The Three C's of your mortgage Loan Approval. Part Two.
February 06, 2014In my last column, The Three C's of Your Mortgage Loan Approval, Roadrunner Jan. 15, 2014, I talked about Credit. This week let's look at the second of the three Cs – Capacity.Capacity is the ability to make your mortgage payments. The most important part of capacity is what is known as a "debt ratio."
A borrower's income is calculated on a monthly basis. Coming up with this number is an art in itself. A W-2 employee who gets no overtime or bonus income is fairly easy to calculate. Just take the yearly income and divide by 12.
If there is bonus or overtime income, this is generally averaged over two years, unless it is declining from year to year, in which case the number used may be reduced or eliminated completely.
A common mistake when calculating income for someone who is paid weekly is to multiply the weekly income by 4 to get the monthly income. This will actually underestimate the monthly income since there are 4.3 weeks in the month. To calculate correctly, the weekly income is multiplied by 52, and that number is divided by 12.
If there is 2106 expense – otherwise known as unreimbursed employee expenses – that number is subtracted from the income as calculated above.
Self employed borrowers can pose an additional challenge. For a business with increasing income over the last two years' tax returns, the income of the last two years is averaged. However, like bonus or overtime income, if the income is declining we may take the lower of the two years instead of the average.
Another common mistake is to try to use the "gross" business income instead of the "net." Using the Schedule C as an example, start with the bottom line of the form, then add back in business use of the home and the depreciation to come up with the yearly income.
Once there is a good income calculation, that number is divided into the proposed housing expense. This is the sum of the principal and interest on the loan, property insurance, property taxes, Homeowner's Association fees, and mortgage insurance. The result is called the "front end" or "housing expense" ratio. An ideal front end ratio is 28 or less. That means 28% of the borrower's gross income By John yeager is going toward the expense of owning a home. In Southern California it is not unusual for the number to be much higher due to our high housing costs.
To calculate the "back end," or total debt ratio, to the housing costs are added other debts such as student loan payments, credit cards, car payments, etc, which are then divided by the income. This number is best at 36 or less.
The new Dodd-Frank regulations that went into effect on January 10th, 2014 cap the total debt ratio at 43 in most cases, although exceptions do exist.
The next part of capacity is "cash reserves." Certain loans, such as FHA and VA loans, require no cash reserves after buying a home. Even though the loan guidelines may allow this, it is not necessarily a good idea. In addition, the loan may not pass underwriting if the borrowers have little or no reserves. 2 months worth of payments in the bank is the beginning of a reasonable reserve. Certain loans require 12 or even 24 months payment reserves in the bank.
The number of borrowers is also a feature of capacity. Two wage earners will be considered to have less of a risk than one. The idea being that if one of the borrowers gets ill and can't work, for example, there is a least some income that can be used to make house payments.
The last part of capacity is the "type of loan." 30 year fixed rate loans are the most common. A 15 year fixed rate loan carries less risk for the lender, but the higher payments on this loan versus a 30 year fixed rate loan make it harder to get. Adjustable loans carry higher risk, and the recent changes under Dodd-Frank have tightened the underwriting of these loans.
Another way to classify loan type is by "purpose." Is it a purchase or refinance? Is it a rate and term refinance where the balance stays the same, or a cash out refinance where the borrower gets money in hand when the loan funds? Of these categories, a cash out refinance has more risk and depending on other factors my carry a higher interest rate.
Next week – Collateral.
John Yeager is the Valley Center Branch Manager for Summit Mortgage, NMLS #219612. He can be reached at 760-749-8931 or by visiting www.john-yeager.com' target='_new'>www.john-yeager.com">www.john-yeager.com, or via email at firstname.lastname@example.org