Conventional Wisdom: The Housing Payment

The Digerati Life had a post last week linking to a tool at CNN Money. It asks you a few questions and then gives you a letter grade for your financial health. It’s Victorian Housejust as subtle and sophisticated in its analysis as you would expect from a web applet on CNN.com.

But it does nicely encapsulate the conventional wisdom on personal finance. So nicely, in fact, that I will use it as the structure for a new occasional series here at BMA, The Conventional Wisdom.

Today the topic is the first question in CNN Money’s quiz: How much is your housing payment? If you enter in more than 28% of your gross income you flunk this one.

The 28% thing bugs me. First, and I hope this is fairly obvious, a general guideline that applies to everybody is a pretty dumb idea to begin with. Yes, spending 80% of your income on housing is universally a poor idea, but just about any percentage south of 60% could make sense for somebody somewhere.

Even if we accept the need for a guideline of some kind, couldn’t it be just a little more subtle than a single nationwide number? Couldn’t we have a different number for each state? Maybe a different one for young families and older couples with grown children? How about an adjustment for income level? Couldn’t we just have a table instead of a single number? Would it really hurt our little heads that much?

28% of gross income has been Conventional Wisdom for a while now. Where exactly it came from is unclear, but it almost certainly began life as a lending guideline for writing mortgages. If you are loaning somebody money you care a lot about how much income they have coming in the door relative to the monthly payments you need them to make. How the mortgage industry settled on 28% and not something rounder, such as 25% or even 30%, is a mystery, but being non-round implies precision, and people tend to confuse precision with wisdom.

I’m sure I am dating myself for remembering this, but back in the Old Days there were people who wanted to buy as big a house as they could (because house prices never go down) but sometimes couldn’t qualify for the mortgage that went with. (Like I said, these were the Old Days.) So they became focused on the 28% lending limit and began to think of a monthly payment of 28% of gross income as the ideal amount, because that was the most the bank would let them get away with, and the goal was to borrow as much as possible.

Of course, banks soon stopped being so uncooperative (because house prices never go down) and 28% became a good idea without much of a reason.

To be clear, there is nothing particularly wrong with spending 28% of your gross income on housing. That might make sense for you. Or not. And the same could be said of spending 20% or 35%. A one-size-fits-all percentage level for housing spending makes as much sense as a single best shoe size or a correct percentage of income to spend on clothing.

Actually, it’s a lot worse than a recommended clothing spending level. Housing is, or should be, just about the most variable expense there is across American households.

First, as any person fond of clichés will tell you, real estate is all about location, location, and location. Nothing varies in price in different parts of the country as much as real estate does. The difference between what it costs in the cheap places and the expensive ones would be considered staggering in any other context. If you haven’t looked at the actual numbers yourself, spend an hour on realtor.com and look at Detroit and New York. NYC isn’t twice as expensive as the Motor City, it’s about ten times as expensive.

Of course, people who live in places like NYC, Boston, and San Francisco tend to have higher incomes. (They’d kinda hafta, wouldn’t they?) But it’s not as proportionately higher as what they pay to keep a roof over their heads. So, naturally, they spend a larger share of their income on housing. Nothing wrong with that. Conversely, somebody who lives in Detroit, Cleveland, or Omaha ought to spend a lot less than the national average.

Then there are personal circumstances and even, dare I bring it up, personal preferences. Lots of things would reasonably affect your level of housing expenditure. How many people are in your household for one. Do you work at home? Would you rather have a big yard and a dog or drive a sports car?

And finally there is income level. When you get down to it, the unspoken premise that housing expenditure ought to be a certain proportion of income is flawed. Housing is what economists call a "luxury good." That means as a person gets richer we expect him to spend relatively more on things like housing and vacations as the portion spent on things like food and utilities shrinks. Everything else equal, we would expect a person making $250K a year to spend a higher proportion of his income on housing than somebody making $50K a year.

What really annoys me about this is that housing expenditure is a big deal for almost everybody. Getting it right is worth some effort. And 28% isn’t helping. If anything, it’s adding to the confusion. Couldn’t we have a somewhat more sophisticated guideline that takes into account such things as where you live and your income level? It could be a web applet. On CNNMoney even.

No Comments

  • By Steve, October 14, 2009 @ 3:22 pm

    The tool is misnamed. It should be called the “Way Overgeneralized Rule Of Thumb-o-lizer.” It makes the most simplistic assumptions about every single one of its grades.

  • By Abby, October 14, 2009 @ 5:15 pm

    Thanks for this, Frank!

    We live in a huge urban area. Housing prices are (yes, even now) relatively high, but mass transit is plentiful. (And lucky me, I’m able to walk to work.)

    Our monthly expenses might look high for housing, but they’re minimal for transportation – our one paid-off car mostly sits in the garage and waits to go to the grocery store on the weekend.

    It’s a perfectly rational trade-off for our family, despite what rules of thumb might say.

  • By KC, October 14, 2009 @ 6:45 pm

    I think housing should be adjusted for income level. My husband and I spend about 25% on housing now. Our income is much higher than it used to be. Back when we were making less money 25% would have been a stretch. Today 25% is no problem and frankly we could swing 40% and still save money each month. There’s only so much money you can spend on monthly expenses. Of course if you waste money a lot – nice, new cars, etc – then you wouldn’t be able to swing the higher house payment, but that’s a personal choice. My point is the more income you have the more you have to dispose of, especially from a percentage standpoint.

    Also there could be circumstances where someone inherited money or had a large stash in the bank and didn’t want to make a down payment. They might put down as little as possible, while still getting the best loan terms. In that case, income has nothing to do with how much you can afford. If you inherited $2M and your mortgage was 60% of your income would it really matter? (Not saying its smart, just saying you wouldn’t go bankrupt cause you have plenty of money in the bank)

  • By Mark Arsenal, October 14, 2009 @ 7:38 pm

    Yaw. That sucked. They also gripe at you if you don’t own stocks, or don’t have enough retirement savings, even if you don’t plan to retire (since retirement won’t exist later this century after we return to the stone age). Then it gripes at you if you don’t have 5 years’ income worth of life insurance, regardless of the fact that it never asked whether you have dependents. Blorg.

  • By Rob Bennett, October 15, 2009 @ 7:13 am

    They also gripe at you if you don’t own stocks

    No way! I’ve never seen anything like that from the sorts of “experts” who make millions by persuading us that we should buy stocks regardless of price.

    (I’m joking.)

    Rob

  • By Kosmo @ The Casual Observer, October 15, 2009 @ 10:02 am

    Definitely overly simplistic. The question about owning your company’s stock doesn’t consider whether or not your company HAS stock :) I got a good grade simply because I work for a mutual company …

    Our mortgage payment (including insurance and taxes) is 10% of our gross income :) Living in a relatively small city in the midwest has its advantages.

  • By Jim, October 15, 2009 @ 1:10 pm

    If you’re going to make a rule of thumb that works better then it should be based on income/wealth only. I don’t think it should be tied to cost of housing in your area. While its true that its more expensive to live in NYC than Detroit, that doesn’t mean that spending a larger % of your money on housing is a good idea simply cause of your zip code.

  • By bex, October 15, 2009 @ 2:31 pm

    Here’s what I’d like to see:

    1) the feds should collect data on past income, age, region, house payments, and rates of bankruptcy

    2) the feds should use this to make a very simple formula: what is the probability you will go bankrupt if you make a house payment of X?

    3) banks should be REQUIRED to issue this probability to borrowers, along with government guidelines — AKA, anything over a 5% bankruptcy rate is probably a very bad idea.

    These tables should be updated yearly, quarterly, or whatever… so long as there is a funded mandate to collect the data, and they have a public web form, we can get rid of the silly 28% metric for good!

  • By MyFinancialIndependenceCoach.com, October 16, 2009 @ 10:35 am

    Yep, extremely simplistic, but good to know it’s there. Over the years though, clients have always asked “what should I be doing”, and they really just want a general sense of how they “stack up” to the rest of their peers.

    I’ve developed my own similar success tracker, that does go into more depth, and it’s helpful to track IMPROVEMENTS for that family.

    Also, take-home pay is really what should be considered. That is a huge flaw in these generalized stats. I threw in $150k for income, $3k for housing per month…and I was great. Then, I threw in $6k for total expenses, and I was in “danger”! I have no auto debt, 1 small credit card, some investment real estate…but what costs a ton for families everywhere is:
    Groceries
    Insurance
    Day care ($1500-$2000 sometimes for 2 kids)
    Gas – $200-$300 per month.

    Suddenly you double your monthly expenditures on all things BUT debt!

    Oh well…fun to play with once. But I’ll stick to coaching clients personally, and customized to each situation.

  • By Craig, October 20, 2009 @ 12:10 pm

    I think it’s really impressive how hard they worked to keep this tool from having any value at all. Asking just one or two questions–adding just one or two parameters–might have improved it by orders of magnitude. It takes real focus to keep something so dumbed-down.

    For instance, I went from a B+ to an A just by quadrupling the actual value of my life insurance. I am a 36-year old man, married to a woman with roughly equal earning potential, who is devoting most of her time to charitable work while we live off my salary. We have no dependants.

    Obviously, the amount of life insurance I “need” is pretty dang close to zero. (I have a modest amount, so that she can pay off the mortgage and take a couple of years off if anything happens to me. She is insured for a similar amount.) But this tool wants me to have a million dollar policy for full marks. Absurd.

    Then, too, as a married person, I never know how to even enter the data in these things. The average of our ages? The highest of the two? Total household income? Average hers and mine? Sure, you can’t plan for every oddball scenario, but: married couples? Surely they’ve met one or two.

Other Links to this Post

  1. Buying a Home -- What You Need To Know And Is Rent Such a Bad Idea? | Studenomics — April 13, 2011 @ 1:37 pm

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