Monday, 01 June 2020

Why Do Some Loan Programs Allow for Higher Debt Ratios for Higher Income Borrowers?

Written by Posted On Monday, 11 May 2020 05:00

When speaking with your loan officer to get a preapproval or just curious what your payments would be on a new loan, one of the more important factors is how much debt you have compared to gross monthly income. This number is expressed as a percentage, or ratio, which then results in a debt ratio. There are two such ratios, a ‘front’ and a ‘back’ ratio. The front ratio includes an amount for a payment toward principal and interest, property taxes and any required mortgage insurance. That final number is then divided by gross monthly income, often referred to as ‘PITI.’ The back ratio includes the front as well as other monthly credit obligations such as credit cards, student loans and so on. Pretty much anything that would show up on your credit report is included but everyday items such as food and utilities are not.

Debt ratios over time have been used to determine affordability and are crucial pieces of information when evaluating a loan application. If a loan program asks for a front ratio of 28, that means the PITI represents 28 percent of gross monthly income. Over time, collective data indicates that when someone is making a housing payment, the suggested debt ratio implies the borrower can afford the payment and is unlikely to default due to an affordability issue. But there are different debt ratio requirements for different loan types. 

When someone has a relatively high ratio, lenders would then have to make a determination of moving forward with the loan or making some sort of adjustments before issuing an approval. Debt ratios not only consider the PITI amount, but also recognizes there needs to be some money left over for everything else. Things like food, gas, car insurance, entertainment and such. Not many would like a mortgage if they didn’t have enough gas to get to work each day, eat Ramen noodles all too often and stay home instead of going out with friends. 

Now let’s look at someone with a gross monthly income of $3,500 and someone with $12,000. Lenders might review the $3,500 borrower with a program needing a 28 but the ratio for the amount the borrower wants is closer to 38. That might give some lenders pause. After the house payment, very little is left for other things. Especially if the new house payment is much higher than current rent. On the other hand, a lender might give the thumbs up on the higher income borrower. Why? Residual income.

Okay, a lender decides to make an exception with the 28 ratio guideline and approve a loan application pushing 35. The leftover income for the first individual would be somewhere near $1,100 or so. That might at first sound like a lot but $260 per week doesn’t last very long. On the other hand, 35 percent of $12,000 is $4,200. The residual income available for everything else beyond the PITI is way much more. $1,500 to $2,000 is fairly realistic. Yes, higher income borrowers will also have higher expenses beyond a mortgage and car payments, but still, the amount left over each month will let a lender breathe a little easier.

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David Reed

David Reed (Austin, TX) is the author of Mortgages 101, Mortgage Confidential, Your Successful Career as a Mortgage Broker , The Real Estate Investor's Guide to Financing, Your Guide to VA Loans and Decoding the New Mortgage Market. As a Senior Loan Officer and Mortgage Executive he closed more than 2,000 mortgage loans over the course of more than 20 years in commercial and residential mortgage lending.

He has appeared on CNN, CNBC, Fox Business, Fox and Friends and the Today In New York show. His advice has appeared in the New York Times, Parade Magazine, Washington Post and Kiplinger's as well as in newspapers and magazines throughout the country.

Reed was the former Technology Chair for the Texas Mortgage Bankers Association, Board Member and President of the Austin Mortgage Bankers Association. He is married and a father of three in Austin.
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