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What ratios are most important as far as mortgage management and risk identification at the financial...

What ratios are most important as far as mortgage management and risk identification at the financial institutions? Please be sure to give the applicable equations, as well as the independent numbers, which feed the equations.

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Expert Solution

The various mortgage management (lending) ratios are Debt-to-Income Ratio(DTI) Loan To Value Ratio Housing expense ratio Working Capital Ratio, Debt To equity ratio and Debt Service Coverage ratio

Debt to income ratio(DTI)=Total monthly payments /Gross Income It is the percentage of gross income that is used to pay off debt.It is widely used by lenders to ascertain an individual's abilty to pay the monthly payments for property that was bought through loan.Example: If a person has a DTI of 12% ,that would mean that 12% of his gross income would go into loan repayments.Lenders prefer a DTI lower than 36%.

Loan to Value Ratio(LTV) =Amount of Mortgage /Property value.The LTV ratio signifies the portion of asset's value that has to be issued as loan to the borrower.Eg: If a person decided to purchase a house worth $120,000 through financing, the bank first determines the inividual's credit score and then specify maximum amount of mortgage that can be given.Lets assume that the bank approves a mortgage of $80,000 that is 80,000/120,000 =66.67% LTV and the remaining 33.33% has to be paid out of borrower's pocket.

Housing Expense Ratio =Housing Expense /Pre tax income .The housing expense ratio and debt to income ratio are used together by the lender to evaluate the credit worthiness of the individual.It can be calculated by using annual or monthly payments.Lenders prefer a housing expense ratio lower than 28%.

Working Capital Ratio =Current asset /Current liability.It indicates the firm's ability to meeet its short term obligations.Current Assets inclue Cash, Inventory, Account Recievables etc and current liabilty include items like accounts payable ,short term debt etc.Example:A firm with Current Assets =$10000 and current liabilty = $5000 will have working capital ratio of (10,000/5000) = 2.If the ratio is more than 1 that means the company has enough current assets to meet its short term obligations.

Debt to Equity Ratio(D/E)= Total liabilities /shareholders equity.The debt to equity ratio provides a comparison of debt of a company to equity.A lower debt to equity ratio is preferred as it indicates the ability of the comapny to meet its obligations via equity rather than using debt.Example: If the total debt of a company(Current Liabilty +Long term debt) = $10,000,000 and total equity = $9,000,000 its D/E ratio =1.11%.Comapnies with high debt to equity ratio may find it hard to secure additional financing.

Debt Service Coverage ratio (DSCR)=EBIT/Interest +Principal It is an indication of firm's ability to pay its short term financing costs from its operating income..A Debt Service Coverage ratio of 1 or lower indicates that a firm is unable to pay its short term debt obligation.Eg: If a firm has EBIT of 1,000,000 and Interest of $20,000 and principal amount which equates to $200,000 the DSCR = $1,000,000/$220,000=4.54.A DSCR of 2 or more is considered acceptable.

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