Module 2: Ratios In-Depth

In the world of mortgage lending, where financial decisions shape the path to homeownership, ratios serve as guiding lights, illuminating the mortgage landscape. These ratios hold immense importance in determining the viability of loans and shaping lending practices. In this section, we will explore three ratios—Debt Service Coverage Ratio (DSCR), Debt-to-Income Ratio (DTI), and Loan-to-Value Ratio (LTV)—unveiling their significance and demystifying their impact on the mortgage lending process.

Consider the story of Sarah, a diligent borrower seeking to realize her dream of owning a home. As she navigates the complexities of mortgage lending, she encounters these ratios like signposts along her path. Each ratio provides a unique perspective, offering insights into her financial health and the feasibility of her homeownership aspirations.

The Debt Service Coverage Ratio (DSCR) acts as a litmus test, examining the income-generating capacity of the property Sarah wishes to purchase. It reveals whether the property's net operating income can sufficiently cover its debt obligations, safeguarding both the borrower and the lender from potential financial strain.

Meanwhile, the Debt-to-Income Ratio (DTI) shines a light on Sarah's ability to manage additional debt responsibly. By considering her existing monthly debt payments in relation to her gross monthly income, this ratio provides a gauge of her financial stability and capacity to take on a mortgage.

Lastly, the Loan-to-Value Ratio (LTV) assesses the risk associated with the loan by examining the relationship between the loan amount and the appraised value of the property. It helps lenders evaluate the borrower's equity in the property and understand the potential loss in the event of default.

By delving into these ratios, we empower Sarah and borrowers like her with a deeper understanding of the framework that governs mortgage lending decisions. Through real-life examples and practical analysis, we unravel the complexities, equipping you with the knowledge to make informed choices and navigate the lending landscape with confidence.

Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is a fundamental metric that plays a critical role in mortgage lending. It assesses the property's ability to generate sufficient income to cover its debt obligations. Lenders rely on the DSCR to evaluate the risk associated with a loan and determine whether a borrower can comfortably meet their financial commitments.

The DSCR is calculated by dividing the property's Net Operating Income (NOI) by the Total Debt Service (TDS):

DSCR = NOI / TDS

Net Operating Income (NOI) represents the income generated by the property after deducting operating expenses but before considering debt payments. It typically includes rental income, but for commercial properties, it may also encompass additional revenue streams like parking fees or ancillary services.

Total Debt Service (TDS) refers to the sum of all debt payments associated with the property, including the mortgage payment, property taxes, insurance premiums, and any other debts tied to the property.

Let's illustrate the calculation of DSCR with an example:

Suppose Sarah is considering a rental property with an NOI of $80,000 per year and a TDS of $60,000 per year. Applying the formula, we find:

DSCR = $80,000 / $60,000 = 1.33

In this scenario, the DSCR is 1.33, indicating that the property's income is 1.33 times higher than its debt obligations. Lenders typically require a DSCR of 1.25 or higher, ensuring a margin of safety and demonstrating that the property generates enough income to cover its expenses.

The DSCR provides insight into a property's financial health and the borrower's ability to manage their obligations. A higher DSCR signifies a stronger cash flow, reducing the risk of default and increasing the likelihood of loan approval.

DTI In-Depth

The Debt-to-Income Ratio (DTI) is a crucial metric in mortgage lending that evaluates a borrower's ability to manage additional debt obligations. It compares the borrower's total monthly debt payments to their gross monthly income, expressed as a percentage. The DTI provides lenders with insight into a borrower's financial stability and their capacity to take on additional debt.

There are two types of DTI: front-end and back-end DTI.

Front-end DTI is a calculation of how much of your gross monthly income goes towards housing costs. It is calculated by dividing your monthly housing expenses (including mortgage, property taxes, insurance, and homeowners association dues) by your gross monthly income. For example, if your monthly housing expenses are $2,000 and your gross monthly income is $5,000, your front-end DTI would be 40%.

The Front-End DTI is calculated using the following formula:

Front-End DTI = (PITIA / Gross Monthly Income) x 100

Back-end DTI is a calculation of how much of your gross monthly income goes towards all of your debts, including housing costs. It is calculated by dividing your monthly debt payments (including mortgage, credit card payments, car payments, student loan payments, and other monthly debt obligations) by your gross monthly income. For example, if your monthly debt payments are $3,000 and your gross monthly income is $5,000, your back-end DTI would be 60%.

The Back-End DTI is calculated using the following formula:

Back-End DTI = (Total Monthly Debt Payments / Gross Monthly Income) x 100

Total Monthly Debt Payments include all recurring debts, such as mortgage payments, credit card bills, car loans, student loans, and any other monthly obligations that require regular payments.

Gross Monthly Income refers to the borrower's total income before any deductions, including salary, wages, bonuses, rental income, and other sources of income.

To better understand the DTI, let's consider an example:

Suppose Sarah has total monthly debt payments of $2,000, including her mortgage, car loan, and credit card bills. Her gross monthly income is $6,000. Applying the formula, we find:

DTI = ($2,000 / $6,000) x 100 = 33.33%

In this case, Sarah's DTI is 33.33%. This means that her monthly debt payments account for 33.33% of her gross monthly income. Lenders typically have specific DTI requirements, which may vary depending on the loan program. For example, conventional loans often have a maximum DTI limit of around 43%, while government-backed programs like FHA loans may allow for higher DTIs with compensating factors, up to 56.9%.

A lower DTI is generally viewed favorably by lenders as it indicates that a borrower has a lower level of debt relative to their income, suggesting a higher capacity to handle additional financial obligations.

LTV In-Depth

The Loan-to-Value Ratio (LTV) is a metric in mortgage lending that assesses the relationship between the loan amount and the appraised value of the property. It helps lenders evaluate the risk associated with a loan and determine the borrower's equity in the property.

The LTV is calculated using the following formula:

LTV = (Loan Amount / Appraised Value of the Property or Purchase Price) x 100

The LTV must be calculated using the lowest amount between the Appraised Value or the Purchase Price.

The Loan Amount represents the total amount of money borrowed by the borrower to finance the property purchase. It includes the principal amount of the mortgage loan.

The Appraised Value of the Property is an estimation of the property's fair market value conducted by a professional appraiser. It takes into account various factors such as location, size, condition, comparable property sales, and other relevant market factors.

To illustrate the calculation of LTV, let's consider an example:

Suppose Sarah is seeking a loan of $200,000 to purchase a property with an appraised value of $250,000. Applying the formula, we find:

LTV = ($200,000 / $250,000) x 100 = 80%

In this scenario, the LTV is 80%. This means that the loan amount accounts for 80% of the appraised value of the property. The remaining 20% represents the borrower's equity or down payment.

Lenders consider the LTV as an important risk factor in mortgage lending. A higher LTV indicates a higher loan amount relative to the property's value, which may increase the risk for the lender in case of default. It also affects the borrower's loan terms, such as interest rates, mortgage insurance requirements, and eligibility for certain loan programs.

Different loan programs and lenders have specific LTV requirements and guidelines. For example, conventional loans often require a maximum LTV of 80% without mortgage insurance, while government-backed programs like FHA loans may allow for higher LTVs, sometimes up to 96.5% with mortgage insurance.

There are two other types of LTV that are calculated by lenders: CLTV and HCLTV.

CLTV (combined loan-to-value ratio) is the ratio of the combined mortgage loan amount to the appraised value of the property or the purchase price (whichever is lower). This includes the first mortgage loan as well as any other liens on the property. For example, if you have a $200,000 first mortgage on a property that has been appraised at $300,000, and you also have a $50,000 HELOC balance, your CLTV would be 83.33%.

HCLTV (high-combined loan-to-value ratio) is the ratio of the mortgage loan amount and the total credit limit to the appraised value of the property or the purchase price (whichever is lower). This includes the first loan amount and the total credit limit of all subordinate liens when at least one subordinate lien is a HELOC. For example, if you have a $200,000 first mortgage on a property that has been appraised at $300,000, and you also have a $60,000 HELOC credit limit, your CLTV would be 85%.