Mortgage rates have constantly been on the rise in recent times. This is a result of changes (specifically increases) in levels of economic growth and inflation. This poses direct and indirect implications on the general state of credit approval.
Generally, mortgage rates and credit approval have an indirect and inverse relationship. To elaborate, here is a look at the factors impacted by rising mortgage rates that influence credit, namely;
- Front end ratio
- Back end ratio
- Inflation
How Front-end ratio Affects Credit approval
Before a loan is processed, prospective lenders make several checks on the borrower’s creditworthiness. Among the factors scrutinized is the ratio of gross income taken by mortgage payments.
This ratio is known as the front-end ratio, also known as the mortgage-to-income ratio.
It is a general rule that lenders find it desirable when the front-end ratio is as low as possible and is normally capped at 28%. The ratio, however, varies depending on the leniency of the lender.
The total monthly amount paid for mortgages consists of four components; principle, interest, taxes, and insurance (PITI).
Fluctuations in four components lead to a direct and proportional change in the front-end ratio. In our case, we are interested in the influence brought by the change in interest rates hence we will hold the three other factors constant.
Illustration
Suppose you earn $4,000 monthly while the principal amount for the mortgage is $100,000. If the tax amount is $100 and the insurance amount is $70, for a loan term of 10 years, your PITI is roughly $980.
Your front end ratio becomes 24.5% = ($980/$400) x 100.
However, using the same online PITI calculator, when the interest is increased to 6%, PITI increases to about $1,224. Consequently, your front-end ratio rises from 24.5% to 30.6%.
This increase (beyond 28%) moves you further away from getting your loan approved. The only option left is for you to search for more lenient lenders who can accept higher front-end ratios, possibly at a higher down payment.
How Back-end ratio Affects Credit Approval
To assess the creditworthiness of an individual, lenders also check the amount of your income that goes to debt repayment. This is termed as back-end-ratio, also known as Debt-to-income-ratio (DTI).
DTI ratio is calculated by dividing your total income by the total amount assigned to debt servicing.
Illustration
If your total monthly income is $6,000 and you spend $1,500 on paying off debts, your DTI ratio is 25% = $1,500/6,000 x 100.
This implies that you spend a quarter of your monthly income on paying off debts. The DTI ratio is, normally, capped at 43% of total income by most lenders. The lower your back-end ratio is, the more your creditworthiness.
An increase in mortgage rates implies an increase in your DTI ratio due to higher monthly payments. While some lenders may choose to be lenient when it comes to your DTI, such loans come with more strings attached.
Basically, an increase in the DTI ratio means a reduction in the creditworthiness of an individual, hence difficulty in credit approval.
How Inflation Affects Credit Approval
Mortgage rates increase is mostly associated with economic growth and periods of social upheaval. This implies that even rumors of inflation can be a causal factor in mortgage rates increasing.
Once inflation rises, money loses its value and as an implication, borrowers pay less valued amounts than the ones they received. Inflation, therefore, becomes advantageous to the borrower and at the same time disadvantageous to the lenders.
Momentarily, lenders refrain from loaning out funds by putting stringent measures that turn off borrowers including increased security for loans. This will in turn hinder the approval of your loan.
The Takeaway
Rising mortgage rates pose a negative effect on credit approval. To offset these adverse effects, you need to increase your income by searching for several income streams.
An increase in your income will mean a reduction in your back-end and front-end ratio hence implying increased credit worthiness.
Lastly, you need to review other options before settling for loans. An increase in loans directly implies that most of your income goes to debt, hence implying a reduction in your creditworthiness.