So, the lender just looks at your credit score and decides whether to give you money, right? Wrong. Loan officers and underwriters use careful processes, analyses, and ratios when deciding whether and how much to loan to a home buyer. The lender is taking on significant risk giving hundreds of thousands of dollars to a borrower secured by a specific piece of property, which the owner must maintain.
Lenders not only want to know how much money a buyer has, makes, and owes, they want to determine the likelihood that the buyer will pay the mortgage payments on time.
Loan underwriters approve or deny a mortgage loan application based on an evaluation and layering of three factors:
- Income and assets: Determine the borrower’s ability to repay the loan.
- Credit: Determines the borrower’s willingness to repay the loan, looking at current credit use, how the borrower treated obligations in the past, and the borrower’s creditworthiness.
- Property: Determines whether the property is adequate collateral for the loan.
How Qualification Fits into the Homebuying Process
Before house hunting, buyers should get pre-qualified, which can be completed online. This is not a deep analysis, but the lender will provide an estimate of the amount they’d lend. While it’s no guarantee, this gives the buyer a good idea of what he or she can afford when looking at listings.
This more serious process involves a loan application, fee, financial documentation, credit score, debt, and history of repayment. The lender completes a formal financial analysis and provides the buyer a clear idea of monthly mortgage payments. With a pre-approval in writing, buyers appear to sellers to be ready, willing, and able to buy a house now.
When the buyer has a sales contract for a specific house, the lender would require updated financial information. During the home searching and buying process, buyers should avoid taking on new debt, changing jobs, and applying for new lines of credit.
After the buyers find the house they want, the financing process generally progresses like this:
- The loan application. The borrower first meets with a mortgage broker or loan officer to fill out the application.
- Within 3 days of applying, the lender must provide the buyer with the Loan Estimate, which states loan terms and settlement charges.
- After the application is filed, its information is checked: For example, the salary and employment information is checked against the Verification of Employment Form sent to the applicant’s employer.
- The loan officer will then order an appraisal of the property.
- This package—the verified application and the appraisal— is sent to the underwriter.
- The underwriter analyzes the buyer’s creditworthiness and the property’s suitability as collateral to qualify the borrower and the property.
- After loan approval, the borrower receives a commitment letter with mortgage loan specifics.
- Three days before the closing, the borrower should receive from the lender the Closing Disclosure form, which details the final, actual loan costs.
So how do lenders qualify home buyers for a mortgage? Loan underwriters look at five things related to the buyer:
- Income: The underwriter looks for a verifiable, two-year employment history, including a consistent working pattern as indication that the applicant’s income will continue.
- Credit: Credit reports, issued by one of the three credit reporting bureaus, Equifax, Experian, or TransUnion, contain detailed information about a consumer’s credit history.
- Source of funds: Buyers should already have some cash on hand often from a variety of sources including liquid assets, gifts, and retirement vehicles.
- Debts: The underwriter looks at two ratios to determine whether that applicant can make the monthly mortgage payments: the housing-expense-to-income ratio and the total debt service ratio. Housing expense is the “PITI payment” (Principal, Interest, Taxes, and Insurance). The total debt service ratio is (PITI + all long-term debts) ÷ gross income.
- Net worth: A person’s net worth is all of her or his assets minus all liabilities.
Credit scores are given on a scale of 300-850, with higher scores indicating lower risk. There is no one score below which a consumer is considered “bad” and above which he or she is considered “good.” Lenders consider a variety of information, such as the specifics of the loan being sought, when they evaluate the risk of a particular borrower.
A few individual risk factors may not be trouble, but several interrelated high-risk characteristics or “layers of risk” can cumulatively increase the likelihood of default, which may lead to higher interest rates or denial of an application.
As you can see, qualifying for a loan is not as simple as having a certain income or a great credit score. Lenders are looking for stable income, a healthy debt-to-income ratio, and an established habit of paying your bills on time.
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TX Real Estate Finance II