Qualifying for a Home Loan Overview

An aura of mystery surrounds the mortgage lending industry. The vocabulary of loan officers and underwriters is filled with acronyms like "LTV" and "FNMA" while the payment calculations on a loan is enough to put a look of worry on any high school algebra student. Compounding it all are the thousand and one mortgage loan programs that are offered every day. You can get terms of 30 years, 15 years or less. There are fixed rate loans, adjustable rate loans and combinations of the two. The whole point is that as an advisor, a counselor, or a consumer, it is up to you to know which are the right programs for you or for your clients. To help you make an intelligent decision, this manual summarizes many of the financing options as well as the pluses and minuses of each. In addition, you will be informed as to the requirements of each to allow you and your clients the greatest flexibility of financing options available.

Before deciding which program best fits your needs, it is important to be able to understand the basics behind each program. The key to understanding mortgage basics lies into three areas: 1) What is the loan-to-value ratio? 2) What are their income ratios? and 3) What is their credit score?

Loan-to-Value Ratios

The loan-to-value ratio (LTV) is probably the most important of all the ratios when deciding to approve a mortgage. The lower the LTV ratio the safer the loan is for a lender. The reason is that the lower the LTV ratio, the higher the equity investment the borrower will have in the property and thus the more the borrower has to lose. Stated as a percentage, the LTV essentially determines the level of risk in the repayment of the loan. The LTV is calculated as follows:

Mortgage Amount divided by Lesser of Sales Price or Appraised Value = LTV

LTV’s will vary from program to program, depending upon other "risks" associated with the program. Traditionally, guidelines have stated that the LTV should not be any higher than 75 to 80%. With the advent of mortgage insurance, LTV’s have been stretched as high as (and in some cases exceed) 95% of the value of the property.

Income Ratios

Before a loan can be approved, a mortgage underwriter is concerned with a borrower’s ability to repay the mortgage debt. The most important test of whether an applicant can afford a particular loan is by computing the various income ratios. These ratios, often established by the secondary market, have evolved through the years after reviewing millions of mortgage loans and are used as realistic guidelines for making mortgages with a low risk of default. Underwriters look at two income ratios: 1) the monthly housing ratio (or front-end ratio, as it is sometimes called) and 2) the debt-to-income ratio (or back-end ratio).

The monthly housing ratio is calculated by determining what percentage the proposed mortgage payment (PITI) would be in relation to the borrower(s) gross monthly income as follows:

PITI divided by Gross Monthly Income = Monthly Housing Ratio

PITI is an acronym that stands for principal, interest, taxes and insurance and includes not only the monthly principal and interest payment but also the hazard insurance payment, mortgage insurance payment, flood insurance payment, homeowner’s association dues and 1/12 of the annual property taxes.

However, individuals often have other monthly debt obligations in addition to mortgage payments. The ratio of these combined debts to gross monthly income must be calculated separately. This ratio is called the debt-to-income ratio and is calculated by dividing the sum of the PITI payment plus the minimum monthly debt payments by the gross monthly income. Also stated as a percentage, calculate it as follows:

(PITI + Mthly Debt Pmts) divided by Gross Monthly Income = Debt-to-Income Ratio

Other debt payments include revolving charges (credit cards, department store cards, etc.), payments on installment debts that have more than 10 remaining payments (car loans, student loans, signature loans, etc.) and any alimony and/or child support payments.

Credit Scoring

In the past 50 years, American society has been radically altered by the "credit revolution." Everyone has credit cards, uses credit to buy cars, furniture, clothing, and even food. No longer are items bought with cash but rather on a line a credit or some type of financing. How much you are worth is often tied directly to how much you can borrow. Having a bad credit rating can hinder your ability to buy, especially in regards to home ownership. Too much debt can and has trapped people into a life without savings where they are chained to scrapping by to just make the minimum payments on their credit cards.

Within the last year or two, creditors have become increasingly dependent upon credit scoring. Credit scores (also known as risk scores) are a numerical interpretation of your credit profile. The score predicts how likely consumers in a specific score range will repay their debts. Experian, for example, uses the Fair Isaac Model (FICO) to determine a risk score with a range from 200 to 900. The higher the number, the better the credit history.

With the advent of the credit scoring revolution, many lenders require borrowers to have acceptable credit scores to obtain a mortgage. In late 1996, for example, the Federal National Mortgage Association (Fannie Mae) instituted minimum acceptable credit scores for all loans they purchase. Many people who once qualified for a mortgage under Fannie Mae guidelines now have to turn to alternative sources for financing a home. This translates into higher interest rates, prepayment penalties for early retirement of the loan, and a larger down payment on a home purchase.