When you apply for a VA home loan, there are certain areas of your personal finances your participating VA lender will analyze to determine if the loan is a good risk. Your FICO scores and credit report contain a lot of important information for the lender at this stage, but those are not the only areas the lender will examine.
Your income and monthly financial obligations are also reviewed and the lender wants to make sure your monthly financial obligations (car payment, rent or current house payment, utilities, credit card bills and more) don’t exceed a certain percentage of your income.
That is known as the debt-to-income ratio (DTI) and at first glance, it might look similar to another metric your lender will use to review your income and monthly payments–something known as “residual income.” But these two are actually not the same.
The debt-to-income ratio is the percentage your debt cuts into your income per month. If you have a debt ratio of 50%, that means fully half your monthly paychecks are eaten up by monthly expenses.
By contrast, the residual income calculation is the actual dollar amount you have left over each month after your payments have been made. This may be referred to in other ways, including the phrase “balance available for family support.”
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VA Loan Rules: The Debt-To-Income Ratio Versus Residual Income
As mentioned above, the lender is required to calculate your debt ratio, including a list of things that must be counted in that tally:
- Housing expenses
- Installment debts
- “Other obligations” as required
VA loan applicants who have a debt-to-income ratio of greater than 41% require additional scrutiny by the lender. There are exceptions, which include but may not be limited to:
- Situations where the ratio is greater than 41 percent unless it is larger due solely to the existence of tax-free income which should be noted in the loan file, the loan may be approved with justification, by the underwriter’s supervisor, OR
- The applicant’s residual income exceeds the guideline by at least 20 percent
VA loan rules for the debt-to-income ratio include an instruction to the lender that the DTI calculation is considered a guide and, “…as an underwriting factor, it is secondary to the residual income.” (Emphasis ours.)
DTI should not “automatically trigger approval or rejection of a loan. Instead, consider the ratio in conjunction with all other credit factors.” That information is found in VA Pamphlet 26-7, Chapter Four, page 70.
How Residual Income Is Reviewed For Home Loan Approval
The VA Lender’s Handbook, VA Pamphlet 26-7, has instructions to your loan officer in Chapter Four that explains what your lender is supposed to do with your residual income information.
For starters, the VA advises the lender that residual income review is intended as a guide–it is not necessarily a make-or-break look at your finances, though the VA does caution that depending on circumstances “inadequate residual income” may be enough justification to deny a VA mortgage. Other areas of your financial qualifications will also be reviewed–no single factor is scrutinized without consideration of the others in most cases.
There are references for the lender regarding minimum residual income guidelines, but the VA cautions that these rules should not force the rejection of a VA mortgage automatically. Instead, the VA official site explains, residual income should be considered “in conjunction with all other credit factors.”
In cases where the lender determines the residual income is “marginal” the lender must reference the borrower’s credit history and history of past payments on “similar housing expenses.”
VA’s debt-to-income ratio is a ratio of total monthly debt payments including housing expense, installment debts, and other obligations listed in section D of VA Form 26-6393, to gross monthly income. It is a guide and, as an underwriting factor, it is secondary to the residual income. It should not automatically trigger approval or rejection of a loan. Instead, consider the ratio in conjunction with all other credit factors.
What Happens If Your Residual Income Or DTI Does Not Meet The Requirements?
It should be noted that all rules and instructions to the lender mentioned here are only one set of rules and regulations that must be followed–your financial institution will have its’ own policies and some may establish standards that are higher than VA mortgage loan minimum requirements.
That said, in cases where a borrower has a debt ratio that is too high, or is in a situation where residual income is not as plentiful as it needs to be, there may be compensating factors that can offset such issues.
What does this mean?
According to VA Pamphlet 26-7, the right compensating factors could make or break the loan application process for a borrower who needs to rely on it to get the mortgage approved.
According to the VA, such factors are “especially important” when the lender must review loans “which are marginal with respect to residual income or debt-to-income ratio.” However, compensating factors may not be used “to compensate for unsatisfactory credit.”
Furthermore, the VA asserts that “Valid compensating factors should represent strengths rather than mere satisfaction of basic program requirements.” What kind of factors do we mean? Here’s a list that should not be considered complete, but does serve as a handy guide:
- Excellent credit history
- Conservative use of credit
- Minimal consumer debt
- Long-term employment
- Significant liquid assets
- Sizable down payment
- The existence of equity in refinancing loans
- Little or no increase in shelter expense
- Military benefits
- Satisfactory homeownership experience
- Low debt-to-income ratio
- Tax credits for child care
- Tax benefits of home ownership
Lender requirements and VA minimums are not always identical–you will need to discuss the lender’s specific guidelines with your loan officer to see where they might differ.
Joe Wallace is a 13-year veteran of the United States Air Force and a former reporter for Air Force Television News
