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Time to Revisit Prudent Lending Standards

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July 15, 2010 – Comments (4)

Ok, I just posted and my reading, this $4 trillion overhang of mortgage debt, has me going on the stupidity of the policy/rules that made this mess. 

If you haver never read my post Low Interest Rates -- As Destructive as Usury, I would suggest reading it.  Higher interest rates have an unearned bad rap, but all things equal, they enable people to take control of their debt in a way that low interest rates prevent by making modest changes to spending to apply the difference to debt.  Those same modest changes make hardly any difference to reducing debt when interest rates are low.  This is based on the insane lending rules that allow a percentable of household income to be applied to mortgage regardless of the rate.

When you examine the issue, prudent policy says you must lower the percentage of income to mortgage or lower the years of the term of the mortgage as rates decline.  I tried to explain this in Sensible lending laws.

My thoughts are to qualify for a mortgage no more then 30% of income should go to mortgage and taxes and the mortgage should be based on a 20-year term at 10%.  That should be the base standard of what you qualify to borrow.  I don't disagree with some room to borrow more with lower rates, but if you read my Six Degrees of Leverage, for a 30-year mortgage with $100k of household income you could borrow $310k and at 4% it increases to $524k. 

$524k is 69% more then $310k.  When rates are lower, you can afford to borrow more actual dollars then when rates are high, but reducing it to simply a percent of income takes away that important ability to control debt and pay it back early and free up cash to spend on other things in the economy.  Both mortgage examples have the same payment, but with the higher interest rate far more of what is being paid is interest and paying extra onto debt can enormously reduced the interest burden.  With low rates it is mostly principal you are paying and there is no way to reduce the principal repayment burden.

I see nothing wrong with starting at the standard I have suggested and then adding an extra 3-5% to what you can borrow for each 1% decline in rates.  So, in this 30-year example you could borrow an extra $56 to $93k rather then the insane extra $214k the current rules would allow. 

But the other thing I would do is make the payment 30% of income if rates are lower and reduce the mortgage term.  This would increase principal repayment and leave room for modifications in the future should the borrow's circumstances change.  The mortgage would actually be paid back in about 20 years rather then 30 years and at 4% it isn't wise to be giving out 30 year loans to their maximum qualifying income even if they have the highest of credit scores.  They will be debt slaves for life and it requires perfect living circumstances, no unexpected expense, or children, or job loss, or illness.

 

4 Comments – Post Your Own

#1) On July 15, 2010 at 4:22 PM, QualityPicks (37.79) wrote:

I agree 100%. My blood boils every time I start thinking of the consequences of such extreme low interest rates as right now. And I get even more anxious thinking that this seems to have no end. Just like a stock of a bad company that goes from $30 to $3, and you think "it can't go lower", and then it goes to $1.5 (50% less), and then to $1 (another big %), and it keeps going and going, and the freaking company never seems to go out of business :) Nor does it seem to be in bankruptcy problems, they are just diluting the shares. That is what seems to be going on with the economy, we are just in an unending spiral, where we keep diluting everything. 

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#2) On July 15, 2010 at 4:37 PM, outoffocus (23.22) wrote:

To add to the prudent standards, I am a huge proponent of one-income mortgages. In other words, even if you are married and have 2 incomes, the mortgage you have should be low enough to be supported on one income. For one it frees up more monthly income to save or do other things and 2, its a form of insurance in case one partner gets sick or loses their job.

Further, I think there needs to be a clarification on the % of income calculation. I believe the mortgage payment should no more that 30% of NET income rather than gross income. Most of us only see 2/3rds of our income after taxes and benefits, so whats only 30% of our gross income can be almost 1/2 our net income. I dont know about you but I cannot see myself giving up an entire paycheck (assuming I get paid twice a month) just for my mortgage. Depending on my income level, that leaves me very little for much else.

I cringe when I see people "overbuy" houses because they based the mortgage on 2 incomes instead of one. Isnt their a little voice in their head that says "what if I lose my job"? It also ticks me off a little because 2 income buyers keep home prices elevated beyond what they should be. It keeps prudent people like me on the sidelines because I cannot find a reasonable home at a reasonable price.  For instance homes are still selling for $300k because couples are buying the homes based on 2 incomes of $50-$60k per year. But if one person loses their job, the remaining $60k per year salary will not be enough to pay that mortgage.  In the meantime I'm sitting on the sidelines hoping for a modest home to drop below $200k, but I'm being beat out by the couples. lol

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#3) On July 15, 2010 at 6:47 PM, ocsurf (< 20) wrote:

Housing prices would have to continue to drop otherwise no middle-class family will ever own a home (if your prudent lending practices were the norm).

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#4) On July 15, 2010 at 10:50 PM, ChrisGraley (29.84) wrote:

I think it's spot on dwot.

I also think that initially ocsurf is half right. Initially about half of the middle class  trying to buy, won't be able to purchase a home. Supply and demand should make that a short term thing though.Supply exceeds demand right now and making it tougher to buy lowers housing prices even more. As usual, the tough answer is the best answer.

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