May192015

## How borrower income affects payments and determines home values

##### Borrower income and mortgage rates determines how much buyers can borrow for a home purchase, making borrower income a major component of market prices.

Since this is the prime season for real estate sales, many people come to this site for basic information on homebuying and the market. Today, I want to look at one of the biggest components of market pricing, incomes of local buyers.

There are four variables that determine the purchase price of a property:

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.

Payment is a direct link to borrower gross income. The debt-to-income ratio is the percentage of monthly income a lender will allow a borrower to put toward loan payments. The debt-to-income ratio has two components: front-end, and back-end.

The front-end debt-to-income ratio is the maximum ratio of monthly income the lender will allow for the loan payment, generally 31%, but some lenders go higher.

The back-end debt-to-income ratio is the maximum ratio of monthly income the lender will allow for all debt service payments, currently capped at 43% for most loans. The back-end ratio limitation is what’s causing student loan debt to be such a problem for Millennials today.

The two ratios described independently limit the maximum allowable loan payment. Based on the lesser of these two amounts, the lender will calculate the maximum amount of borrower income they can use for loan qualification. From this amount, a lender will subtract an allowance for taxes, insurance, and HOAs to calculate the maximum allowable loan payment. Once the maximum loan payment is determined, then 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.

At the end of all this math, the relationship between borrower income and loan amount emerges. The higher the income, the greater the loan, irrespective of other variables, which is why high wage earners end up in more opulent houses.

The borrower takes their available savings plus the available loan amount to calculate the maximum they can bid to obtain a house. They can’t bid any higher because they can’t get a larger loan, and they don’t have more savings. It becomes a rigid ceiling, particularly in this era when toxic affordability products don’t let borrowers overextend themselves.

### 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. Ordinarily, incomes rise over time as the economy expands and workers can demand higher pay for their services. However, in an era of high unemployment, wages generally do not rise because workers do not have the leverage to demand higher pay. In fact, in many industries, wages actually go down as the supply of workers exceeds the demand for their services and those who wish to remain in the field lower their expectations. As a result, stagnant wages are a problem for the economy in general and specifically for housing.

In a stable 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.

Financed buyers complete most home sales, so the borrowing power of financed buyers generally sets the prevailing price levels in most real estate markets. The ability of financed buyers to raise their bids and push prices higher depends on the amount of savings they have, their verifiable wage income, allowable debt-to-income ratios, and mortgage interest rates. Because wages are central to the lending equation, growth of wages is the strongest determinant of long-term housing market prices.

### High DTIs create high default rates

Rising wages have not always been prerequisite for house price rallies. Prior to the Dodd-Frank cap on debt-to-income ratios at 43%, lenders would periodically lend well beyond what borrowers could afford to repay, most often with disastrous consequences for both borrower and banker.

Bankers will make any loan they believe will be repaid with interest. Borrowers will “stretch” to buy any appreciating property by allocating larger and larger percentages of their income toward housing (until the entire system collapses). This stretching is (1) recorded in the aggregate debt-to-income ratio for a particular market and (2) observed in the struggles of individual homeowners.

As you might surmise, the peaks in the DTI ratios correspond to peaks in our three California housing bubbles.

Changes in debt-to-income ratios are not a passive phenomenon only responding to changes in price. The psychology of buyers reflected in debt-to-income ratio is the facilitator of price action. In market rallies people put larger and larger percentages of their income toward purchasing houses because they are appreciating assets. People do not passively respond to market prices (as many erroneously suggest), borrowers actively choose to bid prices higher out of greed and the desire to capture the appreciation their buying creates. This will go on as long as there are sufficient buyers to push prices higher. The Great Housing Bubble proved that as long as credit is available there is no rational price level where people choose not to buy due to prices that are perceived to be expensive. No price is too high as long as they are ever increasing.

### 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?

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