Knowledge Base

Debt Ratio and Commercial Loans

The Debt Ratio is used in commercial mortgage underwriting to make sure the borrower is not overloaded with personal debt.

Example:  

First Careless Bank makes a $400,000 loan to John Loser to purchase a 6-unit apartment building in the neighborhood.  John puts down $100,000 - money that he was given by his aging grandmother to help him get started in the real estate investing business.  The bank doesn’t bother to check out John’s personal financial condition, which is dismal.  John makes just $38,000 a year as a delivery driver for a small chain of flower shops.  He has over $32,000 in credit card debt, a $16,000 car loan, and over $175,000 in student loans.  John dropped out of college with less than a year left to get his degree in nursing.  At first all goes well with the investment.  His net income from the property is $4,000 per month, and his new mortgage payment is just $3,100.   The extra $900 per month in positive cash flow helps him barely keep up with his bills.  Then one of the tenants loses his job and stops paying rent.  When John moves to evict him, the tenant gets angry, rips up the apartment, and then disappears in the middle of the night.  John has no choice but to take the money he had earmarked for repairs and use it to repair the vandalized apartment unit.  Completely out of cash, John can’t afford a painter to cover up some recent graffiti or to repair a huge new crack in the parking lot.  With the apartment building showing some wear and tear, he has trouble finding a new tenant.  Five weeks go by before a new tenant moves in, and the highest rent that the new tenant is willing to pay is $150 less per month than the prior tenant.   Now John is really in trouble because if he doesn’t catch up on this car payments, the bank is going to “pop” the car.  Once again he uses the money earmarked for repairs to pay his personal bills.  Even more necessary repairs go unmade, and in frustration, two more tenants give notice.  The downward spiral continues until the bank forecloses on a run-down, half-empty apartment building with horrible tenants.  This all happened because John was up to his eyeballs in personal debt when he applied for the mortgage to buy the six-plex, and he had to use the money budgeted for repairs to cover his personal bills.

The Top Debt Ratio:

The Top Debt Ratio is used to make sure that the borrower is not trying to make payments on a personal residence that is too much house for him.  It is defined as follows:

Top Debt Ratio = First and Second Mortgage Payments / Gross Income

Experience has repeatedly shown that whenever a borrower spends more than 25% to 28% of his gross income on his housing expense, he is seriously overextended.  This being said, there are, of course, times when an underwriter needs to use some common sense.  One is where the borrower has recently graduated with a desirable college degree, and his income in the future is very likely to increase.  For example, suppose a young woman graduates from Berkeley with a degree in computer science.  She is working at her first programming job, and now she wants to buy herself a starter condo in Silicon Valley.   Even though the condo is only 800 square feet, because of the location, its still very expensive - $450,000.  If her Top Debt Ratio is 29%, her loan probably should still be approved, especially if she is not burdened with a lot of personal debt.

The Bottom Debt Ratio:

The Top Debt Ratio is used to make sure that the borrower is not trying to make payments on a personal residence that is too much house for him.  It is defined as follows:

Bottom Debt Ratio = (Mortgage Payments + Personal Debt Payments)  / Gross Income

Experience has repeatedly shown that whenever a borrower spends more than 33% to 36% of his gross income on his housing payments and personal debt payments, he is seriously overextended.  Here personal debt payments include credit card payments, personal loan payments, car payments, and student loan payments.  It does not include income taxes or utility payments.

Reality:

In real life, commercial real estate lenders almost never calculate the personal debt ratios of a commercial mortgage borrower.  The overwhelming consensus is that if the borrower is wealthy enough to own commercial-investment property and he has good credit, his personal finances are almost certainly in order.  While most commercial lenders will gather a financial statement and two years’ tax returns on each borrower, few Loan Committees spend more than 30 to 45 seconds flipping throughout them.

 

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