The Irony of Having a Higher Income

I always appreciate getting inspiration for a newsletter article from my clients. This week, a very successful physician was dismayed as to why we were having difficulty getting his loan approved.

Now in my 23rd year of mortgage financing, despite the ups and downs of the real estate market, and no matter the interest rate environment, I have realized for years one bizarre piece of irony: Those with higher incomes are short-changed when applying for a mortgage loan.

What? You thought all rich people get approved automatically? Not the case! In fact, in many cases, someone of average to upper-average income is more likely to get their mortgage loan approved that someone in the top 2% of all wage earners.

Here’s why:

First and foremost, every loan application is measured for a critical statistic called the Debt-to-Income ratio. In simple terms, your total amount of monthly debt cannot exceed a pre-determined percentage of your gross monthly income. While there are exceptions to the rule, but for the purpose of this example, the maximum DTI, as we refer to it in the mortgage industry, cannot exceed 45% of your income. If you the borrower (and co-borrower if applicable) earn $90,000 per year, or $7,500 per month, maximum total monthly debt you are allowed to carry, and still be approved for the mortgage, is $3,375 per month. The rationale for the 45% cap came from years of study of loans that were successfully paid, and those that unfortunately ended in foreclosure. The bean counters determined that in general, a mortgage applicant needs the remaining 55% of their gross income to pay for income taxes, food, clothing, utilities, entertainment, and incidentals.

Do the math yourself with your gross income. Would you feel comfortable with having 45% of your pre-tax income spent on housing and consumer debt repayment? The answer for many of you is NO! In fact, the smaller your income, the less comfortable you will feel. That’s because the other side of the equation – the 55% that’s used for everything else is also smaller with a smaller income.

The disparity for large income applicants has to do with the percentages. One can only spend so much on food, clothing, utilities, etc. Yes, those with higher incomes generally eat more expensive food or wear more expensive clothes. But those expenses are almost always a smaller percentage of a wealthier person’s income, than someone of lesser means.

In simple terms, wealthier people can carry a higher percentage of their income paying debt, because they need less disposable income as a percentage of their gross income. Despite this glaring statistic, the DTI of those fortunate to have higher incomes is exactly the same as for those that earn significantly less.

It’s not the big mortgage payment or larger car payment that gives one a sense of wealth – it’s one’s access to disposable income that gives one that sense of wealth. Having the ability to frivolously spend without great concern is the true measure of being better off financially. Rich people make more money, but they also have bigger mortgages and higher car payments. But the big difference is the amount of disposable income they have over those not so fortunate. It’s that feeling of having more disposable income that creates a disconnect when underwriting a higher income borrower. The wealthier person feels they can carry a greater amount of debt – and they aren’t wrong, but may be denied their financing request because of DTI restrictions.

The study I referenced earlier that came up with the DTI ratios never took total income into consideration. They simply looked at successful loans, and those that weren’t, and recorded the percentage of total debt to the gross income. They never analyzed the amount of income the borrower made as part of their risk analysis. If they threw income levels into the calculations, the study would have developed a sliding scale of maximum DTI. Those on the lower end of the income spectrum should have a reduced DTI threshold, and increase as the applicant’s income is greater. Unfortunately what we currently have now in lending is a “one size fits all” mentality.

The good news is that capitalism isn’t dead. Lenders will always look for ways to serve an ever larger customer base. Now that every aspect of your loan (income, assets, credit, appraisal) are all digitally stored (just the numbers, not the actual documents), the bean counters will once again use some new technology to determine how much they can lend without increasing their risk substantially.