440 Chapter 10 Consumer Mathematics
lumped together. This total payment is referred to as the PITI (an acronym for principal,
interest, taxes, and insurance).Example 10.2.6 Let’s revisit Chantal from Examples 10.2.3 and 10.2.4. Suppose
that her annual property taxes are expected to be $3,300 and her homeowners’
insurance premium is $750. PMI is $45 a month. Find her total PITI.We have already calculated her mortgage payment to be $963.88.The annual total for her escrow accounts will be $3,300 $750 $4,050. Each month she
will need to pay 1/12 of that, or ($4,050/12) $337.50.Her PMI is $45. Note that we do not divide that by 12, since it is already expressed as
a monthly value.Her total PITI would then be $963.88 $337.50 $45.00 $1,346.38.Qualifying for a Mortgage
The risk a lender takes on with a mortgage loan is limited by the fact that the loan is
secured, but, as we’ve already discussed, there is still plenty of risk involved. Even if the
lender is completely sure that it would come out ahead if it had to foreclose, the fact is
that a mortgage lender would much prefer to have the payments. As with any other loan,
a lender wants to make sure that the people to whom it makes a loan are likely to pay as
promised.
How does a lender decide whether or not someone gets a mortgage? The simple answer
is that you qualify for a mortgage if and only if a lender decides that you are a good enough
risk. Naturally there are some limitations—antidiscrimination laws apply and government
regulations may restrict a lender from endangering its financial stability by taking on too
many high-risk loans—but lenders do have a fair amount of leeway.
Most lenders, though, will take into account certain common factors:Your credit history. Lenders want to see that you both have a track record with credit
and have handled your obligations responsibly. Those with a history of borrowing
money and paying it back on time are much more attractive to a lender than those who
have a history of getting in over their heads and paying late (or not at all). Those who
have little experience with credit are also less attractive, since the lack of a track record
makes it hard to judge how they will handle their debts.
Employment stability. A mortgage loan is a long-term proposition. A potential
borrower who has a track record of stable employment will be more attractive than a
borrower who has come and gone from a wide range of jobs, or who doesn’t have much
of an employment history. (Lenders are usually willing to consider time spent in school
acquiring the educational credentials for a career as part of employment history.)
Income. This is probably the single most important factor of all. Regardless of how
good your credit and employment history may be, if your income is not large enough
to make your payments you are not going to be a good risk for the loan.How does a lender determine whether or not your income is adequate for a loan? Most
lenders decide this by using ratio tests, comparing the total monthly PITI for the loan to a
percentage of your gross (before taxes and other deductions) monthly income.
There are two commonly used ratio tests. The first is the simplest:The 28% RuleTo tal PITI cannot exceed 28% of gross monthly income.The purpose of this rule is simply to make sure that your income is adequate to cover the
total monthly payment. The 28% figure is commonly used for this test, but different lend-
ers may use different percents. However, even if a different percent is used, that percent is
likely to be used in the same general way.
The following example will illustrate how the 28% rule is used.