Debt Ratios On Your Own Terms

Written by Posted On Thursday, 22 April 2021 00:00

One of the key components to a loan approval is affordability. In fact, there’s a mortgage guideline referred to as ATR, or ability to repay. Lenders are required to make sure the borrowers can afford the new monthly mortgage payments. The new mortgage payment will include not just the principal and interest portion but a monthly allotment for taxes and insurance, even if taxes and insurance are paid separately from the principal and interest part.

Affordability compares the total mortgage payment with gross monthly income. This results in a percentage, or a ratio. Most loan programs carry two such ratios, a ‘front’ and a ‘back’ ratio. The front ratio is the total mortgage payment while the back ratio includes the mortgage payment plus other monthly credit obligations such as car payments or credit cards. Ratios do not include other expenses such as utilities or other such everyday cash outflows.

For example, if a mortgage program asks for a front ratio of 30, that means the mortgage equals 30% of gross monthly income. A $3,000 mortgage would have a 30 front ratio with a $10,000 per month gross monthly income. If the program then asks for a back ratio of 43, then to use the same scenario, total expenses for both front and back would come to $4,300.

Debt ratios however are typically not hard and fast rules. Someone could have a $3,200 mortgage payment and still be able to qualify for the same program. These program guidelines are issued by the entity that will ultimately buy the mortgage, typically either Fannie Mae or Freddie Mac. Individual lenders may also impose their own internal ratio requirements. If Fannie says a program needs a front ratio of 30, a lender could require the ratio be no greater than 30, even if Fannie allows some leeway. What lenders cannot do however is exceed maximum ratio requirements. 

Loan programs, most of them anyway, are approved electronically with an automated underwriting system, or AUS. When a loan application is submitted through an AUS, a decision is issued almost immediately. This process also means a loan application could have a front ratio of 35 and still be approved. If the automated approval is indeed issued, the ratios are essentially ignored. That is unless the ratio exceeds an established limit. For example, if the back ratio limit is 50 and the loan carries a back ratio of 52, the loan will likely be turned down.

Okay, let’s return to affordability as it relates to your comfort level. For those with a sizable down payment and solid credit scores, allowable debt ratios could be as high as 40 and 50. Sometimes when someone asks for a prequalification from a loan officer, they might be surprised at how much they can qualify for, especially in a low-rate environment.

Yet just because someone can qualify for a higher amount, the mortgage payment might be somewhat uncomfortable for the applicant. Sometimes the new payment crosses a ‘payment shock’ threshold. If someone is used to paying $1,000 per month in rent but discover they can qualify for a $2,000 payment, that could be a shock. If this is you and you find out how much you can qualify for but it’s way more than you’re used to, don’t feel obligated to take the maximum. You’re going to be the one making the monthly payments, not the lender. Take what you’re comfortable with. If that’s the maximum, then fine. Otherwise, stay in your own lane and get a mortgage amount that’s familiar with you.

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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. 

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