These soaring housing prices got you down? Have heart — I believe the market will reverse, and here’s what you should consider in getting ready for that turn.
When we think of our financial health, we often think of our FICO or credit score. However, there is another very useful and telling metric known as debt-to-income ratios (DTI). These measures are typically on a monthly basis, with debt payments divided by income. Depending on the particular DTI ratio, either monthly gross income (before taxes) or net income (after taxes) is used.
Generally speaking, there are three different types of debt and their corresponding DTI ratios. The first is known as consumer debt, money that was used to buy near-term goods and services. As examples, this could include credit card debt, auto loans, and personal lines of credit. This ratio is calculated by taking monthly debt payments divided by monthly net income.
The second is known as housing debt (or costs). This ratio is also known as the front-end ratio. This would include the total monthly rent payment mortgage payment including principal, interest, taxes, insurance, and mortgage insurance, if applicable. In this ratio, the monthly payments are divided by gross income.
Lastly, there is total debt, which is simply the combination of both consumer and housing debt. This calculation, known as the back-end ratio, takes both consumer debt and housing costs, then divides by gross income.
There are general debt management rules of thumb based on DTI ratios, which are helpful in predicting (and avoiding) financial strain. Consumer debt should be kept at a DTI ratio of no more than 20%. Housing costs, the front-end ratio, should be no more than 28%. Lastly, total debt, the back-end ratio, should be no more than 36%.
How do these DTI ratios translate into a picture of financial health? Studies have shown that significantly drifting and staying above these ratios can be a sign of financial strain. Such strain has the potential to crowd out the ability to meet other financial obligation such as food, utilities, childcare, vacation, savings, etc.
When it comes to qualifying for a mortgage, lenders weigh these DTI ratios heavily when considering the credit worthiness of a borrower. Lenders, who are bound by the ability-to-repay rule, will typically be most concerned with both the front-end and the back-end ratios. Under this rule, the lender must make a good faith effort to ensure that given the amount borrowed and the interest rate, the borrower has a reasonable ability to make the loan payments. They want to have a reasonable expectation that a mortgage along with other debt servicing is not going to put financial strain on the borrower.
The housing challenge in our region is no secret. According to the Mountain Housing Council of Tahoe Truckee, the median home price in our region was $702,000 in 2020. Yet in less than a year and over the course of Covid-19, it has shot up almost unbelievably. According to Moonshine’s Market Watch in the May/June edition, the regional median home price came in at a whopping $1.4 million in the sales from March to April of this year.
On the income side, the 2019 Local Area Median Income (AMI) for a family of four was approximately $84,000. Keeping housing costs at or below 28% of gross income, this AMI supports a monthly mortgage payment of approximately $1,960, which would not be enough for a home with the median prices shown above, even with a significant 20% down payment. Here are the numbers for that $1.4 million house: Assuming a 20% down payment (equivalent to $280,000) and a 3.5% interest rate, the principal and interest payment would be approximately $5,000 a month. That’s before taxes and insurance.
But as I said, you can put me in the camp that believes our local housing market will correct from the current stratospheric levels. It will likely take a bit of time for a reversal and nobody knows exactly what might cause it. While we await the arrival of this turn, I believe there is an opportunity. Take advantage of this time and aggressively pay down consumer debt. This has three enormous benefits: first, it increases the capacity to afford more house by allowing more of the total DTI to be dedicated to housing costs and less to consumer debt. Secondly, paying down consumer debt has the ability to positively impact your FICO score. This is because the largest contributors to a FICO score are on-time payment history and low outstanding balances compared to credit available. These two items account comprise approximately 65% of our total credit score. Lastly, as debt obligations begin to fade, this frees cash flow to possibly save for that all important down payment. Then you can slide into home base in victory.
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Please consult your financial advisor prior to making financial decisions.
~ John Manocchio is an investment adviser representative with Commonwealth Financial Network, Member FINRA/SIPC. Contact him at Pacific Crest Wealth Planning, jcmanocchio@pacificcrestwp.com or (530) 562-5250.
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