Whether or not a lender chooses to lend you money is based on a decision making process called underwriting.There’s a lot that goes into a mortgage underwriting decision, but underwriting criteria generally falls into three basic categories called the “three Cs”, which stand for credit, capacity and collateral.
As a mortgage borrower, it’s important to understand the basics of the 3 Cs because it will help you better position yourself to get the best mortgage deal possible – which, of course, can save you some good money in the long run!
Let’s take a closer look at each of these categories.
Credit – Does the borrower have a good history of repaying debts?
Your credit scores are one of the most important factors used to make a lending decision because they measure how well you manage credit. Mortgage lenders as a rule require a credit report from the three major credit bureaus (Equifax, Experian, and TransUnion) that documents your credit scores, payment histories for mortgages, auto loans, personal loans, credit cards, and any derogatory information such as collections, foreclosures, judgments, charge offs, bankruptcies, liens, etc. Your credit score is considered to be highly predictive of the probability you’ll default on a loan, so the lenders give it a lot of weight. The higher your scores, the better!
Scores below 620 are generally considered to be “bad” credit and scores above 720 are considered “good” credit. Everything in between is middle-of-the-road or “fair” credit. Ideally, you want to have all three scores in the mid 700s or better to get the best mortgage financing terms.
A lot of borrowers are under the mistaken impression that lenders use the average of the three scores for qualification. This is not true! Lenders use the middle of three scores or the lowest of two to qualify.
Besides your credit scores, one of the most important pieces of credit criteria is how well you manage your housing payments, whether you’re paying a mortgage or paying rent (rent payments don’t show up on credit reports). Payments that are late more than 30 days in the last 12-24 months are pretty much considered unacceptable in today’s lending climate.
If you’ve been more than 30 days late in the last year on a credit card or auto loan, it’s certainly going to damage your credit scores to some extent, but it won’t necessarily disqualify you from a mortgage loan on that basis alone.
The following are some important tips for keeping your credit scores strong:
- Make your payments on time. Again, your mortgage payments are the most critical for keeping up your credit scores, but payments on credit cards, auto loans, personal loans, etc., also have an impact on your scores.
Check your credit on a regular basis and clear up errors immediately. Federal law entitles you to one free credit report annually, which you can obtain at AnnualCreditReport.com.
- Always keep your credit card balances below 30% of the outstanding limit. The credit bureaus hit your scores hard if you over-utilize your available credit, even if you make your payments on time. If you have maxed or near maxed credit cards, expect your scores to be impacted significantly.
- If you have a home equity line of credit, verify that all three of the credit bureaus are reporting it as a mortgage debt. If it shows up as a revolving debt, then it will be treated by the scoring algorithms like a credit card and could damage your scores if you’re carrying a balance higher than 30% of the limit. If you do see an error on your credit, make sure to contact the appropriate credit bureau to get it fixed.
- Keep older credit card accounts open. A lot of people (me included!) have made the mistake of closing out older, well-established credit card accounts because they think it will help their scores to reduce available credit. Big mistake! If you’re going to close out accounts, make sure to keep your oldest ones open. A long credit history carries a lot of weight in the scoring algorithms, so you could be damaging your credit scores by closing out old accounts.
Capacity – Does the borrower have the financial ability to repay the loan?
One of the big reasons for the mortgage bust of a few years ago was that lenders weren’t properly evaluating the capacity of many borrowers to repay their loans. The fact that so many lenders were willing to make loans based on inflated and unverified income (ie, “stated” income loans) was a big reason for the ensuing foreclosure mess that we’re still sorting out today. The lending mistakes of the past highlight why evaluating the capacity of a borrower to repay the loan is so important.
One of the most important capacity criteria an underwriter will look at is employment. When reviewing employment, one of the most important factors is job stability. W2 wage earners typically have more stable employment, therefore they are considered less of a risk from an underwriting standpoint. To document wage earner income, the underwriter will typically ask for the last 2 years of W2s and the most recent 30 days worth of paystubs.
If you make overtime, it’s important to note that it can only be used to qualify if you have been getting it consistently for the last 2 years and the underwriter is comfortable that you will continue to get it in the future.
Self-employed borrowers are viewed as higher risk because they are responsible for the solvency of the business in addition to their personal obligations. Commission income is also viewed as more risky because if a commissioned employee fails to produce business, he also fails to generate income. If self-employment or commission income is used to qualify for a mortgage, the underwriter will want to verify a two-year history of receiving that income with tax returns. A monthly average will be calculated based on the income you were taxed on – after your deductions – and used for qualifying purposes.
It’s important to note that most lenders currently require full income documentation in the form of W2s and/or tax returns whether you’re self-employed or a wage earner. Note that stated income programs, which don’t require proof of income, are all but impossible to find in today’s market.
An important ratio used to evaluate capacity is the debt-to-income ratio (DTI), which is expressed as a percentage. The DTI is calculated by dividing a borrower’s total monthly payment obligations by their total monthly gross (pre-tax) income. For example, if a borrower has a $500 car payment, $100 credit card payment, and a mortgage payment of $1,000 per month, his monthly obligations total $1,600. If he makes $5,000 a month gross, his debt to income ratio is 32% ($1,600/$5,000 * 100).
Assets are often an important component of evaluating capacity because the lender wants to see that you have enough reserves to cover the mortgage payment in case of financial trouble. The amount of qualifying assets required is usually expressed in terms of monthly payments, including the total of the principal and interest payment, taxes, insurance, homeowners insurance, and mortgage insurance (if applicable). Depending on the type of loan, reserve requirements can be anywhere from zero to twelve months worth of payments. There usually are no reserve requirements for loans on a primary residence (one that you live in).
Acceptable assets for reserves include checking, savings, retirement accounts, and any other liquid cash accounts. Accounts that have withdrawal penalties will typically be discounted by 30% to 40% for qualifying purposes. To verify reserves, underwriters will usually ask for the most recent two months worth of statements (or most recent quarterly statements where applicable).
Collateral – What is the security for the loan?
The collateral for a mortgage loan – the property being purchased or refinanced – is an important consideration for the underwriter. Not all collateral is the same, so the type of property has a significant impact on the financing and rates available. Property types are generally classified as follows, in order from highest to lowest risk: single-family residence, duplex, townhouse, low rise condominium, high rise condominium, triplex and fourplexes and condotels. It’s important to note that lower risk properties will typically receive better interest rates than higher risk properties.
Occupancy is also an important part of collateral. A property can be owner-occupied, used as second home, or be an investment. Owner-occupied and second homes have the least amount of default risk and thus receive the lowest rates. Investment properties, on the other hand, have the highest default risk and receive higher rates as a result.
Though property type and occupancy are important, value is probably the most important characteristic of collateral. The chief concern of the lender is that the property is worth enough to easily be sold to recoup losses in the event of a loan default. Professional appraisers estimate the value of a property by comparing it to recently sold properties in the neighborhood that have similar square footage, bedroom count, age, and general appeal, etc.
Once the value is determined, it is used to calculate the loan-to-value (LTV), which is essentially the percentage of the value of the house that is being borrowed. For example, if a home is valued at $200,000 and the first mortgage is $100,000, the LTV is 50%. If there’s a second mortgage on the home as well, then the combined loan-to-value, or CLTV, is 75%. From a lending standpoint, a higher LTV equates to higher risk because it is more likely the lender will take a loss in the event of default. Naturally, if a higher LTV means higher risk, it also will generally mean a higher rate for the borrower.
If the LTV is over 80%, mortgage insurance will typically be required to offset the increased risk of loss that comes with doing high LTV loans. Many mortgage borrowers are under the impression that mortgage insurance insures them, when it fact it insures the lender against loss if the borrower defaults. Usually the cost of the mortgage insurance is passed on to the borrower as an added expense on their monthly mortgage payment, but some banks allow what is called lender paid insurance, where a higher interest rate is charged in exchange for the lender paying the mortgage insurance.
Again, mortgage underwriting can be categorized into three basic categories: credit, capacity, and collateral. Underwriters will evaluate if you have a good history of managing debt (credit), if you have the financial means to repay the loan (capacity), and if your property is adequate security for the loan (collateral).