nothing. Wait for money to fall out of the sky. As you can see, the process takes time. Starting a 20 plus year process works better when you're 25 than when you're 40. (See coveat*, below.)
    • Buy more house than you can afford using the 20/28/36 mortgage rule. I know plenty of people who have violated this rule, been house poor for a while and grew into it because the industry they were in did well, and as a result have done well by taking this risk. But they were lucky, and while luck is always welcomed it's never to be counted on. Residential real estate has increased since 1900 at the rate of inflation. Period. The exceptions were the period following WWI when massive pent up demand for housing hit the market when Johnny came marching home, hurrah. The other was the 2001 - 2005 housing bubble caused by low interest rates. Neither are repeatable events. The baby boomers got two "free" rides, although only time will tell how much the housing bubble will ultimately cost. Don't count on another.
    • Purchase a suicide loan, liar loan or other horrific loan product. (These are soon to be nixed by regulators, anyway.) If you can't afford a home with a fixed rate mortgage or a seven year adjustable on the 20/28/36 rule, look for a smaller house or condo or wait until you've saved more money and your income is higher.
    • Consume your home equity. Never. Ever. Ok, almost never. Legit reasons for taking out a home equity loan: illness or other dire emergency, or education if–and only if–the value of that education in increased income pays back the lost equity with interest. Consuming home equity to pay for a vacation, credit card debt run up buying flat panel TVs, or a car like in the ads? Insane. These ads should be illegal. Why is it illegal to sell oxycontin to drug addicts but legal to sell debt pain killers, like cash-out refis, to debt addicts? Sure, Alan Greenspan said it's okay: "...the surge in mortgage refinancings likely improved rather than worsened the financial condition of the average homeowner. Some of the equity extracted through mortgage refinancing was used to pay down more expensive, non-tax-deductible consumer debt or used to make purchases that would otherwise have been financed by more expensive and less tax-favored credit." He may have recommended that you take a piece of Chinese consumer electronics that depreciates 80% in a couple of years and put it on a 30 year mortgage. But that's really bad advice. Makes you wonder who he's working for. And that's why we don't trust him.
    Just as there is no more ludicrous form of slavery than the one we can impose on ourselves using unsecured debt to purchase depreciating assets like cars, there is no greater freedom than owning a home clear of a mortgage. Getting there isn't rocket science.

    (Note that according to this Harper's article The Road to Serfdom (PDF) by Professor Michael Hudson, the freedom from debt that many of my generation acheived will not be possible for the current generation. His theory is that the real estate and banking industries have evolved over the past twenty years to ensure that a large segment of U.S. society cannot pay off its real estate debt. The purpose is to guarantee a flow of capital from wage earners to banks, to further develop what he refers to as a rentier society comprised of a 90% debtor class and a 10% creditor class. While his points are well taken, I believe that by not buying too much house and not buying at the top of real estate booms, it's still possible for many to eventually own a home outright.)

    * Note on Step 1, Buying your first home. We are early innings in a real estate bust cycle. These tend to last five to seven years but this one may last as long as (ugh) fifteen years, due to the extreme of the housing bubble. This boom peaked around the middle of 2005, and may not bottom until 2010 or even 2015. If I were in the market for my first home, I'd hold off for now, and keep an eye on iTulip's community of real estate veterans like Ishmael over here or Sean over here.

    __________________________________________________

    Special iTulip discounted subscription and pay services flogged here:
    For a book that explains iTulip concepts in simple terms americasbubbleeconomy
    For a macro-economic and geopolitical View from Europe see Europe LEAP/2020

    For macro-economic and geopolitical currency ETF advisory services see Crooks on Currencies
    For the safest, lowest cost way to buy and trade gold, see The Bullionvault
    To receive the iTulip Newsletter or iTulip Alerts, Join our FREE Email Mailing List

    Copyright iTulip, Inc. 1998 - 2007 All Rights Reserved

    All information provided "as is" for informational purposes only, not intended for trading purposes or advice.
    Nothing appearing on this website should be considered a recommendation to buy or to sell any security or related financial instrument. iTulip, Inc. is not liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. Full Disclaimer
    Last edited by EJ; 02-04-07, 11:33 AM.

  • #2
    Re: How much house should you finance? Follow the 20/28/36 rule.

    Glad you added the caveat at the end, because the rent vs. own decision in close-in suburban DC didn't break even for 8-10 (or more) years when I looked at it in 2004.

    And with all the condo re/conversions to apartments rents are being held in check during the housing downturn as well. So it may be awhile before buying here makes more sense than renting and pocketing the cash.

    It's just impossible to make a good purchase when everyone around you is making bad ones.

    Comment


    • #3
      Re: How much house should you finance? Follow the 20/28/36 rule.

      Very good summary, EJ.

      With buying your third home, many people forget that one thing:
      Around 50-55, their lifestyles change significantly, because either their kids move out of the house, or - if they don't have kids - their need for socialising and entertainment increases again (change of partner etc.). If they have kids, the move-out often implies the need to pay college tuition, so increasing even the need for additional funding.

      Therefore many people simply forget about this empty-nest situation when making purchases and often end up having too big houses too far away from the spots where they really would like to live. As a result of baby boomers going to retirement and wanting to draw my prediction (which is to my memory close to your regional housing bubble scenario) is that especially in the US and the UK, larger houses in the suburbs will decrease on value on a larger proportion than smaller houses nearer to the city centres along with even a stabilisation or appreciation of values in the city centres.
      Christoph von Gamm
      http://www.interenterprise.eu - with Queer-O-Pinion!

      Comment


      • #4
        Re: How much house should you finance? Follow the 20/28/36 rule.

        Originally posted by Christoph von Gamm
        Very good summary, EJ.

        With buying your third home, many people forget that one thing:
        Around 50-55, their lifestyles change significantly, because either their kids move out of the house, or - if they don't have kids - their need for socialising and entertainment increases again (change of partner etc.). If they have kids, the move-out often implies the need to pay college tuition, so increasing even the need for additional funding.

        Therefore many people simply forget about this empty-nest situation when making purchases and often end up having too big houses too far away from the spots where they really would like to live. As a result of baby boomers going to retirement and wanting to draw my prediction (which is to my memory close to your regional housing bubble scenario) is that especially in the US and the UK, larger houses in the suburbs will decrease on value on a larger proportion than smaller houses nearer to the city centres along with even a stabilisation or appreciation of values in the city centres.

        I disagree here. As you see the living conditions continue to erode in the US, you will see the nuclear family phased out ( or decrease markedly ) , and extended familys phased back in. Multiple generations will again be living under one roof. Larger houses are needed for this. I am seeing this alot now with the patients who come in my hospital.

        I agree with the premise of EJ's article but there are just to many variables
        with housing to cast anything in stone. Location, your profession and skills, hobbies have to much to do with this. JMHO

        As always I enjoy reading this forum
        I one day will run with the big dogs in the world currency markets, and stick it to the man

        Comment


        • #5
          Re: How much house should you finance? Follow the 20/28/36 rule.

          While what you say makes sense, you forget to include one very important fact that occurs in today's world. Young people coming out of school are already saddled with a very large burden of student loans. This conceivably will put off home buying for five to seven years. This would imply that the first home is not bought at the age of 25 as you suggest, but closer to the mid 30's. Given the earning life span of a person, it makes home equity even more distant.
          Last edited by Rajiv; 01-24-07, 10:02 AM.

          Comment


          • #6
            Re: How much house should you finance? Follow the 20/28/36 rule.

            Originally posted by Rajiv
            While what you say makes sense, you forget to include one very important fact that occurs in today's world. Young people coming out of school are already saddled with a very large burden of student loans. This conceivably will put off home buying for five to seven years. This would imply that the first home is not bought at the age of 25 as you suggest, but closer to the mid 30's. Given the earning life span of a person, it makes home equity even more distant.
            That's an excellent point and a topic for another article. On the moral side, it's simply wrong for young people to have to start their lives in debt. They don't have much choice. Here's a good USA Today article by Sandra Block:
            Students suffocate under tens of thousands in loans

            Tom Dillon, 19, a pre-pharmacy major at the University of Connecticut, is carrying $52,000 in student loans. And he's just getting started. When he gets his pharmacy doctorate in four years, he expects his debt to exceed $150,000. Dillon's been drawn to pharmacy since age 5, when he found out he had epilepsy.

            "The first person who helped me was my pharmacist," he says. Dillon, who no longer has epilepsy, would like to go into pharmaceutical research. But he knows he'd earn more money as a pharmacist for one of the big drugstore chains.

            "When I get out, I'm going to have that $150,000 weighing over me," he says. "What I decide is going to be dependent on that debt."

            And the cost of that debt is about to rise. On July 1, the rate on new federally guaranteed student loans will hit a fixed 6.8%, the highest rate since 2001. It comes as the average graduate owes $19,000. Many undergrads, though, have debt exceeding $40,000.

            Those higher payments carry huge implications for this generation of college graduates. The weight of debt is forcing many to put off saving for retirement, getting married, buying homes and putting aside money for their own children's educations.

            Heavy student debts may also keep young adults from starting businesses, says Diana Cantor, director of the Virginia College Savings Plan. Some graduates will refuse to risk what little money they have on entrepreneurial ventures. And securing loans will now be harder. "It's a real crisis," Cantor says. "You're strapped before you get started."
            The average debt for a college graduate has soared 50% in the past decade, after inflation, according to the Project on Student Debt, a non-profit advocacy group. Just as record-low mortgage rates have eased the impact of soaring home prices, low student-loan rates have let borrowers cut their payments, softening the impact of rising debt.
            "Low mortgage rates" have not "eased the impact of soaring home prices" but rather have caused them. The Monthly Payment Consumer accepts the new higher total cost of a house because the monthly cost was made affordable by low rates and creative financing. A different dynamic drives up tuitions. Without a college education, earning potential is very limited in the US. Yet with a college education, a middle class undergrad student graduates with close to $20,000 in debt. This student debt is bad news for two main reasons: 1) students don't have enough credit left to use to start a business, the best way to build wealth, and 2) they don't have enough credit to buy a house, the second best way to build wealth.

            The median salary for a pharmacist is $98,828 or approx. $68,000 per year after taxes, $5,700/mo. To pay off his $150,000 student loans in ten years, he needs to pay $1726/mo. or 30% of his after-tax income.

            If that's typical, I wonder how this generation is going to have enough money to pay into the entitlements system if they also have to pay off these college education debts.

            Comment


            • #7
              Re: How much house should you finance? Follow the 20/28/36 rule.

              Are we talking about people who refuse to live at home and go to a decent but cheap state school

              or people who have to have an Ivy League degree and absolutely have to go to college on the opposite coast?

              Originally posted by EJ
              it's simply wrong for young people to have to start their lives in debt. They don't have much choice.
              EDIT: I just looked at the pictures again and i realized I'm saying that these people may be getting the equivalent of the BMW, on credit.
              Last edited by Spartacus; 01-24-07, 04:45 PM.

              Comment


              • #8
                Re: How much house should you finance? Follow the 20/28/36 rule.

                Originally posted by Spartacus
                Are we talking about people who refuse to live at home and go to a decent but cheap state school

                or people who have to have an Ivy League degree and absolutely have to go to college on the opposite coast?



                EDIT: I just looked at the pictures again and i realized I'm saying that these people may be getting the equivalent of the BMW, on credit.
                Today, a Bachelor's is the equivalent of a HS diploma 20 years ago. A BS or BA is no sure thing for a "career", and now many professions are requiring a Master's or even a Ph.D. for significant career advancement. So you're not just talking tuition for undergrad, but grad as well. If one is lucky, as I was, they'll take a job for a university and use that benefit to get a free or discounted advanced degree. I did that at Johns Hopkins. The pay absolutely sucked for the 5 years I was there, but I got a free MS from an ivy! Now I've moved on to bigger and better things, because although Hopkins will pay for your school, once you get that advanced degree, no pay raise for you!

                If I could do it over again, however, I would have taken the other route. Find a job with a company that will pay for your advanced degree, or at least contribute significantly to tuition.

                My point is that an advanced degree is becoming more of a requirement, and not everyone can be a TA or work for a university. School debt continues after 22, and if one is in grad school, paying tuition until they're 30, that pushes the timeline out even further.

                Comment


                • #9
                  Re: How much house should you finance? Follow the 20/28/36 rule.

                  EJ, I've always said you were the third smartest man in the world, but how you got a dateline of December 2007 escapes me. Could you bring back a WSJ for me so I can make some time in the market?
                  "The test of our progress is not whether we add more to the abundance of those who have much it is whether we provide enough for those who have little." - Franklin D. Roosevelt

                  Comment


                  • #10
                    Re: How much house should you finance? Follow the 20/28/36 rule.

                    Originally posted by Jeff
                    EJ, I've always said you were the third smartest man in the world, but how you got a dateline of December 2007 escapes me. Could you bring back a WSJ for me so I can make some time in the market?
                    We subject our readers to many intelligence tests, sometimes on purpose. We sleep soundly tonight, reassured that the second smartest man on earth can tell the difference.

                    Comment


                    • #11
                      Re: How much house should you finance? Follow the 20/28/36 rule.

                      You should read Generation Debt: Student Loans, Credit Cards, and Their Consequences

                      In the 1992-93 academic year, just over 49 percent of graduates from 4-year state universities had taken out federal student loans. By the end of the decade, nearly 65 percent of college graduates had taken out such loans. In the decade since the legislative change, inflation-adjusted student loan volume has risen by 137 percent.
                      And here is the data on college cost and inflation. This is the main reason for the increased student loans.
                      Last edited by Rajiv; 01-24-07, 09:45 PM.

                      Comment


                      • #12
                        Re: that's exactly the type of info I was asking about

                        people do seem to be trying to cut expenses but just cannot do it - it's either pay the piper or do without, and doing without is painful - without a 4 year degree one's career choices these days are limited.

                        Originally posted by Rajiv
                        You should read Generation Debt: Student Loans, Credit Cards, and Their Consequences



                        And here is the data on college cost and inflation. This is the main reason for the increased student loans.

                        Comment


                        • #13
                          Re: How much house should you finance? Follow the 20/28/36 rule.

                          Originally posted by Rajiv
                          While what you say makes sense, you forget to include one very important fact that occurs in today's world. Young people coming out of school are already saddled with a very large burden of student loans. This conceivably will put off home buying for five to seven years. This would imply that the first home is not bought at the age of 25 as you suggest, but closer to the mid 30's. Given the earning life span of a person, it makes home equity even more distant.
                          You know what's funny as i sit here with my 20k in student debt after having graduated 4 and a half years ago from grad school, I had never considered this. Everyone has student loan debt nowadays - everyone. I just kind of assumed that it's always been like that and my situation isn't that crazy, but after reading this thread i kind of had a "duh" moment. And I'd probalby have closer to 40-50k if my parents hadn't significantly helped out with the loans.

                          I know plenty of people who are graduating in my field (starting salary around 50k/year) of well over 100k, and they work weekends to be able to make 1000/month student loan repayments. I thought I was getting a deal at 400/month for student loan payments but now I just go uuuuuuugh.

                          In any case that's just one man's story. I'm way better off than most people though, from what I see.

                          Comment


                          • #14
                            Re: How much house should you finance? Follow the 20/28/36 rule.

                            Having gone to grad school in the early to late 70's, I see how much more of a burden we have added on to the backs of young people. It started in the Reagan era, when government support for educational institutions was cut way back. The efforts at privatization have just accelerated the burden on the students.

                            I remember that it was possible to get a 4 year college education working 30hours a week at the sandwich shop (from 6pm to 10pm - 7 days /wk)) - going home to a large 6 bedroom house shared between 8 people -- studying till 2am - getting up at 8 am - rushing to class. Hard work, but that 30 hours a week of low wage work enabled you to do it -- college costs were low enough and you got your education without being in debt. But today that is an impossibility.

                            Comment


                            • #15
                              Re: How much house should you finance? Follow the 20/28/36 rule.

                              is this a set-up or what? inflation, dude! that's how he's gonna pay it off. add a zero into the end of that nominal income. that's the ticket! now let's do the math:

                              median salary for a pharmacist in 2015 is b$988,280 (b$ is bonars, man) or approx. $680,000 per year after taxes, $57,000/mo. to pay off his $150,000 student loans from 2008 - 2014 undergrad and grad school in two years, he needs to pay $6,250/mo. or 11% of his after-tax income. no problemo!!!

                              Comment

                              Working...
                              X