Ownership cost: income, payments and house prices

I revisited my post on Rent Versus Own where I talked about the cost of ownership. Many of the questions people have about our Cost of Ownership analysis are related to the various cost inputs and how they impact values. Therefore, I want to take each of these costs and talk about them in more detail. In order to do this in a logical flow, I have broken this task into a series of four posts that will be debuting all this week. These posts are:free_posts

Ownership cost: income, payments and house prices

Ownership cost: interest rates and down payment requirements

Ownership cost: property taxes, insurance, Mello Roos, and HOAs

Ownership cost: taxes and opportunity costs

Four Major Variables that Determine Market Price


  1. borrower income,
  2. allowable debt-to-income ratios,
  3. interest rates, and
  4. down payment requirements.

These variables are impacted by some other minor cost inputs, but for the most part, the variables above determine market pricing. The first two variables are the focus of today’s post, and the last two are the topics for tomorrow.

Payment is a direct link to borrower gross income. The debt-to-income ratio allowed by a lender applied to the borrower’s monthly income is the maximum allowable monthly housing expense an underwriter will consider. From this amount, a lender will subtract an allowance for taxes, insurance , and HOAs to calculate the total amount of the available housing expense applicable to debt service. Here is where interest rates enter the calculation.

Lenders have complex formulas — which thankfully are distilled into simple spreadsheet commands — that are used to calculate loan balances, payments and other important numbers. If the payment is known, and you apply an interest rate and amortization schedule, the inputs can be put into a spreadsheet or financial calculator (or it can be laboriously calculated by hand) to come up with a loan amount.

Once the largest loan amount a certain level of borrower income can support is known, adding the down payment requirement to the loan amount equals the amount a borrower can pay for a house. At that point it is a numbers game. Are there more buyers at these income levels than properties available? If so, then prices stabilize or go up. If there are fewer buyers than available property, then prices go down. As a society are we going to allow banks to be the new housing cartel releasing product only as they get their price? That is where we are headed.

Borrower Income and Wage Inflation

Borrower gross income is the basis of all lending… or is it? With Stated Income (liar loans), income doesn’t matter… When you think about that for a moment, it isn’t a mystery why liar loans went away first; they undermine the foundation of all lending — accurately measuring borrower capacity.

Wage inflation is the slow increase in aggregate wages over time in a given area. Wage inflation is a driver of price inflation because workers will use wage increases to bid up the cost of goods and services they demand. in a housing market, wage growth pushes up prices as follows: Assume a worker is earning $100,000 and can borrow $400,000 to bid on property in today’s market. In one year, if this worker gets a 3% raise (not this year), he will be making $103,000, and if other terms do not change, he will be able to borrow $412,000. If he has also increased his savings, the amount he can bid on real estate has also increased by 3%. A property that might sell for $500,000 today can sell for $515,000 in one year and it is no more expensive in terms of its financial impact; debt-to-income, savings impact, time of amortization — the key variables remain the same. This is “normal” home price appreciation.

Prices should mirror incomes

In a normal real estate market, people at each income strata compete with each other for available properties in their price range. If there is a shortage of supply, shoppers learn to settle for less. Rather than a 3/2, someone settles for a 2/2 with a den. A shortage of supply does not necessarily make for higher prices; it can simply result in a lowered standard of living as people take the income they have and compete for what is available.

Assuming supply is sufficient — which in the long term it always is — the most desirable properties will be held by the highest wage earners, and the least desirable properties will be inhabited by the lowest wage earners. That is how markets work. Is there a better way? The median income will control the median property over time, and the median home price should represent the median income applied to conventional financing metrics. And in fact, when looking at this data during periods when the housing market is not gripped with a bout of irrational exuberance, these numbers track fairly closely.

With the collapse in prices and the federal reserve’s response of lowering interest rates, payment affordability is the best it has been in years, and it may not improve even if prices fall further.

What would create demand?

Payment affordability is at an all-time high thanks to the Federal Reserve. IMO, this indicator is likely near its peak for the cycle. The Federal Reserve can make the cost of borrowing so low that any price can be made to cashflow.

Markets in Coastal California have not crashed as hard as subprime markets, and since prices are still greatly elevated there, a huge increase in affordability brings the ridiculous into reach. In the beaten down subprime markets, affordability is remarkable. People who buy now will experience payment affordability at unprecedented levels in many markets. Payments using conventional financing are now affordable. Will they remain that way?

Allowable Debt-to-Income Ratios

The Allowable Debt-to-Income (DTI) Ratio is a limit lenders determine is the largest percentage of your wage income you can give them before you go into default on the loan. Lenders have been steadily increasing allowable DTIs since the 1970s. They are intent on squeezing every available penny out of your life. Lenders permit these higher DTIs ostensibly to allow customers to bid on more expensive homes. The result is a higher equilibrium price for all properties in a market and a higher percentage of income that the general population is putting toward debt service. Lenders are knowingly putting their customers in a state of perpetual servitude.

Borrowers sacrifice disposable income in order to service a higher DTI — wait! — is there a way to increase disposable income and service a higher DTI? It would be a panacea…. Lenders solved this problem with the Option ARM, and they used it to inflate The Great Housing Bubble. The moment lenders allowed customers to pay debt with increasing debt, it became a Ponzi Scheme, and it was doomed to crash. It is amazing how large it became; hundreds of billions of dollars flowed into these Ponzi Scheme assets. The collapse of the subprime home mortgage Ponzi pyramid was a precipitating factor that lead to the financial meltdown of 2008.

The beauty of the arrangement was the sales pitch; you can get a huge pile of spending money, pay less per month on your mortgage, and whenever you needed more, the California ATM house will magically refill itself with money through home price appreciation. It was self-reinforcing delusion used to hide a Ponzi Scheme beneath. I can see why the idea is popular with bankers and customers alike; lenders get to write larger loans which put more investor money to work, and borrowers get to borrow and spend like maniacs. All Ponzi Schemes work well in the beginning.

In the end, we are left with a large number of people who greatly overborrowed. The overleveraged masses are realizing that they will have to give up the disposable income and lavish lifestyle if they are going to keep their homes. It is the inevitable result of the failure of lenders to resolve the basic dilemma of increased payments with increased borrowing. Many people are walking away.

The mortgage market is struggling to find an equilibrium DTI where borrowers do not default. The first round of loan mods back in 2008 tried to use 38%, and it was a dismal failure. The latest round of loan mods is using 31% (like the FHA), and although the success rates are not much better, the current defaults are strategic based on being underwater, not because they cannot afford the payment. In short, allowable DTIs are going to retreat to stable levels between 28% and 32% before terms stabilize and we begin on the next Ponzi Scheme.