Lenders look to ‘leftover’ cash to gauge housing affordability

Residual income — what’s left after bills — is gaining popularity as the way to measure what borrowers can afford

What’s the monthly payment? After the sale price of the home, that’s the main number homebuyers fixate on.

So, too, do mortgage lenders.

Stacking the new mortgage payment — which usually includes the monthly portion of the annual property tax and homeowner’s insurance premium — plus all other regular monthly debts, like a car loan payment, against the gross monthly income of a mortgage applicant produces the all-important debt-to-income ratio.

The government-backed FHA loan program, for instance, doesn’t like to see the total recurring monthly debt exceed 43 percent of income; other lenders may want a significantly smaller number.

But that’s not the best way to evaluate affordability, says Laurie Goodman, director of The Urban Institute’s Housing Finance Policy Center.

A much better measure is examining what’s left in a household’s budget after the regular debts are paid. In the mortgage business vernacular, that’s called “residual income.”

Consider, for example, a two-person family making $100,000 annually with a DTI of 44 percent, compared to a family of six making $70,000 with a DTI of 43 percent. Each household must pay the same price for a loaf of bread, but the bigger family needs more loaves and has less residual income to pay for it.

Now, the popular FHA mortgage program will consider residual income when DTI exceeds standard limits. For instance, if a five-person family in the Midwest seeking a mortgage less than $79,999 has a residual income of at least $902 they may qualify even with a high DTI ratio.

Goodman thinks that other lenders may choose to apply a residual income test when evaluating higher-risk borrowers. Some banks will weigh residual income heavily when they are making mortgages that will be kept in their own portfolio, says Ron Haynie of the Independent Community Bankers of America. Certainly, borrowers can calculate for themselves whether their “leftover” dollars will be adequate or not, Haynie adds. — Marilyn Kennedy Melia © CTW Features