Unsound Lending Policy

Where have these guys been?

This email came across my desk last week from a mortgage lender looking for business.

“More bad news yesterday from the agencies with reduced LTV’s and increased fico’s for cash-out. How can you avoid this latest problem? With a Dream House “combo loan”!

85% cltv with a 650 fico (won’t get there now without a 700!)

No MI required!
DTI to 55%

AVOID LOAN LIMITS and get easier approval with lower LTV 1st mortgage

Call me today for more details!”

Please note that this lender is allowing a debt to income (DTI) ratio of up to 55%. This means that they are offering to lend mortgage money to someone who ultimately will never be able to make the payments on his mortgage, for the following reasons. Calculation of debt to income ratios are a routine part of the underwriting process in determining loan approval, along with credit and collateral review. The front end DTI is the ratio of an applicant’s monthly payment of principal and interest on the mortgage, plus the monthly amount due for property taxes and home owners insurance divided by his gross monthly income. Thus, if the PITI (principal, interest, taxes, and insurance) is $2,000 per month and the applicants gross income (before taxes) is $5,000 per month, the front end DTI will be 40%. The back end debt to income ratio includes the PITI and all other recurring payments for installment and revolving debt, such as credit cards, car loans, personal loans, etc. If the PITI is $2,000 per month and other debt payments total $750 per month, and gross income is $5,000 per month, the total back end debt ratio would be 55%.

If a loan applicant accurately reports his income and has a debt ratio of 55%, he faces almost a certain future of defaulting on the mortgage.

Debt ratios are computed using “gross” income before any deductions for payroll taxes, etc. In this example, the borrower with a gross income of $5,000 will be lucky to take home $4,000 of spendable income after deductions for social security, Medicare and federal income tax deductions. This would leave him with only $1,250 per month for everything else in life such as food, dining, gas, car repairs, home repairs, tuition, medical expenses, life insurance premiums, gifts, clothing, entertainment, etc. etc., you get the idea. If the borrower has no savings, as is frequently the case, one large home or car repair could easily result in a missed mortgage payment. Typically, one missed mortgage payment will easily lead to another until the borrower is in default.

Question???? Why would anyone make a mortgage loan to a borrower with such a high debt ratio? The time tested banking limits on the back end DTI of 32-35% were used for a reason – it prevented the borrower from overextending himself and falling into default. Theoretically, lenders should be able to lend to whomever they wish to using whatever underwriting standards they chose to use. In addition, some borrowers have additional income that they cannot provide documentation for and thus are not able to use this type of income when applying for a mortgage. Therefore, they may have debt ratios that are in reality better than what appears in the formal debt calculation.

The only problem with this rationale is that allowing very high debt ratios is what has led us as a nation into a financial crisis based on easy lending to borrowers who really never had a realistic chance (absent eternal home price appreciation) of paying back the money that they were approved to borrow. Also, it was not a great leap, once you allowed high debt ratios, to also allow approvals of mortgages by applicants with low credit scores and minimal down payments, which totally guaranteed foreclosures for this type of borrower profile.

Given the the large number of mortgage defaults that we already have, I believe that lenders should be constrained in their enthusiasm to make aggressive loans to borrowers who may not fully realize their financial limitations.  In fact, in many ways, lending to a borrower with a verified high debt ratio is worse behavior than the approvals previously given to subprime and altA stated income borrowers since in those cases, at least the lender could look with two blind eyes at the income the borrower stated that they made and say, “ok approved”.  However, approving a loan where you have verified the income and know that the borrower’s income is insufficient is simply irresponsible .

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