One of the primary methods mortgage lenders use to approve a loan application is to make sure the new mortgage payment is one the borrower can afford with the least likelihood of default. “Affordability” can be a relative term for many. Someone may feel completely comfortable carrying more debt while others can wilt when even one new credit payment is added. But for mortgage lenders, they compare monthly credit obligations, including the mortgage payment, with gross monthly income and arrive at a percentage, or a ratio. This ratio is referred to as a “debt ratio” and is the moniker implies it reviews monthly credit payments with income.
What is included in the debt ratio? With credit card payments, lenders use the minimum monthly payment required as listed on the credit report, even if the consumer pays off most or all of the balance every month. Whatever appears will be used. If someone wants to lower their debt ratios and there is a credit card balance, they can pay off the balance and either wait for the credit card company to report the zero balance or provide the lender with a receipt or statement showing the balance is in fact zero. Credit card payments are referred to as revolving debt.
Installment debt is when someone buys something on credit and pays off the new item with regular payments over time. For example, someone might buy a new washer and dryer and the total is $1,000 and their new monthly payments stretched out over 60 months is $49 per month and will remain there until the balance is paid off. However, when an installment payment has less than 10 months remaining, the payment is ignored. Support and alimony payments are included in the monthly debt ratio calculation as are monthly payments for day care.
The mortgage payment is an important part of the debt ratio and for most loan programs it has its own ratio outside of any other credit obligations. This is referred to as the housing ratio or “front” ratio. The mortgage payment used include the principal and interest payment and a monthly installment for property taxes, insurance and mortgage insurance where needed. If there is a homeowner’s association fee, that too is part of the mortgage payment used when calculating the debt ratio. A common front ratio for most loan programs is around 28. That means the total mortgage payment represents 28 percent of gross monthly income. Total monthly credit payments including both the mortgage and other payments have a target ratio of 43. When adding all credit payments and the new mortgage payment, the ideal number should be at 43.
Let’s say a couple makes $9,000 per month. They have two car payments totaling $700, student loan payments of $200 and credit cards showing a minimum monthly payment of $200. Okay, now multiply the $9,000 per month by 43 and you get $3,870. Subtracting the car payments, student loan and credit card minimum monthly payments and you’re left with $2,770. That’s the amount available for the total mortgage payment. If property taxes on a proposed property were $600 and the estimated insurance payment were $170 that leaves $2,000 for the principal and interest payment.
If you take a $2,000 monthly payment on a 30 year mortgage and use a sample rate of say 3.50%, that provides a loan amount of $445,000, or a 30 front ratio. That’s how loan officers prequalify you for a loan amount.
But it’s important to note that debt ratios aren’t hard and fast rules. Lenders have some flexibility with debt ratios and just because a guideline says the preferred ratio is 43 doesn’t mean if it’s 45 the loan will be turned down. Other factors will be considered at the same time. For example, debt ratios can be relaxed if someone is putting down 20% instead of 3.0%. Or, someone with an excellent credit score can have higher acceptable debt ratios compared to someone with lower credit scores.
Because we’re a direct lender we have the ability to adjust lending guidelines based upon the overall loan file and take into consideration other factors that improve the quality of the loan and not just look at a number. For example, we have the ability to approve a loan with a debt ratio as high as 56.9 on many loan programs. Not every loan can be approved with debt ratios in the 50’s but it’s possible given other positive factors in the file. For example, someone who has been at the same employer for 10 years or shows a solid savings and retirement account could allow us to approve a higher debt ratio loan.
The point is to let your loan officer make the determination on how much you can qualify for and don’t make the mistake of thinking a mortgage payment is out of reach. After a brief conversation and a review of your loan application and credit report we can provide you with a preapproval letter that you’ll be comfortable with knowing all you need to do next is find that perfect home!
The author, Matt Herbolich, MBA, JD, LLM NMLS #1649154, is a senior loan officer at USA Mortgage, a division of DAS Acquisition Company, LLC NMLS# 227262. Contact Matt Herbolich, MBA, JD, LLM for your Real Estate and Mortgage Questions. USA Mortgage is a direct lender with no lender overlays on Government and Conventional Loans. Mr. Herbolich can be reached 7 days a week at 888-900-1020 by phone, on his cell at 786-390-9499 by either phone or text, or by email email@example.com.