A common problem I run into when prequalifying a prospective homebuyer for a home loan is the one who just bought a car, or rather, financed its purchase, right before our initial meeting. While the mortgage industry seems to be tightening up, with ever more restrictive regulations and guidelines, it appears the auto financing industry still subscribes to the fog-a-mirror standard, i.e., if they can fog a mirror, they qualify for a car loan.
Car payments generally represent one of the greatest monthly debts of a borrower and, consequently, significantly increase their debt-to-income ratio (DTI). DTI is an important factor in qualifying a borrower for a loan. If DTI is excessive, it can disqualify a borrower.
There are two types of DTI, the non-mortgage liabilities, referred to as front-end DTI, and total liabilities (non-mortgage obligations plus housing expense), referred to as back-end DTI. Front-end DTI consists of liabilities such as credit cards and lines of credit (revolving accounts) and installment accounts, such as car loans. Housing expense is the principal and interest portion of the mortgage payment, plus real estate taxes, hazard insurance, mortgage insurance, and HOA dues.
While many loan products consider just the back-end DTI, some, such as USDA Rural Development and V.A., also have maximums on the front-end. Exceeding either the front-end or back-end DTI may disqualify the borrower for the loan amount they need. Although there are exceptions, 43% as a maximum total DTI is a good rule-of-thumb. So, let me give you an example of how that works.
Assume a borrower has monthly gross income of $3,000. Her total debt, including the proposed mortgage, should not exceed $1,290 ($3,000 x .43). Her non-mortgage debt amounts to $350, consisting of a car payment of $275, and balance of $75 in credit card payments. That means, she would qualify for a mortgage payment of $940. However, that $940 must include principal and interest (PI), real estate taxes, and home insurance, plus mortgage insurance (MI), and HOA dues, if any.
If estimated real estate taxes and home insurance are $150/month, that means the mortgage PI payment cannot exceed $790. A monthly payment of $790 on a 30-year fixed-rate conventional loan at 4.125% interest results in a loan amount $163,004. If there is mortgage insurance (because borrower pays less than 20% down) of, say, $80, and HOA fees of $10/month, that means the monthly PI payment cannot exceed $700, resulting in a loan amount of $144,434.
Now, let’s assume the same as the latter case, but this borrower does not have a car payment of $275. In this case, her PI payment could be as much as $975. And that qualifies her for a loan amount of $201,176. That $275 car payment makes a difference of $56,742 in the amount of the loan for which she would qualify! Chance are good that she would then easily qualify for a $275/month car loan after she closes on the purchase of her new home.
The moral of the story—buy the house before the car!!