The Rationale Behind Ratios

Over the years, lending guidelines for the purchase or refinance of a home have become increasingly prescribed. Complexes must meet specified owner-occupancy percentages, credit scores must exceed specified numbers, and down payments must meet a lender’s minimum criteria.

All of these come under the heading of “underwriting guidelines”. And one of the first guidelines written was how to calculate the borrower’s “top and bottom ratios”. No, this does not refer to a borrower’s ideal waist and hip measurements. Rather, it is a formula to assess whether or not the borrower can meet her loan payment obligations. If a borrower falls within certain ratios, the lender feels comfortable with the borrower’s ability to repay the loan. Here’s how these ratios are calculated.

The “top” ratio refers to the monthly cost of running the property divided by the borrower’s monthly gross income. The lender calculates the proposed monthly mortgage payment, adds the monthly property taxes, insurance and homeowner’s dues (if any). This number is divided by the borrower’s gross monthly income and the resulting number is the “top” ratio.

The “bottom” ratio is calculated the same way, except that, along with the property costs, the lender includes all other regular monthly expenses. This would include such items as child support, alimony, car payments, credit card payments, student loans, boat docking fees, etc.

Let’s look at an example. Say a borrower makes $50,000 a year and wants to borrow $100,000 at 7% for 30 years. The monthly payments would be $662. Property taxes and insurance might be $250 per month, bringing the total monthly expense for the property to $912. The borrower’s monthly gross is $4,167, and when that is divided by 912, the result is 22%, well below 28%, the maximum lenders like to see for a “top” ratio.

Now let’s add in other monthly expenses like $300 for credit cards and $175 for a car loan. Add this to the monthly $912, and our borrower now has a projected monthly expense of $1,387. Divide this by the monthly gross and you have a “bottom” ratio of 33% which just meets the lender’s guidelines.

Most lenders have a variety of loan programs for borrowers who don’t fit into these ideal ratios. But they are generally at less favorable rates and terms. And many of them will be adjustable rate loans, rather than fixed rate.

While it is still possible to convince an underwriter to consider “extenuating circumstances” when reviewing your loan, more and more, the human element in underwriting is being replaced by cold numbers. The trend in the industry is towards computer programs designed to evaluate a borrower’s credit-worthiness. And though they may be efficient, computers are rarely sympathetic.