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Mortgage Acceptance Considerations on the Real Estate License Exam

By John A. Yoegel

The Real Estate License Exam will have questions pertaining to mortgages and lenders. A primary lender has two considerations when it is making a loan for the purchase or refinancing of real estate: the value of the property and the borrower’s ability to pay off the debt.

In checking out the value of the property, lenders want to be assured that if their borrowers can’t pay off their mortgages, they can sell the properties and get back their money. Assuming the property value is sufficient to guarantee the loan, a lender wants to make sure that the borrower can make the monthly payment, including taxes and insurance, for the life of the loan.

The property value

The value of the property has a direct effect on the amount of money the lender will lend you, and you need to be prepared to do a math problem about this topic on the state exam. The percentage of value of the property that can be borrowed is called the loan to value ratio (LTV), an amount that is set by the bank and the secondary mortgage market.

The value of the property is based on an appraisal. In the event that an appraised value and selling price are different, the amount of money that can be borrowed is based on the lower of the two numbers. And yes, that means that if you’re paying more than the appraised value for the house, your down payment will be higher than expected. Here are some examples.

A property sells for $200,000. Its appraised value is $200,000. The LTV ratio for the mortgage is 80 percent. How much money will the bank lend? What down payment is required?

$200,000 (appraised value) x 0.80 (80 percent) = $160,000 mortgage amount

$200,000 – 160,000 = $40,000 down payment

The sale price of the house is $315,000. The appraised value is $300,000. If the bank offers an 80 percent LTV ratio, what down payment will be needed?

$300,000 (appraised value) x 0.80 = $240,000 mortgage amount

$315,000 – $240,000 = $75,000

A final problem shows you how to calculate the LTV, if you’re given value and loan information. Say the bank will lend you $240,000 on a property valued at $300,000. What is the LTV ratio?

$240,000 ÷$300,000 = 0.80, or 80 percent

Note that in these problems the appraised value was used to calculate the amount of the mortgage, and then the mortgage amount was subtracted from the selling price to find out the down payment that’s needed. In doing a problem like this, just take the numbers for what they are.

The borrower’s ability to pay

The second type of calculation involves determining how much a buyer can afford to pay for a mortgage loan. You need to understand some of the terminology and how it works.

The lender uses a qualifying ratio to determine what a borrower can afford to pay for a mortgage loan. When using a qualifying ratio, you work backward from the buyer’s gross income, usually using monthly numbers for principal, interest, tax, and insurance expenses to arrive at what the buyer can afford to spend on housing every month.

You need to note that the acronym used for the payment of principal, interest, taxes, and insurance is PITI. When lenders do affordability calculations, they use PITI as the total monthly expense for mortgage loan payment calculations.

For example, a lender may say that a buyer can afford to pay 28 percent of total gross income in monthly payments (principal, interest, taxes, and insurance expenses). This percentage is called the front-end ratio. The lender also establishes that the borrower’s total monthly debt payments, including PITI, can’t be greater than 36 percent of the borrower’s total gross income. This percentage is called the back-end ratio.

You may or may not find a qualifying ratio calculation question on the exam, but calculating them is a service that real estate agents routinely provide for their customers and clients. And just in case you’d like to do your own calculations, here’s an example.

Say you make $96,000 a year. Using the fairly standard qualifying ratios of 28 percent for principal, interest, taxes and insurance (PITI) and 36 percent for total debt, how much can you afford to pay for PITI per month?

$96,000 x 0.28 = $26,880

$26,880 ÷12 (months) = $2,240 maximum monthly PITI

Alternatively, you can do the calculation this way:

$96,000 ÷12 (months) = $8,000

$8,000 x 0.28 = $2,240

Now where, you ask, does the 36 percent back-end ratio come in?

$96,000 x 0.36 = $34,560

$34,560 ÷12 (months) = $2,880 maximum total monthly debt payments including PITI

Together, the front-end and back-end ratios work in such a way that the borrower’s PITI and total debts have to fall below both criteria. So if in the example the borrower’s total monthly long-term debt payments without PITI were $2,000 a month, the lender would allow the borrower to spend $880 or less on PITI.

On the other hand, if the borrower has no other debt, the lender still wouldn’t allow the borrower to spend more than $2,240 on PITI. Whatever amount of money is available for PITI, the lender uses that amount to calculate how much of a mortgage the borrower can afford to pay off.