Qualifying the Borrower & Property Flashcards
In order to determine a borrower’s financial qualifications, an underwriter will typically look at five aspects of the applicant’s financial profile:
Income
Credit
Assets
Debts
Net worth
Each of these deserve a closer inspection, don’t you think? Glad to hear it, because that’s just what we’re going to do over the next several screens in this chapter, starting with income.
The Borrower & The Underwriter Five
Underwriters review borrower income to determine whether or not it is sufficient and reliable enough to meet the responsibility of the desired mortgage loan, along with the applicant’s other recurring debts.
Sources of Income
In general, the underwriter looks for a two-year employment history. What they want to see is a consistent working pattern that provides a good indication that the applicant’s income will continue.
All income reported by the applicant should be verified by the underwriter. Employers should be sent Verification of Employment (VOE) forms, which can shed light on:
Length of the applicant’s employment
Gross salary
Additional income (such as overtime, bonuses, and royalties)
Likelihood of continued employment
Employers are not required by law to complete VOEs from mortgage lenders, but they typically try to comply with the request. Employers MIGHT require written consent from employees before providing information to mortgage lenders.
The Commission Conundrum
If the applicant’s sole income is from commission, they’ll need to provide the previous two years’ worth of tax returns. If only part of the applicant’s total income is from commission, two years of W-2 forms and a completed Verification of Employment form are typically proof enough of such income.
Filling in the Gaps
Any employment gaps of more than 60 days must be documented by the lender.
Child Support & Alimony
An applicant’s alimony or child support can also be considered a source of income (provided that it has been court-ordered and has a history of payment that can be verified). Of course, the length of time such an income can be expected to continue should be taken into consideration as well.
A lender may NOT ask an applicant whether they receive alimony or child support, although the applicant can choose to reveal this knowledge to qualify for the loan.
Net Operating Income (NOI)
A loan applicant may also receive income from investment properties that they hold. Income from these investments comes primarily in the form of rent.
The NOI of each investment property held by the applicant should be considered as income (or as long-term debts, if negative cash flow) for the purposes of the loan.
Income
A credit report and a credit score are two separate but related things.
A credit report contains information regarding an individual’s credit history (loan payments, etc.) as well as the present credit status of all open credit accounts.
A credit score is calculated using a formula that takes into consideration the information contained in those credit reports.
The Big Three Reporters
The three major credit reporting companies are:
Equifax
TransUnion
Experian
Credit Scores
Higher credit scores reflect a better loan repayment history and, therefore, will result in lenders offering better rates to those perceived as lower risk.
Errors on a credit report can adversely affect an individual’s credit score, so, as a proactive real estate professional, you should advise your clients to stay on top of their credit reports, periodically checking them and addressing any errors well before they need to apply for a loan. (You can receive a free credit report from each nationwide credit reporting company once every 12 months.)
Many Sources = Many Scores
The same person with the same credit history can have their credit checked and end up with different scores. Why? Because there are three different influences that account for the variance in credit scores. For example…
Data
Each credit reporting company issues reports using slightly different data to calculate a person’s score.
Timing
Credit score calculation doesn’t necessarily happen at a fixed time, so the score will be based on the last data update from the credit reporting agency.
Scoring Models & Formulas
Different companies employ different formulas and scoring models, so even if they were to use the same data at the same time, the end result could still be a different credit score.
The largest credit scoring corporation is best known by the acronym FICO. And to think, you’re just one screen away from learning all you’d ever want to know about this company and its scoring system!
Credit: Reports & Scores
A FICO score is a credit scoring system created by the Fair Isaac Corporation. Historically, it has been demonstrated that the higher the FICO score, the less likely it is that the borrower will default on a loan.
Score Minimums
FICO scores range from 300 to 850.
Normally FHA requires a minimum FICO score of 580; prospective borrowers with scores under 500 are not eligible for FHA loans.
Fannie Mae and Freddie Mac look for a FICO score of at least 620. They may require, however, a higher rate of interest or a higher down payment if the score is under 660.
Credit Score Factors
The way a person uses credit and manages debt has a direct bearing on their credit score, whether we’re talking about FICO or some other scoring company. Timely payments and staying well beneath one’s credit limit is key to a good credit score.
Here’s a quick list of the major factors influencing credit scores:
Payment history
Current unpaid debt
Length of credit history
Percentage of available credit used
Debt type/start date
New applications for additional debt
Credit: FICO Scores
To meet the specific needs of residential mortgage lenders, credit reporting agencies have developed the residential mortgage credit report (RMCR), which provides a comprehensive overview of an individual’s credit history and current status.
They accomplish this by merging the information contained in the separate reports of the three major credit reporting agencies (Equifax, Experian, and TransUnion) into a single report.
The individual FICO® scores, as calculated by each of the three agencies, are given in the RMCR. Lenders will typically base their approvals off the middle of the three scores.
This report generally includes detailed information about credit account activity in the past two years, including:
Late payments
Date(s) on which an account was delinquent
Number of times each account has been past due
Duration of the past-due status (30-59, 60-89 or 90+ days)
Type and balance of each account
Credit: The Residential Mortgage Credit Report
At the beginning of this chapter, I said that there were five areas of interest to the underwriter regarding the applicant’s financial profile.
We’ve covered two of those, and the last three on the list — assets, debts, and net worth — are related:
Income
Credit
Assets
Debts
Net worth
Let’s look at those last three now and discuss how they relate to each other.
Colored blocks with mathematical symbols on their tops.
Net Worth: The Math
A person’s net worth is simply the sum of all of their assets minus all of their debts (also known as liabilities).
The math formula for this is:
Assets - Debts = Net worth
Assets
Assets can include such things as:
Bank accounts
Stocks and bonds
Retirement funds
The net cash value of insurance policies
Real estate
Automobiles
Personal possessions
Business equipment
Liquid Assets: Assets that can be quickly converted to cash without losing their value are said to be liquid assets.
Debts
Debts (liabilities) can include the following:
Mortgage loans
Credit card debt
Student loans
Auto loans
Personal loans
The $20 you owe your friend Craig*
*Craig made me put that last one on the list.
From this list, you can see that there are a few different types of debts:
Short-term debts: usually taken care of with one payment or, perhaps, a few but is not considered an ongoing obligation
Long-term debts: often paid as installments over a predetermined timeframe, which can extend for years
Revolving debts: an ongoing line of credit, as with a credit card, where the amount of debt can fluctuate as the borrower uses it to manage cash flow issues
All debt types are accounted for in an underwriter’s evaluation of a borrower’s net worth. Long-term debt and revolving debt are offset by assets like income or other ongoing revenue streams when net worth is being evaluated.
Assets - Debts = Net worth
A lending underwriter must use the applicant’s financial information they have gathered to determine whether or not that candidate can make the monthly mortgage payment and service all of their other debts over the term of the loan.
To do this, the underwriter examines what are known as qualifying ratios, of which there are two:
Payment-to-income ratio (also known as housing expense ratio or housing expense-to-income ratio)
Debt-to-income ratio (also known as debt service ratio or total debt service-to-income ratio)
Let’s look at payment-to-income ratio first. Once you’ve mastered that, we’ll move on to a more in-depth look at debt-to-income ratio.
Qualifying Ratios
The first of the two qualifying ratios we are going to look at is the payment-to-income ratio, which definitely qualifies as a rose by other names.
The Front-End Ratio
We’ve already established that payment-to-income ratio, housing expense ratio, and housing expense-to-income ratio are all names for the same thing: they compare the monthly house payment (PITI) to the borrower’s monthly income.
But, in addition to these two aliases, the payment-to-income ratio is also referred to as the front-end ratio.
The reason for calling it the front-end ratio is that the lender can choose to establish the payment-to-income ratio based solely on the borrower’s statement regarding their income without having gone to the expense of pulling credit reports or gathering other verification documentation.
In other words, the applicant is taken at their word regarding their income, and, for that reason, this front-end ratio is primarily used to pre-qualify the applicant for possible loan amounts.
All that said, the purpose of this ratio is to determine whether or not the applicant’s income is sufficient and reliable enough to repay the mortgage amount.
And, it’s worth noting, that once income verification has been achieved, greater confidence in the payment-to-income ratio can be had.
Here’s a visual example of what the payment-to-income ratio looks like.
A monthly payment of $1500 divided by the monthly income of $6000 equals a payment to income ratio of 25%.
Payment-to-Income Ratio Conventional Loan Requirements
For a conventional loan, monthly payments cannot exceed 28% of a borrower’s monthly income. FHA loan payments generally cannot exceed 31% of a borrower’s income. (These amounts can change from time to time, but the FHA always publishes the most up-to-date limits on their website.)
Monthly (Mortgage) Payments = PITI
Those monthly payments I just mentioned? They are fondly known as PITI. (Fondly might be stretching things.)
PITI stands for:
Principal
Interest
Taxes
Insurance
Combined, these costs equal a monthly (mortgage) payment.
Payment-to-Income Ratio
There are three variables that make up a payment-to-income ratio formula. Those variables are:
Monthly payment
Monthly income
Payment-to-income ratio
Since there are three variables to consider with payment-to-income ratios, I’m going to give you three formula variations to help you find whichever variable is missing.
Solving for Payment-to-Income Ratio
If you know your monthly payment and monthly income, the formula to solve for payment-to-income ratio is pretty straightforward:
Monthly payment ÷ Monthly income = Payment-to-income ratio
Solving for Monthly Payment
If you know your monthly income and desired payment-to-income ratio, this would be the formula to solve for monthly payment:
Monthly income x Payment-to-income ratio = Monthly payment
Solving for Monthly Income
Although you’ll rarely use it, if you know your monthly payment and desired payment-to-income ratio, this would be the formula to solve for monthly income:
Monthly payment ÷ Payment-to-income ratio = Monthly income
On the next screen, we’ll look at a scenario using one of these variations of the payment-to-income ratio formulas. It’s fairly typical of what you’ll see in your career as a real estate professional.
Payment-to-Income Ratio: Three Variables
Like the payment-to-income ratio, the debt-to-income (DTI) ratio is an underwriting tool used to measure a borrower’s creditworthiness and ability to take on a mortgage loan.
The difference between the two is that a debt-to-income ratio includes other debts beyond the PITI (housing payment) that the borrower has.
That debt could include a car payment, credit card debt, or any type of loan or court-ordered payment.
Here’s a visual of what the debt-to-income ratio looks like.
$1500 + $300 expenditures divided by $6000 monthly income = 30% debt-to-income ratio.
AKA “The Back-End Ratio”
Establishing a debt-to-income ratio requires the more rigorous work of pulling a credit report and collecting other verification documents. These are underwriting activities that do not happen upfront when a quicker assessment with a payment-to-income ratio is made.
Consequently, you may also hear this ratio referred to as the back-end ratio. Although it’s more work, it is also what is needed for a lender to be comfortable enough to qualify a borrower for a loan.
Debt-to-Income Ratio Loan Requirements
For manually underwritten loans, Fannie Mae will limit the debt-to-income ratio to 36%. That is, the total PITI plus the other debts cannot exceed 36% of the borrower’s monthly income.
They will make some exceptions and allow the DTI to go as high as 45%, depending on borrower credit score, reserve requirements, and other eligibility or specific-case scenarios.
For Fannie Mae loans underwritten through their automated system, Desktop Underwriter (DU), the maximum allowed DTI is 50%.
FHA loans limit the debt-to-income ratio to 43%.
A Gift = No Strings
If the lender becomes aware that all or part of the borrower’s down payment is a result of a gift from friends or family, they might demand an official statement of that fact from the donor.
Lacking evidence that the “gift” is not expected to be repaid, the lender will see this as another debt obligation and factor that amount into the debt ratio — which may serve to reduce the amount they are willing to loan.
Debt-to-Income (DTI) Ratio
As with payment-to-income ratios, there are multiple variables and variations of the formula used to solve for debt-to-income ratios.
Variables in Debt-to-Income Ratio
The debt-to-income ratio formulas are just a bit more complicated than the ones we use with the payment-to-income ratio because there are four variables or pieces of information involved.
Monthly income
Monthly payment (PITI)
Other debt (monthly)
Debt-to-income ratio
Formulas for Debt-to-Income Ratio
With four variables to consider with debt-to-income ratios come four formulas. Let’s look at each.
Solving for Debt-to-Income Ratio
If you know the monthly income, monthly payment, and other debt, this is the formula you would use to solve for debt-to-income ratio:
(Monthly payment + Other debt) ÷ Monthly income = Debt-to-income ratio
Solving for Monthly PITI Payment
If you know the monthly income, the other debt, and the desired debt-to-income ratio, here’s the formula to use to solve for monthly PITI payment:
Monthly income x Debt-to-income ratio - Other debt = Monthly payment
Solving for Other Debt
If you know the monthly PITI payment, the monthly income, and the desired debt-to-income ratio, here’s the formula to solve for the other debt:
Monthly income x Debt-to-income ratio - Monthly payment = Other debt
Solving for Monthly Income
And for the rarely used formula, if you know your monthly PITI payment, other debt, and desired payment-to-income ratio, this would be the formula to solve for monthly income:
(Monthly debt + Other debt) ÷ Debt-to-income ratio = Monthly income
Debt-to-Income Ratio: Variables & Formula Variations
There are a number of rules, regulations, and laws in place to protect the consumer in their interactions with lenders and creditors. You’ll hear more from me on this elsewhere in this course, but I want to lightly touch on two right now because they directly apply to what we’ve been talking about:
Fair Credit Reporting Act (FCRA)
People have the right to know what’s going on with their credit scores, and lenders and businesses have the duty to be honest and transparent with their reporting.
To that end, we have the Fair Credit Reporting Act (FCRA), an act from the U.S. Federal Government to promote the accuracy, fairness, and privacy of consumer information contained in the files of consumer reporting agencies.
FCRA was enacted with the intention of protecting consumers from willful and negligent inclusion of inaccurate information in their credit reports.
FCRA Protections
The Fair Credit Reporting Act grants a number of rights to consumers. Here is a summary of those rights potentially affecting persons seeking a mortgage loan:
Consumers must be told if information in their file has been used against them, and, if so, what credit reporting agency was used.
Consumers have the right to know what is in their file.
Consumers have the right to ask for a credit score.*
Consumers have the right to dispute incomplete or inaccurate information.
Consumer reporting agencies must correct or delete inaccurate, incomplete, or unverifiable information.
Consumer reporting agencies may not report outdated negative information.
Access to consumer files is limited.
Consumers may seek damages from violators.
*The Fair and Accurate Credit Transaction Act (FACTA) is an amendment to the Fair Credit Reporting Act that requires the three major credit reporting agencies to provide credit reports free of charge to consumers once every 12 months upon request.
The Equal Credit Opportunity Act
Lenders are required to abide by the Equal Credit Opportunity Act (ECOA), which makes it unlawful for a creditor to discriminate against any applicant, with respect to any aspect of a credit transaction, on the basis of demographic information such as race, color, religion, national origin, sex, marital status, or age.
It also mandated that loan companies may not ask about marital status beyond inquiring if the borrower is married or single. For example, lenders may NOT ask if an applicant is widowed or divorced.
ECOA rules apply to any person who regularly participates in making credit decisions, like banks, retailers, bankcard companies, finance companies, and credit unions.
Other Rights under ECOA
Other rights of note under ECOA include:
The right to know whether their application was accepted or rejected within 30 days of filing a complete application.
The right to know why their application was rejected: The creditor must tell the applicant the specific reason for the rejection or that the applicant is entitled to learn the reason if they ask within 60 days.
An acceptable reason might be: “Your income is too low,” or “You haven’t been employed long enough.”
An unacceptable reason might be: “You didn’t meet our minimum standards.” That information isn’t specific enough.
The right to learn the specific reason they were offered less favorable terms than applied for, but only if they reject these terms. For example, if the lender offers a smaller loan or a higher interest rate, and the applicant doesn’t accept the offer, they have the right to know why those terms were offered.
The right to know why their account was closed or why the terms of the account were made less favorable unless the account was inactive or they failed to make payments as agreed.
Protecting the Borrower
If you can remember way back to the first chapter in this level, you’ll recall that there are two steps to loan approval:
Pre-qualification: using the Pre-Qualification Form to establish the pre-qualified loan amount
Loan Status Update: using the Loan Status Update form to document the underwriting progress from pre-qualification to loan commitment
And in step two, there are two parts or components of the underwriting approval process:
Qualifying the borrower
Qualifying the property
So, the remainder of this chapter’s discussion will focus on the topic of qualifying the collateral: part two of step two.
Last but not Least
If you’ve wondered why property approval comes at the end of the loan approval process, I can clear that up for you real quick.
While it’s clearly important to a lender that the property securing the loan has an estimated value sufficient to justify the loan, they want to spend most of their upfront underwriting effort on determining the creditworthiness of the borrower.
The bank’s interest in the property only extends to wanting to be assured their loan is properly secured. If their interest were greater than that, they’d spend their investment dollars bidding on the property themselves.
Since that’s not their intention or desire, the lender first gives the borrower a good going-over before putting any time or expense into property approval.
If the borrower is perceived as too risky, the value of the property is of no matter, the bank will not extend a loan. If the borrower checks out, however, all the previously expressed motivations for evaluating the property come into play.
Qualifying the Property: Part Two of Step Two
There are two primary types of properties that will be evaluated in a mortgage loan approval process:
Residential (non-income-producing)
Commercial (income-producing)
The concerns of the underwriter and the tools/approaches used in the evaluation process will vary, depending on which of these property types we’re talking about.
Since your real estate career will likely begin with residential properties, that’s where we’ll start with our discussion.
Lender’s Due Diligence
To properly evaluate a residential property, the underwriter will need to undertake a series of activities, all of which fall under the umbrella term of due diligence.
The Preliminary Title Report
The underwriter will start by requesting a preliminary title report. This is a precursor to a title insurance policy. It indicates current property ownership, along with any liens or encumbrances that may exist (and which would NOT be covered by a title policy).
The Appraisal
A property valuation from a licensed appraiser will provide the lender with a professional opinion of the current market value for real property. An appraiser is an independent, third-party expert.
We will go into greater depth on the appraisal process elsewhere in this course. So, for now, just know that an appraisal is a licensed appraiser’s opinion of a property’s market value as of a specified date.
Completing the Underwriting Picture
In the course of the underwriter’s efforts, other valuation factors may come to light. This could include such things as the present occupancy status of the property or signs of recent work or improvements to the property.
Improvements to the property should raise a red flag as that is the sort of thing that could give rise to a mechanic’s lien or other claims.
If anything of this nature is found, the underwriter will certainly investigate the matter and determine to what degree it might influence the property valuation and/or loan approval.
Residential Property Valuation
A loan-to-value ratio (LTV) is the gap between the appraised value of the property and the actual amount (or value) of the loan financing the property. The smaller the gap, the riskier the loan for the lender.
The LTV Ratio is loan amount divided by purchase price. Here, the LTV = 80,000 divided by 100,000, which = 80%.
The LTV is the tool of choice for underwriter evaluation of residential loan properties. Before it can be used, of course, an appraised value of the property must be obtained.
Risky Appraisals
An appraisal is really nothing more than a very educated guess by an appraiser concerning the market value of the property at the moment in time when the appraisal is done.
So, right off the bat, the lender faces two risks:
The appraisal could be a guess that is inaccurate from the start.
The appraisal could be a guess that was accurate when written but subsequently becomes outdated with any movement in the real estate market. And if the lender ends up foreclosing on the property after a downward market movement, they might find that the collateral no longer covers the loan.
Gap = Risk Mitigation
Because of these possibilities, lenders want some wiggle room in the form of a nice, wide gap.
They generally do not want to make loans for 100% of the appraised value of the property. Instead, they prefer a gap between the appraised property value and the loan value — a gap that serves as a buffer against the risks just described.
A loan-to-value ratio is simply the numerical expression of the existing gap.
Gap Minimums
Typically, the LTV on a conventional loan is 80% of the value of the property or less, which would be evidence of a down payment of 20% or more. If the LTV were greater than 80%, private mortgage insurance would be required.
At the present time, the maximum LTV for most conventional loans is 95% (which implies a 5% down payment).
In comparison, the VA guarantees loans up to 100% of the property value (no down payment) and the FHA insures loans up to 96.5% (a 3.5% down payment).
Supporting the Gap
Three ways to support the LTV gap and make lenders feel better include:
Private mortgage insurance (PMI) - borrower-paid insurance for conventional loans
Mortgage insurance premium (MIP) - for FHA loans
VA guaranteed loans
(Details of the workings of these programs have been given in earlier levels; please feel free to review that material if desired.)
Loan-to-Value Ratio
