Any conversation of debts should begin with a discussion of ratios. There are two different kinds of ratios that a lender will use when examining your ability to qualify. The first ratio is the mortgage ratio. The mortgage ratio is the ratio obtained when we take your mortgage payment and divide it into your gross income. Your mortgage payment would consist of the principal and interest on your new mortgage, homeowner’s insurance, property taxes, applicable flood insurance, applicable Private Mortgage Insurance, and applicable Homeowner’s Association (HOA) fees. (Note: If you are purchasing a 2nd home or investment property, the mortgage ratio is always based on your current primary residence housing expense)
Mortgage ratio requirements can vary depending on several factors including the type of loan (FHA, VA, Conventional), and can range from 33% to 45% however, with some FHA options the housing ratio could be as high as 50%.
The other ratio that will be considered is your debt ratio. This is simply calculated by taking the mortgage ratio and adding to it any applicable debts that you will be carrying on a monthly basis once you close. Debt ratio maximums may be anywhere from 45-50% on conventional financing and 55-60% on FHA and VA. These requirements will vary depending on other compensating factors such as credit, down payment, etc.
What Types of Debt Will Lenders Look At?
There are several different kinds of debts that the lender will take into consideration.
Installment debt involves a fixed initial balance that is to be paid back over a fixed period. This type of debt would include car loans, student loans, and personal loans. Debts such as child support, alimony, and accounts payable would also fall under this category. The lender will consider what is paid out monthly and count that towards your ratios. If there are fewer than 10 months remaining on installment debt at the time of closing the lender will usually not count the debt against you. As a result, one solution for high ratios is to pay down installment debt to less than 10 months and consequently not have it counted against you.
The one exception to this is car leases. Most lenders believe that if your lease is running out, chances are you will still need a car, therefore, there is a great likelihood that you will go out and buy or lease another car at the end of your current lease term. In this way, they rarely will allow you not to count an auto lease towards your debt.
A unique exception to installment loans in almost all cases is a loan against your 401K. This type of monthly obligation is generally not counted against your ratios since the agencies consider this a repayment to yourself.
The next type of debt is revolving debt. This would consist of any form of credit where you receive a credit line that can be drawn up again once it is paid down. This would include credit cards and revolving lines of credit.
With revolving debt, the lender will apply the debt as it exists at the time of application. Generally, the lender will take the minimum monthly payment required for the credit card, as it appears on the credit report, and this will serve as the “snapshot” payment requirement that the lender will use for qualifying. This is fairly critical because information on credit reports can be as dated as 60 days. Keep this in mind when you’re applying and you know your situation will be tight. Always try to pay down your cards as much as possible at least 60 days prior to application. Most banks will allow you to pay off your credit cards to qualify, however unlike installment debt which needs to be paid down to 10 months, credit cards generally need to be paid off in order to eliminate the obligation.
The last type of debt is mortgages. If you own additional property, the principal, interest, taxes, insurances, and HOA fees will count in your debt ratio. If you own rental property and have a tenant to help offset expenses, the bank will allow the rental income to be counted. The bank will usually ask for 2 years of federal tax returns to verify your rental income after expenses. As with commission or bonus income, they will use a two-year average of income brought forward from Schedule “E” of your return to qualify. They will, however, allow you to add back items such as depreciation since this simply represents a paper loss. If you have owned the property less than two years the bank will allow you to use leases and mortgage statements to qualify, however, they will always back out a vacancy and maintenance factor. This is usually 25% on conventional rate mortgages. This means that if you have a rental income of $1000.00 the bank will only give you credit for $750 to offset the mortgage on the property.
Example: If your PITI payment on an investment property that you have owned for less than 2 years is $1500/ month and you are receiving $1200/month in rent the bank would allow you credit for $1200 x 75% or $900 per month. In this way your debt obligation on this property would be $1500 less $900 or $600 per month that would be counted towards your debt ratio for qualifying.
Finally, bear in mind that any money you would use to pay down debt to qualify would be subtracted by the bank from your eligible cash to close. Make sure that after paying down your debt you are still showing enough funds to cover your down payment, closing costs, and reserves.