How do lenders decide how much I can borrow

From a lender's point of view, a "good loan" is one to a borrower who can demonstrate both the ability and the willingness to repay it. Qualification has to do with determining the borrower's ability to repay only. The borrower's willingness to repay is assessed 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 "approval."

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 require ments of the transaction? The lender must be satisfied on both counts.

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. It 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. 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 28% and 36%, which the actual ratios must not exceed.

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 the property contains two to four separate dwelling units, the property is a co-op or a condominium or a second home or manufactured or 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.

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 be waived.

  • 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 credit record.
  • The borrower is a first-time homebuyer who has been paying rent equal to 40% of income for three years and has an unblemished payment record.
  • The borrower is making a large down payment.

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, anyway, extending the loan to 40 years doesn't reduce the mortgage payment much.

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 (points are fees the borrower pays the lender at the time the loan is closed) to reduce the interest rate, or funding a temporary buy-down.

The last is the most effective. With a temporary buy-down, which some lenders allow on some programs, cash is placed in an escrow account. An escrow account is a deposit account maintained by the lender and funded by the borrower, from which the lender makes tax and insurance payments for the borrower as they come due. But in this scenario, cash is also used to supplement a borrower's mortgage payments in the early years of the loan.

For example, on a 2-1 buy-down, 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.

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 United States 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 making the contribution the buyer needs to qualify may be less than the price reduction that would otherwise be needed to make the house saleable. (See "What is the down payment?" in Chapter 3.)

There may be circumstances where borrowers can change the income that the lenders use to qualify them for the loan. Lenders count only income that can be expected to continue, so they tend to disregard overtime, bonuses, and the like. The burden of proof is on the applicant to demonstrate that such 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 is permanent.

To qualify, applicants also need enough cash for the down payment and settlement costs. In the United States, however, mortgage insurance has substantially reduced down payment requirements. The quid pro quo is the mortgage insurance premium, which is like a higher interest rate.

On Federal Housing Administration (FHA) loans (see Chapter 4) and Veterans Administration (VA) loans, down payment requirements have been largely eliminated and all borrowers pay an insurance premium to the government. On conventional (not FHA or VA) loans, borrowers who put down less than 20% pay for private mortgage insurance. Premium categories are 15-19.99%, 10-14.99%, 5-9.99%, and 3-4.99%, with the premium rate highest for the last category.

In general, lenders want borrowers who put less than 20% down to meet the requirement with funds they have saved, as opposed to 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. Funds borrowed for the down payment raise lender hackles even more, since they impose an additional repayment obligation on the borrower.

Recent years have seen the emergence of zero-down or 100% loans, as well as 107% and 125% loans. These loans carry higher interest rates rather than mortgage insurance premiums and they generally require that the borrower have excellent credit.

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