How The Income-Equity-Credit Triangle Helps Define Mortgage Planning

All mortgage approvals are loosely based on what I call the Income-Equity-Credit Triangle. 

The stronger the elements of the triangle, the more likely a person will qualify for a conforming (or "prime") mortgage.

The triangle's three corners are defined as follows:

• Income: The relative strength of income versus debts.  Also referred to as debt ratio.
• Equity: The percentage of equity in a home.  Also referred to as loan-to-value, or LTV.
• Credit: The middle of a person's three credit scores, as reported by the three major credit bureaus.

When all three elements of the Income-Equity-Credit triangle are average, the "Morgage Approved" target is fully visible.  This means that the home loan application is very likely to be approved.

When any one element is weak, on the other hand, the triangle's area shrinks and a home loan approval becomes much less likely.

Weakness in one of the three areas usually requires exceptional strength in the two other categories to outweigh the drag on the mortgage approval. 

The industry term for these strengths is "compensating factors", as in:

The income is weak but the mortgage is still approvable -- the strong credit scores and healthy equity position are compensating factors.

The Compensating Factors concept is illustrated by the graphic below.  Note that the income is low, but credit and equity are strong.  This borrower profile -- just like the one that is average in all three areas -- is likely to be approved.

The concept of the Income-Equity-Credit triangles can go a step further. 

By applying its principles, we can guess with relative certainty for which category of home loan a borrower will qualifiy -- Prime, Alt-A, or Sub-Prime.

• Prime: Average or better in all three categories
• Alt-A: Deficient in one of three categories
• Sub-prime: Deficient in two of three categories

And herein lies the inherent problem of risk-based lending models like those used for home loans.  The "risk triangle" is defined as of the home loan close date, and is never adjusted thereafter.

Consider this. 

In theory, a homeowner is never more risky to a bank than on the day of closing.

In time, a homeowner's risk profile should theoretically improve because:

1. Personal income tends to increase over time, thereby decreasing debt ratios
2. Credit scores tend to improve with credit depth and history
3. Home values tend to increase over time, thereby decreasing loan-to-value ratios

Despite these risk-reducing events, however, homeowners can't petition mortgage lenders for lower rates just because they're now "less of a risk".  That contract was set on the day of closing.

Thankfully, though, it works both ways. 

If a homeowner worsens in either Income, Equity or Credit, his lender can't call him up to make mortgage rate adjustments; the rate was signed and agreed upon at closing and is immutable.

Both parties have a lot to lose in the wrong (or right) circumstance.

Therefore, if you are a borrower and know your long-term economic viability will deteriorate, it may be prudent to finance your home(s) with a long-term, fixed-rate mortgage.  In this sense, you are working the triangle in your favor. 

Examples include:

• Two-income households that are planning to become a one-income household
• Families that live in "declining markets" or other areas that face long-term depression
• Families that are adding multiple children to the household in the near-term

On the other hand, if you expect economic prosperity over the long-term, a short-term, adjustable-rate mortgage may be more appropriate as a mortgage strategy. 

Again, it's about working the Income-Equity-Credit triangle in your favor.

Understanding the nuances of mortgage lending is the best way to make sound strategic decisions.  Talking with a mortgage planning professional is a smart first step.

(Image courtesy: Photobucket)