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Generally, mortgage rates and credit approval have an indirect and inverse relationship. To elaborate, here is an overview of the factors affected by rising mortgage rates that influence credit, namely:
- Frontal report
- Back-end report
- Inflation
How Initial Ratio Affects Credit Approval
Before a loan is processed, potential lenders perform several credit checks on the borrower. Among the factors examined is the ratio of gross income taken to mortgage payments.
This ratio is known as the front-end ratio, also known as the mortgage-to-income ratio.
Generally, lenders find it desirable for the initial ratio to be 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 result in a direct and proportional change in the initial ratio. In our case, we are interested in the influence brought by the variation in interest rates and we will therefore keep the other three factors constant.
Drawing
Let's say you earn $4,000 a month and your mortgage principal amount is $100,000. If the tax amount is $100 and the insurance amount is $70, for a 10-year loan term, your PITI is approximately $980.
Your initial ratio becomes 24.5% = ($980/$400) x 100.
However, using the same online PITI calculator, when interest is increased to 6%, PITI increases to approximately $1,224. Therefore, your initial ratio increases from 24.5% to 30.6%.
This increase (beyond 28%) puts you further away from loan approval. The only option left is to look for more lenient lenders who can accept higher initial ratios, possibly with a higher down payment.
How the Back-End Ratio Affects Credit Approval
To assess an individual's creditworthiness, lenders also look at how much of your income goes toward repaying your debts. This is called the back-end ratio, also known as the debt-to-income ratio (DTI).
The DTI ratio is calculated by dividing your total income by the total amount allocated to debt service.
Drawing
If your total monthly income is $6,000 and you spend $1,500 to pay off debt, your DTI ratio is 25% = $1,500/6,000 x 100.
This implies that you devote a quarter of your monthly income to paying off your debts. The DTI ratio is normally capped at 43% of total income by most lenders. The lower your back-end ratio, the higher your creditworthiness.
An increase in mortgage rates means an increase in your DTI ratio due to higher monthly payments. Although some lenders may choose to be lenient when it comes to your DTI, these loans come with more strings attached.
Basically, an increase in the DTI ratio means a reduction in an individual's creditworthiness, hence difficulties in credit approval.
How Inflation Affects Credit Approval
Rising mortgage rates are primarily associated with economic growth and periods of social upheaval. This implies that even rumors of inflation can be a causal factor in rising mortgage rates.
When inflation increases, money loses its value and, as a result, borrowers pay less than they received. Inflation therefore becomes both advantageous for the borrower and disadvantageous for lenders.
For now, lenders refrain from lending withdraw funds by putting in place strict measures that put off borrowers, including increased loan security. This will in turn hinder your loan approval.
Takeaways
Rising mortgage rates have a negative effect on credit approval. To offset these detrimental effects, you need to increase your income by pursuing multiple sources of income.
An increase in your income will lead to a reduction in your back-end and front-end ratio, thus implying increased solvency.
Finally, you should look at other options before settling for a loan. An increase in loans directly implies that most of your income is spent on debt, which therefore implies a reduction in your creditworthiness.
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