A lender looks at many, many financial factors when you apply for a loan, one of the most important of which is your debt ratio. Your debt ratio is the ratio of personal debt to income. Ideally, the ratio will be greater than one. If it is greater than one, it means that you have enough income to pay your debts and make other routine payments such as those necessary for utilities, food, and entertainment. If you have a ratio of less than one, you do not have enough income to make your debt payments, let alone those other expenses. Not surprisingly, a lender does not want to lend to someone who does not have enough income to pay off all his debt. Instead, a lender prefers to see a ratio of about 1.3, which means you have about 30% more money than you need to pay your debt. The lender considers this a comfortable margin for you not to be tempted to use your mortgage money to go on vacation or pay medical bills or go out to dinner.
The debt ratio is one of the most important factors and most financial information the lender gathers is used to figure out this ratio. For instance, tax returns and pay check stubs are used to determine monthly income. However, there are other things a lender takes into consideration. A lender will also review your
payment history because, even if you have a good debt ratio, a lender does not want to loan money to someone who pays his debts late. A lender will also look to see if you have other assets besides monthly income. First, a lender prefers you have enough cash to make an equity investment – a down payment – in the home. This lessens the risk of default. Second, if you have significant assets and they are fairly liquid, such as a stock portfolio, a lender may make you a loan even though your debt ratio is high because you have the ability to come up with payments outside of your wages or the ability to purchase the property in full if you have to. If the lender makes this type of loan – a so-called asset based loan – it will probably take a security interest in the assets instead of, or in addition to, your house. The typical bank will not make an asset based loan for the purchase of residential property, and you’ll probably have to seek out a lender who specializes in this.
The other major financial factor a lender considers, fortunately, has nothing to do with you. The lender also reviews an appraisal of the house to make sure it doesn’t lend more than the house is worth. This is because, in the event of foreclosure, the lender wants to be sure it recovers all of the money owed to it. It can’t do this if the house it must sell to do so is not worth what it paid for the house.