May 15th, 2020 11:27 AM by Jackie A. Graves
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
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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