Most potential borrowers are
nervous about getting a mortgage loan because they share a widespread
misperception: the misperception is that they have no bargaining power
relative to lenders, and therefore must approach them hat in hand. That was
the way things were for much of our history, and the way things still are
in much of the world, but it has not been true in the US for many years.
Today lenders compete fiercely among themselves for good loans.
A "good loan" is one to
a borrower who has both the ability and the willingness to
repay it. If you can demonstrate both the ability and the willingness to
repay, lenders will be anxious for your business. You are in the
driver�s seat. If your position is weak on either score, you will be
limited to lenders who specialize in weak applicants and are prepared to
take larger risks. These lenders are fewer in number, and their interest
rates and other terms will be less favorable than those available to
Determining the borrower's ability
to repay is what "qualification" is all about; it is the subject
of this article. Determining the borrower's willingness to repay is
determined largely by the applicant's past credit history. For a loan to
be approved, the lender must be satisfied on both scores.
This is the difference between "qualification" and
The process of making a final
determination on approval or rejection is called
"underwriting". Underwriting involves verifying the
information that has been obtained from the borrower and that served as
the basis for qualification, as well as assessing information on the
applicant's credit worthiness.
Qualification and Affordability
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 it also
depends on the mortgage terms available in the market at the time you are
shopping. The tables below shows some ballpark estimates of affordability
based on the availability of 7% and 8% 30-year mortgages. For each of 7
sale prices, the table shows the total cash required to meet down payment
requirements and settlement costs, the total monthly housing expense, the
minimum income required to cover housing expenses, and the maximum amount
of debt service allowable on the minimum income.
To afford a $400,000 house, for
example, you need about $54,400 in cash, which assumes a 10% down
payment. With a 7% mortgage your monthly income should be at least
$11,200 and (if this is your income) your monthly payments on existing
debt should not exceed $895. The numbers are estimates mainly because of
variations in closing costs and in taxes and insurance.
House Can You Afford With a 7% 30-Year Mortgage?
To Spend This
Amount on a House�
You Need At Least
This Monthly Income�
To Cover This
Monthly Housing Expense�
Other Monthly Debt
Payments Should Not Exceed�
And You Need at
Least This Much Cash�
For the Down
Payment Lenders Are Likely to Require�
And the Closing
Notes: Minimum monthly income is
based on a ratio of monthly housing expense to income of 28%. Closing
costs include points and are assumed to total 4% of the loan. The maximum
monthly debt service payment is assumed to be 8% of minimum monthly
income. Monthly housing expense includes principal and interest, mortgage
insurance, taxes and hazard insurance. Taxes and hazard insurance are
assumed to be 1.825% of sale price. The down payment requirement is
assumed to be 10% on prices of $250,000-400,000, 5% on $150,000-200,000,
and 3% on $100,000. Mortgage insurance premium rates are .79% with 3% and
5% down payments, and .53% with a 10% down payment.
How Much House
Can You Afford With a 8% 30-Year Mortgage?
To Spend This Amount on a
You Need At Least This
To Cover This Monthly
Other Monthly Debt
Payments Should Not Exceed�
And You Need at Least
This Much Cash�
For the Down Payment
Lenders Are Likely to Require�
And the Closing Costs
Lenders ask two basic questions
about the borrower's ability to pay. First, is the borrower's income large
enough to service the new expenses associated with the loan, plus any
existing debt obligations that will continue in the future? Second, does
the borrower have enough cash to meet the up-front cash requirements of
the transaction? The lender must be satisfied on both counts.
Expense Ratios: In
general, the lender assesses the adequacy of the borrower's income in
terms of two ratios that have become standard in the trade. The first is
called the "housing expense ratio" and is the sum of the monthly
mortgage payment including mortgage insurance, property taxes and hazard
insurance divided by the borrower's monthly income. The second is called
the "total expense ratio" and it is the same except that the
numerator includes the borrower's existing debt service obligations. For
each of their loan programs, lenders set maximums for these ratios, such
as, e.g., 28% and 36%, which the actual ratios must not exceed.
Variations in the Ratios:
Maximum expense ratios actually vary somewhat from one loan program to
another. Hence, if you are only marginally over the limit, nothing more
may be required than to find another program with higher maximum ratios.
This is a situation where it is handy to be dealing with a mortgage broker
who has access to loan programs of many lenders.
But even within one program,
maximum expense ratios may vary with other characteristics of the
transaction, and this can work against you. For example, the maximum
ratios are often lower (more restrictive) for any of a long list of
program "modifications", such as, e.g., the property is 2-4
family, co-op, condominium, second home, manufactured, designed for
investment rather than owner occupancy, the borrower is self-employed, the
loan is a cash-out refinance, and combinations of any of these.
Ability to Raise the Maximum Ratios: The maximum ratios are not
carved in stone if the borrower can make a persuasive case for raising
them. The following are illustrative of circumstances where the limits may
The borrower is just marginally
over the housing expense ratio but well below the total expense ratio
� 29% and 30%, for example, when the maximums are 28% and 36%.
The borrower has an impeccable
The borrower is a first-time
home buyer who has been paying rent equal to 40% of income for 3 years
and has an unblemished payment record.
The borrower is making a large
Remember, lenders wantto make loans!
Your Expense Ratios by Reducing the Term: If expense ratios
exceed the maximums, one possible option is to reduce the mortgage payment
by extending the term. If the term is already 30 years, however,
there is very little that can be done. Few lenders offer 40-year loans,
and extending the loan to 40 years doesn't reduce the mortgage payment
much anyway. This is illustrated below for a $100,000 loan at 7%.
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 debt, paying points to reduce the interest rate, or
funding a temporary buydown.
The first two approaches will work
only in a small percentage of cases, however. For example, paying an extra
2.625 points to reduce the rate from 7% to 6.375% will reduce your housing
expense ratio by only about 1 percentage point.
This assumes, furthermore, that
the reduced down payment does not push you into a higher mortgage
insurance premium category, which would offset most of the benefit. For
this to happen, the smaller down payment must bring the ratio of down
payment to property value into a higher insurance premium category. These
categories are 5 to 9.99%, 10 to 14.99% and 15 to 19.99%. For example, a
reduction in down payment from 9% to 6% wouldn't raise the insurance
premium, but a reduction from 11% to 8% would.
Using the extra cash to pay off
debt will work only if a) you exceed the maximum total expense ratio but
not the maximum housing expense ratio (your ratios are 27% and 38%, for
example, when the maximums are 28% and 36%); and b) your existing debts
have short terms and high rates. For example, if you increase your loan by
2.6% and use the increase to repay debt, and if the debt has an average
rate of 15% and is being repaid over 5 years, you would reduce your total
expense ratio by about 2 1/2 percentage points.
Much the most effective way to
reduce both expense ratios is to use a temporary buydown, which some
lenders allow on some programs. With a temporary buydown, cash is placed
in an escrow account and used to supplement the borrower's payments in the
early years of the loan. For example, on a 2-1 buydown, the mortgage
payment in years one and two are calculated at rates 2% and 1%,
respectively, below the rate on the loan. The borrower makes these lower
payments in the early years, which are supplemented by withdrawals from
the escrow account. The expense ratios are lower because the payment used
is the "bought down" payment in the first month rather than the
total payment received by the lender.
For example, assuming a market
interest rate of 7% on a 30-year FRM, an increase in the loan amount of
2.5% will fund a 2-1 buydown, where the payment is calculated in year one
at 5% and in year 2 at 6%. This would reduce the expense ratio in year one
by about 4 1/2 percentage points.
It is relatively easy for lenders
to overcharge for temporary buydowns, and some do so. Read What
Is a Temporary Buydown?
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 US 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 or the
buydown escrow the buyer needs to qualify may be less than the price
reduction that would otherwise be needed to make the house saleable.
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 which can be
expected to continue, and they therefore tend to disregard overtime,
bonuses and the like. The burden of proof is on the applicant to
demonstrate that these other sources of income can indeed be expected to
continue. The best way to do this is to show that they have in fact
persisted over a considerable period in the past.
Borrowers who intend to share
their house with another party can also consider the feasibility of making
that party a co-borrower. In such case, the income used in the
qualification process would include that of the co-borrower. Of course,
the co-borrower would be equally responsible for repaying the loan. This
works best when the relationship between the borrower and the co-borrower
More borrowers are limited in the
amount they can spend on a house by the cash requirements than by the
income requirements. Cash is needed for the down payment, and also 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
Down payment requirements range
from 30% to zero and below -- in some cases, lenders will lend more than
the value of the property. The requirements depend on the type
of program, loan amount, property characteristics, and the borrower's
VA-guaranteed loans (available
only to veterans) require no down payment on loans up to $203,000.
FHA-insured loans also require no down payment, with loan limits that vary
by area, topping out at $219,849 in the highest cost areas.
On conventional (non-VA non-FHA)
prime loans, the lowest down payment requirement is generally 5% on loans
up to $400,000. It notches up quickly after that and is generally 40% on a
$1,000,000 loan. Some special affordability programs are available from
Fannie Mae and Freddie Mac with 3% down on loans up to $275,000.
On subprime loans, which carry
higher interest rates, some lenders will advance up to 125% of property
value to borrowers with good credit ratings.
Down payment requirements will be
higher whenever a transaction has characteristics that lenders view as
risky. The million dollar loan has a high requirement, for example,
because it is secured by an expensive house which may have unique features
which appeal to a limited number of potential buyers, and is therefore
subject to much greater price variability than a less expensive house. For
similar reasons, lenders will usually require a larger down payment if the
borrower has a poor credit record, is purchasing a house as an investment
rather than for occupancy, wants to refinance for an amount significantly
larger than the existing balance, and so on.
In general, lenders want borrowers
to meet the down payment requirement with funds they have saved because
this indicates that the borrower has the discipline to save, which bodes
well for the repayment of the loan. For this reason, they may restrict the
amount of the down payment that is provided by gifts from family and
friends. (Borrowers looking to parents for a major chunk of the down
payment should make sure the money is in their own account several months
before they apply for a loan). Borrowed funds will raise their hackles
even more, since they impose an additional repayment obligation on the
Copyright Jack Guttentag
Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.
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