SANTA CRUZ (February 17, 2008) - There is nothing more basic in the mortgage industry than the Debt-to-Income (DTI) ratio. It is the first test that we put borrowers through to determine their eligibility for a mortgage. Prospective borrowers can apply this simple test to their own situation.

The DTI is calculated by dividing the borrowers long term monthly debts by their gross monthly income. Lenders reason that if borrowers were prudent and did not over extend their budgets they would be more likely to be able to afford their mortgage payments and, consequently, pose less risk to the lender. Twenty years ago lenders had come to the conclusion that they would restrict buyers to spending no more than 25 percent of their gross monthly income on their long term monthly debts. These debts included the car payment, credit card payments, student loan payments, child and spousal support payments along with the proposed house payment of Principal, Interest, Taxes and Insurance (PITI). Car insurance, PG&E, utilities, etc. did not factor into this equation.

That 25 percent DTI ratio meant that a couple earning a gross income of $5,000 per month could spend a maximum of $1250 per month on their PITI, assuming that they had no long term debt payments. Twenty five years ago that $1,250 monthly payment would have been just adequate to purchase a median priced home in Santa Cruz of $120,000 with 10 percent down at a 30 year fixed rate of 10 percent.

Over the years, as homes have become more expensive, relative to incomes, lenders have eased off on their 25 percent debt-to-income ratio requirement. In fact, the standard acceptable ratio has crept up and today for conforming loans (the current limit is still $417,000) goes to 65 percent and even higher in some cases. The other 35 percent of a borrower’s income would have to pay for income taxes, utilities, food, etc. For jumbo loans (above $417,000), lenders generally restrict the DTI to 50 percent or less and require interest rates about 1 percent higher than conforming loans.

Let’s look at an example of a $700,000 home in Santa Cruz today and assume that this home will be purchased with a down payment of $70,000. Based on a 30 year fixed rate first mortgage of $560,000 and a 30 year fixed rate second mortgage of $70,000, the PITI for a loan to buy this home would be on the order of $4750 / month. At a DTI of 65 percent, a borrower would have to make a minimum of $88,000 per year to qualify for this loan. That is assuming that the borrower has no other long term debts. This also assumes that Freddie Mac and Fannie Mae will allow the same lenient underwriting standards for loan amounts between the now-current conforming limit of $417,000 and the new limit of $729,750.

Don’t forget to consider the tax savings. Uncle Sam will help make these payments for an owner occupied home as well as one vacation home. If the borrower is in a 33 percent tax bracket, the tax savings each month would be a whopping $1370 per month. This would effectively lower the monthly payment from $4750 down to $3380.

There are many options available and many considerations to take into account. Get prepared to take advantage of today’s soft real estate market, higher conforming limits and lower mortgage rates by meeting with a mortgage professional to determine what your options are.

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 or email him at Peter@SantaCruzHomeFinance.com.