We’ve already discussed the importance of credit in consideration of the Underwriting Process, so it’s time to discuss capacity. Many investors and borrowers aren’t sure what capacity is, in terms of a loan, so we’ve broken it down here:
Can a borrower repay the mortgage? Capacity refers to the borrower’s ability to make the payments on the loan. To determine this, the UW will analyze the borrower’s debt ratios. This can be done by qualifying monthly housing expense-to-income ratio, or the monthly debt payment-to-income ratio. The current debt and assets will all be analyzed.
Employment is also factored in to the equation as well. People who are employed by a company and earn salary or hourly wages pose the lowest risk to lenders. But, self-employed borrowers pose the highest risk, since they are typically responsible for the debt and well-being of the business in addition to their personal responsibilities. Usually if self-employment or commission income is used to qualify for the mortgage, a two year history of receiving that income is required. The underwriter will average the last 2 years of income on the 1040 tax return and divide by 24 months to get the person’s monthly income to calculate the debt to income ratio. Just make sure that if you are employed that you have a steady employment history, the lender will also want W-2’s for the past 2 years as well as recent paycheck stubs. They will also, more than likely, complete a verification of your employment.
Retired people are required to show evidence that they are eligible for Social Security and document the receipt of payments, while people who receive income through cash investments must provide statements and prove the continuance of income from those payments which usually needs to show that the payment will continue for three years or more.
The underwriter must determine and document that the income and employment is stable enough to pay the mortgage in years to come. Furthermore, UW’s evaluate the capacity to pay the loan using a comparative method known as Debt-To-Income ratio (or DTI). This is calculated by adding up all of the monthly liabilities and obligations and dividing it by the monthly income.
If a borrower has bills/obligations of $2,100 a month and makes $5,000 a month, his debt-to-income ratio equals 42%. Typically, the ratio must be at least 45% or a max of 50% to get the loan approval.
Assets are also considered when evaluating capacity. Borrowers who have an abundance of liquid assets at the time of the closing statistically have lower rates of default on their mortgage.
- The amount of cash reserves is qualified by the numbers of payments the borrower can make on their total housing expenditures (the total of the principal and interest payments, taxes, homeowners insurance, mortgage insurance, and any other applicable charges) before the reserves are exhausted.
- Lenders typically require between 2 to12 months of reserves in the bank.
- The reserves needed for an investment property approval are 6 month’s worth of payments.
- Besides income and credit, the lack of proper reserves is the #1 investment property loan deal killer.
- The most typical assets that banks look to for reserves are the borrowers checking and savings accounts.
- Other sources include: retirement funds (e.g. 401k), investments (e.g. stocks and bonds), life insurance that has cash value or any other liquid source of funds.
- Funds that have penalties for withdrawing must be considered conservatively and are evaluated at 60% or less of their actual value.
- Accounts such as pensions and other accounts and personal property that lack liquidity may not be used as assets typically.
The number of borrowers is also another factor in the underwriter’s assessment of capacity to pay. As well as the characteristics of the loan, such as the product: 15, 20 or 30 year fixed rate verses an adjustable rate mortgage.
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