Nearly 20 years ago, when I first tackled the topic of qualifying for a mortgage in this column, I felt it necessary to emphasize to potential borrowers that they were not beggars who had to approach lenders hat in hand.
There are multiple hundreds of lenders in this market who compete fiercely among themselves for good loans, I told readers.
That remains the case today, although the financial crisis has changed some of the rules.
Qualification and Approval
A good loan is one to a borrower who has the ability to pay, the willingness to pay and the capacity to make a down payment.
Lenders base judgments of borrower ability to repay mainly on their income relative to their mortgage and other recurring obligations. They assess the willingness to repay mainly by the applicant’s credit history. They assess the capacity to make a down payment from the borrower’s current financial statements.
The term “qualification” is used in two ways.
In a narrow sense, a qualified borrower is one with the ability to pay. Real estate agents qualify borrowers in this sense to make sure they will look at houses in the right price range.
But qualification is also used in a broader sense to mean that the applicant meets all the requirements for approval. Approval requires that an applicant have the ability to pay, the willingness to pay and is capable of making an adequate down payment. Which meaning is intended is usually clear from the context.
Qualification and Affordability
On a purchase transaction, qualification is always relative to property value. A borrower who is well qualified to purchase a $200,000 house may not qualify to buy a $400,000 house.
The property value for which you can qualify depends on your own personal financial condition, and on the mortgage terms available in the market at the time you are shopping.
To afford a $400,000 house, for example, you need about $55,600 in cash, assuming you put 10 percent down. With a 4.25 percent 30-year mortgage, your monthly income should be at least $8,178 and, if your income is $8,178, your monthly payments on existing debt should not exceed $981.
Meeting Income-Expense Requirements
In general, lenders assess the adequacy of borrower income in terms of two ratios that have become standard in the trade.
The first is the housing expense ratio, also known as the front-end ratio. This is the sum of the monthly mortgage payment including mortgage insurance, property taxes, hazard insurance, and condo fees, if applicable, divided by the borrower’s monthly income.
The second is called the total expense ratio, or back-end ratio, or debt-to-income ratio. It is the same except that the numerator includes the borrower’s existing debt service obligations, such as credit card or student loan payments.
For each of their loan programs, lenders set maximums for these ratios, which the actual ratios must not exceed. Following the financial crisis, these ratios were decreased. Emphasis also shifted to placing greater weight on the more inclusive measure.
- Lower maximum ratios on riskier transactions: Maximum expense ratios are not carved in stone. They are lower (more restrictive) for any of a long list of program modifications that are considered riskier. For example, the property is a co-op, condominium, second home or manufactured. Or the transaction is for investment rather than owner occupancy, the borrower is self-employed, or the loan is a cash-out refinance.
- Higher maximum ratios on less risky transactions: The following are circumstances where the limits may be raised:
The borrower’s high housing expense ratio is offset by exceptionally high disposable income.
The borrower has an impeccable credit record.
The borrower is a first-time home buyer who has been paying rent equal to 40 percent of income for three years and has an unblemished payment record.
The borrower is making a down payment well above the amount required. - Reducing expense ratios by changing the instrument: Before the financial crisis, expense ratios could be reduced by extending the term to 40 years, selecting an interest-only option, switching to an option adjustable-rate mortgage on which the initial payment did not cover the interest, switching to an adjustable rate mortgage with an exceptionally low interest rate for the first six or 12 months, or taking a temporary buy-down where cash placed in an escrow account was used to supplement the borrower’s payments in the early years of the loan. None of these options exist today.
- Using excess cash to reduce your expense ratios: If you have planned to make a down payment larger than the absolute minimum, you can use the cash that would otherwise have gone to the down payment to reduce your expense ratios by paying off non-mortgage debt, or by paying points to reduce the interest rate.
Just make sure that the reduced down payment does not push you into a higher mortgage insurance premium category, which would offset most of the benefit. This happens when the smaller down payment brings the ratio of down payment to property value into a higher insurance premium category. These categories are 5 to 9.99 percent, 10 to 14.99 percent and 15 to 19.99 percent.
For example, a reduction in down payment from 9 percent to 6 percent wouldn’t raise the insurance premium, but a reduction from 9 percent to 4 percent would.
- Getting third parties to contribute: Borrowers sometimes can obtain the additional cash required to reduce their expense ratios from family members, friends and employers, but the most frequent contributors in the U.S. are home sellers, including builders. If the borrower is willing to pay the seller’s price but cannot qualify, the cost to the seller of paying the points the buyer needs to qualify may be less than the price reduction that would otherwise be needed to make the house salable.
- Income is not necessarily immutable: While borrowers can’t change their current income, there may be circumstances where they can change the income that the lender uses to qualify them for the loan. Lenders count only income that is expected to continue and they therefore tend to disregard overtime, bonuses and the like. They will include overtime or bonuses only if the borrower has received them for the last two years, and the employer states on the written verification-of-employment form that they expect the payments to continue.
Borrowers who intend to share their house with another party can also consider making that party a co-borrower. In such case, the income used in the qualification process would include that of the co-borrower. The co-borrower’s credit should be as good as that of the borrower, however, because lenders use the lower of the credit scores of co-borrowers. The co-borrower must also be on the title and reside in the house. This works best when the relationship between the borrower and the co-borrower is permanent.
Meeting Cash Requirements
More homebuyers are limited in the amount they can borrow by the cash requirements than by the income requirements. They need cash for the down payment, and for settlement costs including points, other fees charged by the lender, title insurance, escrows and a variety of other charges. Settlement costs vary from one part of the country to another and to some degree from deal to deal.
The Federal Housing Administration requires 3.5 percent down on the loans it insures. Fannie Mae and Freddie Mac require 5 percent down on most of the loans they purchase, though lenders may raise it to 10 percent on larger loans. On jumbo loans that are too large to be purchased by the agencies, lenders generally require 20 percent down, though some lenders will accept 10 percent if the loan is not too large.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
