At a recent entrepreneurial conference that I was invited to sit in on a guest panel, our panel was asked a really good question by a young female college student regarding mortgage payments. The nature of the question was this:
My parents had always advised me about how much of a house payment I could afford based on a percentage of my salary. But I know the rules have changed since my parents time and even more so since the financial crisis since 2008. What is the approximate percentage that is advisable for one's mortgage payment vs. their gross income?
Wow! What a great question. My initial thought when I first heard this question was “How better off would be financially if more people would ask questions like this?”
The answer is: much, much better.
Going to the Books
Not being able to remember the exact ratios, the first place I knew to check was my CFP® study materials. Still on my bookshelf for situations like this, I headed to the chapter on “Cash Flow and Debt Management” to find my answer. In my study guide, it refers to the most commonly used debt management ratio as the “consumer debt ratio“. This is the ratio of monthly consumer debt payments to monthly net (or after-tax) income. In this case, consumer debt refers to everything other than your house payment.
Please note: A general rule of thumb in the financial planning world is that this ratio should not exceed 20%.
In addition to the consumer debt ratio, another ratio can be used to determine how financial stable a household is. This ratio includes all your debt, including your housing debt, as a percentage of your overall debt. Here are the percentages that these ratios should not exceed:
- 28% of gross monthly income for housing costs, such as rent or an individual's monthly mortgage payment, including principal and interest payments on the mortgage, property taxes, and homeowner's insurance premium (PITI)
- 36% of gross income for total debt, including costs and consumer debt.
As a reminder, you should not exceed these percentages.
Consumer Debt Ratio Example (This is a sample test question from the CFP® exam):
John makes $80,000 a year as engineer. He is currently saving 10% into his company's 401k plan. He lives in modest home where his monthly mortgage payment is $1,500 and that includes taxes and insurance. Based on this, what is the ratio of John's income that is dedicated to housing costs?
Remember, the ratio includes “gross income” so the fact that he's deferring $8,000 into his 401k is irrelevant. In his case, the housing cost ratio is 22.5% ($1,500 divided by $6,666- his monthly income).
Okay, now that we had decent idea of what financial planners think is an appropriate percentage of your mortgage payment to your gross income, I thought it would be neat to get an opinion from a different perspective.
Contact The Banker
I contacted my banker who was instrumental if helping us prepare for the financing steps that we needed to build our first home. John Streuter, with People's National Bank has been in the mortgage industry for over 25 years, so I knew he could shed some light on how the industry has evolved over the years.
Before he gets started here are some of the more common terms and their definitions in the industry:
- PITI – principal/interest/taxes/insurance
- PTI – payment to income
- MOTI – monthly obligations including taxes and insurance (r.e.taxes and homeowners insurance)
- DTI – debt to income
- PITI ratio and PTI ratio are the same and also referred to as the “front-end ratio”.
MOTI ratio and DTI ratio are the same and often referred to as the “back-end ratio”. They are interchangeable it just depends who you're talking to as to which lingo they use. Whomever you talk to will either use PITI and MOTI together, or PTI and DTI together, or front-end and back-end together as they discuss these ratios, Very seldom will one not use them in one of those three groupings.
Clear as mud? Good 🙂 For our discussion, I will be using PTI (Payment to Income) and DTI (Debt To Income).
Evolution of Mortgage Ratios
I'm sure the ratios have evolved beginning with much lower numbers, but as a reference point I've been in the mortgage business since 1985 and this is where my discussion will begin.
When underwriting for mortgage loans 25yrs ago, the ratios that we used were 25% PTI (Payment to Income) and 35% DTI (Debt to Income). Loans were underwritten manually by the loan officer and normally approved by either a combination of two loan officers or a loan committee. Ratios were very seldom allowed to exceed that, but systems were in place to make exceptions. Somewhere along the late 80's/early 90's the ratios expanded to 28% PTI and 36% DTI for conventional loans and Gov't loans (FHA, VA, USDA-RD) were 29% PTI and 41% DTI (Gov't loans use the PITI – MOTI lingo). Officially, for manually underwritten loans, those two sets of ratios (28/36 & 29/41) still exist.
The explosion began by the early 90's when FICO scores became prevalent in the industry and three major national credit bureaus (often called repositories) evolved, Prior to this, a bank would request a Residential Mortgage Credit Report (RMCR) from one local credit service agency.
A local credit service agency would usually be tied into just one of the national repositories. As an example, for many years we had a local agency located in Mt Vernon that was tied into the St Louis branch office of TransUnion. Most lenders in Southern Illinois used this service, so almost all in our area used Trans Union reports.
As the age of computers expanded and the onset of FICO scores, all the small regional credit service agencies closed because banks could receive credit information via computer download from one of the major repositories (TransUnion, Equifax, and Experian).
In very short order, the repositories began offering a “tri-merge” report which means they connected their computer and merged customer's information and reported it in one concise report, rather then 3 different reports. So by the mid 90's, secondary market underwriting began requiring a “tri-merge” report in order to have a complete picture of a borrower's credit history.
Don't Forget Freddie and Fannie
All this leads into the mid to late 90's when Freddie Mac and Fannie Mae developed computer models for underwriting called “Automated Underwriting Systems” or AUS. Freddie Mac called there's “Loan Prospector” (LP) and Fannie Mae called there's Desktop Underwriter (DU).
These systems were able to score clients based on ones credit score, credit history, amount of credit outstanding, credit card limits vs credit card balances, loan to value ratio, PTI ratio and DTI ratio.
To this day, the exact scoring models for both credit scores and AUS are proprietary secrets and, as lenders, we can only guess as to what some of the large factors are that go into these models. We are told that the models contain multiple factors, but the ones I've stated are the obvious. With these AUS models, a borrower was scored as an Accept or a Caution.
Accept meaning that if all the information was verified the customer was approved for sale to Fannie and Freddie. A caution required a manually underwritten loan using the old standards of underwriting with 28/36 ratios. With the advent of AUS, Fannie and Freddie allowed their models to expand the ratios to 33% PTI and 40% DTI.
It did not take but a few years for Fannie/Freddie to fine tune their models based on access to statistical information that they and the credit bureaus were obtaining on the likelihood of default by combining credit score information with AUS information. So very soon we were able to underwrite borrowers, using AUS, with 33/45 ratios, then 35/49 ratios.
Watch Out: Here Comes Sub-prime
By early 2000, the non-conforming or what we call “sub-prime” lenders exploded. Using hybrid AUS models of their own (called Desktop Originator, “DO”) we saw the industry begin to ignore the PTI ratio and the DTI ratio expanded to 55%.
Sub-prime lenders would approve borrowers with DTI ratios as high as 60-70%.
It was not long after, I'm thinking by 2003, Fannie and Freddie were so confident in their AUS models they began the process of “ratio waiver”. If their AUS model scored the customer as an Accept, you could ignore the PTI and DTI ratios.
Their claim is that LP & DU were taking into account the customers ratios along with the other factors in determining the likelihood of default. So you had customers with high credit and large equity that in theory could be approved with 100% DTI. Thus opening the door for all the “no income – no asset” loans and the “stated income” loans.
Here Comes the Bubble
By 2007 the housing bubble began to leak and even though we still operated on ratio waivers, you could see the AUS models begin to tighten on the DTI ratio and seldom would get an Accept above 55%. In 2008 we all know the housing bubble burst, market tanked, and as the market got worse each month, Fannie & Freddie were fine tuning their AUS models on almost a monthly basis. In very short order we saw the DTI ratio reduced to 49% then 45%.
Debt Ratios For Modern Day
Today, we actually have a many different ratios to live by. The standard for manual underwriting is 28% PTI and 36% DTI on conventional loans and 29% / 41% for Gov't loans.
Editor's note: I find it funny that the ratios have resorted back to the original ratios found in my CFP® study guides.
For AUS underwriting, PTI is still waived if we receive an Accept on our AUS profile. For borrower's with high credit scores and 20% or more equity the allowable DTI can be as high as 49%. For consolidation refinances or cash out refinances, the maximum allowed DTI is 45%. For borrowers with less than 20% equity, which requires PMI, the maximum allowable is 42%, but in cases where the credit score is above 740, the PMI company may give a waiver and allow up to 45%.
That gives you my 25yr history in the mortgage industry. If you understand all that, then there are some mortgage companies that would like to hire you. I've seen more changes in the past 2 years then I've seen in the decade prior to 2008. With computers still gathering the stats on the probability of a borrowers likelihood to default, we will continue to see the industry evolve.
I want to thank John for sharing his experience of the mortgage industry for the past 2 and half decades. I think the biggest takeaway from this is simple: live within your means. Just because you're allowed to borrow more, doesn't mean you should. This is where common sense has to come into play. Trust your gut before taking on a mortgage payment that can potentially wipe you out.