Affordability is one of the key elements in the mortgage loan approval process. If lenders want to approve a marketable loan, making sure the new mortgage payments fall into a comfort zone for the borrowers. This is accomplished by comparing monthly debt payments to qualifying gross monthly income. Qualifying debt payments are those associated with a credit account such as credit card payments or a monthly payment for a car loan.
Other monthly payments counted include spousal or child support. Monthly installments for property taxes and insurance are in the mix as well. When the comparison is made, the result is a percentage, or a ratio. Other debt not included in this ratio are things such as daily living expenses, utilities, health insurance, groceries, etc.
If monthly debt is $3,000 and gross monthly income is $10,000, the debt ratio is then 30. This ratio is for the principal and interest payment, taxes, insurance and monthly mortgage insurance when needed. Common qualifying housing ratios for most loan programs are around 30-33%. Note, these are guidelines only. A loan might be approved for someone whose debt ratios are closer to 40. Higher acceptable debt ratios are typically the result of other positive factors in the loan file. Higher credit scores or a larger down payment are such factors.
In addition to the housing payment calculation, there is a secondary ratio that includes the house payment along with other monthly qualifying credit obligations. Most debt falls into either an installment or revolving category. An example of revolving debt is a credit card. Each month, the card holder charges on the card and also makes a monthly payment against those charges. There is a credit limit assigned but the balance will rise and fall during the course of use.
Installment debt is counted but with most loan programs when the loan is nearing the end of its term, lenders will ignore the debt. Typically the timeline for not counting an installment payment is when the end of term is less than 10 months away. If a car loan payment is $500 but the credit report shows the debt has only eight payments remaining, the $500 amount is ignored when establishing affordability. The lender knows the payment will soon be gone and won’t affect long term affordability.
But not if the car is leased.
Why, you ask? When someone buys a car and finances it with a traditional car loan, at the end of the loan term, the owners keep the asset (the car). Someone might have a car loan that lasts for three years but after three years the car is paid for and owned outright. With a lease, that’s a different story.
A lease is likened to a rental payment. When renting a car, a daily rate accumulates and at the end of the rental period the car is turned back in. The rental agency owns the car, not the renter. Similar with a lease. A lease means the borrowers don’t own the car. The leasing company does. So, at the end of the lease period, there needs to be some decisions made.
One, is it better to return the car once the lease is over? If so, a mortgage lender will want to know what your plans are. After all, you need a car to get to work or go to school or to take you wherever you want to go. But if the car is turned in, how do you get to work, school, or wherever? The lender assumes you’ll take out another lease or make arrangements to buy the car outright at the end of the lease period. Buying the car with cash is an option but many decide to finance the car instead with an installment loan. This is the information the lender will want to know. If there is a lease and it is soon to expire, what are the plans for transportation? This is why lenders treat a lease differently compared to an outright purchase.