One of the main drivers of whether a home loan is considered a “Qualified Mortgage” or non-QM loan comes down to the associated debt-to-income ratio, or DTI, of the borrower.
When the Consumer Financial Protection Bureau (CFPB) finalized the QM rule, they set a hard 43% DTI as the threshold.
This was probably established based on historical standards of housing affordability.
Assuming other key underwriting requirements are met, this should ensure the borrower has the ability to repay the loan.
And importantly, it protects the lender from any lawsuits claiming the contrary.
What Is a DTI Ratio?
In short, it’s a measure of affordability that considers a borrower’s monthly obligations (those that appear on a credit report) relative to their monthly gross income.
Aside from helping a borrower determine what they can afford, it safeguards them from getting in over their head when purchasing a home.
Ultimately, you can’t borrow every single dollar of your income each month. There has to be a cushion for other expenses beyond the mortgage and what appears on a credit report.
That’s why DTIs exist, and why they’re set modestly low. Lenders know you’ve got other expenses, along with monthly savings (hopefully).
This key measure of affordability promotes safe and sound lending, and ideally lowers default rates for lenders.
Prior to the Great Recession, DTI ratios were also used by virtually all lenders, but many allowed stated income to be used as opposed to verifying income via tax returns and/or pay stubs.
Simply put, borrowers could enter any amount they wanted on the loan application, which basically made the calculation worthless.
Today, DTI ratios are verified with real documentation, making them a strong indicator of future payment/default behavior.
As a result, a DTI limit was included in the QM rule to reduce risk and create a more stable housing market moving forward.
Some DTI Examples
Now let’s look at a few DTI examples to illustrate how it works and why it’s important, especially for mortgage lenders.
If a prospective homeowner makes $10,000 per month gross (before taxes), and spends $4,000 on things like the mortgage, car payments, credit cards, and so on, their DTI would be 40%.
In this case, they would satisfy the 43% max DTI limit imposed by the QM rule.
However, imagine a would-be borrower who only makes $7,500 per month and has $3,500 in monthly obligations.
This would make their DTI ratio roughly 47%, which would exceed the max limit of 43%. As a result, their loan wouldn’t technically meet the QM definition.
The 43% DTI Limit Isn’t Actually Enforced
However, since the inception of the QM rule, there has been a very large loophole known as the GSE patch, which allows loans that meet Fannie Mae or Freddie Mac’s underwriting guidelines to be exempt.
Additionally, there isn’t a hard DTI limit on home loans backed by the FHA, VA, or USDA.
Collectively, these government and quasi-government entities back an overwhelming share of the total residential mortgage market.
That has effectively made the DTI limit on QM loans useless in practice, though this patch expires in 2021, which is rapidly approaching.
Assuming it expires as planned, DTIs will become a lot more important for future home buyers and those looking to a refinance an existing home loan.
It will mean that individuals with DTIs above 43% will no longer be able to get a mortgage backed by Fannie Mae or Freddie Mac, at least not a qualified one.
Instead, they’ll need to go an alternate route, such as FHA, VA, or USDA, or simply apply for a non-QM loan.
In the non-QM space, there are DSCR loans, which don’t include DTI ratios at all. Instead, they use a ratio derived from the operating income of the property itself.
Anyway, there’s a decent chance the CFPB will modify the rule before that happens, as many lenders have already expressed their discontent with the rule.
Opponents of the hard DTI limit argue that the measure on its own doesn’t accurately predict default, and that other things like credit score and loan-to-value ratio (LTV) are much more important.