Desperate homeowners are stretching their finances to buy a home, and lenders and mortgage backers are increasingly willing to accommodate them.
It’s difficult to purchase a home in a buyer’s market – and 2018 certainly meets that standard. Pent-up demand and an extreme shortage of homes have led to a rapid increase in prices that outpaces recent wage gains. The problem is acute in the market for starter homes and critical in high-value markets like San Jose, Seattle, and Austin.
Desperate homeowners are stretching their finances to buy a home, and lenders and mortgage backers are increasingly willing to accommodate them. This strategy increases homeownership but puts more households at risk of future default by overloading them with debt – increasing the chances of another housing crisis.
How much debt is too much? Lenders gauge this through your debt-to-income ratio – the total monthly debt you have as a percentage of your income. Traditionally, a debt-to-income ratio of 45% is the upper limit for allowing conventional loans without special circumstances.
In July of 2017, the mortgage backer Fannie Mae raised this limit to 50% in an attempt to help potential homeowners who could meet mitigating criteria (at least twelve months cash reserves and a 20% down payment). New data from CoreLogic suggests that many new homeowners have taken advantage.
CoreLogic found that approximately 20% of conventional mortgage loans over the past winter were taken out by borrowers with DTI ratios above 45%. That’s nearly three times the percentage of loans made in the eighteen months prior to Fannie Mae’s DTI ratio limit increase, and the largest percentage since the housing crisis.
Since the supply of homes is unlikely to improve anytime soon – especially in the starter-home market, where builders make minimal profits – the concern is that lenders will loosen credit even further and authorize too many risky loans.
As a potential homebuyer, you must resist the temptation to stretch your budget on the assumption that everything else will fall into line. Homeownership has significant running costs that first-time homebuyers may not fully grasp.
Personal finance expert and author Jordan Goodman says, “The biggest mistake people make when they are buying their first home is underestimating the expenses involved.” Goodman cites property taxes, insurance, and maintenance as typically underestimated expenses.
When your total expenses already leave you with little financial cushion, it only takes one large unplanned event such as a medical emergency or a job loss to push you into a debt spiral. A high DTI also means that it’s unlikely that you have an adequate emergency fund and are saving enough for retirement.
Take this into account as you search for affordable homes. Even though a lender may offer you a loan that raises your DTI above 45%, there’s no reason you must accept it. Scale back your search to homes that don’t force you into an excessive DTI – and if you can’t find one, lower your spending and pay down other debts to drop your DTI to a more manageable level.
The desire for homeownership can overcome common sense when it comes to finances. Don’t let your dreams overrule your pocketbook. Assess your housing needs and finances properly to make sure that you aren’t overpaying for your new home – and know your realistic limits in case a bidding war starts.
Consider the advice of Greg McBride, Chief Financial Analyst for Bankrate.com, who suggests limiting your home purchase to no greater than three times your annual income. Otherwise, you may end up in a situation that Jordan Goodman describes as, “The house owns you. You don’t own the house.”