Asymmetry in the Residential Mortgage Process
So, most of us have experienced getting a mortgage for a home at this point and most of us have used the mortgage platform that follows the governmental rules for residential mortgage qualification vs using a local bank making a portfolio loan. And, we are familiar with the headaches involved for that oh so cheap money.
But, what is really going on behind the scene there? Have you ever wondered what affects your qualification ability and how people with different scenarios have the same results?
Let’s start with the simple approach - Portfolio lending.
Portfolio Lending
With portfolio lending, a bank lends out its own money. They make their own rules and decide who qualifies and who doesn’t. The result is that this typically follows a formula based on equity in the project or house, income stream and ability to repay and net worth. It’s pretty simple and can be broken down like thus - The more wealth you have, the more willing they are to grant you a loan. While they concern themselves with ratios and such, basically it comes down to whether they think you can repay and if you don’t, how much other wealth do you have that they can come and get. The process is often very quick and rarely involves constant employment checks, credit checks, bank account checks, re checks, etc. etc. For this privilege though, you often pay a bit more in interest rate and the loan is often a variable rate loan. While this is common in commercial lending, most people don’t use a portfolio lender for their home loan as a first choice.
Government backed lending
This is a broad category and not all loans are government backed. But, in this sector, standard rules are followed regarding underwriting the loan in order for the loan to be sold in the secondary market. So, regardless of which bank or broker you go to, the process will largely look the same. This is where it gets fun and funny and I’m going to show you how.
The core goal is to have all your payments under 45% as a ratio to your monthly gross income. Payments include largely the following:
AlimonyChild supportPrincipal, interest, taxes and insurance on your personal and vacation homesCar paymentsMinimum credit card paymentsOther loan paymentsNet rental income/loss as calculated on any personally owned rental properties with individual mortgages. This is loosely calculated using your previous year rent and expenses excluding interest and depreciation and adding back in principal and interest on the note payment.
That seems all fairly logical, right with the goal of assessing payment capability? Well, not exactly. Let’s examine it more closely.
Alimony - All contemplations of marriage should really start with an examination of alimony, right? I’ll save that for another time though. Two people are married and one person makes all the money. They make $200,000 a year and have $40,000 in annual payments for the items above. That’s a 20% ratio. Now, they get divorced. The man is ordered to pay his ex wife $30,000 a year. Doesn’t matter for how long. In this world, that payment is in perpetuity if it exists. So, if he retains the same payments of $40,000 and adds on the $30,000, his ratio jumps 15 points to 35%. However, the reality is he was likely already paying this and more. It’s possible that he even limited his losses by getting divorced and accepting the alimony albatross. Yet, in the eyes of the mortgage system his attractiveness just dropped. A lot.
Child support - Same scenario as above. The man gets tagged for child support, and, let’s be honest, even if income is nearly identical the man gets tagged for child support. If he has to pay $30,000 a year for his two kids, that bumps his ratios up 15 points. The ironic piece here is two fold. One, this makes it that much harder for him to buy a house in which to keep the kids on his every other weekend schedule. Two, when he was married, he was very likely paying the same amount. But, when you’re married, what you pay to take care of your kids doesn’t factor into any equation. Moreover, how many kids you have isn’t even considered.
     Marinate on that a bit. You have a couple making $200,000 a year combined with $80,000 a year in payments. 40% ratio. Couple A has 4 kids. Couple B has no kids. Which one has more free cash flow with which to repay debt? It doesn’t take rocket science to figure this out. Any parent will tell you it’s the couple with no kids. Normally, kids don’t get cheaper as you add them and normally they don’t contribute income. Yet, in mortgage world, these two couples are the same risk.

PITI on your personal and vacation residences. Well, this makes sense. Something had to.
Car payments - Don’t purchase a car and finance it until after you get a mortgage. Car payments calculate as though they go on forever. Have 10 months left on that $500 a month payment. That calculation acts as though you will have it for all 30 years of the mortgage. And, of course, you might - with a different car. But, own the car outright and it acts as though you will never have a payment. Ever. See the problem here? Most people have recurring transportation needs yet you can manipulate the system a bit by placing those costs in place after you get a mortgage.Minimum credit card payments - That’s right. Owing $10,000 is the same as owing $40,000 except for the small difference in that minimum payment. What kind of tortured financial analysis is that? Everyone knows that owing more credit card debt is exponentially worse.
Net Rental Income - Now this gets really fun. If you are working this system to gain loans for rental real estate, pay close attention. A 15 year loan is better than a 30 year in a pure financial sense. The interest rate is typically lower, resulting in lower costs. But, in mortgage world, this penalizes you because it produces a greater cash expense.
     For example, you have a mortgage payment of $2,000 a month on a 30 year note. That same mortgage on a 15 year note would be $2,600 (for discussion sake…). The calculation in mortgage world would add a $600 increase to your monthly payments and would adjust your ratio by 3.6 points. So, if you have three of those, you’ve just taken 10 points of your ratio and probably prohibited yourself from any more borrowing. While it is correct to look at cash flow, this alone does not tell the entire story for a lender. All it does is tell them what is happening right at this moment and doesn’t even tell that very clearly.
     However, what if you had a rental property that didn’t affect the payments positively or negatively? WHAT???? It’s true.
     Let’s say you form a legal entity that buys a duplex. The legal entity takes out a loan with a local bank and it is guaranteed by you. Now, let’s say that duplex generates no taxable profit or loss but produces negative cash flow of $20,000 a year due to principal reduction on the note of $20,000. In mortgage world, this flows through into top line income and has no effect (zero net income) and doesn’t affect the payment ratio. However, had you purchased this individually with a mortgage in your name, you would be hit with a $20,000 annual payment amount on your ratio calculation. With $200,000 in income, that would cost you 10 points on the ratio. Exact same economic effect. However, in the legal entity scenario, you remain attractive for a mortgage on that new house you want. In the second, you are much less attractive.

So what lessons have we learned here?
In mortgage world, payments are everything. Don’t have them if you want to qualify for as much mortgage debt as you can handle. Don’t buy a new car. Know where you are vis a vis the amount of mortgage you will need and plan accordingly.
If you have a lot of kids and think you may get divorced (or, IPO equivalent if you’re the one cashing out), secure any house purchases before divorce because child support and alimony could eat your ratios up such that you no longer qualify.
Alimony is a bitch. Why would you ever put yourself in this position? Think first.
Rental properties. Think through where you are going with a rental portfolio and set yourself up in the best way to allow continued access to debt. Debt is your lifeblood with real estate. Keep your amortization period long. Put any big cash flow drains into an entity and have the entity take out the loan. This is particularly key for development properties where there is high negative cash flow in the short run followed by a sale. If you structure this wrong, you could cut off your lifeblood during the project which could affect your timing on future projects.