Freddie Mac--the second biggest source of American home mortgage money--has begun using a new creditworthiness yardstick to evaluate all new mortgage applications.

It’s called the “gap ratio.” The test measures the relationships among your consumer, mortgage and total monthly debtloads with respect to your total monthly income. Here’s how the new test works. Most lenders traditionally have looked closely at how much of total monthly income applicants devote to paying their monthly debts. A totoal debt-to-income ratio above 33 or 35 percent, for instance, once was the standard maximum for mortgage applicants. In other words, if you had monthly household income of $3,000, your total debt service--credit cards, car payments and mortgage payments--should not exceed about $1,000-$1,100.

Lenders traditionally have also been concerned that your mortgage payments alone should not consume too much of your total monthly income. For years, the standard maximum for mortgage debt was 25 percent of monthly income. In the 1990s, lenders relaxed those debt-to-income limits somewhat, but never abandoned them as rough indexes of borrowers’ abilities to handle their credit reponsibilities.

Freddie Mac’s new mathematical test, based on what the corporation says is substantial research into consumers’ credit behavior and loan delinquencies, focuses squarely on how much credit card and other non-mortgage debt a borrower is carrying. When loan applicants’ monthly consumer debt loads are high, Freddie now concludes that those applicants may be on thin ice financially.

Take this example. Say you and your spouse earn a combined $4,500 a month. You apply for a mortgage that will cost you $1,500 a month (33 percent of income). But you also have credit card, student loan and car payments that eat up another 17 percent of monthly income ($765). That pushes your total debt-to-income ratio to 50 percent.

That’s a high debt load to carry, but Freddie Mac’s research suggests that that figure is not the key predictor of later default. Rather, it is the “gap ratio”--in this case the 17 percentage point difference--between the mortgage debt-to-income ratio (33 percent) and the total debt-to-income ratio that is more worrisome.

When a borrower has a gap ratio of 17 percent, according to Freddie’s research, the applicant is more likely to get into trouble paying some or all debts than an applicant with a gap ratio of 15 or less. The solution: Either the amount of consumer credit payments need to come down, or the mortgage debt needs to be less. If the applicant wants a new mortgage at the best available rates, he or she needs to cut down on those credit cards and auto debtloads.

The new “gap ratio” test is part of Freddie Mac’s so-called “layering of risk” analysis on all new loans. It is now built into the corporation’s electronic underwriting system, and is to be used for all “manual” underwritings as well. The company has long believed that risk of default depends on three major factors:

Published: April 1, 2002

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.