Much of the analysis of the housing bubble has focused on the fundamental measures of price-to-income and price-to-rent. These are valid statistical measures of what the market should do, and they reflect the fundamental valuations to which prices ultimately return. However, debt-to-income ratios are very revealing of the buyer/borrower activity due to kool aid intoxication and irrational exuberance.
There was a significant price bubble in residential real estate in the late 1980s crashing in the early 1990s. This coastal bubble was concentrated in California and in some major metropolitan areas in other states, and it did not spread to housing markets nationwide. When comparing this previous bubble to the Great Housing Bubble, the macroeconomic circumstances were different: Prices and wages were lower in the last bubble, interest rates were higher, the economies were different, and other factors were also unique; however, the evaluation of personal circumstances each buyer goes through when contemplating a purchase is constant. The cumulative impact of the decisions of buyers is represented in the debt-to-income ratios – how much each household pays to borrow versus how much they make. Comparing the trends in debt-to-income ratios provides a great tool for elucidating the behavior of buyers.
Typically debt-to-income ratios track interest rates. As interest rates decline, it becomes less expensive to borrow money so borrowers have to put less of their income toward debt service. The inverse is also true. On a national level from 1997 to 2006 interest rates trended lower due to low inflation and a low federal funds rate. During this same period people were increasing the amount of money they were putting toward home mortgage debt service. If the cost of money is declining and the amount of money people are putting toward debt service is increasing, the total amount borrowed increases dramatically. Since most residential real estate is financed, this increased borrowing drove prices up and helped inflate the Great Housing Bubble.
Figure 21 – Debt-To-Income Ratio and Mortgage Interest Rates, 1997-2006
A refresher from Fundamentals at a Market Bottom:
The figure below shows the historic debt-to-income ratios for California, Orange County and Irvine from 1986 to 2006. It is calculated based on historic interest rates, median home prices and median incomes. Lenders have traditionally limited a mortgage debt payment to 28% and a total debt service to 36% of a borrower’s gross income. The figure shows these standard affordability levels. During price rallies, these standards are loosened in response to demand from customers when prices are very high. Debt service ratios above traditional standards are prone to high default rates once prices stop increasing. In 1987, 1988 and 1989 people believed they would be “priced out forever,” so they bought in a fear-frenzy creating an obvious bubble. Mostly people stretched with conventional mortgages, but other mortgage programs were used. This helped propel the bubble to a low level of affordability. Basically, prices could not get pushed up any higher because lenders would not loan any more money.
Figure 22 – Debt-To-Income Ratio, California 1986-2006
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 are not passively responding to market prices, they are actively choosing to bid prices higher out of greed and the desire to capture the appreciation their buying activity is creating. 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.
In market busts, people put smaller and smaller percentages of their income toward house purchases because the value is declining. In fact, it is possible for house prices to decline so quickly that no mortgage program can reduce the cost of ownership to be less than renting. The only thing justifying a DTI greater than 50% is the belief in high rates of appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment? Once it is obvious that prices are not increasing and even beginning to decrease, the party is over. Why would anyone stretch to buy a house when prices are dropping? Prices decline at least until house payments reach affordable levels approximating their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. In a bubble market when the market debt-to-income ratio falls below 30%, the bottom is near.
The graphs and charts are pretty, and they do illustrate what is happening in a macro sense in the market, but now it is time to look at the micro. The reason prices are still so high is not because of interest rates, high incomes or any fundamental measure of pricing. It is due to the debt-to-income ratios lenders are still permitting and kool aid intoxicated buyers are still willing to utilize to buy real estate.
Take a look at how even small changes in the debt-to-income ratio used by a borrower can make a huge difference in the amount financed and ultimately in the amount paid for real estate. At very low interest rates, every 3% of gross income put toward a housing payment adds 10% to the amount borrowed. Of course, the phenomenon also works in reverse. As DTIs fall due to both lender reluctance and borrower reluctance, the amounts financed decline precipitously.
|$ 91,101||Irvine Median Income|
|$ 7,592||Monthly Median Income|
|Payments, Taxes, Insurance||DTI Ratio||Max Loan *|
|$ 2,126||28.0%||$ 336,580|
|$ 2,353||31.0%||$ 372,643|
|$ 2,885||38.0%||$ 456,788|
|$ 3,644||48.0%||$ 576,995|
|$ 4,024||53.0%||$ 637,099|
|* Max Loan based on 85% of payment going to debt service|
The example above uses the most recent Irvine Median Household Income Data. From this it calculates the gross monthly income. Notice this is the gross amount, not the after-tax income. Someone making $91,101 per year would be taking home between $5,000 and $6,000 a month depending on the number of exemptions claimed and the amount of their tax write-offs. Note the effect this has on the take-home DTI ratio. Someone using a DTI of 31% is really spending almost 50% of their take-home pay on housing and related expenses. The maximum loan amount is calculated using a 30-year fixed-rate conventionally amortizing mortgage assuming 85% of the payment, taxes and insurance amount will be going toward the mortgage payment.
The FHA currently allows a 31% DTI for housing debt. Years of experience has shown that DTIs in excess of this amount have high default rates. This isn’t terribly surprising when you see how much a higher DTI starts to cut in to other lifestyle expenses. Prior to the Great Housing Bubble, lenders only allowed DTI’s of 28% for housing debt and a total back-end DTI of 36% which includes car payments, credit cards, and other debt-service payments. That is where standards are headed.