The Old 28/36

One element of the Homeowner Stability Initiative announced yesterday got me thinking about debt ratios.

One element of the plan calls for a shared effort to reduce monthly payments: For a sample household with payments adding up to 43 percent of his monthly income, the lender would first be responsible for bringing down interest rates so that the borrower's monthly mortgage payment is no more than 38 % of his or her income. Next, the initiative would match further reductions in interest payments dollar-for-dollar with the lender to bring that ratio down to 31%. That lower interest rate must be kept in place for five years, after which it could gradually be stepped up to the conforming loan rate in place at the time of the modification.

Back in the day, the standard underwriting formula for approving mortgage loans was known as the 28/36. Borrowers were qualified for the loan if the proposed new mortgage payment equaled 28% of their gross monthly income and their total monthly payments (including the new mortgage payment) did not exceed 36%. This analysis in effect, controlled the amount borrowers could borrow which translated to the type of property they were buying. Of course, they had to have acceptable credit and a required down payment of at least 20% (10% with PMI insurance).

As we know, for the last 15 years, that type of loan analysis fell by the wayside. If a borrower had a pulse, and a job, he/she could get a mortgage loan by following one of the myriad scoring matrices. This resulted in way too many borrowers buying homes beyond their means and hence the issue we are now stuck with.

It will be interesting to see what the underwriting practices will be in the future. Will we go back to a debt/income ratio analysis or will we create new scoring models that will remain untested until the next cycle. Stay tuned.