`Gap ratio' valuable test for applicants

Nation's Housing

January 27, 2002|By KENNETH HARNEY

THE COUNTRY'S second-largest source of home mortgage money, mega-investor Freddie Mac, has come up with a new credit standard for judging loan applicants. Though it hasn't shared it with the public, the new standard - dubbed the "gap ratio" - offers a valuable test for consumers nationwide who are anticipating buying a home or applying for a mortgage.

Already in use whenever loan applications are submitted to Freddie Mac electronically for underwriting, the gap ratio essentially measures your household monthly debt load against your proposed home mortgage-related debt load. If you've got too much revolving credit card, auto or student loan debts in relation to your mortgage debts, it shows up in your gap ratio.

Here's how it works. The gap ratio is the difference between your monthly debt-payment-to-income ratio and your monthly housing-expense-to-income ratio. Freddie Mac's new standard suggests that the "gap" between those two debt ratios generally should not exceed 15 percentage points.

Think of it this way. Lenders already judge your creditworthiness in part based on how much of your total monthly income you devote to servicing your debts. In the 1970s and 1980s, a common rule of thumb was that your mortgage-related payments shouldn't eat up more than 25 percent of your monthly household income. During the late 1980s and into the 1990s, that rule began to stretch into the 31 percent to 33 percent range and sometimes higher.

What about the other common credit yardstick - your monthly-income-to-total-household debt? That's your mortgage payments, plus your credit card, auto and other monthly debt service expenses. In the 1990s, acceptable ratios began creeping above 40 percent.

Late in the decade, even Freddie Mac confirmed that it no longer had hard and fast rules on total-monthly-debt-to-monthly-income ratios, and lenders reported selling loans to Freddie with debt-to-income ratios of 55 percent and higher.

But now Freddie has revealed that it is looking carefully at how much applicants' total debt ratios exceed their housing debt ratios, as a key tip-off to potential future difficulties in handling new credit. For example, say your monthly mortgage expenses eat up 33 percent of your monthly income. In and of itself, that won't get you into hot water applying for a loan. But if you're rolling over credit card balances, student loans and other monthly revolving credit to the tune of another 17 percent of your income, then your total-monthly-debt-to-income ratio hits 50 percent.

More important than the 50 percent, though, is the fact that your total monthly revolving debt load is more than 15 percent above your housing debt load. That, according to Freddie Mac, puts you into a higher-risk category. Based on Freddie's analyses of millions of loan files, you are statistically more likely to miss future mortgage payments and get into credit trouble than someone with less than a 15 percent "gap ratio."

The new standard was articulated for the first time this month in technical guidance distributed to Freddie Mac lenders. The guidance is to be used in so-called "manual" underwriting situations. The same guidance also contained a variety of other credit-related standards that home loan applicants may be able to use to their benefit.

For instance, Freddie Mac has long stressed its belief that "layers" of risk are the keys to evaluating the likelihood of future payment defaults by borrowers. That means that you might have something negative in your application - a low credit score or a late payment at Sears. But the presence of one bad mark on your report card at application may be acceptable. The presence of multiple factors - "layered" one on top of the other - is more ominous.

In its new guidance to lenders, Freddie Mac spells out risk-layering factors in three categories:

Credit. Freddie Mac considers "high overall utilization of revolving credit" an important factor. Its key internal test is whether you have more than one credit line - such as credit cards - with more than 50 percent of the credit maximum used.

Capacity. This is your ability to manage the debts you're taking on, and the key tests here are the new "gap ratio," lack of cash reserves and whether you are applying for a "cash-out" refinance.

Collateral. Freddie Mac sees you as higher risk whenever you're putting in a small down payment, seeking "maximum financing," or are financing a two- to four-unit property, a condominium or a manufactured home.

Taken alone, none of these factors is a deal-killer. But when you pile them up, you've got a problem. And you can pretty much count on a higher rate quote, higher fees or, worst of all, a rejection.

Kenneth R. Harney is a syndicated columnist. Send letters in care of the Washington Post Writers Group, 1150 15th St. N.W., Washington, D.C. 20071. Or e-mail him at kenharney@aol.com.

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