For as long as anyone can remember income has been a crucial measure when it comes time to approve a mortgage application. Lenders are always happy to see more income, see steady income, and to see income which is not encumbered by huge monthly debts. But now there is good reason to reconsider the system because it is increasingly obvious that not all income is spent equally.
Consider the debt-to-income ratio or DTI. In basic terms most loans today require that borrowers have a DTI which does not exceed 43% of their gross monthly income. Imagine that a household has a gross monthly income of $10,000. With a 43% DTI they would be allowed to use as much as $4,300 for such recurring monthly expenses as housing costs, auto payments, student debt, and credit card bills.
“The concept of the DTI has been a widely accepted measure within the mortgage industry, and is simply a way of saying that lenders want to reward borrowers who manage their spending,” said Rick Sharga, executive vice president at Ten-X.com, an online real estate marketplace. “The DTI also gives lenders a quick way to view borrowers who are less disciplined with their spending, and therefore might create additional lender risk.”
However, the tax proposals now on Capitol Hill should make lenders – and mortgage investors – begin to wonder if this traditional measure needs to be refined. That’s because both the Trump and the Ryan tax plans envision the system where the standard deduction rises significantly and itemized deductions are limited to write-offs for mortgage interest and charitable contributions. Gone are itemized deductions for state and local income taxes as well as property taxes and uninsured medical bills. In exchange, the standard deduction would rise. For a married couple the standard deduction would be $30,000 under the Trump plan and $24,000 under the Ryan proposal.
So what does this have to do with mortgage applications and the DTI?
When figuring the DTI lenders compare debts against gross monthly income – that is, income without any deductions for taxes. The problem with this concept today, and the problem with the DTI concept should something like the Trump or Ryan tax proposals actually pass, is that the idea of gross monthly income is no longer so certain.
Imagine that you have married mortgage applicants in New Jersey and Texas. Each household makes $120,000 per year, or $10,000 per month in gross income. Each has a 42% DTI.
It would seem that both of our model borrowers are equally qualified but that’s not the case. The folks in New Jersey pay $5,345 in state income taxes, the borrowers in Texas pay nothing so do the couples really have the same financial profile?
A few thoughts:
First, under the current tax system the New Jersey residents can deduct the cost of state income taxes on their federal returns if they itemize. The Texas couple has no state income tax to deduct.
Second, if the Trump or Ryan plans become law the probability is that the New Jersey couple will opt for the standard deduction because it’s a bigger write-off than the combination of property taxes and charitable deductions. However, the obligation to pay the state income tax will remain, it’s a real cost.
The current loan application process penalizes residents of states with low income taxes and the seven jurisdictions without any state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. They simply have more spendable cash each month because there’s no mandatory state income tax deduction from their paychecks. Their effective gross income is bigger than that of residents in high-tax states and yet there’s no mortgage application benefit.
Alternatively, residents in high tax states today get a break of sorts because they’re not dinged in the lending process for the state taxes they’re required to pay. According to TurboTax, the jurisdictions with the highest state income taxes are California (a max of 13.3%), Oregon (9.9%), Minnesota (9.85%), Iowa (8.98%) and New Jersey (8.97%).
The logical solution is to redefine “gross income” for mortgage application purposes. We could simply say that “gross income” equals monthly earnings less state and local income tax payments. Such a standard would instantly create application parity among borrowers nationwide.
Will such a system be adopted? Nope. If we had a mortgage application system which fairly reflected state tax burdens then the instant result would be fewer mortgages in high-tax states, an outcome which because of lost business not be acceptable to local brokers, lenders, or state tax collectors.
Whether the current tax proposals are passed or not, they’ve shined a light on the value of itemized deductions for mortgage applicants. What’s the difference between a required payment of $500 a month for a car loan and a required payment of $500 a month for state income taxes? Why does one count against the debt-to-income ratio but not the other? Given the tax conversations on Capitol Hill this is a question mortgage investors may increasingly want to review.