Today I read some crazy stuff online that is pretty worrying. On the real estate forums, it’s a common story for people to share their loan information and more and more, I see people putting themselves in a very tight position.
Why is this bad? Well, we like ot remember the GFC as being a subprime problem. But the truth is many more prime buyers defaulted as well. And research has shown that the reasons for defaulting were not as straightforward as credit scores (which is what defines subprime). Basically people default because they have negative equity and then they can’t afford their mortgage payment.
That means loan-to-value and DTI are the real triggers for foreclosure. And it’s really scary what is happening with DTI.
73% DTI post-tax
A homebuyer shared this on reddit today.
I recently bought a house, and currently paying about $5500 (with possibility of increasing even more in the future) for mortgage. It’s taking a huge portion of my monthly income, and making me stressed. I take home about $7500 per month after tax.
Source: redditcom/r/personalfinance
Which of course made everyone ask: How can this happen? Isn’t 73% of net income spent on housing totally unsustainable? How did they even get a loan?. I thought these kinds of loans weren’t happening. The user chimes in:
When calculating DTI, I think they factored in my commission, about another 70k. But I don’t think it will be stable, and I still have to live on my monthly paycheck.
Okay so they factored in a commission that isn’t expected to be stable. So one can blame the buyer or the lender for this – how well did the lender educate the buyer? Did the lender explain what DTI means to the buyer and why it’s important? Probably not, mine didn’t.
They aren’t told that it’s a calculation that should help them evaluate the risks behind the decision they’re making. Only the buyer knows their true cost of living.
Or did the buyer make it seem like the commission was a sure thing? It certainly doesn’t sound like a sure thing. But who cares about the blame? At the end of the day, this is an unsustainable loan. One economic shock and this buyer won’t be able to afford their mortgage.
Shit like this is happening. On top of which, this was an ARM loan which means his payment can go even higher in the future.
51% DTI pre-tax
Here’s another:
It’s an FHA loan our loan officer told us our monthly payment is going to be $3100. We are freaking out! I make 55k a year and my husband makes around the same. He is commission so it varies, I am on salary.
We have 2 car payments $600 and $370 we do have cc debt $586 in min monthly payments. How can we back out of the loan or can we make it work? We are terrified to be house poor.
Source: reddit.com/r/FirstTimeHomeBuyer
That’s $3100 + $600 + $370 + $586 = $4656 they have in debt monthly. In income, 110k / 12 = $9160 monthly, and some of that is commissions. That’s a DTI of 51% which is really high – and allowed by FHA loans. Have one rough year where commissions drop and what does that DTI rise to?
So why would they do this? Well, this one broke my heart. Here’s what they say
We live in IL house market will never go down and we will never buy.
We are the first in our families to buy a home, we were never shown how to do work credit or how life works, or parents are both Hispanic so they have very little knowledge of home buying and credit.
Source: reddit.com/r/FirstTimeHomeBuyer
The first line is the kind of fearmongering buyers are hearing from their realtors: “Houses will never go down and you will be priced out forever if you don’t buy NOW”. The second line broke my heart. As a first-gen immigrant, I know what it’s like to try to figure it out on your own.
So did any of these people have DTI explained to them? From what I can tell, if buyers have heard of DTI at all, it’s just something for lenders to worry about. Childcare, elder care, long commutes, utility costs are not taken into consideration by this ratio. They aren’t told to calculate it for themselves realistically and also take their expenses into account. They aren’t told that it’s a calculation that should help them evaluate the risks behind the decision they’re making. Only the buyer knows their true cost of living.
DTI is something that every buyer should think very carefully about. And yet, I don’t think any real estate professional I spoke to told me how to calculate it, or told me what mine was at different house prices and mortgage rates. I think the only time they mention it is when you exceed their limit. So at some point I had to look it all up for myself.
What’s a DTI Ratio?
DTI Ratio is the debt-to-income ratio. It’s a measure that compares the amount of debt you have to your overall income. Lenders use it to assess whether to give you a loan. As a buyer, it’s worth understanding it to see what your own affordability is.
Better.com asked me a few questions, then took my entire life savings as downpayment and told me I could buy a $2.3m house. Which of course I laughed heartily at. I have no idea what DTI that represented.
My lender asked me what price range I was looking in and gave me the rates and mortgage payment at that price. To her credit, she walked me through the full worksheet with closing costs. But she did not tell me what my DTI was for the two extremes of my price range of $850k – $1m.
To his credit, my financial adviser did tell me to take what income I have left over after retirement savings and monthly expenses, and add that to my rent, and that should tell me what I’m able to pay. That still could put me in a tough position but at least it keeps aside both savings and expenses. Notably, he is not a real estate professional.
What’s a “good” DTI?
Eventually I did learn how to calculate DTI. Here’s a good article from Investopedia if you want to do the same. I found for my price range, my DTI ranged from 24-28% which is not terrible.
However, Investopedia also says the following, “Lenders prefer to see a debt-to-income ratio smaller than 36%, with no more than 28% of that debt going towards servicing your mortgage.” So actually, I am at the edge of affordability if I buy at the top of my range.
This surprised me. Why? I guess I thought I was richer than I am. I have zero debt and make a good salary and save a lot. But hey, this is California and houses are expensive. So even if this seems very NORMAL around here, it is worth realizing that as mortgage rates go up, even I would be stretching.
This led me to temper my enthusiasm and take a step back from that end of the range as mortgage rates go up. I think it’s a valuable calculation for any buyer to make for themselves.
Disclaimer: I’m an idiot first time home buyer. I’ve never taken an econ class in my life. I’m just sharing what I see and learn as it happens. I am 100% certain I will get things wrong, so don’t take any of this as the golden truth.