Tuesday, April 29, 2008

The "three-times" rule....

L.A. Guy left a good comment that I wanted to chat about a bit more (his statements are italicized).

In my experience the rule of thumb is your mortgage payment can not be more than 1/3 your monthly gross income. I don't know where the 3x your annual income rule comes from, but in as much as the median household income for LA is something around $45K, it would mean no one should finance a mortgage of more than $135K. (Which even in the "good times" wouldn't buy you a garage)

Yes, but keep in mind that $135k is the mortgage -- not the price of the housing. So if you had a $100k to put down, then you'd be able to swing at $235k condo. You will be able to find some decent units in that range right now and even more by the end of the year.

If you made $45K per year, got a 30 year conventional at %5.75 you could finance $200,000 for payments of $1,167.00, still less than 1/3 your gross.

I don't disagree with you assuming we are talking about somebody who has strong odds of a higher income in a few years (e.g. a newly licensed nurse). But for people with unpredictable income streams or who have government jobs that provide reliable but small cost of living increases, that payment might be a bit high. I think they would be more comfortable with a payment that was 1/3 of their net pay (not gross pay).

I guarantee most people buying $1M homes are not grossing $330K per year. Of course if you buy a $1M home today you'll need to put $200K down, so if you finance the balance of $800K on a 30 year conventional at 6.25% you'd be looking at mortgage payments of around $5,000 per month, meaning you need to gross $15,000 per month or $180,000 per year.

Again I agree with you: many people buying $1M homes are not grossing over $300k per year. But that doesn't mean it's a good idea. They *should* be grossing that much to buy a $1M home. But let's say you were grossing $180k, I still think that $5k a month could be a steep payment for you. After taxes and retirment contributions, that $5k would be about 70% of your take home pay.

And no you never have to buy a house, but I think if you find a house you love, is reasonably priced and can comfortably afford, then why not buy it now?

Because you know with an absolute certainty that you will lose money for several years.

To me it would be like trying to time the stock market.

Typically the stock market is far more volatile than the housing market. And I'm not suggesting that you have to buy at the absolute bottom -- I'm just saying don't buy when you know it's the peak of a market that resulted from irrational exuberance.

Buy sensibly, enjoy your house and don't obsess over every last penny. Yes it may go down another ten thousand.

Again, I totally agree. Obsessing over every penny is ridiculous. But what if it's not just $10k -- what if it's 30% of the value of your home evaporating over the course of a year or two? That's something to think about for a minute.

Interest rates may go up another point too. $100K at 5% is the same monthly payment as $90K at 6%.

Yep. And that's why if interest rates go up, housing prices will go down even further. Because people won't be able to afford them otherwise. Indeed, that's part of the reason prices went up so much over recent years: low interest rates.

I'm not really disagreeing with your point, I just don't like these broad generalizations that anyone who buys now is an idiot. It depends on the circumstances and it depends on the house.

I do think that on 90% of the issues we agree. I'm not saying everybody who buys now is an idiot. And certainly there are lots of people who would think I'm an idiot for buying a pair of Dolce & Gabbana shoes recently (which lost about 50% of their resale value the second I wore them). I get that everybody has to make their own choices. But for most of us, this is not the time to buy a house.

Most of us can't afford to lose twenty or thirty percent of the biggest investment of our lives over then next several years. But for some of us that loss would be the equivalent of the Titanic losing a deck chair -- it's almost imperceptible. So if you are in the latter camp, this is a great time to buy because there is a lot of selection and you can afford it. But if you are a regular Joe like me, then all I'm saying is wait a bit longer. There's probably nothing wrong with your rental. And if there is, rent a different place.


Anonymous said...

Used shoes????

50% of their resale value????


Who in their right mind buys used shoes?

kate said...

Dear Anon:

The gross factor is what accounts for the 50% off. And trust me, people buy used designer shoes.

I don't. But people do.

l.a.guy said...


As you say, we're not really disagreeing about much, but just a couple of thoughts:

Yes, but keep in mind that $135k is the mortgage -- not the price of the housing. So if you had a $100k to put down, then you'd be able to swing at $235k condo.

It would also mean you made a down payment of 42%. I'll bet if you spoke to a mortgage broker the number of people who fall into the category can be counted on one hand.

A far more common scenario is 10% down, which means if abide by the 3x your gross rule, you're looking at $135K plus 10% for a purchase price around $148K. (and if you bought a property for $148K, don't invite me over)

We can argue whether or not 3x your gross income ought to be the rule, I'm just making the point that (in my experience) it isn't a real world requirement, and as a matter of practically, would shut an enormous amount of people out of the market.

...then why not buy it now?
Because you know with an absolute certainty that you will lose money for several years.

Not necessarily, there are some reasonably priced properties out there, frequently bank owned, that are probably pretty close to the bottom. But more importantly, you haven't lost money unless you sale. So if a house I buy today is worth less in two years but I'm selling in ten years then it doesn't matter.

I agree it's important to take into account that anything you buy today will likely decline in value for couple of years. You certainly shouldn't by now if there is any chance you can't stay in the house for at least 5 years. I think anyone buying today who has to sale in the next 3 years is probably looking at a minimum 5-10% loss.

(And yes, I'm sure there are properties that will lose even more because they weren't priced correctly to begin with, but again if you buy wisely that will not be a problem.)

One assumption that seems to underly a lot of the "just buy next year when it's cheaper" attitude is that buying a house is like going to McDonalds to pick-up a shake. Maybe it is for a lot of people. If all houses were the same then unquestionably it would make sense to wait because you could get the same house in a year as you can today. But as we all know no two houses are alike, hell that's what makes looking fun, but after you've looked at 30 homes it's not as much fun. Suddenly you start to wonder if you'll ever find a house you really like, much less love.

We found a house we love. For us the decision was do we wait for 3 months and see if this house drops in value and risk not getting it, or do we just buy it now if we can make a good deal?

For us the answer was to buy now and make sure we got a house we really like. But everyone has to decide what's right for their own circumstances.

And you're right, I would consider buying Dolce & Gabbana shoes a total waste of money, but my wife would have been in line right behind you. Men just don't get the shoe thing. ;-)

AndyA said...

This is a fantastic thread of conversation! There is an underlying assumption that I'd like to expose for further discourse:
The family with the median income should be able to purchase the median-priced home. It might follow that there should be a home priced for every income, lowest to highest.

This doesn't seem to match reality (certainly not in LA, currently), but is that how it *should* work?


l.a.guy said...

The family with the median income should be able to purchase the median-priced home.

I think broadly speaking that's certainly true. However, as you can see from the thread, what constitutes "affordable" housing is open to some interpretation depending on the loan requirements and interest rates. If you wanted to by a $500K home, your choices would range from an FHA loan at 3% down to 30 year fixed conventional with 10 or 20% down to interest only or even (amazingly they're still available) option ARM's. Those are very different loans and have a huge impact on what you can "afford". So the point at which houses become affordable again may be difficult to pinpoint.

AndyA said...

Interesting! That's pretty pinko-commie of you, LA Guy, but I'm right there with you. The upshot of that is that there should be homes to rent AND homes for sale at EVERY level of income within a market. The buyer/renter chooses which best suits his/her lifestyle, but the $value$ in the long run is about the same.

That is, homeowners pay more upfront and monthly through mortgage and upkeep because they gain equity when they sell. Renters pay less upfront and monthly, but don't gain equity. For any given time period, the difference would be more-or-less nil.

I like that as a goal, but that's not the way it seems to work. After 30 years of home ownership, the homeowner should have a house free and clear (100% equity) equal in value to the savings the renter has accumulated over the same period. Do our renters simply not save enough?


Anonymous said...

Welllllllllll said!!! I think people just can't fathom how home prices could possibly fall as low as they will.

Patient Renter said...

Awesome commentary Kate. When I first stumbled on your blog a while back you weren't quite in this mindset, so it's glad to see this and good to know you didn't wind up buying something back then :)

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