Sensible Lending Laws
I have written previously that with lower interest rates mortgage terms should be reduced and I have given sketchy guidelines for debate., I have even calculated some differences in what I would have qualified for compared to what I actually borrow and what a reasonable guideline would allow.
I have come with guidelines that jump and I was thinking about how to approach what a sensible guideline should be by applying a formula.
If you look at the mortgage table in Six Degrees of Leverage Part IV you see a mortgage qualification table based on how it has been done, percent income and how that varies by interest rate. From the bottom left corner, at $243K, to the top right corner, at $1.127 million, has an over 400% increase in qualifying for mortgage amount. I have stated that for a 30 year term the qualifying should be at 12% because of the risk of such a long term mortgage.
I think there is room for a fudge factor based on interest rates being lower. Say the qualification standard used 12% and interest rates were at 7%. If the payment is kept the same the 360 month mortgage changes to 143 months or just under 12 years. And say it was 4% instead, then the term would be 117 months or just under 10 years.
Essentially what lenders did was maximize risk to the point that an investor could be completely wiped out financially. What I have suggested is at the opposite end of the spectrum. What is sensible is to have a balance between the builder being able to get a higher price, the investor having an acceptable level of debt and the homeowner having a future. What happened was a transferrence of wealth so out of line from any measure of reality from the investor and the new homeowner to the selling homeowner, builders and bankers. Certainly later in the game the bankers and builders have also gotten into trouble, well it seems everyone except for the homeowner who sold.
So, the fudge factor has to be a ratio of rate standard, 30% of income qualifying at 12%, but then if interest rates are lower the fudge factor would allow the homeowner to borrow a little more. One fudge factor would be to take a ratio of (1+12%)/ (1 + the lower rate) and multiply that by the total loan amount, so 1.12/1.07*234k gives $254k. That adds about 1 year onto the repayment time, which comes in at 154 months, or just under 13 years. At 4% the mortgage amount increase to $262k and it takes about 129 months to pay back or almost 11 years. These are still very low risk in terms of the homeowner being able to pay back the debt.
Another fudge factor would be to take the same ratio and square it. At 7% the amount a borrrower would qualify for would be $266k and the term would be 167 months, or about 14 years. At 4% the mortgage would be $282k and 184 months, or 15 years. Notice that using the ratio squared the increase interm at 7% was about a year, yet it at 4% the term increases by 4 years to 15 years.
At 4% there is a lot more probablitity the rate ends up being reset higher over the term, so 15 years is about the longest repayment schedule you want with low interest rates.
The table eligibility allowed the qualifying amount to go to $524k at 4%, for an increase of an insane $281k, or a 115% increase. The rational standard I suggest would allow an increase in mortgage of $39k or 16%.
The bidding up of home prices creates gross problems in the economy so lending laws are necessary and they should sensible and balanced.