Mortgage lending raises two financial issues which are interfaced: an issue of credit-worthiness, and another of affordability. The banker will not lend unless he is assured of the credit-worthiness of the borrower. Symmetrically, the borrower should not borrow unless he can afford the debt service on the loan. Such a simple problem can be solved with simple solutions. Ratio analysis, presented in this chapter, is the appropriate tool.
Ratio analysis in mortgage financing has several advantages; simplicity is the foremost. Simplicity is a feature not emphasised enough in the use of statistics. Ratios have a meaning to both lenders and borrowers as measures of the ability of individuals to pile up debt. It is particularly important in housing finance that borrowing and lending decisions should be based on an indicator which can be understood by both sides because it involves numerous one-time borrowers, usually not literate in finance.
This chapter reviews the definitions of key ratios, describes the data source based on a case study, outlines the limitations of these indicators, and provides recommendations on their use.
The most commonly used ratio is the debt-service over income ratio (DSI). It is defined as the monthly or yearly principal and interest payments due on the loan divided by the borrower’s monthly or yearly income, and it is stated as a percentage of income. Despite major drawbacks (see below), the mortgage industry is holding to this imperfect indicator because of its simple application. A loan applicant who is unable to set aside up to x per cent of his income for debt-servicing is taken to be not creditworthy.