Consumer borrowing is so rampant in America that most people who took out a mortgage last year to buy a home ended up spending more than a third of their income to pay that loan and other debts.
Now, a federal proposal would target these borrowers by making it tougher for them to get the cheapest mortgages. The initiative is part of a broader measure that aims to prevent another foreclosure crisis and could confront borrowers who do not meet certain conditions with higher interest rates and fees.
The debt restrictions are on top of other conditions, including a requirement that borrowers pony up a 20 percent down payment to qualify for the cheapest mortgages.
While the down payment condition has captured the public spotlight since the government unveiled its plan in March, experts who track the housing industry say the proposed debt limits could be just as onerous for borrowers.
"The debt limits are far and away the most binding constraint," said Mark Zandi, chief economist at Moody's Analytics. "It's probably the one thing that will knock the largest number of borrowers out of the market by keeping them from getting the most favorable rates."
The proposal not only restricts a borrower's total debt — including credit cards, auto loans and student loans — to 36 percent of gross monthly income. It would also limit the mortgage payment itself to no more than 28 percent of gross monthly income.
Nearly three out of every five U.S. borrowers who bought homes last year would not have met the proposed restriction on total debt, according to an analysis by mortgage research firm CoreLogic.
A separate federal analysis showed that more than half of buyers whose loans were sold to Fannie Mae and Freddie Mac in 2009 would have fallen short of one or both of the two debt requirements.
If the rules were in effect now, Todd Pearson of Ashburn, Va., predicts he would be shut out of the market. Pearson wants to sell his house and buy another across the river in Chevy Chase, Md. He says he has no debts other than his mortgage. But he figures his mortgage payment alone would exceed the threshold proposed by the new rules.
While Pearson said he's all for reforming the housing finance system, he would prefer that regulators look at many factors overall when scrutinizing borrowers: "Why not look at my credit score, my salary and everything else?"
The new proposal aims to make sure that mortgage-backed securities, which contributed to the financial crisis, are based on high-quality loans. It seeks to do this by requiring banks to retain a stake in the mortgage securities they assemble instead of selling them all off.
Loans made to borrowers who meet stiff conditions, such as the debt restrictions, will be exempt. Bank executives say the cost of retaining a stake in the rest of the loans will be high and will be passed on to borrowers through higher fees and interest rates.
The proposed rules would not apply to loans backed by the federal government — including those guaranteed by the Federal Housing Administration, Fannie Mae and Freddie Mac. These loans now account for most of the mortgage market. But the government role is expected to shrink dramatically as the housing market returns to normal.
The proposal, which should be finalized in about a year, acknowledges that some creditworthy borrowers may be penalized, but "incorporating all of the trade-offs that may prudently be made . . . would be very difficult."
For decades, lenders have considered a borrower's indebtedness when deciding whether to approve them for a loan. There were no mandates dictating what the acceptable levels should be, but rather guidelines set by the mortgage finance companies Fannie Mae and Freddie Mac.
Yet those firms, the biggest buyers of mortgages, make exceptions for borrowers who make big down payments, have large cash reserves or other attributes that offset concerns of the amount of debt they're taking on.
"These guidelines were never rigidly enforced because they were not useful predictors of a borrower's likelihood to default," said Paul Willen, a senior economist at the Federal Reserve Bank of Boston. "It's an erratic and sloppy measure."
That's because income is volatile, Willen said. For instance, what if a couple applies for a mortgage, has a child and then one spouse quits work to stay home with the kids? "There's no way a lender can anticipate that," he said.
What matters more is a borrower's "residual income," said Greg McBride, chief economist at Bankrate.com. A family that makes $10,000 a month would have $7,200 left to spend if a quarter of their income goes toward the mortgage. By contrast, a family that earns $4,000 a month has less than $2,900 left, giving them a smaller margin for error.
In their proposal, federal regulators said residual income is "neither widely used nor consistently calculated," and therefore is ineffective in determining a borrower's ability to repay.
Instead, regulators limited a borrower's mortgage payment to no more than 28 percent of gross monthly income. The total debt, including the mortgage, was limited to 36 percent.
George Light, a partner at Home Savings and Trust Mortgage, said mandating those requirements today would be unnecessarily harsh.
Light offers a profile of a retired couple in their early 70s who want to put down $400,000 on a $600,000 home and take out a $200,000 mortgage. They have $1 million in the bank but their monthly income is limited to $2,300 in Social Security.
Today, that couple would easily qualify if their credit is good because they have lots of equity in the house, Light said. But under the federal proposal, they would not get the cheapest loan because their debt would be 82 percent of their income.
Jennifer DuPlessis of George Mason Mortgage said some borrowers may have to pony up larger down payments or settle for more modest homes.
Ric Edelman, a financial adviser in Virginia, said he's not surprised that the industry opposes the debt limits. After all, they will likely shut out some potential buyers, hurt home sales and undermine efforts to boost home prices — all of which cuts into the industry's profits.
"But we are better off not letting someone buy a house than letting them buy one and putting them in such a precarious position that they end up losing it in a few years," Edelman said.