Loan Qualifying Standards:
Conventional Measures


Our intention is to provide our clients with enough background information to help them understand the basics of financing a real estate transaction, and the knowledge to ask Lenders questions other than "What's the interest rate today?" Even though the subject matter may be cumbersome at times, we feel it is important enough in robust market areas for any Buyer to explore the possibility of investing in property.

Loan Underwriters follow the guidelines established by Fannie Mae and Freddie Mac to ensure the salability of loans they grant in the secondary market. For this reason, it is not enough for Borrowers to calculate expense amounts for a particular purchase. That is just the beginning.

Among other qualifying characteristics, such as good credit, sources of income, and expense obligations, Borrowers must also offer a favorable comparison between their expenses and their total income. This is known as the "expense-to-income ratio." There are two types of expense-to-income ratios Loan Underwriters calculate when qualifying a Borrower: "housing-expense-to-income" ratio (maximum qualification) and "total-debt- to-income" ratio (minimum qualification).

Housing-Expense-to-Income Ratio

Monthly housing expense includes all the costs associated with property ownership; for example, mortgage principal and interest payments, principal mortgage insurance (PMI, when owner equity in the property is less than 20%), property taxes and insurance (PITI). The sum of these costs is compared to the Borrower's total income. The suggested standard housing-expense-to-income ratio is currently 36%.

The following example shows how to calculate this ratio at the rudimentary level. (To do the calculations, you will need to see or download the Amortization Table from the Northwest Eddy Library.)

Purchase price: $600,000
Down payment: $120,000
The property taxes for a given year are $8,500 and annual insurance premium is $1,400, interest rate is 6.0%.

To determine the housing expense for a 30-year fixed, fully amortized loan:
1. Subtract 120,000 (down payment) from 600,000 (purchase price) to arrive at 480,000.
2. Divide 480,000 (loan principal) by 1,000 resulting in 480.
3. Look at the Amortization Table's grid under Row "6.0%" (interest) and Column "30 year" (loan term).
4. Multiply 480 by 6 (number which appears in the intersection of the row and column mentioned in Step 3) to get 2,880 (PI).
5. Dividing 8,500 (annual property taxes) by 12 (months) equals 708.34.
6. 1,400 (annual insurance premium) divided by 12 (months) equals 116.67.
7. 2,880 (PI) plus 708.34 (property taxes) plus 116.67 (insurance premium) equals 3,705.01.(PITI).

The housing expense on this transaction is estimated at $3,705/month (PITI). To determine the minimum amount of income needed to qualify for financing this transaction, divide 3,705 by 36% (acceptable housing expense to income ratio). The answer is 10,291.

Total Debt to Income Ratios

To calculate this ratio, Loan Underwriters add up all the Borrower's monthly debt service payments; such as credit card payments, student loans, car payments, revolving loans and other real estate loans, and compare the result with the Borrower's monthly income. The suggested standard total-debt-to-income" ratio is also 36%.

If we were to continue with the example above... in addition to the housing expense of $3,705/month, for example, let's assume you have additional monthly debt payments equaling $5,000. To determine the minimum amount of income you would need to qualify for financing this transaction:

1. Add 3,705 (PITI) to 5,000 (other debt payments) to get 8,705.
2. Dividing 8,705 (monthly expenses) by 36% (acceptable total debt to income ratio) equals 24,180.

The buyer in this example would need a total income of at least $24,180/month. "Quick & dirty" calculation: take your monthly income, multiply this figure by 36%, and subtract your monthly debt payments other than housing expense. The balance is your mortgage payment allowance.

The Loan Underwriter will take into consideration both these figures to determine the amount of risk involved in authorizing a loan. However, it is important for you to realize that the suggested 36% housing-expense-to-income ratio and total-debt-to-income ratio standards are very conservative underwriting guidelines.

How Does One Qualify for a Loan?

We strongly urge you to consult a Lender as soon as you have determined that you are interested in investing in any properties. Many Lenders have become more creative by introducing financial loan programs which enable Borrowers to qualify for the same loan principal amount as used in the example above, but at lower monthly payments. This allows the Borrower to have higher ratio levels than the suggested 36% standard.

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