While mortgage lenders review a loan application, affordability is determined. Affordability can sometimes be a moving target as different loan programs may have different acceptable levels of debt. There are two primary types of debt, installment and revolving. Installment debt is where one loan is taken out and paid back over time with regular monthly payments until the balance is paid off. Think of an automobile loan, for example. Revolving debt is debt where the balances can rise and fall over time as new charges are made while making payments against the debt each month. Revolving debt allows borrowers to either pay the minimum amount required or anything beyond. Credit card debt is a classic example of revolving debt.
Affordability is viewed as a percentage of gross monthly income. This percentage is referred to as a debt ratio. If a loan program suggests a ratio of say 30, that means the mortgage payment including principal and interest, taxes, insurance and mortgage insurance (when required) must be 30% of the gross monthly income for all borrowers on the loan application. And this is where the difference between installment and revolving debt comes into play. Installment debt is relatively simply to calculate because it’s listed on the credit report and the lender knows that monthly debt won’t change. Revolving debt can change each month, but lenders will still typically use the minimum amount shown on the credit report.
With installment debt, consumers can pay off the entire balance in order to help qualify for the selected mortgage loan. Further, because lenders know the installment loan will soon vanish, lenders can ignore completely a monthly amount if there are less than 10 months remaining on the note. With revolving debt, it’s a little different. It’s important to note here the difference between an automobile loan and an automobile lease. With a loan, the consumer owns the car while the lender has an active interest in the collateral (the car). When the loan is paid off, the lender releases the interest and the consumer owns the car outright. With a lease, when the lease period expires, the car is either turned back in to the lender, pays for it outright in cash, or takes out an installment loan to buy the car.
Consumers can pay a credit card balance down to zero. In this instance, there won’t be any minimum required payment shown on the credit report. But the lender knows the consumer can charge things on that same card the following day, even up to the maximum credit card limit. For example, let’s say there is a credit card balance of $5,000. This balance and minimum monthly payment however pushes the debt ratios above the guidelines. The consumer can then pay off the credit card balance entirely in order to get debt ratios at acceptable levels. But if the consumer’s ratios are too high before paying down any credit card, the lender may ask the consumer to not only pay off the credit card to but to close it down. This isn’t a common occurrence but if an applicant is just barely qualifying as it were, the lender can make that request.
One more thing, information on credit reports can be up to 30 days old. That’s because businesses that issue credit don’t report to the credit bureaus all at the same time. Some can report information to Experian, Equifax and TransUnion on the 1st of every month while others report on the 15th or even the 30th. When paying down debt or paying an account off completely, a paper trail must be kept and provided to the lender showing the account has been settled if required. Someone can pay off a car loan today, but the monthly payments can still show up on a credit report for up to another 30 days. Documentation showing this transaction will prove the debt is paid down to zero or otherwise closed down completely. If someone wants to pay off a credit account to help qualify, having a paper trail is key.