43% Debt-to-income cap strongly favors borrowers with no consumer debt

With no rigid cap on front-end DTIs, those with no consumer debt could borrow more to finance a home purchase.

It’s no secret that I don’t think consumer debt is a good idea (See: Think you want consumer debt? Think again…) With the ongoing war on savers waged by the federal reserve, it’s been a difficult time to maintain a discipline of saving instead of consuming. However, buried in the new qualified mortgage rules is a loophole that may give those with little or no consumer debt a major competitive advantage when bidding on houses.

The new qualified mortgage rules cap overall debt at 43% of gross income. Legislators enacted this provision in response to the enormous debt burdens exposed when lenders abdicated all lending prudence and gave Ponzis unlimited debt. The back-end ratios of the average borrower, not the extreme, the average borrower, was over 75%. Remember, this is of gross income, so unless these people don’t pay taxes or don’t eat, they ran personal Ponzi schemes relying on fresh infusions of debt to sustain their lives.

The 43% debt-to-income cap is a good idea. Nobody should be paying more than that to lenders, and realistically, nobody can unless they go Ponzi. However, there is a loophole. There is no cap on the front-end DTI a borrower can put toward their mortgage payment. I’m not saying it’s a good idea, but borrowers with little or no consumer debt can service a payment of up to 43% of gross income, and the loan would still qualify under the new qualified mortgage rules. This additional leverage gives those with little or no consumer debt a major advantage when bidding on houses relative to their indebted competitors.

Right now, the GSEs cap front-end ratios at 31%, and since they are most of the market, finding a loan with a front-end ratio in excess of 31% is difficult. The FHA will do it, but their costs and fees are so high, there isn’t much leverage advantage to doing so. However, at some point, private lenders will start making these loans, packaging them into MBS pools and selling them off. Since these loans will meet the QRM requirements, they won’t have any risk retention requirements. Investors will likely feel comfortable with buying them because they know the borrowers were prudent enough to avoid consumer debt and are probably more creditworthy than their more indebted peers.

No endorsement

Make no mistake, I am not endorsing this. Most people should probably not put more than 25% of their gross income toward a housing payment, but here in overpriced California, people have become accustomed to putting the maximum allowable 31% toward housing, and if given the chance, many will put even more toward getting their dream home. I believe lenders will likely give them that chance, whether it’s good for the borrower or not.

New bubble?

All my affordability calculations are based on a 31% front-end ratio as a cap to borrowing power. If circumventing this limit becomes widespread, we have the potential to inflate prices above what would be expected due to the increased leverage of these borrowers.

Will this be unstable? It depends on what you believe about the borrower’s ability to repay. If people can really handle 43% DTI ratios, and if they can live without consumer debt (no credit cards, no car payments, and no student loans), then these higher front-end DTIs will be stable, and the housing market may seek a higher equilibrium price. In the process, those who live with excessive amounts of consumer debt will be left on the outside looking in.