The Business Monthly: The Mortgage Debt Time-Bomb

As we approach the end of the third quarter of 2002, short-term interest rates set by Federal Reserve Policy are at 40-year lows of 1.75%, and could be headed even lower to stimulate a sagging economy that is potentially on the verge of entering a double-dip recession.  Mortgage rates are also at extremely attractive levels. Fixed mortgage interest rates are driven by the yield on 10-year Treasury bonds currently around 4.08% – the lowest level since 1963!

It is an excellent time to take advantage of low mortgage rates and consider refinancing.  It is possible to obtain a 5.50% fixed rate mortgage with zero points, or perhaps a fixed 30-year mortgage rate with a rate around 6.125% with zero points.  When considering refinancing, keep in mind that even with zero points, there will be closing costs to pay.  Closing costs include appraisal fees, processing costs, and title exam, title insurance, and recording fees.

Until recently, continued robust consumer spending helped to keep the economy out of a serious recession.  To a great extent, consumer spending has been fueled by lower monthly mortgage payments.  Many consumers have also taken advantage of these low rates to get “cash out” of existing mortgages by refinancing and incurring even more debt that in turn has been used to propel spending and consumption.

Many consumers are reaching a point of inflection, however, where they are now tapped out with high debt levels.  Consumer spending is starting to weaken and impact the economy.  The unemployment rate is steadily increasing as companies are increasingly cutting back the work force to deal with declining profits.

There is an emerging trouble spot for many families that has, up to this point, gone relatively unnoticed.  Historically, a prudent mortgage credit policy was to borrow just enough so that an ideal comfortable monthly mortgage payment (principal & interest) was 25% or less of gross monthly income.  Refer to the exhibit “Prudent Credit Management Guidelines”.  Recently, however, aggressive mortgage lenders are approving mortgage payments over 50% of gross monthly income!

Lets look at the consequences from a feasibility perspective by making a few generic assumptions for discussion purposes.  If gross monthly income represents 100% of available funds, 35% of income typically can be expected to be eaten-up by payroll taxes, deductions, and withholding.  In this generic example, net income or disposable income would be 65% of gross income.  Actual individual case-by-case figures, of course, can be higher or lower.

If 50% of monthly income is being used to service mortgage debt, then only 15% of income is available to cover all other monthly lifestyle expenses.  Lifestyle expenses include essential spending items like food, clothing, utilities, property taxes, insurance, and transportation.  There are also discretionary expenses to be covered such as recreation, entertainment, travel, etc.

As you can see, we have not even considered saving for intermediate needs like auto replacement, home maintenance or saving for longer-term goals such as retirement, or perhaps education for children.  Retirement savings alone should be at least 10% of gross income, and perhaps much more for many families who started late, or suffered serious stock market declines over the past two years.  The bottom line is that such a high level of mortgage debt is clearly not feasible for many families.  Many consumers are compensating for the shortfall by taking on increasing levels of consumer debt (credit cards, home equity loans, and personal loans.

A healthier financial model is to start with gross income at 100% and deduct perhaps 35% (or your specific percentage) for payroll taxes and deductions. Next, deduct an appropriate percentage for long-term and intermediate term savings goals.  This follows the rule of “pay yourself first”.  Then structure your ideal mortgage payment to provide a comfortable monthly payment while still having room for adequate lifestyle expenses.  This ultimately will point you toward a policy of living comfortably below your means and while building your nest egg toward the long-term goal of financial independence.

There are a few exceptions that should be considered.  If household income can be expected to grow at a steady pace, higher levels of debt can be manageable and you can “grow into” a comfortable mortgage payment.  Another exception might be if both spouses have stable jobs and can independently support the family on a single income.

These comments are designed to be a wake-up call for many families.  They will also make you think twice about common rules of thumb like these:

–       Borrow as much as you can and invest the difference.

–       Buy as much house as you can afford so that you can have the largest income tax deduction for mortgage interest expense.  (You still are much better off in the long run not paying the interest to begin with!)

–       Consider the lower interest rates available on adjustable mortgages (ARM’s).  While certainly attractive today, your payments will increase when the economy eventually begins to recover and interest rates start to increase.  An adjustable mortgage may be the best option, however, if you plan to stay in your home for a relatively short period of time.

On a final note, no one knows when the housing market bubble could burst.  If you borrowed the maximum, and this situation occurs, you could find your house “underwater” where you owe more than the value of your home.  This in fact happened in the rust belt, in Texas, and in California in the past 20 years as the local economies fell upon hard times and the real estate market collapsed.  Many people defaulted on their loans, lost their homes, and were forced to simply walk away.

This article originally appeared in a 2002 issue of The Business Monthly.

Copyright © by PARR Financial Solutions, Inc. 2002