Your monthly budget likely accounts for every dollar coming into your home. Perhaps detailing each payment and expense you’ll be required to pay for that month while the amount of cash left over you designate toward savings. When you’re sitting at your kitchen table trying to calculate if you can afford another loan, I bet you review that cash that you are currently putting toward savings to cover your new loan payment. This may reduce the amount left over for savings at the end of each month, but all your bills will be paid. Surely a bank understands this, and will make that new loan to you – right?
Well, it really isn’t that simple as it depends on how much of your cash income goes towards covering principal and interest (P&I) payments each month. Mortgage and housing financial entities define gross debt servicing (GDS) and total debt servicing (TDS) ratios and provides acceptable levels in all of their outlines and guidelines for lending criteria. We’re assuming that we are talking about a legitimate and sound banking institution with acceptable ethical practices and procedures in place. We are not talking about these derivative swap morons and leveraging idiots we have come to know so well in 2008 and 2009. I am talking about REAL bankers and REAL professionals.
What Is Your GDS Ratio?
The borrower should not commit more than 32% of their gross household income toward the payment of the principal + interest + property taxes + heat and utilities. (For condominiums, this formula can also include 50% of condominium fees. For Chattel Loans / Mortgages, it must include site rent).
What Is Your TDS Ratio?
Successfully Approved for the Loan!!!
The borrower should not commit more than 40% of their gross household income toward housing obligations and all other debts. (total principal and interest payments + payments on all other debts X 100).
Self-employed individuals may find it a challenge when borrowing funds as they usually position their lifestyle around their business expenses. This reduces the amount of income they report to the IRS and the tax they are required to pay. Although this is a good way to reduce taxable income, it adversely affects GDS and TDS ratios. In most cases self-employed people need to review their tax returns with the lender when applying for credit. Usually they are able to add items back into income that were declared expenses such as: depreciation, amortization, capital cost allowance is, interest, and one-time expenses to name a few. It is most likely lenders will only add back depreciation, and authorization and capital cost allowance in when lending to a sole owner using their tax return as evidence of income. If they need to add back many small items in order to prove GDS and TDS your request may be reviewed as being too risky and declined out right.
It is also important to note that most lenders will require you to be in business at least three years before using your self-employed income to service debt. Banks like to review historical information to establish likely trends. By reviewing three years of tax returns they are able to establish the direction in which you’re headed, and the average income likely to continue through the full-life term of the new loan for which you are currently applying.
If you are a self-employed sole proprietor (owner), consider carefully your tax structure and planning to include the necessary income required for personal and business debt combined. Also consider immediate and future needs to establish a historical ability to service future needs. This room can be found not only in net earnings, but also in draws, depreciation, amortization, and additional forms of receivables.
It is a good idea to have a meeting with your accountant and banker to review your three-year plan. Know now what you want to own in the near and distant future, and position your financial affairs to service that debt. Meeting with your accountant and banker helps add clarity to what everybody needs to do to help you reach your goals. We will be discussing this much further later in my series.
Let’s Discuss Equity Lending Shall We
Even though you may only be requesting to borrow approximately 50% of the value of an asset you intend to purchase, that doesn’t mean a bank will automatically finance the balance for you. Lending in this respect is referred to as Equity Lending (an EL), or lending against the value of an asset.
Financing such as Equity Lending reflects a strategy that if you don’t meet your commitments the lender will own the asset, then sell it to recover the money owned by the borrower (such as a foreclosure). This ensures that you have money invested in the asset as well, and likely don’t want to lose the equity you’ve built up and will be more willing to pay as agreed and avoid foreclosure. In true essence, the bank is your financial backing partner.
Equity Lending is commonly seen when financing mortgages, or lending to a business. At the end of the day, despite how small your loan may be compared to the value of the asset, cash is the only thing that repays debt. If you can’t prove that you have the necessary amount of cash to meet regular monthly payments you won’t get your loan or mortgage approved. Even if all you need is $5000 financing on a $1 million asset. Of course this is never likely to happen and would likely never ever occur within the financial industry, but it makes a point in which many people seem to have misinformation on.
Continued in the Carol’s Borrowing Series Category of Clf.
Other Posts of Interest
A LOAN CALCULATOR FOR CRUNCHING YOUR NUMBERS IS BELOW; Enter your loan amount, how many years, the interest rate, and payment frequency (14 for biweekly, 30 for monthly, 7 for weekly. Very helpful so you know exactly what the loan will cost you in interest payments and you will know the total COB (cost of borrowing).
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