Most loans today employ the use of calculated debt-to-income ratios. A debt ratio compares outstanding monthly payments with gross monthly income. If someone has $3,000 in monthly debt and the maximum limit is $10,000, the ratio is 30. This application will qualify if a mortgage program asks for a maximum of 33. Typically, there are two “ratios,” referred to as the ‘front’ and ‘back’ ratios. The front ratio is assigned to the mortgage payment. In contrast, the back ratio considers the mortgage payment, taxes, insurance and mortgage insurance when needed, and other revolving and installment debt. Revolving debt is like a credit card, while installment debt is typically associated with a car payment.
Yet as it relates to debt ratios, while the front ratio might be in line, additional consumer debt might just put the qualifying out of reach. This means too much installment debt or revolving debt. Most programs today allow you to pay down outstanding credit to help you qualify. But there are differences between the types of credit.
With installment debt, one must pay down the current debt with a lump sum payment. The monthly payment may still be the same after a paydown. And it may be necessary to pay off the debt entirely. Many times, this is too big of a challenge. Not everyone will have enough cash on hand to accomplish this.
Yes, one can borrow from someone else. Still, when that happens, the lender will want to know where the payoff funds came from and then calculate monthly payments independently. But, paying off installment debt will lower ratios, hopefully to a qualifying level.
Revolving debt differs from installment debt, but paying down a revolving account can help a little more. Paying down a revolving debt will lower the monthly payment and result in lower ratios. This can be a strategy and is allowable in most instances. However, it’s not unheard of for a lender to ask someone to close the account. Why? Because the lender knows the borrower can go back out the day after closing and run up those accounts again.
If you’re unsure about your qualifications, speak to your loan officer or accountant, who can guide you through the process.
Cheryl Fox is a Real Estate Broker and CPA 818-207-2013