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.

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