Sensible Mortgage Lending Standards Two of my previous posts, “Low Interest Rates – The Two Faces of Dr Jekyll and Mr. Hyde” and “What Can Housing Bubbles Teach,” have been about housing bubbles and how much more challenging debt is to manage when it at low rates and lending standards do not account the Mr. Hyde nature of debt repayment as rates decline. Low interest rates are only good if the principal being loaned is not increasing. The very nature of lending policy that bases the qualifying principal on ability to service the debt at a fixed level of income regardless of rate has enormous problems as rates decline -- increased default risk, economic stagnation, and creation of asset bubbles. Additionally, the challenges of managing the debt most likely means that saving for retirement will be difficult. There are many ways to strength lending standards that would allow some increase in borrowing as rates decline, but would not enslave borrowers and create enormous risk for investors. Declining Term with Declining Rates Standard A simple solution would be to reduce the term by 1 year for every percent below 12%. Reducing Term Standard 1 Yr/1% Under current standards a person can borrow 178% more at 2% than at 12%. The declining term standard would limit the range to 103% difference. At 6% the increase declines from 71% to 57%. With 20% down the maximum house price would be $476k. This is considerably above the 3.0 affordability ratio of home price to income. It is asking for trouble, but it is better than existing standards. Perhaps 1.5 years less for each 1% below 12% would work better, or an exponentially declining term. Reducing Term Standard – 1.5Yr/1% 30% 30% - 30 Term % Rate / % Declining $ Year (Years) Increase income 1.5 Yr increase Term at 30% in Loan Term 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 676,000 592,000 524,000 465,000 416,000 375,000 340,000 310,000 285,000 262,000 243,000 388,500 390,000 384,500 373,300 357,800 339,500 319,700 299,500 279,600 260,600 243,000 15 16.5 18 19.5 21 22.5 24 25.5 27 28.5 30 60% 60% 58% 54% 47% 40% 32% 23% 15% 7% -1,500 5,500 11,200 15,500 18,300 19,800 20,200 19,900 19,000 17,600 - Another problem with the 1year per 1% standard is that the dollars increase as the rates decline has increased considerably, from an extra $18.4k when rates go from 12% to 11% to $29k when they go from 5% to 4%. An extra $29k is 29% of household income and that is a lot for a 1% decline in rates. The 1.5-year per 1% standard is much better. The maximum increase for a percent decline is 20% of household income and rate of increased lending declines as rates decline from 8%. My post “Low Interest Rates” showed that at 12% increasing the payment by 10% reduced the payment schedule to 216 months, whereas at 2% it only declined to 316 months. Another standard could be to preserve the ability to pay back the mortgage in 18 years with 33% of income. Fixed 18 year with 33% of income Standard Limit the term to 18 years with 33% of income so the standard of being able to pay for your home in 18 years with motivation is not lost. Fixed 18 year term with 33% of income This table shows that growth in the amount one can borrow is slower at first and accelerates as interest rates decline. Again, it allows for more than doubling the loan amount as rates go from 12% to 2%. Allowing an extra 40% of household income towards debt as interest rates go from 3 to 2% is not reasonable. Setting the standard to the ability to repay the loan in 167 months with 36% of income would work better. However, setting the standard to a different term at a different higher percent of income would still result in the same exponential growth of qualifying principal as rates decline. The table on the next page shows the 14-year term with 36% of income from 3% to 2% allows an extra $28k of borrowing. This is the price of a car and paying for a car is a significant financial strain for a family with $100k of income. This is still not reasonable and is increasing the qualifying loan principal too much. Fixed 14 year term with 36% of income A third method would be to simply raise the amount a borrower qualified for by percent of household income and add it on. The starting standard is 30% of household income to service a 30-year-mortgage. My sense is that allowing an additional 10-15% of household income of borrowing for every 1% decline in rates from what a person qualifies for at 12% would be a realistic balance. If you are paying less interest on debt, you can afford to borrow more, but my “Low Interest Rate” post clearly shows the enormous difference in ability to reduce debt repayment burden. When rates were higher people made modest increases to payments and they got enormously ahead for it. The economy has no data on what happens when people are trapped by debt. Borrowing to qualifying levels based on a percent of income at low rates enslaves borrowers. Fixed Increased Principal with Declining Rates Allow an extra 10-15% of household to qualifying principal for each 1% decline in rates from 12% Linear Increase, 15% of income for 1% rate decline Rate / % income 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 30% - 30 15% of Term % $ Year household (Years) Increase Increase Term income up at 30% in Loan 676,000 592,000 524,000 465,000 416,000 375,000 340,000 310,000 285,000 262,000 243,000 393,000 378,000 363,000 348,000 333,000 318,000 303,000 288,000 273,000 258,000 243,000 15.2 15.8 16.6 17.4 18.3 19.4 20.7 22.3 24.2 26.7 30 62% 56% 49% 43% 37% 31% 25% 19% 12% 6% 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 - At an extra 15% of household income allowed for each 1% decline the total allowable mortgage increases 62%. At 6% the principal allowed is 37% more than at 12%. A household with $100k of income would qualify to buy a $416k home. This still gives a challenging 4.16 home to income ratio, but with an accelerated ability to pay back the mortgage the homeowner has more choices and the risk is reasonable. Regulation for Households with less 40% Equity In a rising interest rate environment from 6% to 12% homes could decline in the range of 25% in value purely from the mathematics of what people would qualify to borrow. Households can also have financial set backs that can cause their equity to decline. For a healthy and strong financial system homeowners should be required to make strong payments towards equity when their equity is less than 40%. The chart for the linear increase standard shows the mortgage term declining as interest rates decline and the payment is fixed at 30% of household income. As long as equity is less than 40% homeowners the maximum length of loan term as in the linear chart should be used. So, if interest rates are 6% the maximum mortgage term should be 18.3 year. Further, households with less than 20% equity should have to pay an extra 0.5% of household income towards mortgage for each 1% less than 20% of equity, so a household with only 10% equity should have to pay an extra 5% of household income towards the mortgage until 20% equity is realised. A mortgage at 6% with 10% down would take 3 years to get to 20% equity. If the payment is then reduced to an 18.3 year term it would take an additional 7 year to get to 40% equity. Once 40% equity is achieved then loan repayment terms can be relaxed. Mortgage regulations should be about ensuring investors get their money back, but also that homeowners do not get themselves into a level of debt and payments that mean they are quickly in trouble with a layoff, or relationship breakdown, or a setback. The Rule of 50 After there is 40% equity my rule of 50 should apply, the number of years plus the percent of household income should not exceed 50. So households could extend loan terms to 30 years as long as it doesn’t take more 20% of income. This also prevents a household from borrowing at 30% of income for 30 years if they buy a more expensive home. The investment would be safe, but that is a level of debt that is very high for a very long that it might not be affordable. Borrowing with 30% of income for 30 years simply leaves the economy too open to excessive stagnation and lending laws should also account for this.
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