Loan Qualification Standards - Debt to Income Ratio

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Many people have no clue how qualified they are as buyers, or borrowers.



There are two ratios that, together with the credit score, determine how qualified someone is for a loan.



The first, and by far the more important, is debt to income ratio, usually abbreviated DTI. This is a measurement of how easy it will be for you to repay the loan given your current income level.



The debt to income ratio is measured by dividing total monthly mandatory outlays to service debt into your gross monthly income. Yes, due to the fact that the tax code gives you a deduction for mortgage interest, you qualify based upon your gross income. This ratio is broken into two discrete measurements, called front end ratio and back end ratio, for underwriting standards. The front end ratio is the payments upon the proposed loan only (i.e. principal and interest), whereas the back end ratio adds in all debt service: credit cards, installment loans, finance obligations, student loans, alimony and child support, and property taxes and homeowner's insurance on the home as well. The front end ratio is almost ignored; I cannot remember an instance of when front-end was a deal-breaker. The thing that will break most loans is the back end ratio, to the point where some lenders don't really care about the front end ratio anymore.



Now, as to what gets counted, the answer is simple. The minimum monthly payment on any given debt is what gets counted. It doesn't matter if you're paying $500 per month, if the minimum payment is $60, that's what will be counted.



"Can I pay off debt in order to qualify?" is a question I see quite a lot and the answer depends upon your lender and the market you're in. For top of the market A paper lenders, who have to underwrite to Fannie Mae and Freddie Mac standards, the answer is largely no. If you pay off a credit card where the balance is $x, there's nothing to prevent you going out and charging it up again. Even if you close is out completely, the thinking (borne out in practice, I might add) is that you can get another one for the same amount trivially. "Won't they just trust me to be intelligent and responsible?" some people will ask. The answer is no. Actually, it's bleep no. A paper is not about trust. A paper is about you demonstrating that you're a great credit risk. Even installment debt is at the discretion of the lender's guidelines. If they believe that what you really did was borrow money from a friend or family member who expects to be repaid, expect it to be disallowed. Therefore, the time to pay off or pay down your debts is before your credit is run and before you apply for a loan.



For subprime loans, the standards are looser because the lender controls the money. As long as they can see where the money is coming from, they will usually allow the payoff in order to qualify.



Now many folks think that stated income loans don't have a DTI requirement. They do. As a matter of fact, stated income is even less forgiving than full documentation loans in this regard. As I keep telling folks, for full documentation, I don't have to prove every penny you make, I only have to prove enough to justify the loan. If what I proved before falls short, but if the client has more income, I can always prove more. For stated income, we still have to come up with a believable income for your occupation, and then the debt to income ratio is figured off of that. Even if the lender is agreeing not to verify income, they're still going to be skeptical if you change your story. "You told me you make $6000 per month three days ago. Now you're telling me you make $7000 per month. Which is it? Please show me your documentation!" In short, this loan has now essentially changed to a full documentation loan at stated income rates. Nor are they going to believe a fast food counter employee makes $80,000 per year. They have resources that tell them how much people of a given occupation make in the area, and if you're outside the range it will be disallowed. So you need to be very careful to make certain the loan officer knows about all the monthly payments on debt you're required to make. Sometimes it doesn't show up on the credit report and the lender finds out anyway. This has nothing to do with utilities (unless you're in the process of paying one of them back). That's just living expenses, and you could, in theory, cancel cable TV if you needed to. Once you owe the money, you are obligated to pay it back.



As for what is allowable: A paper maximum back end debt to income ratios vary from thirty-eight to forty-five percent of gross monthly income. I'm a big fan of hybrid adjustables, but they are, perversely, harder to qualify for under A paper rules than the standard 30 year fixed rate loan despite the lower payments. This is because there will be an adjustment to your payment at a known point in time, and you're likely to need more money when it does. Note that for high credit scores, Fasnnie Mae and Freddie Mac have automated underwriting programs with a considerable amount of slack cut in.



Some things count for more income than you actually receive. Social security is the classic example of this. The idea is that it's not subject to loss. Once you're getting it, you will be getting it forever, unlike a regular paycheck where you can lose the job and many people do.



Subprime lenders will usually, depending upon the company and their guidelines, go higher than A paper. It's a riskier loan, and you can expect to pay for that risk via a higher interest rate, but even with the higher rate, most people qualify for bigger loans subprime than they will A paper. Some subprime lenders will go as high as sixty percent of gross income on a full documentation loan.



Whatever the debt to income ratio guideline is, it's usually a razor sharp dividing line. On one side you qualify, on the other, you probably don't. If the guideline is DTI of 45 or less, and you are at 44.9, you're in, at least as far as the debt to income ratio goes. On the high side, waivers do exist but they are something to be leery of. Whereas many waivers are approved deviations from guidelines that may be mostly a technicality, debt-to-income ratio cuts to the heart of whether you can afford the loan, and if you're not within this guideline, it may be best to let the loan go. You've got to eat, you probably want to pay your utility bills, and you only make so much. Debt to Income ratio is there for your protection as much as the bank's.



Caveat Emptor.



The companion article on Loan to Value Ratio is here.

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About this Entry

This page contains a single entry by Dan Melson published on May 4, 2007 10:00 AM.

Buying Off A Prepayment Penalty was the previous entry in this blog.

One Loan Versus Two Loans is the next entry in this blog.

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