The way it used to be...

[exnzpat]

What follows is a simple mathematical calculation that banks and mortgage lenders used to use to consider an applicants application for a home mortgage.


I post it here in the hope that it will help those of you who will need to figure out their future finances and give pause to those of you who seem to derive their income by convincing other people that property investment is a path to incredible wealth -- and that any fool can do I!.


In an effort not to be sexist -- imagine your spouse makes $48,000 per year, and you too make make $48,000 per year. Total annual income $96,000 per year.


STEP 1
Calculate your Adjusted Monthly Income (AMI):


Total: $96,000 per year / 12 = $8000 per month


Now subtract any loans with 10 or more months remaining, i.e. car, student, personal, credit card etc. Let's say they all total $600 per month.


$8000 - $600 = AMI


Therefore, the Adjusted Monthly Income (AMI) = $7,400 per month.


STEP 2
Find Maximum Monthly Mortgage Allowable (MMMA):


Find 28% of the AMI x 0.28 = MMMA


Therefore, the Maximum Monthly Mortgage Allowable (MMMA) = $2072.00


STEP 3
Find a house to buy. The average home price in NZ is $332,000 so let's use that price. The norm. over the last few years is no-money-down"" so we are looking at 100% financing.


STEP 4
Find our Monthly Payment (MP) on a 25 year loan at 9.5% for $332,000


This rate equates to $8.74 per each $1000 borrowed.


$332,000 / $1000 = 330 x 8.74


This equals a Monthly Payment (MP) of $2901.68


STEP 5
Now we need to add our monthly Insurance fee and Property Taxes (Rates).


I'm only guessing on the Rates and the Insurance but both amounts will reflect the value of the home. Let's say $80 for Insurance and $180 for Rates (remember this is per month).


So, $2901.68 + $80 + $180 = $3161.68


STEP 6
Compare maximum monthly mortgage allowable to the monthly payment:


Maximum Monthly Mortgage Allowable (MMMA) = $2072.00
Monthly Payment (MP) = $3161.68


As you can see the Monthly Payment is higher than the maximum mortgage allowable so as a result a family with an annual income of $96,000 cannot buy a $332,000 house under the current scenario. But wait, you say, their current AMI is $7,400 -- they can easily afford this house! Why did you consider only 28% of the AMI?


This is of course, the way things used to be done. Lenders once only considered 28% of your gross income minus outstanding debt (10 months or more). I'm not sure where the 28% came from but basically it excludes 72% of your AMI for taxes (including rates), food, utilities, schools, children etc. and any other basic living expenses. Simply put, since “man” has been borrowing money there have been bubbles, unemployment, an unexpected events. I'm guessing that someone somewhere figured out that 28% equated to an approximation of built-in debt protection; given even before the loan was issued. A natural buffer, so to speak, that protects borrower and the lender. Sometime in the last ten years this good business practice went out the proverbial window and we are left in the mess we are in today.


So, how can this little math demo help you if you already have a home(s), or even considering buying a home, and are wondering what to do next?


Here's how:


Using the example above let's assume you did in fact purchase the $332,000 house at an interest rate of 9.5% on a 25 year schedule without considering 28% of your AMI.


Subtract your Maximum Monthly Mortgage Allowable (MMMA) from you current Monthly Payment (MP)


MMMA $2072 - MP $3161.68 = -$1089.68


If you come up with a positive number then you're probably in pretty good shape, but even so, it can't hurt reduce your exposure. There is always more you can do!


If you come up with a negative number (like our example) then you should strive to make up the difference. One way (using our example) would be to actually find a way to earn an extra $1089.68 (or more) each month. Another, could be to refinance at a lower interest rate equalizing the MP and MMMA or by putting down a large chunk of money during refinancing that has the same effect. Yet another is to Budget: eliminate $1089.68 per month in debt. I'll admit, no option is easy – so I can only hope that this post can be used as a guideline for those of you who are determined to hang-in-there and make it through this financial crisis.


I've included the cost, per thousand dollars, based on a 25 year schedule, borrowed below. Use the steps above to do your calculations.

Rate -- $ per $1000.00
7.0% – $7.70
7.5% – $7.39
8.0% – $7.72
8.5% – $8.05
9.0% – $8.40
9.5% – $8.74
10.0% – $9.09
10.5% – $9.44
11.0% – $9.80
11.5% – $10.16
12.0% – $10.53




Lastly, property is a valuable commodity and when you consider a long-term investment strategy over a short-term investment strategy; property takes on a whole other face. Buying back mortgage debt by investing in what you already have is always good in a falling market, so to is home improvement.




Good Luck!

[k1w1]

When you say this is how it used to be done, how far back are we going?

I'm in my early 40's and when I bought my 1st house at 19yo it wasn't done this way. How old are you, Grandad?

Interesting calc though.

[k1w1]

Of course, using your numbers (interest rate incl), this family on $96000 combined, in order to break even on the MMMA can only afford a house (at 100% borrowing) worth $237,000.

Good luck with that in Auckland.

I suppose it'd be fine if you wanted all your key service personnel like teachers, nurses and firefighters all based in Ranui.

[Jumpin]

Kiwi, I think ExNZpat is implying that by the time everything settles down again, the banks will adopt 'sensible strategies' or be forced to, so 28% or thereabouts will be re-adopted. Then house prices will adjust, (so $237k for a house in Auckland will be the norm - or least an inflation adjusted equivalent) hmmmm, maybe.

I think perhaps it would be more realistic to use a longer term average for the interest rate, rather than the 9.5%. I'm guessing 7.5-8% may be nearer the mark? That would give a bit more breathing space perhaps.

[k1w1]

Fair enough, but I think the idea that the lending controls adopted by banks is a way of setting house prices is a little like the tail wagging the dog.

I guess you could argue that the current state of affairs exists precisely because of the casual lending, but I think it is much more complex than that. It obviously played a part.

[Gibber]

Fair enough, but I think the idea that the lending controls adopted by banks is a way of setting house prices is a little like the tail wagging the dog.

I guess you could argue that the current state of affairs exists precisely because of the casual lending, but I think it is much more complex than that. It obviously played a part.

Yup. Tail wags Dog. When the Tail is large enough.

Steve Keen uses the Tail wagging the dog analogy in a couple of places.

One of his theories is that banks make money when lots of money is lent and the money is paid back slowly.

If the money is paid back fast they don't make as much money
If not much money is lent they don't make as much money

Therefore the ideal customer base is one that borrows lots of money and takes a long time to pay it back.

If true then the banks have an incentive to lend as much as possible.

Borrowers, on the other hand, if they see house prices going up in what appears to be a straight line, have an incentive to borrow as much as possible.

If banks relax their criteria, borrowers, in the above scenario, will borrow to their limit. As the limits relax, the more they borrow in relative terms. Which means the more they can bid prices up.

During times of rising asset prices, not many people get into problems, banks relax their criteria. People leverage up. Leverage helps people make money during time of rising asset prices

The problems occur when asset prices start to drop and people deleverage. We told banks have now restricted lending and borrowers have to have 20% deposit. That in itself will restrict how much some buyers can bid prices to compared to the days of 95% or 100% deposit.

Keen has a couple of documents that discuss this better.

http://cpd.org.au/sites/cpd/files/KeenCPD_DeeperInDebt_FullDoc_1.pdf

And for those who are mathematically inclined you can have a look at his power point presentations at

http://www.debunking-economics.com/Lectures/Index.htm

His work on Minsky appears to be the one that will describe any change to lending behaviour brought about by this credit crunch.

http://www.debunking-economics.com/Lectures/Index.htm#FE

[exnzpat]

When you say this is how it used to be done, how far back are we going?

I'm in my early 40's and when I bought my 1st house at 19yo it wasn't done this way. How old are you, Grandad?

Interesting calc though.

Same age as you.


When I say “the way it used to be” I'm only referring to the 1990's.


What I deliberately left out (for ease of calculation) was that if your total debt exceeded 33% (this included the 28% of your adjusted income to that mortgage – leaving you a scant plus 5% to play with) they would also deny you a mortgage. It was, in most circumstances, common practice in the US. Of course there are always exceptions to the rule. But those exceptions were confined to new home construction, adjustable floating rate loans, government assisted, and specialty type loans such as bridge loans and the like. So, unless you had a large cash deposit to equalize the debt to loan amount – you were out of luck!


Unfortunately, over the last ten years salaries have stagnated and people have compensated for their shortfall by borrowing. Interest rates fell and money got even easier to get... and you know the rest.


Today, when the 28% rule is applied to an applicant who cannot qualify for a mortgage he, like in the past, will be denied. This leaves only a couple of options:

1. Home values will fall
   or
2. Interest rates will lower
   or
3. Incomes will rise

So, what do you think will happen – short term, especially in a country with house prices as inflated as New Zealand's?

[Tucker]

During the past 5 years or so some banks went up to 40%. Before that it was around 30 - 33% and may be back down to that now.

[k1w1]

The mistake you make, expat, is the "or". It isn't OR, it's AND.

All 3 of those things will happen. Home values are falling. Interest rates are falling, and inflation is/will push up earnings. These will occur in various guises until an equilibrium is found.

[tpr2]

The calculation I was taught when I started mortgage broking was a heck of a lot simpler than that austro.

Gross income x 33% / Benchmark rate.

Benchmark Rate equaled 2% over the variable rate at the time.

If you were buying a rental property or had a rental property add in 80% of the rental income.

So it was quick and easy to work out someones capacity to borrow.

That was in 1996.

In 2000 we started to see all sorts of funky calculations.

[revdev]

In 2000 we started to see all sorts of funky calculations.

Alarmingly, this seems to coincide with the rise of the seminar friendly, funky chicken dance.

G

[cube]

The funky seminar friendly dances have been around long before 2000 - its just this incarnation that started then.

[tpr2]

and with borrowing capacity formulas starting to look like something out of NASA is it any wonder we need another seven aunties to help us pay our mortgages these days.

[exnzpat]

During the past 5 years or so some banks went up to 40%. Before that it was around 30 - 33% and may be back down to that now.

I had a long discussion on this very subject with my local bank manager (here in the States) the other day. Not only were they not looking at the debt to income ratio, lenders were not even verifying an applicant’s income!

Talk about setting the scene for a horror movie!

[tpr2]

That's why they were called NINJA loans.

No Income No Job No Assets