A New Method for Evaluating Your Debt

WASHINGTON--The second-largest source of home mortgage money in the country, mega-investor Freddie Mac, has come up with a new credit standard for judging loan applicants. Though it hasn’t been made public, the new standard--dubbed the “gap ratio”--offers a valuable test for consumers nationwide who are anticipating buying a home or applying for a mortgage.

Already in use whenever loan applications are submitted to Freddie Mac electronically for underwriting, the gap ratio measures your household monthly debt load against your proposed home mortgage-related debt load. If you’ve got too much revolving credit card, auto or student loan debts in relation to your mortgage debts, it shows up in your gap ratio.

Here’s how it works: The gap ratio is the difference between your monthly debt-payment-to-income ratio and your monthly housing-expense-to-income ratio. Freddie Mac’s new standard suggests that the “gap” between those two debt ratios generally should not exceed 15 percentage points.

Lenders already judge credit-worthiness in part based on how much of your total monthly income you devote to servicing your debts.

In the 1970s and 1980s, a common rule of thumb was that your mortgage-related payments shouldn’t eat up more than 25% of your monthly household income. During the late 1980s and into the 1990s, that rule began to stretch into the 31% to 33% range and sometimes higher.

What about the other common credit yardstick--your monthly-income-to-total-household debt? That’s your mortgage payments, plus your credit card, auto and other monthly debt service expenses.

In the 1990s, acceptable ratios began creeping above 40%. Late in the decade, even Freddie Mac confirmed that it no longer had hard and fast rules on total monthly debt to monthly income ratios, and lenders reported selling loans to Freddie with debt-to-income ratios of 55% and higher.

But now Freddie has revealed that it is looking carefully at how much applicants’ total debt ratios exceed their housing debt ratios, as a key tip-off to potential future difficulties in handling new credit.

The new standard was articulated for the first time earlier this month in technical guidance distributed to Freddie Mac lenders. The guidance is to be used in so-called “manual” underwriting situations.

The same guidance also contained a variety of other credit-related standards that home loan applicants may be able to use to their benefit.

For instance, Freddie Mac has long stressed its belief that “layers” of risk are the keys to evaluating the likelihood of future payment defaults by borrowers. That means that you might have something negative in your application--a low credit score or a late payment at a department store. But the presence of one bad mark on your report card at application may be acceptable. The presence of multiple factors--”layered” one on top of the other--is more ominous.

In its new guidance to lenders, Freddie Mac spells out risk-layering factors in three broad categories:

* Credit. Freddie considers “high overall utilization of revolving credit” an important factor. Its key internal test is whether you have more than one credit line--such as credit cards--with more than 50% of the credit maximum utilized.

* Capacity. This is your ability to manage the debts you’re taking on, and the key tests here are the new gap ratio, lack of cash reserves and whether you are applying for a “cash-out” refinance.

* Collateral. Freddie sees you as higher risk whenever you’re putting in a small down payment, seeking “maximum financing” or are financing a two- to four-unit property, a condominium or a manufactured home.

Taken alone, none of these factors is a deal-killer. But when you pile them up, you’ve got a problem. And you can pretty much count on a higher rate quote, higher fees or worst of all, a rejection.

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Kenneth Harney’s e-mail address is kenharney@aol.com. Distributed by the Washington Post Writers Group.