Loan Modification Part 3 -Determining if you qualify!

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So far in this series we’ve talked about the process of loan modifications, how to get started and how to collect the information you need to accurately complete your monthly expense worksheet. The monthly expense worksheet is going to be used by your lender to determine if you qualify for a loan modification or not. Therefore this is an extremely important step that must be taken with care. Once you submit your monthly expense worksheet it becomes part of your file and is very hard to change it once submitted. Take your time and make sure it is correct!

Tip: Never lie on your monthly expense worksheet. Loan fraud is a federal crime. Knowingly submitting false information will jeopardize your modification application and may subject you to legal action from your lender.

Understanding debt to income ratio (DTI)

Debt-to-income (DTI) is the key determinant in most lending situations. In a traditional home loan the DTI plus the loan to value (LTV) play roles; but in a modification it is assumed that the LTV is negative (you are upside down on your home and unable to refinance) so the key decision factor is DTI (along with your credit worthiness as demonstrated by your monthly payment history and credit report).

DTI is calculated as follows:

Total Monthly Expenses / Total Gross Income

For example if your gross monthly income is $5,000 per month (you make $60,000 per year) and your monthly expenses are $3,000 then your DTI is:

$3,000 / $5,000 = 60%

Understanding gross monthly income

Before we can accurately calculate your DTI we need to accurately calculate your gross monthly income. Gross means the dollar amount you earn before deductions such as state and federal taxes, health insurance, 401(k) and FSA contributions.

If you are a salaried employee this is relatively easy to determine. Take your yearly salary and divide by 12. This number is your gross monthly income. If you make $60,000 per year, your gross monthly income is $5,000.

Tip: Many salaried people are paid every two weeks, not twice a month. Being paid every two weeks means you receive 26 paychecks instead of 24 (bi-monthly checks). If you take your last two paychecks and add them up before deductions you have short-changed yourself in calculating your DTI. Double-check with your employer to see if you get 26 or 24 paychecks in a year, or better, use the method described above to get your gross monthly income.

If you are paid by the hour this becomes a bit more difficult. First, you cannot count overtime pay towards your gross monthly income. Even if you’re a California-state prison guard who has been working overtime for 5 years in a row, you still have to use your base hourly income to qualify.

Take the last two-months paychecks (4) and add up the hours (except for overtime). Divide by 2. That is your average monthly hours worked. Take that hour amount and multiply it by your hourly wage. If you worked an average of 160 hours per month (40 per week) and make $20 per hour you make $3,200 per month gross income.

Tip: Including overtime is one of the biggest reasons loan modifications get rejected for hourly workers. Don’t include it in your monthly calculation. The bank won’t count it and calculating your DTI including overtime will throw off your calculation.

If you receive social security or long-term disability you may be able to “gross up” you benefits. Because social security is not taxed banks often add 25% to the value of your monthly benefit to more accurately represent the value of this money. Be sure to ask your bank if they “gross up” social security before doing the calculation with “grossed up” social security.

How to “gross up” social security:

$1,000 monthly social security benefit x 1.25 = $1,250 grossed up benefit for DTI calculation

Tip: Most banks gross up these benefits, but we always recommend asking your representative in the loss mitigation department if they gross up social security in their underwriting to ensure that you’re making an accurate calculation.

Target debt to income ratio

The target debt to income ratio that you’re looking to achieve is 50%. That means that your total monthly expenses including your mortgage comprise only half of your gross monthly income. If you make $5,000 per month ($60k/annually) your monthly expenses can’t be more than $2,500.

In reality, if you’re considering a loan modification, it is likely that your monthly debt to income ratio is closer to 100% or worse. The modification is going to help that, and we have to figure out what that will do to the ratio first.

Calculating a reduced mortgage payment

This step gives you an idea of what you’ll negotiate for when you submit your package to the bank. Use an online mortgage calculator (there’s a good one at bankrate.com: http://www.bankrate.com/brm/mortgage-calculator.asp but anyone will do) to play around with different loan modification scenarios.

Tip: Banks will typically not reduce your principal owed, and rather adjust the interest rate to reduce your payments. They will typically reduce them between 2-4%. If you qualify for the new Making Home Affordable federal modification program you may be eligible for an even greater reduction. We will talk more about that program in future posts.

Example mortgage calculation

Say you have a $165,000 mortgage that recently adjusted from 5.25% to 9.25%. Your situation would look like this:

Loan amount: $165,000

Term: 30-years

Interest rate: 5.25%

Monthly payment: $911.14

After adjustment

Loan amount: $165,000

Term: 30-years

Interest rate: 9.25%

Monthly payment: $1357.41

Lets say that you’re still making that $60,000 per year and that you had total monthly expenses (not counting your mortgage) of $1,800 per month.

Your DTI prior to adjustment:

$1,800 + $911.14 = $2,711.14 / $5,000 = 54.23%

Your DTI after adjustment:

$1,800 + $1,357.41 = $3,157.41 / $5,000 = 63.15%

Now the target DTI is 50%. Some banks vary and it’s very hard to get them to tell you exactly what they’ll accept; but industry standard is 50%. They’ll sometimes accept higher; but if you’re not near the 50% mark you’ll often not qualify for a modification.

So what can we do to get down to a 50% DTI in the above example?

Well we can request a modification of our mortgage back to the original 5.25%?

That would give us a monthly mortgage payment of $911.14 and a debt to income ratio of 54.23%. That’s not quite at 50% and ideally we want to be under 50%. So what else can we do?

We can:

• Double check our expenses for items that shouldn’t be included (such as work-related expenses)
• Call our credit card companies and ask for a reduction in monthly payments
• Reduce our utility bills by cancelling premium cable subscriptions, opting in to programs that reduce utility bills in exchange for power-flexibility in the summer, switching to a smaller trash can size, etc.
• Exclude expenses like eating out, food, clothes and discretionary expenses from your DTI

Because your monthly expenses can fluctuate quite a bit each month you want to focus on big ticket items and not rack up lots of little dings.

What if we:

• Saved $300/month by not eating out
• Cancelled a gym membership worth $100/month
• Reduced our utilities by $50/month

That would give us a DTI of: 45.22% – bingo. That’s the number we want to work with.

So when we complete our monthly expense worksheet we’re going to report the big ticket items that are always there, but we’re going to leave off for now the variable items that we can control, such as food, etc.

If they ask for it later we’ll give it to them; but for now we want to present a case that with a new “hoped for” mortgage amount (the modified rate and monthly payment) plus our monthly expenses that we’re a good candidate for a mortgage at under 50%.

Tip: Never lie to your bank. What we’re doing here is making an assumption that we can control variable monthly expenses through good judgment and sacrifice in order to keep our home. If we must present this information we will.

In the next article we’ll talk about tips for qualifying for a loan modification.