National Standards
The majority of lenders today process and underwrite loans according to generally accepted national standards. These standards are dictated by Wall Street investors and government agencies who invest in mortgages or insure them against default. These investors are known as the secondary mortgage market. Knowing their standards will help you choose a mortgage and a lender.
Within the context of these standards, a lender has some leeway to be lenient and flexible, or strict and even picayune. If, after reading through this chapter, you have concerns about qualifying for the loan amount that you want, shop for a lender that is flexible.
What does a lender look at before saying "yes" (or “no”)? The lender looks at the following:
• Each applicant's monthly income and expenses
• Each applicant's credit history
• Property appraisal
• Source of cash for down payment and settlement costs
• Each applicant's employment history
Your Monthly Income and Expenses
The first question that lenders must ask is "Can you afford the monthly payments on this new mortgage?” To find the answer, they examine your current income and expenses plus the cost of the new mortgage, and they apply mathematical formulas to see if you can afford the payments. Government loans (FHA/VA) and conventional loans use different formulas. Chapter 4, “Choosing the Right Type of Mortgage,” explains the differences between government and conventional loans.
Conventional Loans
For conventional loans, lenders make two calculations that compare your income and mortgage expenses. These calculations determine your housing ratio and debt ratio. Your housing ratio (also known as front ratio or top ratio) is your total monthly mortgage payment (your payment of principal, interest, taxes, and insurance, or PITI) divided by your total monthly income (see Figure 2.f). Your debt ratio (also known as total obligations ratio, back ratio, bottom ratio, debt-to-income or DTI) is the sum of your total monthly mortgage payment and other monthly debt payments divided by your total monthly income (see Figure 2.2). If your ratios are too high, the lender may decide to deny your application. If you can demonstrate your ability to cany greater debts, the lender may allow you to exceed national standards, but usually not by very much. These ratios are very important. You can use the Do-
FIGURE 2.1 Housing Ratio
FIGURE 2.2 Debt Ratio (Debt-to-Income/DTI)
It-Yourself Prequalification Worksheet in Appendix C to calculate your own ratios. Figure 2.3 is a sample worksheet.
Your monthly housing expenses include:
• Mortgage principal and interest payments
• Monthly cost of homeowners' insurance and flood insurance (if required)
• Monthly mortgage insurance payment (if any)
• Annual real estate tax divided by 12
• Monthly condominium or homeowners' association dues
Your monthly housing expenses do not include utilities, telephone bills, and so on.
For all applicants, whether or not married, your monthly income includes:
• Gross monthly salaries (pretax, not take-home pay)
• Commissions
• Bonuses
• Investment income (dividends, interest, and rent)
• Pension or trust income
• Alimony or child support (that you receive, not pay)
Monthly income does not include anticipated raises or unsubstantiated estimates of future commissions and bonuses. It also
FIGURE 2.3 Do-It-Yourself Prequalification Worksheet (For Conventional Loans)
does not include investment income on bank accounts or other assets that will be used for your down payment. It does include the salaries and other income of both husband and wife for two-income families.
All claimed income must be verifiable. The lender may send a letter to your employers to confirm your earnings, or, for alternative documentation loans, the lender may call your employers. Lenders may reduce your estimates of future income from commissions if you do not have at least a two-year history of consistent earnings that support those estimates.
Investment, pension, and trust income also must be verifiable. Lenders may ask for copies of stock certificates, brokerage account statements, and pension or trust documents. If you own a rental property, some lenders assume a 25-percent vacancy rate when calculating the property's cash flow, unless you show them a longterm lease. In almost all cases, lenders deduct some amount for maintenance and repairs to the rental property.
Your fixed monthly obligations include:
• Monthly housing expense (from housing ratio in Figure 2.1)
• Car payments
• Student loan payments
• Alimony or child support (that you and/or your co-appli- cant(s) must pay)
• Credit card or charge account payments
• Other loan payments (including loans for which you have cosigned or guaranteed, even if you don't make the payments on those loans)
As with your income, your lender may require documentation on your debts. Installment loans (such as car loans) with ten or fewer monthly payments (six payments for FHA and VA loans) remaining do not have to be included in your fixed monthly obligations, but you still must disclose them to your lender.
If you or your co-applicant(s) are paying (or receiving) alimony or child support, you may be required to provide a copy of the divorce decree. Even if you are not paying alimony or child support, many lenders require a copy of the divorce decree to prove that you are not obligated, especially if there are minor children involved.
The maximum allowable housing and debt ratios depend on your lender, the type of loan, the property, and the loan amount. For purposes of prequalification, you should use a maximum housing ratio of 28 percent and a maximum debt ratio of 36 percent (28/36). These are the generally accepted standard ratios that most lenders use for conforming loans. Some lenders use ratios that are much higher than national standards, especially for applicants with strong credit scores or large down payments. It is not uncommon for some loan programs to accept debt ratios of 50 percent.
An underwriter, who is the lender's employee evaluating your credit application, is not completely tied to strict standards. Offsetting factors are taken into account. If you can add further explanation to your income or expense situation that makes your numbers look better, by all means do so. However, document your claims in writing if possible.
In the sample Do-It-Yourself Prequalification Worksheet in Figure 2.3, Mr. and Mrs. Homebuyer's housing ratio is 25.4 percent, and their debt ratio is 38.2 percent. National standards for a 30- year, 87-percent LTV ratio loan are 28 percent for the housing ratio and 36 percent for the debt ratio. If their credit score and other factors in their application were strong, a 38 percent debt ratio would be accepted. If their credit or job history was weak, they would possibly have to get a loan with less stringent standards and probably pay a bit more.
In January 2006, Fannie Mae announced that they are de-emphasizing the use of the housing ratio in underwriting loans. If your housing ratio is too high, but your debt ratio is within acceptable guidelines, your high housing ratio is no longer a significant problem.
Self-employment. You are considered self-employed if you own a 25-percent or greater interest in the business that employs you. If you fit this definition, you may have to supply the following additional documentation:
• Signed copies of your two most recent personal federal income tax returns with all applicable schedules
• Signed copies of your two most recent federal business income tax returns, if your business is a corporation, S corporation, or partnership
• A year-to-date profit and loss statement, if the loan application is dated more than 120 days after the end of the business's tax year
• A balance sheet for the previous two years, if the business is a sole proprietorship with significant business assets, has employees other than the owner and his or her spouse, and regularly prepares separate business financial balance sheets
• Your written permission to request copies of your tax returns for the past two years from the IRS
The stability of your income is very important to mortgage lenders. For salaried employees, lenders look at your job history for at least the past two years. For self-employed borrowers, they look at the profitability and cash flow of your business for the past two years in addition to your individual income. If you have started a business within the past two years, or if your business was unprofitable for one or both of the past two years, this presents a problem for most mortgage lenders.
Limited documentation loans. In Chapter f, in the section on Applying for a Loan, there is a list of documentation options. Most lenders charge a slightly higher interest rate or more points for loans with reduced documentation requirements. If you are self- employed or your personal finances are complicated by unverifiable sources of income, and you can afford to make a large down payment, you should definitely look into these “low doc" or “easy doc” loans. This helps you avoid the hassle of verifying all of your finances. You may still be required to disclose your income, but the verification requirements are minimal. In addition, for audit purposes, lenders may require signed authorization to obtain your tax records from the IRS.
Government Loans
Federal Housing Administration (FHA). The FHA calculates ratios using the same method that is used for conventional mortgages. The FHA's standards, however, are more lenient than those of conventional loans. Its maximum housing and debt ratios are 29/41.
Department of Veterans Affairs (VA). The VA uses two methods of calculating a borrower's ability to afford a mortgage: a maximum 41-percent debt ratio (and no housing ratio) and a calculation to determine residual income. Residual income is the amount of money you have left after paying your mortgage, and other housing expenses. Figure 2.4 shows an example of that calculation.
The VA guidelines for required residual income depend on your family size, the requested loan amount, and the region of the country where you are buying a home. (For example, a family of four living in the northeast and seeking a $100,000 loan would need a residual income of $1,025 per month.) In the example in Figure 2.4, residual income of $1,288 would be large enough to quality a family of four for a VA loan.
