When lenders qualify you for a mortgage, they look at a number of things. They’ll check your credit, income, assets and they’ll take the property you are buying in to consideration as well. When they determine how much you qualify for, they will look at your debt ratios. In simple terms, your debt ratio is the amount of your monthly income that is going toward the repayment of your debt, including your potential new mortgage payment.
The amount of your new mortgage payment depends a lot on the rate used to calculate the payment. The higher the rate used to calculate the payment, the higher your payment will be on the application. The higher the payment, higher your debt ratios will be and the lower the purchase price you will be able to qualify for. With me so far? 🙂 Here’s how lenders determine the rate used to calculate your mortgage payment:
- if you are taking a 5 year fixed rate mortgage, or longer fixed rate mortgage, then we can use the rate you are actually getting to calculate your payment on your application.
- if you are taking a fixed rate term of *less* than 5 years OR if you are taking a variable rate mortgage, then lenders will use the benchmark rate to calculate your mortgage payment on the application. So even if you got a 3 year term, or a variable rate that is lower than what a 5 year rate would be, the amount used to qualify you on the application would be higher, so you end up qualifying for less.
Clear as mud? 🙂
Now for the *why* part. This rule was put in to place to help make sure people aren’t buying something they can’t afford if rates were higher. With a shorter term, or with a variable rate, the rate has the potential to increase in a shorter time frame than if it’s guaranteed to stay the same for 5 years or longer. In order make sure that people can afford a higher payment if their rate goes up in the short term, the benchmark rate (aka qualifying rate) is used to lower the amount that people spend and keep payments manageable in the future.