Confusion in lending agreements is a recipe for disaster! (See how nicely I tied in that soup metaphor?)
Here are some letters I hear all the time. This list is not for you, it is for your borrowers! Don’t use these shortcuts around your borrowers unless they know them, too.
Debt to Income…the ratio we use to determine if the personal debt of the owner/guarantor is more than they can afford based on their income. Heck, we don’t even mean income in that ratio. We are looking for cashflow.
DCR or DSR
Debt Coverage (or Debt Service) Ratio…This is the flip of the DTI. Or if you liked algebra in high school, you might remember it as the reciprocal. It is used in small business, commercial and commercial real estate lending. It compares the Cashflow Available to Pay Debt to the debt. A 1-to-1 ratio would mean they just have enough cashflow to pay the debt. We used to want 1.2-to-1 (a 20% cushion). These days we are more likely interested in 1.25- or 1.3-to-1.
Home Equity Line of Credit…otherwise known as the substitute for charge cards or personal savings before the sky fell and people needed to start living within their means. (Oh, did I write that out loud?)
I am not asserting that every home equity line of credit was used irresponsibly. Some people used it to remodel their home or buy a needed vehicle. Or perhaps pay off an unexpected medical bill.
The challenge with the HELOCs was the drop, in some areas precipitously, of home values. With the combination of a mortgage that might have been 90% LTV (see below) and a HELOC that brought the total loans secured by the home to 125%…well, you can see the problem.
Line of Credit…not to be confused with the HELOC. This is typically for commercial or business use. The anticipated use is usually to gear up for seasonal activity (buy inventory for holiday sales) or to take care of a short-term need (such as a major roof repair before refinancing a building).
There is a lot of pressure on lines of credit (often called operating lines) as business borrowers’ fundamentals drop, they miss loan covenants or the value of the collateral is impaired.
The lines of credit are expected to be at zero at least part of the year. If the borrower cannot retire the line when promised, the lender has the option to extend it, term it out (set it up for payments that will retire the line within three to five years), or take the collateral.
Loan to Value…the relationship between the amount of the loan and the value (fair market) of the underlying collateral. Once again, reductions in property values caused havoc with LTVs.
Besides, when the sun was shining and someone convinced too many other someones that real estate values would go up forever, lenders were comfortable with up to 100% LTV. No longer.
What other terms are you using that your borrowers do not understand?
- Do you think they’ll ask if they don’t understand you? Actually, I think most of them will not. Scary but true.