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Introduction
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 ¸ 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) ¸ 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.
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