For years, mortgage lenders have used the ratios of 28 percent and 36 percent for sizing up borrowers as commonly as bakers have used a tablespoon or a cup in measuring out the quantities dictated by a recipe.
Lenders long held to the conventional wisdom that a mortgage payment should not total more than 28 percent of a borrower’s gross (before tax) monthly pay, and that all his debts, including the mortgage, shouldn’t eat up more than 36 percent of the total monthly paycheck.
Conventional wisdom worked pretty well until recently, when something better came along. Experts say sophisticated computer technology and statistical analysis provide a better predictor of how well a borrower will pay his mortgage than does the judgment of a human loan officer who relies on reviewing paper documents such as income tax returns and who employs accepted industry standards.
“Ratios don’t even matter anymore,” says Terry Meland, president of The Mortgage Alliance Corp. in Evanston. What has happened, explains Meland, is that the large agencies that buy mortgages from lenders, such as Fannie Mae, have used computers to scrutinize accumulated data on millions of mortgage borrowers. From that sophisticated analysis, lending organizations now know that borrowers who fit certain profiles are excellent risks.
For instance, if you have a good credit history, and don’t have umpteen credit card accounts, the computer will spin out a good “credit score” on you. (Numbers for credit scores sound a whole lot like scores on the SAT college entrance exam. A respectable score is over 620, say lenders. A really top-notch score is in the 700s.)
“Credit scoring has definitely changed the world,” says Richard Garrigan, a finance professor at DePaul University. “If you have a score in the high 7s, you can pretty much get the money you want, because you have demonstrated a capacity to pay your bills and an ability to manage your financial affairs that suggests you know what you are doing.”
While a credit score is key, it is not the only important factor in the computer analysis of a borrower, notes Maureen Warren, a vice president in Fannie Mae’s Chicago office. “A credit score is one element, but also in the mix is the amount of down payment and the steadiness of a borrower’s income.”
When a computer gives the nod to a borrower, explains Ken Perlmutter, president of Perl Mortgage in Chicago, he can be approved for a very big mortgage in relation to his income. “I have heard of some borrowers whose total indebtedness was 65 percent,” says Perlmutter. Although, he notes, that’s the real extreme. More common, he and other lenders say, are borrowers who are devoting 44 percent or so of their total pay to debt.
“When you consider that we are talking about before-tax pay, that is really a big chunk,” says Reed Brunzell, senior loan consultant with Hartford Financial Services in Skokie.
More liberal underwriting standards mean good news for home buyers who couldn’t get the mortgage they needed under the old 28-36 rules. Meland relates that he recently was able to grant a loan to a single woman who suddenly found herself paying 75 percent of her income in rent after her roommate suddenly moved out of the apartment. She decided to buy instead of hunting for another rental, and her new mortgage and other debts, such as her car loan, totaled 50 percent of her monthly pay. “She couldn’t have received the loan 10 years ago, but today she can,” says Meland.
Of course, not every loan applicant walks out of a lender’s office with approval for whatever size mortgage he requests. For one thing, not all lenders use computerized or “automated” underwriting systems. Some lenders still do things the old-fashioned way, and stick relatively closely to the old ratios relating debt to income. For another thing, the more sophisticated analysis may actually severely restrict how much you can borrow.
“Maybe the ratios will be even stricter,” notes Warren, if a loan applicant’s credit, amount in down payment and other factors don’t fit the computerized model of what makes a reliable borrower.
When borrowers don’t come up to snuff, says Larry Schaal, loan officer with Presidential Mortgage Co. in Arlington Heights, he often counsels them to pay off credit card debt to boost a credit score, and then reapply for a loan after a few months. Because some borrowers can’t immediately obtain the loan they want, Schaal says he recommends the growing practice of getting “preapproval” for a loan, or seeing a mortgage loan officer for information on the amount you’re eligible for before actually signing a contract to buy a home.
Ironically, adds Schaal, some borrowers who have marred credit that resulted from an unusual event, such as an accident or illness, can find the loan they need if they submit documentation to a lending organization that relies on human underwriters. “Sometimes I want a real body to look at it (a borrower’s application) so that he can understand (the extenuating circumstances).”
And, of course, just because a borrower can qualify for a big mortgage that eats up a sizable portion of his income, doesn’t mean he will actually want to live in a stately home, eating a diet of macaroni and cheese and dimming the lights and thermostats to keep costs down.
“We warn people that there are two numbers,” says Dru Bergman, director of the DuPage Homeownership Center, a non-profit organization in Wheaton that counsels first-time home buyers. “One is what you qualify for, the other is what you can sleep with at night.”
When Mike and Kate Swihart recently bought in Wheaton, it was a house priced lower than they could have qualified to purchase. But a smaller, more affordable home was definitely more comfortable financially. “We pay private school tuition, and for us the education of our kids was more important than having a bigger house,” says Kate.
The wisdom of taking on a hefty mortgage in relation to your income depends in part on whether you’ll experience “payment shock,” contends Meland. “Let’s take a young couple who are renting,” he says. “Given the cost of rent these days, they may be paying a big part of their income on rent. If the mortgage isn’t that much bigger, they are really not altering their budget at all.”
Making a careful comparison of what your budget will look like before and after the purchase is just what Bergman urges all home buyers to do before they actually sign mortgage and purchase contracts.
“List your current rent or current mortgage, and all your current expenses,” says Bergman. “Then plug in the mortgage amount that you are prequalified or preapproved for. Then figure in other expenses that you’ll add as a new homeowner. For instance, maybe you’re not paying for water and sewer now if you’re a renter; maybe your commute to work will be longer; maybe, if you have a bigger house, you’ll have a bigger electric bill than you currently pay.”
If you don’t think you can easily meet the projected expenses, it would be wise to scale down your home-buying plans, counsels Bergman.
Justifying biting off as much mortgage as you can chew with the thought that you’re investing in real estate probably isn’t a sound strategy either, notes finance professor Garrigan.
For one thing, housing prices would have to escalate at a rapid clip for you to build equity or ownership in your property, especially during the early years when most of your mortgage payment goes to interest, not principal. “My view is that unless we get into a very different inflationary environment where housing prices appreciate at 8 percent or 10 percent a year, then it doesn’t make a lot of sense to stretch.”
Adds Warren: “A mortgage is just like any other trade-off in your financial life. You may decide to spend more on tuition, and less on a house, or less on the car and more on the house.”
