Mortgage lenders want to make sure applicants can afford a new mortgage payment, and this means looking at your current revolving debt and installment debt. This mortgage payment includes not just the principal and interest amount toward the outstanding balance but also includes a monthly amount for property taxes, homeowner’s insurance and mortgage insurance when needed. Taxes and insurance payments are included even if they’re both paid once or twice per year. Affordability is certainly an issue, after all, the lender wants to make sure it gets paid back, right? Affordability is determined by comparing monthly payments with gross monthly income. This comparison is done by calculating debt-to-income ratios, or simply “debt ratios.”
How Debt Ratios are Calculated
Most loan programs establish suggested debt ratios. One ratio is for the mortgage payment and another ratio includes not just the mortgage payment but other required monthly credit obligations. These additional debts can include such payments as a car loan, student loans or credit cards. If a debt ratio for the mortgage payment is 33, that means the principal and interest, taxes and insurance, or PITI, should be one-third of gross monthly income. This is rarely an exact number but most generally a guideline. Those with high credit scores or a larger down payment than required might allow a debt ratio to be higher than the 33 guideline.
As it relates to other debt, it simply means adding these payments to the mortgage amount. These additional debts can fall into an installment or a revolving category. An installment debt is one where the payments remain the same until the loan is paid off. Perhaps the most common of installment debts is a car payment. An automobile loan might be for 60 months. As each payment is made, an amount is allotted toward the outstanding loan balance and an amount to interest. Each payment reduces the outstanding balance until the loan is completely paid off.
Revolving Debt vs. Installment Debt
A revolving debt is something like a credit card payment. A credit card balance will rise and fall as purchases are entered and payments made. A credit card will have a required minimum payment each month but consumers also have the option of paying more than the minimum or paying off the outstanding balance altogether. A revolving debt will have a line of credit where the balance should not exceed this limit. The limit can increase over time as the creditor gradually increases the credit limit with a history of timely payment.
When calculating debt ratios, revolving debt and installment debt are treated differently. Installment debt amounts won’t change each month, so the amount added is fairly straightforward. If the car payment is $500 and the PITI is $2,000, the total amount used to calculate the total debt ratio would then be $2,500. Further, with installment debt, most loan programs discount the payment if there are less than 10 months remaining until the debt is paid off completely. But what about revolving debt? If the minimum amount can rise and fall each month, what amount do lenders use?
A credit report will list a revolving debt account showing the last reported outstanding balance, the last payment made, and if there are any outstanding payments due as well as the minimum payment required. It’s the minimum payment showing on the credit report that will be used when calculating debt ratios.
One note here, lenders will run one final credit report prior to ordering closing papers to make sure no additional revolving debt accounts or installment debts have been taken on since the application was first submitted and a credit report requested. This is why borrowers are asked to not apply for credit or change their credit profiles in any manner but instead just sit tight until after the loan has closed. New accounts can affect final debt ratio calculations. The final credit report needs to look almost exactly the same as the initial one. Installment payments will be the same, it’s the revolving ones that can change.