California home loans

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The Important Ratios



Most of real estate lending comes down to the results of three ratios:

Debt Service Coverage Ratio (DSCR)

Loan-To-Value Ratio

Debt Ratio




The "processing" of a loan is merely an attempt to verify the numbers that go into the numerator and denominator of the above 3 ratios.


The most important ratio to understand when making income property loans is the Debt Service Coverage Ratio (DSCR). It is defined as:
DSCR = Net Operating Income (NOI) / Total Debt Service (mortgage payment(s)

Net Operating Income is the income from a rental property after deducting for real estate taxes, fire insurance, repairs, and all other operating expenses; and Debt Service is the mortgage payment on the property (principal and interest of ALL Loans, not just the first mortgage). Most lenders insist that this ratio exceed 1.0. A debt service coverage ratio of less than 1.0 would mean that the property did not produce enough net rental income for the owner to make the mortgage payments without supplementing the property from his personal budget.

Obviously the higher the DSCR, the more net operating income is available to service the debt. The Lender wants as high a DSCR as possible.

The borrower, on the other hand, wants as large a loan as possible. The larger the loan, the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be.

Life insurance companies are very conservative and generally require a 1.25 or 1.35 DSCR. This means that their loan-to-value ratios are low. Savings and loans (S&L's) generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.



LTV Ratio

The loan-to-value (LTV) ratio is probably the most important of the 3 underwriting ratios.

The loan-to-value ratio is defined as:
LTV Ratio = Total Loan Balances (1st mtg+2nd mtg +3rd mtg) / Fair Market Value of the Property

If the borrower is only applying for a first mortgage, and there will be no other loans on the property, then the beginning balance of the new loan requested should be inserted in the numerator.

However, if the borrower is applying for a second mortgage, then the "underwriter" (the person who determines whether or not the loan qualifies) should insert the sum of the first and second mortgages in the numerator. Similarly, if the borrower is applying for a third mortgage, then the underwriter should insert the sum of the first, second and third mortgages into the numerator.

When the borrower is applying for a second or third mortgage, the loan-to-value ratio is often known as the combined loan-to-value ratio (CLTV ratio).

Generally the fair market value of a property is determined by an appraisal. There is one important exception, however. When the proceeds of a mortgage loan are used to buy the same property that is securing the loan, then that mortgage is known as a "purchase money loan." If the appraisal comes in lower than the purchase price in a "purchase money" transaction, then the lender will use the LOWER of the purchase price or appraisal.

Mortgage brokers are often asked by real estate agents and buyers to base their loan on the appraised value rather than the purchase price. Their claim is that they have negotiated a super deal and that the property is worth much more than what they are paying for it. This may be so (although generally untrue), but lenders always base their maximum loan on the lower of purchase price or appraisal. The lender's argument (its their money, so there is really very little argument) is that an appraisal is really no more than an estimate of fair market value, no matter how competent or conscientious the appraiser may be. The only true indicator of value is the marketplace in which "a willing buyer and a willing seller, each in full knowledge of the salient facts, and neither under undue pressure, agree upon terms." If the property sells for "X," then it is probably only worth "X."

Loan-To-Value Ratios seldom exceed 80% on commercial loans, because the lender always wants some protection against default.


Debt Ratios

Another ratio that lenders use when underwriting a loan is the Debt Ratio. The Debt Ratio compares the amount of bills that the borrower must pay each month to the amount of monthly income he earns. More precisely, the Debt Ratio is defined as:
Debt Ratio = Monthly Debt Obligations / Monthly Income

When analyzing the personal budget of a borrower, lenders use two different debt ratios to determine if the borrower can afford his obligations. These two debt ratios are:

  1. Top Debt Ratio
  2. Bottom Debt Ratio

The "top" debt ratio is defined as:
Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income

By "monthly housing expense" we mean either the borrower's monthly rent payments, or if she owns her own home, the total of the following -

Monthly Housing Expense

  • 1st mortgage payment on home plus
  • Real estate taxes (annual cost/12) plus
  • Fire insurance (annual cost/12) plus
  • Homeowner's association dues(if home is a condo or townhouse) plus
  • Second mortgage payment (if any) plus
  • Third mortgage payment (if any).

You will often hear the term P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While P.I.T.I. is not exactly the same as Monthly Housing Expense because it does not include homeowner's association dues, the two terms are often used interchangably.

Lenders have learned over the years that a borrower's "top" debt ratio should not exceed 25%. In other words, a person's housing expense should not exceed 1/4 of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems.

The second ratio that lenders use to determine if a borrower can afford her obligations is the "bottom" debt ratio. It is defined as follows:
Bottom Debt Ratio = (Total Housing Expense + Debt Payments)/Gross Monthly Income

The only difference between the two ratios is the inclusion in the numerator of "debt payments." Debt payments include the following:

Debt Payments

  • Car payments
  • Charge card payments
  • Payments on installment loans, for example - a payment on a washer & dryer that the borrower purchased.
  • Payments on personal loans, for example - a signature loan from the borrower's bank.

What is not included in "debt payments" is Utilities such as PG&E, water or telephone and payments on real estate loans. Real estate loans are usually offset first by the net rental income from the property. If the borrower has a net positive cash flow from all his rentals, then the net income is usually added to his "gross monthly income." If the borrower has a net negative cash flow from all of his rental properties, then the amount of the negative cash flow is usually added to the numerator of the "bottom" debt ratio as if it were a monthly debt obligation, like a car payment.

Traditional lending theory maintains that a borrower's "bottom" debt ratio should not exceed 33 1/3%. In other words, the total of the borrower's housing expense and debt obligations should not exceed 1/3 of his income. Lenders often will stretch on this ratio to as high as 36%, and some have even been known to stretch as high as 40% or more. Obviously a loan with a debt ratio of 40% is a far more risky loan than a loan with a debt ratio of 32%.