By Arnold King
Special to the News-Sentinel

The article explains the mortgage qualification process by describing the calculations that lenders typically make in determining how large a mortgage loan you can afford. First, it describes the requirement for a minimum down payment. Next, it explains the ratios used to factor in your income and monthly debts.

Down payment

We start by assuming a minimum down payment of 3 percent, and that your savings funds will have to cover closing costs as well as the down payment. You can override the default requirement of a 3 percent down payment when you recalculate. As recently as early 1998, a minimum requirement of 5 percent was more common.

If the calculator shows that you are constrained by the down payment, there are a number of options. FHA, VA and some private lenders allow a low down payment (although few private lenders allow down payments of under 3 percent). Also, you will find that by saving up for a while you can really increase the size of the home you can purchase.

It is a good idea to put down 20 percent if you can find it possible to do so for the house that you which to buy. However, 20 percent is a “nice -to-have” as opposed to a “must have.” I have seen estimates that over 1/4 of all mortgages go to borrowers with lower down payments.

People with high incomes and very little savings tend to get very upset with the down payment arithmetic used in the calculator. One extreme reaction was “your qualification calculator is pathetic. “However, the fact is that if you have $5,000 in savings and the down payment requirement is 5 percent, then basic arithmetic says that the house price cannot exceed $100,000. It will be less, because some of your savings has to go toward closing costs.

There is no need to take offense at the arithmetic. If you think that you can afford more, change the closing cost percentage, lower the down payment requirement, or increase what you enter for your savings.

Income and debt ratio

Mortgage qualification, or mortgage underwriting, is a pseudo-science. The mortgage lender is trying to determine whether or not you can and will meet the payments on the mortgage. Because no one can predict exactly who will meet the payments and who will default, mistakes will be made. Some “good” borrowers will be turned down, and some “bad” borrowers will receive loans.

What this means to you as a borrower is that your application for mortgage credit will be evaluated according to some rules of thumb that appear to be precise, such as “the ratio of your monthly payment to your income should not exceed 28 percent,” or “the ratio of your monthly payment plus monthly non-housing debt to your income should not exceed 36 percent.”

Because the rules of thumb are simplistic lenders are not rigid in using them. On the one hand, you can “pass the test” of having enough income to satisfy the 28/36 percent ratios and still get turned down for a mortgage loan. On the other hand, you may “fail” to meet the test and still have your application accepted. These exceptions are discussed below.

Risk factors

Factors that could disqualify a borrower who “passes” the simple ratio test include:

• Poor credit history: If you have a previous bankruptcy or mortgage default on your record, lenders will be reluctant to grant a new mortgage. However, an occasional late payment on a monthly credit card bill will not disqualify you for a mortgage.

• Unstable income source: If your income is subject to fluctuations (for example, if you are paid on commission), the lender will qualify you on the basis of a conservative estimate of likely earnings. Self-employed borrowers receive particularly close scrutiny.

• Inadequate cash reserves: If after the down payment you will have less cash in reserve than you would need to meet three mortgage payments, the lender may conclude that your loan could go ad if you were laid off briefly or had some other minor financial problem.

Qualifying in spite of a high ratio

On the other hand, do not be discouraged if the prequalification calculator does not show that you can obtain as large a loan as you would like. Lenders will try as hard as they can to meet your needs. Among the options that they have are:

• Accepting a higher ratio: The lender can choose to allow you to pay more than 28 percent of your income to meet mortgage pay

ments. However, usually the lender must find some other factor in your favor. For example, if the new payment will represent little or no increase from what you previously were paying in rent or a mortgage payment, this may help. Lenders also take into account compensating factors such as large down payment or sizable cash reserves.

• Alternative loan products: If you do not qualify for a 30-year fixed rate loan, you may qualify for the same loan amount if a lower-rate mortgage can be found. However, few prudent lenders will use the initial rate on a short-term adjustable rate mortgage (ARM) as the qualifying rate. One rule of thumbs is to use the maximum possible second-year rate. This often is below the 30-year fixed rate.

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