Down payment is often the scapegoat for mortgage defaults. Regulators think low down payment loans are more likely to foreclose. Today, I offer you a different perspective. In fact, I’ll argue down payment is not the key factor related to mortgage defaults. My money is on something called “residual income“. Residual income is a metric more loan products should rely on.
What is Residual Income?
Residual income measures the income left over after a homeowner pays ALL bills. While standard mortgage debt to income ratios include some debt, they exclude several common debts. Residual income on the other hand includes debts such as utilities, child care and income taxes. All expense that typical debt to income ratio measurements to not consider.
Residual income reveals a borrower’s ability to adjust to financial changes in the future. Another benefit of residual income is determining what “net” dollars or actual money is available to pay for the new home loan. Traditional debt to income ratios use a loan applicant’s gross earnings and neglect income tax expenses. You may be surprised to learn residual income is only standard on one common loan product – a VA Loan.
Strong Residual Income Equals Fewer Foreclosures
While law makers feel homeowners should put up to 30% down, statistics show more money down is not always better. VA home loan stats show residual income’s importance and value. VA mortgages do not require a down payment. However, VA home loan default rates are among the lowest in the entire mortgage industry. Why? Besides the character of our veterans, the 2nd reason is that VA home loans have a residual income requirement.
To qualify for a VA home loan, veteran’s must show they have a certain amount of residual income. Even when a veteran meets all other VA home loan rules, they cannot obtain loan approval without meeting the residual income requirement. There is more that adds to the validity of residual income. VA home loans overall debt to income ratios are higher than Conventional loans by 9% to 14% on average. In other words, a VA borrower may be able to borrow more than a Conventional borrower. However, VA still has a lower default rate which is attributable in part to residual income requirements.
Residual Income Should be on all Loans
Rather than debate minimum down payment requirements, the government should consider residual income based rules. In conclusion, implementing a residual income rule we would result in a much more “make sense” set of mortgage regulations and lower defaults.
By Jeremy House