Relying on Ratios; What Lenders Look at When Approving a Mortgage

There are several factors that mortgage lenders consider when determining if a borrower is credit worthy. The borrower’s income, credit score, employment history, reserves, and assets are all considered. However, key pieces of information that lenders rely on before committing to lend are qualifying ratios and the loan-to-value ratio.

What is a ratio?

A ratio is simply looking at how much there is of one thing and comparing it to how much there is of another thing. Mortgage lenders use these comparisons to determine if an individual will be able to fulfill their financial obligations after obtaining a home loan.

Qualifying ratios:

These ratios compare monthly debt obligations to the amount of income a borrower generates. There are two components: the housing ratio and the total debt ratio. Both ratios use a similar calculation and are expressed in terms of a percentage.

Housing ratio (also referred to as front-end debt-to-income ratio) compares total monthly housing related costs against gross monthly income. Total housing payment consists of PITI: principal, interest, property taxes, hazard insurance and mortgage insurance and if applicable, any condo/co-op or association fees.

Total debt ratio (also referred to as back-end debt-to-income ratio) compares a borrower’s total monthly housing payments PLUS any other recurring monthly debts against gross monthly income. These debts include car payments, student loans, personal loans, credit cards, etc.

Acceptable DTI ratios:

Acceptable ratios vary based on the lender, loan program and other factors, but in general, the lower the better. DTI indicates what percentage of a borrower’s monthly income needs to go toward paying debt and if too high, it may result in a loan denial.

Most lenders prefer a housing (front-end) ratio to be less than 28% and a debt (back-end) ratio no higher than 43%. Again, this can vary depending on the lender, loan program, and the borrower’s overall financial picture but staying under these ratios demonstrates the ability to meet ongoing financial obligations while still affording the expenses of daily living.

Loan programs backed by the government, may allow for higher ratios based on compensating factors such as a low loan-to-value (LTV) ratio, an excellent credit score or substantial reserves.

Calculating ratios:

To calculate front-end DTI (housing) ratio, the lender will add up the estimated principal, interest, property taxes and insurance and divide this total by the borrower’s monthly income, then multiply by 100. (Total monthly PITI ÷ gross monthly income x 100 = DTI%). For example, if the monthly housing cost is $1,200, and the borrower’s gross monthly income is $4,855 (1,200/4,855 = 0.2471 x 100) that equates to a 24.71% housing ratio.

Using the same example income and housing costs, let’s say the borrower’s additional monthly debts come to $800 for student loans, credit cards and a car payment. This would equate to a back-end DTI of 41.19%. (1,200+800 = 2,000/4,855 = 0.4119 x 100).

While this ratio isn’t unacceptable, the borrower in this scenario may find it easier to get approved for a government-backed mortgage, like an FHA or a USDA Rural Development (RD) loan rather than a conventional loan.

Loan-to-Value (LTV) ratio:

Another key factor when it comes to qualifying for a loan, is the Loan-to-value ratio of the property being mortgaged. LTV is described as a percentage of the loan amount against the purchase price or value of the property.

For example, a borrower who is buying a home valued at the purchase price of $300,000 and has a down payment of $30,000 is obtaining a loan for $270,000. $270,000 divided by $300,000 = 90% LTV.

Lenders use this ratio to evaluate their risk of lending. The higher the LTV, the riskier the loan. A higher LTV does not however, prevent a borrower from obtaining a loan. Instead, to offset the risk, borrowers will pay what is known as mortgage insurance.

Depending on the loan program, mortgage insurance can be paid upfront, monthly or both.

Some loan programs have set LTV thresholds that cannot be exceeded. The United States Department of Housing and Urban Development (HUD) for example, has established a maximum LTV on FHA loans of 96.5%. In other words, borrowers who utilized the FHA loan must have a down payment of at least 3.5% of the purchase price.

Other loan programs however, such as the Department of Veteran Affairs VA loan or the United States Department of Agriculture (USDA) Rural Development loan, allow up to 100% LTV, meaning no down payment is required.

How to improve DTI and LTV ratios:

DTI and LTV are key factors in determining if and what type of loan a borrower qualifies for and at what cost. Borrowers with low LTV and DTI ratios will be eligible for a wider range of mortgage products, get better interest rates and lower their costs of borrowing.

Ways to improve DTI:

• Pay off debt: Prior to applying for a mortgage, borrowers should get a sense of how much total debt they have and find ways to improve it. Tactics like the “snowball method” or the “waterfall method” may help reduce debt. Also, borrowers should avoid taking on any new debt when preparing to buy a home.
• Refinance existing loans: Refinancing to extend the loan term can reduce the amount owed each month. Refinancing for a better interest rate may help to pay the loan off faster.
• Negotiate on credit cards rates: Contacting the credit card issuer to secure a lower annual percentage rate (APR) can impact how much of each payment is going toward the debt owed.

Ways to improve LTV:

• Negotiate: When buying a home, negotiating with the seller for the best price possible may help lower the LTV.
• Increase down payment: One way to decrease LTV is to put down more than the minimum down payment required.
• Consider other homes: Borrowers with little room to increase their down payment could consider a less costly home to improve LTV.

The Bottom Line:

Understanding debt-to-income and loan-to-value ratios can help potential homebuyers maximize their ability to obtain a mortgage and get better terms. Making a plan to reduce debt, holding off on large purchases, increasing down payment savings and being open minded to less expensive homes, are all ways to improve these ratios.

One way that borrowers can know for sure how these ratios will affect their ability to buy is to work with a MiMutual Mortgage Loan Officer even before they start looking for a home. Developing a strategy early is the best way to ensure homeownership.