Tag Archives: auto loans

Understanding Homeownership

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The Housing Finance Policy Center at the Urban Institute released its House Finance at a Glance Chartbook for December. It states that financial education “can help reduce barriers to homeownership.” As I argue below, I do not think that financial education is the right thing to emphasize when trying to get people to enter the housing market.

The Introduction makes the case for financial education:

While mortgage debt has been stable to marginally increasing, other types of debt, particularly auto and student loan debt have increased far more rapidly. Our calculations, based on The Federal Reserve Bank of New York’s Quarterly Report on Household Debt and Credit, show that over the past 5 years (Q3 2012 to Q3 2017), mortgage debt outstanding has grown at an annualized rate of 1.3 percent, while non-mortgage debt (which includes credit card debt, student loan debt, auto debt, and other debt) has grown by 6.8 percent annualized rate. Student loan debt has grown by 7.3 percent per year while auto debt has been growing by 9.6 percent per year. In Q3 2012, the number of accounts for mortgage loans and auto loans are very close (84 million vs 82 million). By Q3 2017, the number of accounts for mortgages had fallen to 80 million consistent with declining homeownership rate, while the number of accounts for auto loans had increased to 110 million.

Another metric where auto loans have diverged from mortgages is delinquency rates. Over the past 5 years, mortgage delinquencies have plummeted (pages 22 and 29) while the percent of auto loans that is more than 90 days late is roughly flat despite an improving economy. However, the percent of auto loans transitioning into serious delinquency has risen from 1.52 percent in Q3 2012 to 2.36 percent in Q3 2017. While these numbers remain small, the growth bears monitoring.

When we looked at the distribution of credit scores for new auto origination and new mortgage origination, we found no major change in either loan category; while mortgage credit scores are skewed higher, the distribution of mortgage credit scores (page 17) and the distribution of auto credit scores have been roughly consistent over the period. Our calculations based off NY Fed data shows the percent of auto loan origination balances with FICOs under 660 was 35.9% in Q3, 2012, it is now 31.7%; similarly the percent of auto origination with balances under 620 has contracted from 22.7 percent to 19.6 percent. There have been absolutely more auto loans with low FICOs originated, but this is because of the increased overall volume.

So what might explain the differences in trends in the delinquency rate and loan growth between these two asset classes? A good part of the story (in addition to tight mortgage credit) is that many potential low- and moderate-income borrowers do not believe they can get a mortgage. As a result, many don’t even bother to apply. We showed in our recently released report on Barriers to Accessing Homeownership that survey after survey shows that borrowers think they need far bigger down payments than they actually do. And there are many down payment assistance programs available. Moreover, it is still less expensive at the national level to own than to rent. This suggests that many LMI borrowers who are shying away from applying for a mortgage could benefit from financial education; with a better grasp of down payment facts and assistance opportunities, many of these families could be motivated to apply for mortgages and have the opportunity to build wealth. (5)

I am not sure if financial education is the whole answer here. Employment instability as well as generalized financial insecurity may be playing a bigger role in home purchases than in car purchases. The longer time horizon as well as the more serious consequences of a default with homeownership may be keeping people from stepping into the housing market. This is particularly true if renters have visions in their heads of family members or friends suffering during the long and lingering foreclosure crisis.

What is the Debt to Income Ratio?

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OppLoans.com quoted me in What is the Debt to Income Ratio? It opens,

One of the great things about credit is that it lets you make purchases you wouldn’t otherwise be able to afford at one time. But this arrangement only works if you are able to make your monthly payments. That’s why lenders look at something called your debt to income ratio. It’s a number that indicates what kind of debt load you’ll be able to afford. And if you’re looking to borrow, it’s a number you’ll want to know.

Unless your rich eccentric uncle suddenly dies and leave you a giant pile of money, making any large purchase, like a car or a home, is going to mean taking out a loan. Legitimate loans spread the repayment process over time (or a longer term), which makes owning these incredibly expensive items possible for regular folks.

But not all loans are affordable. If the loan’s monthly payments take up too much of your budget, then you’re likely to default. And as much as you, the borrower, do not want that to happen, it’s also something that lenders want to avoid at all costs.

It doesn’t matter how much you want that cute, three-bedroom Victorian or that sweet, two-door muscle car (or even if you’re just looking for a personal loan to consolidate your higher interest credit card debt). If you can’t afford your monthly payments, reputable lenders aren’t going to want to do business with you. (Predatory payday lenders are a different story, they actually want you to be unable to afford your loan. You can read more about that shadiness in our personal loans guide.)

So how do mortgage, car, and personal lenders determine what a person can afford before they lend them? Well, they usually do it by looking at their debt to income ratio.

What is the debt to income ratio?

Basically, it’s the amount of your monthly budget that goes towards paying debts—including rent or mortgage payments.

“Your debt to income ratio is benchmark metric used to measure an individual’s ability to repay debt and manage their monthly payments,” says Brian Woltman, branch manager at Embrace Home Loans (@EmbraceHomeLoan).

“Your ‘DTI’ as it’s commonly referred to is exactly what it sounds like. It’s calculated by dividing your total current recurring monthly debt by your gross monthly income—the amount you make before any taxes are taken out,” says Woltman. “It’s important because it helps a lender to determine the proper amount of money that someone can borrow, and reasonably expect to be paid back, based on the terms agreed upon.”

According to Gerri Detweiler (@gerridetweiler), head of market education for Nav (@navSMB), “Your debt to income ratio provides important information about whether you can afford the payment on your new loan.”

“On some consumer loans, like mortgages or auto loans, your debt to income ratio can make or break your loan application,” says Detweiler. “This ratio typically compares your monthly recurring debt payments, such as credit card minimum payments, student loan payments, mortgage or auto loans to your monthly gross (before tax) income.”

Here’s an example…

Larry has a monthly income of $5,000 and a list of the following monthly debt obligations:

Rent: $1,200

Credit Card: $150

Student Loan: $400

Installment Loan: $250

Total: $2,000

To calculate Larry’s DTI we need to divide his total monthly debt payments by his monthly income:

$2,000 / $5,000 = .40

Larry’s debt to income ratio is 40 percent.

David Reiss (@REFinBlog), is a professor of real estate finance at Brooklyn Law School. He says that the debt to income ratio is an important metric for lenders because “It is one of the three “C’s” of loan underwriting:

Character: Does a person have a history of repaying debts?

Capacity: Does a person have the income to repay debts?

Capital: Does the person have assets that can be used to retire debt if income should prove insufficient?

What is a good debt to income ratio?

“If you listen to Ben Franklin, who subscribed to the saying ‘neither a borrower nor lender be,’ the ideal ratio is 0,” says Reiss. But he adds that only lending to people with no debt whatsoever would put home ownership out of reach for, well, almost everyone. Besides, a person can have some debt on-hand and still be a responsible borrower.

“More realistically, in today’s world,” says Reiss, “we might take guidance from the Consumer Financial Protection Bureau (CFPB) which advises against having a DTI ratio of greater than 43 percent. If it creeps higher than that, you might have trouble paying for other important things like rent, food and clothing.”

“Requirements vary but usually if you can stay below a 33 percent debt-to-income ratio, you’re fine,” says Detweiler. “Some lenders will lend up to a 50 percent debt ratio, but the interest rate may be higher since that represents a higher risk.”

For Larry, the guy in our previous example, a 33 percent DTI would mean keeping his monthly debt obligations to $1650.

Let’s go back to that 43 percent number that Reiss mentioned because it isn’t just an arbitrary number. 43 percent DTI is the highest ratio that borrower can have and still receive a “Qualified Mortgage.”

Return to the Great Recession?

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US News & World Report quoted me in What Happens if Trump Dismantles the Financial Regulations of the Great Recession? It opens,

On Feb. 3, 2017, President Donald Trump signed two executive orders that will affect the financial sector. That change will come to consumers is undeniable. But exactly what change is coming is, naturally, up for debate.

One of the orders requires the Treasury secretary to review the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010 and designed to address some of the shortcomings in the financial system that led to the Great Recession. The other executive action mandates that the Labor Department review its Department of Labor Fiduciary Rule and look at its probable economic impact. As it stands now, the fiduciary rule is supposed to be phased in from April 10, 2017 to Jan. 1, 2018. The rule requires financial professionals who work with retirement plans or provide retirement planning advice to act in a way that’s only based on the client’s best interests.

What do these executive orders portend for consumers? Nobody knows, but what follows are some educated guesses – with best-case and worst-case outcomes.

How the housing market might be affected. There’s potential good news and bad news here, according to Francesco D’Acunto, a finance assistant professor at the University of Maryland. In a study performed by D’Acunto and faculty colleague Alberto Rossi, in the wake of Dodd-Frank, banks decreased mortgage lending to middle class families by about 15 percent in 2014.

“Title XIV, which regulates the mortgage market, could be in for a full-scale renovation that might ultimately improve the fortunes of potential homebuyers from the middle class,” D’Acunto says.

So if you’ve been having trouble getting a mortgage for a house, you may have less trouble – provided you find a reputable lender. Because the downside, according to D’Acunto, is that “such a move risks bringing a return of predatory behavior in lending and mortgage cross-selling, especially by large banks and by non-bank mortgage originators.”

To avoid that, D’Acunto hopes that Congress intervenes “surgically on Title XIV” and only reduces the regulatory costs imposed by the new Qualified Mortgage classification. Created by the Consumer Financial Protection Bureau, the Qualified Mortgage category of loans includes features designed to make it more likely that a consumer will be able to pay it back.

But if they don’t intervene with the careful attention to detail D’Acunto advises, then expect “big changes, most of them negative,” says David Reiss, a Brooklyn Law School professor whose specialty is in real estate finance.

Potential best-case scenario: After being denied a mortgage for some time, you finally get your house.

Potential worst-case scenario: Because you were steered to a high-interest loan you can’t afford, you lose your house.

How credit cards, auto loans and student loans might be affected. There has been a lot of talk that the CFPB could be a casualty in the executive order that asks the Treasury secretary to review Dodd-Frank. But will it be ripped to shreds or have its power diminished?

The latter seems to already be happening. For instance, lawmakers, led by Sen. David Perdue (R-Ga.), are in the midst of trying to repeal a rule that is scheduled to go into effect this fall. The rule, among other things, would mandate prepaid-card companies to disclose detailed information about their fees, make it easier to access account information and would curb a consumer’s losses if the cards are lost or stolen.

A little weakening might not be so bad, Reiss says. He thinks the CFPB has tightened “the credit box too much, meaning that some people who could manage more credit are not getting access to it.”

But he also thinks if the CFPB were dismantled, the negatives would far outweigh the positives.

Potential best-case scenario: Easier access to loans and more choices. And for some consumers who can now get that car or credit card, their quality of life improves.

Potential worst-case scenario: Thanks to that easier access, some consumers end up stuck with high-interest loans with a lot of hidden fees and rue the day they applied for them.