Mortgage management

Dear Dr. Don,
My husband and I are moving from an affordable suburb to an expensive city. We also have two car payments, which limits our borrowing power. According to Bankrate's calculators, we could borrow more if we only had one car payment. Should we use some of the proceeds from selling our home to pay off a car loan in order to borrow more for a house?
-- Jennifer Joist

Dear Jennifer,
Besides reviewing your credit, a mortgage lender is going to look at your income, too. Lenders use loan underwriting standards to ensure that loans meet established parameters for risk. Two key financial ratios in underwriting are the front-end and back-end ratios. Deciding to pay off one of the car loans has an impact on both of these ratios.

The front-end ratio, or front ratio, looks at your monthly housing expenses as a percentage of your monthly before-tax income. Most lenders require that the front-end ratio not exceed 28 percent of that monthly income number.

Bankrate's glossary of mortgage terms defines the back-end ratio or back ratio as:

The sum of the house payment and all other monthly debt -- credit cards, car payments, student loans and the like -- divided by before-tax income. Traditionally, lenders were loath to extend borrowers' back-end ratios past 36 percent, but they often do now.

Paying off a car with equity from your current home will free up room in your back-end ratio but increase your front-end ratio because you'll have less money to use as a down payment. A smaller down payment means a higher mortgage payment.

Since $10,000 paid back over 30 years in a mortgage is a smaller monthly nut than $10,000 paid back over five years as a car payment, you free up more debt capacity by paying off the car than you do by putting that money toward the down payment. The table shows how each contributes to the ratios in this hypothetical example. You can make your own table by using the mortgage calculator on Bankrate, figuring what the monthly mortgage payment would be on the outstanding loan balance on your car.

There are other considerations. For example, a smaller down payment can mean that you will pay private mortgage insurance -- at least in the early years of the mortgage.

-- Posted: Sept. 15, 2004