How does lender determine potential borrowers can afford the mortgage
Determine how potential borrowers can afford the mortgage
Determining how potential borrowers can afford the mortgage is a comprehensive process that centers on assessing risk. This evaluation is federally mandated by the Ability-to-Repay (ATR) rule and executed through stringent underwriting procedures that examine both the borrower’s capacity and character.
we must make a good-faith effort to determine that the applicants have the ability to repay the mortgage. This commitment is formalized by ensuring all covered loans comply with the ATR provisions outlined in the Truth in Lending Act (TILA) and the CFPB’s Regulation Z, Section 1026.43(c).
The Foundational Underwriting Framework
We evaluate loan eligibility using established risk assessment principles, traditionally referred to as the “C’s of Credit”.
- Capacity (Ability to Manage Debt): This is the core metric for affordability, assessing the borrower’s income relative to their debts.
- Credit (History of Repayment): This evaluates the borrower’s willingness to repay past and current debt obligations in a timely manner.
- Cash/Liquidity: This examines the borrower’s available funds for the down payment, closing costs, and required financial reserves.
- Collateral (Property Secured): This ensures the property’s value is sufficient to cover the loan amount, should the borrower default.
The Eight Minimum ATR Considerations
For most consumer loans that utilize the General ATR Option, we must verify and underwrite based on eight minimum ATR considerations. These steps ensure a comprehensive financial profile of the borrower’s capacity is developed:
1. Calculating Imputed Monthly Income: The qualifying monthly income is calculated by dividing the Net Qualifying Assets by a fixed term. This method is used to prove sufficient income even without regular employment earnings.
- The consumer’s current or reasonably expected income or assets (excluding the dwelling value).
- The consumer’s current employment status (if employment income is relied upon).
- The consumer’s monthly payment on the covered transaction.
- The consumer’s monthly payment on any simultaneous loan.
- The consumer’s monthly payment for mortgage-related obligations (e.g., taxes, insurance).
- The consumer’s current debt obligations, including alimony and child support.
- The consumer’s monthly debt-to-income (DTI) ratio or residual income.
- The consumer’s credit history.
Key Metrics for Measuring Affordability (Capacity)
We rely on Debt-to-Income (DTI) and Residual Income to mathematically determine if the borrower can manage the new mortgage payment.
A. Debt-to-Income Ratio (DTI)
The DTI ratio is a key underwriting determinant of loan affordability, calculated by dividing the gross monthly expenses by the gross monthly income.
- Qualified Mortgages (QM): For traditional loans, the DTI ratio is typically capped at 43%.
- Non-Qualified Mortgages (Non-QM): Loans that fall outside QM standards often allow a higher DTI, commonly up to 50%, and in some expanded programs, up to 55%.
B. Residual Income
Residual income acts as a compensating factor, especially when DTI is high or income documentation is alternative. It is defined as Gross Monthly Income less Total Monthly Obligations.
- Residual income is required for all primary residence transactions (except Investor Cash Flow).
- It is specifically required for Higher Priced Mortgage Loans (HPML) or when the DTI exceeds 43% on primary residences and second homes.
- Minimum residual income requirements vary based on the number of household members (e.g., a minimum of $2,500 for a two-person household).
Methods of Income Verification
The method used to determine qualifying income (ATR Factor 1) depends heavily on the borrower’s employment structure. All sources of income must be stable, verifiable, and expected to continue for a minimum of three years.
A. Full Documentation (Traditional Income)
For salaried and W-2 wage earners, we qualify using:
- Pay Stubs and W-2s: Typically, 30 days of pay stubs and one or two years of W-2s are reviewed.
- Tax Transcripts: A signed IRS Form 4506-C is required for all borrowers on Full Doc loans.
- VVOE: A Verbal Verification of Employment (VVOE) must be obtained, usually within 10 business days prior to the note date.
- Self-Employed (Full Doc): For self-employed borrowers, income is calculated using tax returns (including 1040s and business returns), associated schedules (K-1s, Schedule E), and a year-to-date Profit & Loss (P&L) statement to determine the qualifying net income. Declining income must be closely reviewed, and the lesser income should be used if the trend has not stabilized.
B. Alternative Documentation (Non-QM Income)
For borrowers who are self-employed, gig workers, or asset-rich (and thus may not qualify using tax returns), Non-QM use alternative methods to meet ATR.
| Loan Program | ATR Affordability Method | Key Calculation |
| Bank Statement Loans | Cash Flow Analysis: We review 12 or 24 consecutive months of bank statements to determine the average monthly deposits. | If business statements are used, an expense ratio (e.g., a fixed 50%) is applied to the gross deposits to calculate the net qualifying income. |
| P&L Statement Only Loans | Audited Business Income: Qualifying income is derived from a Profit & Loss statement prepared by a CPA, EA, or licensed tax preparer. | The net income from the P&L is divided by the number of months covered and multiplied by the borrower’s ownership percentage. |
| Asset Depletion Loans | Asset Utilization: Used for retirees or high-net-worth individuals with minimal employment income. | Qualified liquid assets (e.g., checking, stocks, retirement funds) are divided by a fixed term, typically 84 months or 360 months, to create an imputed monthly income for DTI calculation. |
Investment Property Qualification (DSCR Exemption)
For investment property loans secured by non-owner-occupied real estate (DSCR loans), affordability is determined based on the property’s cash flow, not the borrower’s personal ATR.
- ATR Status: DSCR loans are generally structured as business purpose loans, which are typically exempt from the ATR rule.
- Income Requirement: No personal income, employment, or DTI ratio is required or calculated.
- The DSCR Metric: We calculates the Debt Service Coverage Ratio (DSCR) by comparing the property’s gross rental income to its total debt obligations (PITIA: Principal, Interest, Taxes, Insurance, HOA).
- Affordability Threshold: A DSCR above 1.0 means the property generates positive cash flow sufficient to cover its debt. We typically prefer a ratio of 1.25 for the best rates and terms.
Assessing Credit History and Stability
Beyond calculating capacity, we assess a borrower’s credit history (ATR Factor 8) and housing payments (ATR Factor 5) to gauge reliability.
- Credit Scores: The credit score determines the borrower’s risk level, which directly impacts the down payment requirement and the interest rate. A minimum score of 620 to 660 is often required for Non-QM programs.
- Housing History: We verify the borrower’s previous housing payments (mortgage or rental) for at least the most recent 12 months to ensure timely payments.
- Derogatory Events: Underwriters review for significant derogatory credit events (like bankruptcy or foreclosure). While QM loans typically require a multi-year waiting period, Non-QM programs offer more flexibility, sometimes allowing borrowers to qualify soon after these events.
- Reserves: We often require the borrower to hold liquid assets (Reserves) equivalent to several months of the Principal, Interest, Taxes, and Insurance (PITIA) payment as a financial safety net after closing.
FAQ's
For these loans, affordability is assessed solely based on the debt service coverage ratio (DSCR) of the subject property, as the loan is generally exempt from the personal ATR rule because it is classified as a business purpose loan.
The lender assesses the borrower’s credit history, reviewing their repayment record for prior and current debt obligations.
All current debt obligations, alimony, and child support must be included. Additionally, debt payments scheduled to begin or come due within 12 months of closing must be included as anticipated monthly obligations.
Lenders calculate an imputed monthly income by taking the Net Qualifying Assets and dividing them by a fixed term, such as 84 months.
Lenders use alternative documentation such as reviewing 12 or 24 months of personal or business bank statements to analyze the applicant’s monthly cash flow.
For wage earners, income must be verified with paystubs and W-2s, and lenders must obtain a Verbal Verification of Employment (VVOE) within 10 business days prior to the note date.
While Qualified Mortgages (QM) generally cap DTI at 43%, Non-QM lenders often approve mortgages for borrowers with a maximum DTI ratio of 50%.
The primary metric is the Debt-to-Income (DTI) ratio, which compares the borrower’s monthly debt against their monthly income.
Lenders weigh four core factors, known as the “four C’s of Credit,” including Capacity/ability to manage the debt and Credit/history of repayment.
The Dodd-Frank Act imposed the obligation on lenders to make a good-faith effort to determine that the applicants have the ability to repay the mortgage. This is known as the Ability-to-Repay (ATR) rule.
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