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Lenders are in the business of assessing how likely you are to default on your mortgage. The process of assessing the risk you pose to a lender is conducted as part of your loan application process. You'll hear it called mortgage "pre-qualification" or "pre-approval." (The "pre" indicates that you are seeking approval before you are actually in contract to purchase a home.) Your mortgage professional will run some standard analyses and collect a standard set of your personal information, combining these items into your actual loan application. A single, standard form loan application is used by all the lenders. Mortgage pros receive rate sheets daily or weekly from the bank. Unless your situation is really unusual, a mortgage professional can look at your scores on the different risk measures, glance at a bank's rate sheet, and tell (a) whether you qualify for a particular program, and (b) the interest rate and other terms of the particular program(s) for which you qualify.
The risk factors that lenders - and mortgage professionals - care about are:
Your Credit Scores & Report
Your credit score is a number ranging from 400 to 850 which reflects how responsible you've been in the past with credit cards, loans, lines of credit, and deferred payment arrangements. The number that marks your spot on this continuum of responsibility is calculated based on a system created by Fair, Isaac & Co. Hence, industry insiders refer to your credit score as your FICO score. As you probably know, there are three national credit bureaus. Creditors report to these bureaus on a monthly basis with a snapshot of your accounts, providing information such as: how much you owe (account balance), your credit limit, whether you are paying on time and in the amount you agreed to and, if not, how late your payments have been.
Each bureau will calculate its own version of your FICO score, based on the information that each bureau has received directly from your creditors. Lenders usually throw out the lowest and the highest of the three FICO scores, and qualify you for interest rate, programs, and other terms based on your middle score (a.k.a. "mid-FICO").
Lenders know that the best predictor of your future behavior (whether or not you'll pay on your mortgage) is your past behavior, as reflected by your mid-FICO score. Overall, lenders tend not to be concerned with the specific items reported in your credit report, but rather with the mid-FICO score that was compiled on the basis of that information. There are two exceptions to this rule:
- Mortgage Lates - Having made even one late payment (late = over 30 days past due) on a mortgage in the past seven years can really impact your ability to qualify for a mortgage. The lenders' thought process is this - you could forget to pay a credit card, or have a really bad month financially and not be able to make your car payment. If you have paid your credit card or your car payment late, your mid-FICO will reflect this, and mortgage lenders may offer you a somewhat higher interest rate.
But mortgage payments are a different story - making them on time ensures that you and your family keep a roof over their heads. Even people who lose their jobs and are totally broke will beg, borrow, steal or sell their homes before they will miss payments. Lenders see late mortgage payments as an indication of either financial ruin or extreme irresponsibility, and will often refuse to lend to people whose credit reports show "mortgage lates."
- Bankruptcies - We call these "BKs" for short. Times have changed since the day when a bankruptcy tolled the death knell for a mortgage application. Nowadays, there are lenders who tout their willingness to approve mortgages for folks with bankruptcies dated as recently as a day prior to their application! Lenders do look for bankruptcies on your credit report, though. Certainly, many of the traditional, more conservative banks do not offer mortgages to people with recent bankruptcies, and almost all of the banks who do will charge a significant premium interest rate and/or require special terms (e.g., automatic deduction of monthly payments from your checking account) of those buyers/borrowers with recent bankruptcies.
Your Income
Lenders want to know how much money you make on an annual basis so they can ascertain your financial capability to make your monthly mortgage payments, and cover the other financial obligations of home ownership, such as property taxes, insurance and HOA dues (if applicable). There are two methods of communicating your income to your lender:
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Full-Documentation - "Full Doc" loan programs require that you document the income required to qualify for the mortgage you want with either a W-2 form, a 1099 form (for independent contractors), or two years of tax returns. Some lenders are now accepting a year's worth of bank statements - showing deposits adding up to your income - as documentation of the required income.
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Stated Income - "Stated" loan programs allow you to simply state what your income is, without documentation or verification. Why on earth would a lender simply take a borrower at their word? Two reasons: (1) self-employed buyers get no form at the end of the year, and are often so aggressive with their tax deductions that their tax returns show very little net income, (2) many buyers have hard-to-document income, like folks whose income is largely cash (e.g., tips). To be approved for a stated income loan, the income you state must make sense based on your line of work; it wouldn't fly for a valet parking attendant to state an annual income of $200,000 just to qualify for a loan. Interest rates on these loans are generally higher than those charged on full-doc loans unless your credit scores are quite high, like over 720.
Your Liquid Assets
This is not about how many bottles of water are left in your Y2K stockpile. This is about how many dollars are in your rainy day stockpiles. Some loan programs have reserve requirements - a minimum dollar amount of liquid assets you must own in order to qualify for that particular program. Lenders want to know that you have an emergency fund to fall back on to make your mortgage payment in the event you become disabled, lose your job, or have some other disruption in your normal income and/or have to make a major, unexpected home repair.
On your loan application, there are spaces for you to list all your assets, including furniture, cars, and so forth. However, when lenders look at liquid assets, they really care about assets which could pretty easily be liquidated at their face value. Your liquid assets include:
- Checking and savings accounts;
- Money market accounts;
- 401K and other retirement accounts which you can convert to cash;
- Stocks, bonds, and other publicly traded securities.
Seasoned reserves are liquid assets that have been in the bank for a certain period of time, usually about two months. Seasoning requirements were imposed to ensure that the liquid assets actually belong to you (i.e., are not borrowed), and will actually be accessible to you if you need to draw from them to make your monthly payment or to fund an emergency home repair.
Lenders state reserve requirements in terms of multiples of the minimum monthly payment on the mortgage for which you are applying. For example, if the minimum monthly payment on your mortgage would be $2,500, and the lender requires three months' reserves, then you must have at least $7,500 in verifiable liquid assets. If your loan program has a reserve requirement, your mortgage professional will ask you to provide account statements. If your lender requires that your reserves be seasoned, you'll be asked for the account statements from the two months (or the seasoning period required for that program) immediately prior to your loan application, and the lender will be looking to see no unusually large deposits during the seasoning period.
If you don't have a big chunk of cash in the bank, and have no IRA or 401K account - don't despair! Many lenders offer "No Reserve" or "No Seasoning" mortgage programs, some of which may be a little more expensive in terms of interest rates, but are available to help you literally get your foot in the door nonetheless. Also, if you have assets, which are not easy to verify, there are "Stated Assets" programs as well.
Your Job Tenure
Lenders are looking for information about how stable and reliable your income has been in the past and, thus, will be in the future. They want to know what you do for a living and who your employer is, as well as how long you have worked for that employer. Historically, lenders wanted you to be with the same employer for a minimum of two years. Recently, most lenders have expanded their employment criteria to allow you to have changed employers over the last two years, so long as you have stayed within the same industry or line of work for at least that long. They figure that if you have demonstrated a commitment to working in the same industry, you will probably stay in that industry and have a similar level of income going forward.
Word to the wise - lenders will verify your employment (company and job title at minimum) by calling your company's HR Department, usually right after you apply for the loan and the day before they fund the loan, even if they don't verify your income. Make sure that whatever job title and tenure you put on the application jives with what your HR rep will tell the lender when they call.
Your Loan-to-Value Ratio
When you buy a home on the open market, the purchase price is usually equal to the fair market value of the home. At the time you first purchase your home, your down payment is the same as your equity - if you put 20 percent down, then you have 20 percent equity. What's the other 80 percent? Well, that is money you owe to the mortgage company. So, your loan-to-value ratio is 80 percent - you owe 80 percent of the value of your home.
Lenders view LTV ratio as an indicator of their risk. The lower the LTV ratio, the less likely you are to default. For example, if you have 70 percent equity in the home (i.e., a 30 percent LTV ratio), and you default on the mortgage, you face the risk of losing all of your equity if the lender forecloses. So chances are very good that you will do whatever you need to do to make that payment - no matter what.
You'll virtually never want to take on a single mortgage for greater than 80 percent of the value of the property. This prevents you from paying Private Mortgage Insurance, or PMI. However, if you break up your purchase price and get, say, two mortgages, the lender on your second mortgage will calculate your Combined LTV ratio based on all the mortgages on the property. So, if you are buying your home using an 80 percent mortgage and a 20 percent mortgage, then you have a 100 percent CLTV ratio.
o Your Debt-to-Income Ratio
Lenders want to know how much of your income will be committed to paying debts on a monthly basis after you have a mortgage payment to pay. You can calculate your debt-to-income ratio (a.k.a. DTI or debt ratio) the same way the lenders will in two steps:
- Add up all the minimum payments you are required to make on credit cards, department store cards, credit line, student loan, car, department store to get your minimum monthly debt payments;
- Divide your minimum monthly debt payments by your gross income to get your DTI ratio. For example:
If these are the minimum payments you must make every month on your credit-related bills:
Auto Payment $ 300
Visa $ 75
Mastercard $ 75
AmEx $ 100
Macy's $ 50
Student Loan $ 200
Proposed Mortgage $2,000
Minimum monthly debt payments $2,800
If your gross monthly income is $7,000, then your DTI is:
$2,800 divided by $7,000 = 40 percent Debt-to-Income Ratio
This is really just a mathematical way to tell whether or not you are overextended; the lower your DTI ratio, the more disposable income you have monthly to spend on things like food and utilities, and the more likely you are to have the money to pay your mortgage payment consistently. From the lenders' perspective, the lower the ratio of your debt to your income, the less risk you pose of defaulting on your loan.
Many moons ago, lenders required DTI ratios below 30 percent. As housing prices increased faster than incomes did, acceptable DTI's crept up to 35 percent and 40 percent. Now, 40 percent is acceptable to many lenders, and some will allow DTI's up to 50 percent. The bigger revolution in acceptable DTI has been the advent of "No Ratio" mortgages, a whole universe of loan programs that do not even have a DTI requirement.
Keep in mind that these ratios are driven by both debt and income - people who have difficulties in documenting their income often run into DTI problems. The stated income loans we discussed above make it possible for every cent of your income to be included in calculating your DTI, whether or not you can document it.
The Mortgage's Position
If there are multiple mortgages on your property, the lender on the first mortgage has first priority for recovering if you stop paying. The second mortgage company gets what's left over until that loan is paid off, then comes the third mortgage holder. The further down a lender is on the food chain of mortgages, the greater the risk that the money will run out before they get paid off!
This is especially true once you get into a situation where there are four or five mortgages. It is pretty unusual to even have this many mortgages on a property unless the homeowner is in some sort of financial distress. Homeowners with financial problems are at the highest risk of over-mortgaging their homes and ending up "upside down" - owing more on mortgages than the property is even worth.
The Level of Risk You Bear
In any mortgage, either the bank or the owner must bear some level of uncertainty on a number of issues, including interest rates and monthly payments, among other things. During the mortgage application and approval process, the lender starts determining the levels of uncertainty you assume relative to those they assume, based in large part on the type of mortgage you apply for.<
Their Guaranteed Profit
Many people refinance frequently, paying their mortgage loans off every year by taking a new mortgage. Usually the new mortgage model comes with cash that can be used however the homeowner likes, or with a lower interest rate. Lenders' business model is set up for them to reap most of their profits by charging interest over a long period of time. At the time you apply for your particular mortgage, lenders know there is the risk that you will refinance anytime you'd like, which keeps them from making their money in the long run.
There are two ways in which lenders can reduce their financial risk on your mortgage, by pinning down the minimum amount of profit they will make on your loan at the very beginning:
- Discount Points - In money matters, a "point" is simply 1 percent of the amount you're talking about. In mortgage matters, a discount point is a 1 percent fee you can pay at the time you close your transaction in exchange for a discounted interest rate over the life of your loan. For example, if a lender offers you a mortgage at a 7 percent interest rate, they will also tell you up front that if you choose to "pay a point" up front, your rate will drop to, say, 6.875. You can pay as many points as you want, and they are fully tax deductible for the year in which you buy your home. If you don't plan to be in your home - or in that mortgage - very long, it may not make sense to pay points. (See "Points or No Points," below for a decision guide on whether or not to pay points.) If you do pay a point, the lender knows that even if you refinance the next day, they've made some money on your mortgage!
- Prepayment Penalties (a.k.a. Prepays) - These are fees the lender will impose if you pay your loan off (or substantially off) within the first one to five years of the mortgage. The amount of a prepay is usually based on about six months' worth of interest - about the same as six months of mortgage payments! We call these "prepays" for short, and they are described in terms of how long they apply from the time you take out your mortgage. For example, if a mortgage broker says a particular mortgage comes with a two-year prepay, that means that if you pay your mortgage off within two years from the time you buy your home, then you will incur the penalty. With a hard prepay, you incur the penalty whether you pay off your home because you sell it or because you refinance it. With a soft prepay, the penalty is assessed only if you refinance the home. Lenders often impose prepays when they offer competitive terms to somewhat risky buyers. These same buyers often qualify for loans without prepays at a higher interest rate. If you take a mortgage with a prepayment penalty, the lender is guaranteed to make a minimum amount of money on your loan, either because you'll stay in the loan a minimum number of months, or because you'll pay the prepay penalty if you elect not to.
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