August 14th, 2009 4:07 PM by Dan Marchiando
Let’s say a lender qualifies our intrepid home shoppers Kyle and Steph for a certain loan amount—the “maximum loan amount.” Can they really afford it? Or will they be comfortable paying that amount?
Home buyers should not assume that just because the lender will qualify them for a certain loan amount, that that is in fact the loan amount they should seek.
I’ll try to explain what I mean here. In spite of tougher lending standards today in 2009, lenders still approve loans where the borrowers spend a high percentage of their income on debt payments. When underwriting a loan, a lender computes and looks at two different debt ratios. In simple terms, a debt ratio is just expenses divided by income, or the percentage of income that gets consumed by recurring payments. The first of these ratios is the Housing Ratio, and the second is the Total Debt Ratio. Some lenders only consider the Total Debt Ratio which is always the higher of the two ratios anyways.
Lenders do not consider the borrower’s age, tax situation, plans for retirement, plans for a new car or vacation, or plans for a family. Borrowers know their circumstances the best and should adjust their borrowing to suit their particular situation.
The Housing Ratio is computed in this way: The lender adds the total monthly principal and interest payment of the proposed loan(s), to the monthly cost of property taxes (in California they always assume 1.25% of the purchase price), plus the monthly cost of homeowner’s insurance, plus the monthly cost of a homeowner’s association condo or PUD fee. Utilities and maintenance are not included. Payments are broken down into monthly amounts, even though in reality they may be paid annually or semi-annually (i.e. insurance and property taxes). All these housing costs are then divided by the GROSS Income of the borrowers to compute the borrowers’ Housing Ratio.
The Total Debt Ratio is computed by taking all the housing costs discussed above, plus all the other monthly “debt” payments, and dividing that by GROSS Income. Examples of other monthly debt payments include all the required minimum payments from credit card accounts, plus car loan and lease payments, plus student loan payments, plus alimony and child support, etcetera, etcetera. It bears mentioning that lenders do not consider the outstanding balance of credit card revolving accounts in the equation, even if it is the borrowers’ habit to pay off credit card balances every month. Lenders only take into account the minimum payment that requires payment each month. Generally this amounts to about two percent of the outstanding balance at the time the statement cycle ends. So a credit card account with a $1,000 balance on the monthly statement might have a minimum payment of only $20, and this would be the minimum payment that a lender would use to compute the Total Debt Ratio. While this practice may increase the maximum mortgage that borrowers qualify for, it may conflict with the actual habit or intention of borrowers who choose not to carry balances on their credit cards.
I think it is important here to emphasize that all lenders use GROSS Income, not “take-home” pay or NET Spendable Income, which is the income that is left after taxes, social security, SDI and everything else is taken out. Think of Net Spendable Income as the amount that you might actually receive on your pay check.
Many lenders allow Housing Ratios and Total Debt Ratios to exceed 50% of GROSS Income and to approach 60% of GROSS income, and this is where the rub can come. For some people, these “one-size-fits-all” ratios may be too much. I think it might be easiest to explain my point by using an example.
Borrowers Kyle and Steph have combined GROSS income of $8,000 per month, but after taxes etcetera, they take home about $5,515. They charge ordinary expenses to their credit cards and pay off the balance most every month. This is where their monthly money goes as renters:
Household Budget as Renters
Gross Combined Income:
Net Spendable Income After Taxes etc. (take home pay):
Utilities, Cable and Internet:
Steph's Car Payment:
Car Insurance 2 Cars:
Car Maintenance and Washes:
Gas for 2 Cars:
Retirement: $200 each to Roth IRA
Saving for House Down Payment:
Medical, Dental, Eye Care and Deductibles:
Pocket Money for Lunches, Dry Cleaning etcetera:
Charged to Credit Cards and Paid Off Each Month:
Food and Meals Out:
Credit Card Misc:
Gifts and Christmas:
Total Monthly Credit Card Charges:
Total Monthly Expenses:
Now a lender qualifying borrowers Kyle and Steph may decide that they can afford to spend 50% of their GROSS income on housing, or $4000 in this example. What affect would this have on their monthly budget? Well, $4000 is the majority of their “take-home” pay! Now they will most likely realize some income tax savings eventually, which means that their spendable income could increase in the future. And they will no longer be paying rent or saving for a down payment. But they will have maintenance costs for the home that they didn’t used to have. So here’s what their monthly budget might look like immediately after they purchase a home:
Household Budget as Homeowners v.1
New Housing: mortgage, prop taxes, insurance
Charged to Credit Cards:
As you can see, their income doesn’t cover all their expenses, and they “go-in-the-hole” by $914 if they don’t change their spending habits. Can they align their spending with income again? Let’s see if we can help them trim some expenses:
Household Budget as Homeowners with Expenses Trimmed
Total Monthly Credit Card Charges
If Kyle and Steph are willing to give up HBO, wash their cars in their new driveway, stop saving for retirement temporarily, take more brown bag lunches, cancel their gym membership, suspend taking vacations, cut out restaurant meals, slash their gift giving and defer some maintenance on the house, they can almost make it. As you can see, Kyle and Steph have to make a lot of sacrifices to their lifestyle to make this scenario work.
This exercise is not intended as an indictment of lending practices, or as an indictment of home ownership. Rather it is a cautionary exercise to use good sense when asking to be qualified for the MAXIMUM loan amount. Take the time to crunch the numbers yourself, to determine what you can comfortably afford. With careful thought you are probably the best person to determine what you can afford.