Held Hostage -- By Your House
The Obama administration has put forth an ambitious $75 billion plan to right the sinking ship that is the US housing market. With nearly 1 in 10 American mortgages either delinquent or in foreclosure, such a plan comes none too soon. According to the widely quoted Case-Shiller index the national average home price is off nearly 25% from its peak, and many bears say we haven't seen the bottom of the housing market yet. While the airwaves are filled with much debate about whether the Obama plan goes far enough... or perhaps too far, one key question is glossed over with alarming frequency.
"How Did We Get Here to Begin With?"
This is a vital query because if we do not fully understand the roots of this housing debacle the odds of it repeating down the road (albeit in a different asset class... perhaps with student loans or reverse mortgages) is high indeed. Stripped to their core, the primary culprits appear to be twofold:
1. With the increasing complexity of the American financial landscape, the old structural safeguards have crumbled. In plain English, years ago if you wanted to buy a home you HAD to put down 20% and your choices for a mortgage were either a 15-year or a 30-year fixed rate loan. Period. These limited options helped you save yourself from yourself. The similarities with food and body weight are striking. Think about this... In your parents' generation, people were essentially forced to eat healthier because there weren't as many pre-packaged, processed foods available. Then came the proliferation of unhealthy food choices and 24/7 fast food chains and our nation became physically obese. The past two decades have been the financial equivalent of super-sized fries. Up until the freezing of the credit markets in the fall of 2008, you had almost unlimited options for financing your home - low money down, no money down, adjustable rate mortgages, option-ARMs, etc. The scope of choice was breathtaking. Now, to carry the analogy a bit further, would you ever walk into a fast food restaurant and say, hmmm... let me see how much of the stuff they sell I can eat in one sitting, would you? Hopefully not! But that's exactly what so many of us did - often unwittingly - when it came to shopping for a home and a mortgage. We asked the sellers of the loans how much we could afford and they said the financial equivalent of "well, sit down at the buffet table and see how much you can pile in - it's all you can eat."
2. Most Americans don't have a solid understanding of how much housing costs they can easily digest. It would have been one thing if we Americans had walked into this financial smorgasbord as fully informed consumers. But we didn't. Most Americans do not know the answer to this simple but powerful question: How much house can I afford? Had we known this, we may have stopped ourselves from biting off more home than we could chew. The rough rule of thumb is that a family can comfortably afford a home that is up to 3 times their average annual household income. From where does this number come? Well, think of your annual income as a pie. It has 4 slices: Taxes, Savings, Needs, and Wants. For most people taxes chew up about 25% of their gross income. In an ideal world you are saving 15% of your gross income. So that leaves you with 60% of your gross (or pre-tax) income for EVERYTHING else - your housing costs, your transportation costs, your health care, your childcare, your food, your entertainment, etc. (And, of course, if your effective tax rate is higher than 25%, that leaves even less for everything else). If you buy a house with a 20% down payment and a 30-year fixed rate mortgage - in an average interest rate environment the way the math works out is that you will end up spending about 30% on your total all in housing costs (think: mortgage, insurance, property tax, maintenance, upkeep). That leaves you with 30% for everything else in your life. If you buy a house for significantly more than 3x your annual income, the bite that housing costs take out of your budget pie grows - and that's when the financial trouble starts. You will either have to cut back on your wants, or what happens more often - is you end up cutting back on your savings. The way housing prices got so out of control is that we all collectively bid them up WAY past the point of 3x the national average income by thinking we could keep eating at the financial buffet without getting financially obese.
So where to from here? Thanks to the Obama plan, many - but not all - homeowners will be helped. However, for our country to truly move forward it is vital that we all learn to make wiser spending choices when it comes to buying a home from this point onwards. Here are three rules of thumb that can help:
• Only buy a house when you can afford to make a 20% down payment
• Only use a 15-year or 30-year fixed rate mortgage.
• Only buy a house if you think you will live there for at least 5 years (because otherwise the costs associated with buying and selling your home have high odds of exceeding any gains you might make from price appreciation).
Finding the right home is like finding the right diet, there are many nuances that are particular to your specific situation. The aforementioned rules of thumb are meant to serve as broad, general framework, not a one-size-fits-all answer.
The key point to take away from this discussion is that for a free-market economy to function efficiently, we must have informed participants. When it came to buying homes, lenders often did not disclose enough about their terms and buyers did not ask enough questions.
There are many parties to blame and likewise, it will take all hands on deck to right this ship. Each of us as Americans can do our part by taking personal responsibility for learning how much home is right for our personal circumstances. You want your home to be your haven, not hold you hostage!
Manisha Thakor and Sharon Kedar are the co-authors of ON MY OWN TWO FEET: a modern girl's guide to personal finance
Loading comments…
Want to reply to a comment? Hint: Click "Reply" at the bottom of the comment; after being approved your comment will appear directly underneath the comment you replied to
"Most Americans do not know the answer to this simple but powerful question: How much house can I afford?"
Frightening if true. If true, the only reason I can see for not knowing the answer to this question is that most Americans must be too flippin' lazy to get a pencil and paper and spend a couple of hourse figuring their household inputs/outgoes.
It's not exactly rocket science!
Sure if one would have stayed with the three times rule and stayed away from ARM's they wouldn't have gotten into this mess.
But something else you didn't mention that I think is a problem with our culture is the buy, buy and buy bigger attitude. Why does a family of three need a five bedroom house with four baths, a family room plus a bonus room, full finished basement, four car garage and on and on and on. That attitude was never substainable. Not economically , not environmently, and not with renewable and nonrenewable resources. And you don't refinance to tear out cabinets and granite marble tops every few years because you want to change your cannisters and curtains. Quit watching HGTV and quit listening to the home improvement stores telling you what all you can do yourself in a weekend even if it's not needed!
While everything you say is true -- you have vastly oversimplified the causes of this problem. Deregulation of the industry allowed the banks to take huge risks, and become essentially gambling agencies, everyone gambling on the price of houses continuing to rise and no one realizing that the market was in a huge bubble. These problems were sweeping and systemic and someone in authority should have seen the dangers and acted. Look at how lax regulation was in Florida if you want to see a complete collapse of the system. When houses become casinos, everyone loses.
As for the arm mortgages-- they should be illegal.
"As for the arm mortgages-- they should be illegal."
Why? I've taken advantage of them a couple of times. You just have to think ahead a bit.
Same thing for the interest-only loans. While I never used one, it was an option I considered (2002-03 time frame). In the end, I chickened out and went conventional that time. But looking back, I could have saved a considerable chunk of change (over 20K) by using the interest only (while paying as if I had a regular P&I payment to make) and then converting to fixed after 4 or 5 years.
Like I said, though, I was too chicken to risk it. But if I'd been unmarried (and not had 4 kids), I would probably have taken the chance.
For generations the "American Dream" has been to own a home.
People have worked for this their whole lives. I am not talking about a part time waitress buying a million dollar home, I a, talking about a working family buying a modest home.
Mortgage companies said they could help with that dream. Many people jumped at the chance, they were told not to worry about the ARM, they could refinance into a fixed rate down the line, and their house would increase in value exponentially, so they could also help with an equity line of credit, just sign here.
Rick Santelli recently said shame on them for signing something without reading the fine print. I read it and didn't understand it either. That's why I hired a mortgage broker in the first place.
RE: The rough rule of thumb is that a family can comfortably afford a home that is up to 3 times their average annual household income.
I really, really disagree with this comment and I'd advise any home buyer to take this "3 times their average annual household income" and cut that in half. The money you would have spent on the mortgage, put it into savings.
"I'd advise any home buyer to take this "3 times their average annual household income" and cut that in half."
No argument there.
People I have known have always had a hard time buying a house because of the 20% down. It use to be less than this and then grew to 20%. When the bubble began to bubble I ran into a woman who had a part time job and was able to buy a house well out of her means. I knew it was trouble for her. What is sad about this is that she did not have a grip on reality. There was no way that she could afford the house she bought on her modest salary. She did not seem to care. I thought she was nuts. Well anyways she lost the house and hates everybody because she did not want to deal with reality. Could it be that Americans are really not in touch with reality. Would this not be a psychological condition/impairment/psychosis of sorts. I have never been able to put down 20% on a house. I had to do it otherwise and more creatively. How in god's name is anyone going to find 40,000 dollars in their bank account to buy a $200,000 house which is an average going price currently even for garbage property. I don't know anybody with that kind of money in my neighborhood. Maybe you do but well, I guess you are what we call the rich folk. Your idea of saving 20% is actually out of range for most people and always has been.
In a mortgage contract both parties are not perfectly equal. A bank is an expert, at least we trust it to be. A borrower is not an expert; despite that we expect him or her to examine the contract skeptically. In this light, the theoretically free market is not perfectly free. We can see the current mortgage crisis as a result of this imperfection of the free market.
We can address this problem in two ways.
We can declare the free market as inefficient and have the government to step into fixing troubled mortgages. This is the essence of the Obama’s proposal.
Contrary, the government may recognize that banks had unfair advantage in manipulating the homeowners. Subsequently, the government will use its power to correct this flaw of the free market. However, will do it not by limiting freedoms of banks in conducting their business (as proposed by Obama), but will do it by expanding freedoms of homeowners. It can be done by forcing banks to take the government loans to cover all the defaulting mortgage payments for the next six months.
This way, the government will stay as the guarantor of the constitutional freedom of enterprise. Details of this proposal are here, http://www.huffingtonpost.com/henryk-a-kowalczyk/the-simplest-plan-for-hel_b_167642.html . In this concept, the government does not spend a dime, and does not need any new bureaucracy. Can someone explain to me what is wrong with this approach?
Yes-- the banks need to be regulated. Obviously. Deregulation failed to protect consumers, and it also proved that bankers acting in their own self interest will not necessarily do what is best for the Bank's long term health. Lots of people made huge profits bundling mortgages, and convincing people to buy into these ARM schemes, to the detriment of the entire system.
Nationalize the banks-- and regulate them. Declare the republican revolution a huge and costly failure.
May I also suggest that everyone look into building their own home. Cut out that crazy 6-8% reality charge. That alone will pay for the land. If you don't have the technical know how to do the actual construction, learn to be your own contractor. There are gazillions of books and online resources to help you. You can save 15-30% just making all arrangements for materials and labor. As an added bonus, you get what you want. I built a house in 2002 when construction prices were already quite high. My total investment with land was 119,000 and 8 months of sweat equity. It's bigger than most would need at 1700 sq feet with another 1700 available in the basement. Even with today's depressed prices it still appraises at 205,000. What really makes it a good idea is that most construction materials are at or below prices I paid in 2002. Nothing beats sweat equity.
Darn good idea!
You must be logged in to comment. Log in or connect with
