July 22nd, 2014
When a mortgage provider is evaluating a potential borrower, many factors are considered, but a recent report from FICO said that debt-to-income (DTI) ratio may be the most important dimension of getting approved for a loan.
The credit score analysis software company surveyed credit-risk managers at financial institutions to determine the factors that are more likely to cause a borrower to be rejected. When respondents were asked which single factor was most likely to cause them to deny a loan, 60 percent said that DTI was the top risk, nearly five times the share of respondents for the No. 2 concern. Multiple recent credit applications were ranked second, and credit scores ranked third.
Much of the current concern around DTI stems from the Qualified Mortgage (QM) rule, which was part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and is regulated by the Consumer Financial Protection Bureau. This rule is meant to protect borrowers from risky mortgages by setting standards for which lenders need to adhere to for their products to count as a QM. In exchange for offering these home loans, mortgage providers are protected from a lawsuit filed by the borrower for allegations that the loan was risky.
What do borrowers need for DTI?
The QM rule caps DTI at 43 percent, which means that a borrower’s total monthly debt payments cannot exceed 43 percent of his or her monthly household income. This is known as the back-end ratio. Typically, it is recommended that household expenses – property taxes, homeowners insurance and mortgage principal and interest payments if the lender approves the mortgagee – do not exceed 28 percent.
As a result of the QM rule, many lenders have stricter internal requirements so they can ensure they are compliant, especially if the loan is to be sold to Fannie Mae or Freddie Mac. Citing data from Ellie Mae, the Washington Post reported that the average back-end ratio for home loan approval in May was 34 percent, well below the QM threshold. For loans offered through the Federal Housing Administration, which tend to have looser standards than Fannie and Freddie, the average back-end ratio was 41 percent.
According to mortgage forum Loan Safe, lenders’ reservations about DTI indicate that they are fearful of another housing bubble, the first of which came about because of the subprime mortgage crisis.