Qualifying the borrower - Capacity

Over the years, mortgage lending institutions have learned what qualities are necessary to protect their investment in a borrower.  These qualities are broken down into three
basic categories.  Known as the “Three C’s” they are Capacity, Credit and Collateral.  A lending institution asks three simple questions before they say yes or no to a potential borrower.  Can the borrower pay?  Will the borrower pay?  What happens if the borrower doesn’t pay?

Can the borrower pay?  Capacity is defined as the relationship between a borrower’s income and their reoccurring liabilities.  It also looks at assets the borrower can use to repay credit if their income is reduced or lost.

Income

• 2 year history in specific profession or field required
• Reported income used (income reported on W-2 prior to taxation)
• Strong chance on continuance for three years

Liabilities

• Mortgage Liability – principle, interest, taxes, insurance and HOA dues

***Insurance includes Hazard, Mortgage, and Flood Insurance

• Car Loans
• Student Loans
• Credit Cards
• Alimony/Child Support

Assets

• Liquid – Bank Accounts, 401K, Money Market Funds, Stocks, Bonds
• Non Liquid – Cars, Art Work, Jewelry

Borrower Ratios
Underwriters will look at two ratios called the front-end and back end ratios.  A borrower must meet the requirements of both ratios.

Front End or Housing Ratio

• Total mortgage liability divided by gross income
• 28% Conventional or 29% Government

Back End or Debt Ratio

• All liabilities divided by gross income
• 36% Conventional or 41% Government

***There is no limit.  Borrowers often exceed these limits.  Well-qualified borrowers can even have ratios as high as 60% although this is very rare.

Qualifying the borrower - Credit

Will the borrower pay?  As with most human habits the best predictor of future behavior is past behavior.  Lenders make no assessment of a borrower’s credit.  Instead they use credit reporting agencies to determine someone’s historical habits of repaying credit.  This credit report is quantified in a number, also known as a FICO score that ranges from 400 – 900.  Most people have a credit score somewhere between 475 and 805.  FICO is an acronym for Fair, Isaac & Company.

FICO Thresholds

• 585 FHA
• 620 Standard Conventional
• 720 Excellent Credit – qualifies for most high LTV no MI loan products (ex. 80/15/5)

What’s not on a credit report?

• Race
• Gender
• Marital Status
• National Origin
• Religion

Credit Reporting Mistakes

• Credit scores can be re-scored with proper documentation
• Expedited re-scoring may be accomplished in 5 business days
• Approximate fee for a re-score (as billed by the credit agency) is $100

FICO Scores are calculated from a lot of different credit data in your credit report. This data can be grouped into five categories as outlined below. The percentages in the chart reflect how important each of the categories is in determining your score.

These percentages are based on the importance of the five categories for the general population. For particular groups - for example, people who have not been using credit long - the importance of these categories may be somewhat different.


Payment History

• Account payment information on specific types of accounts (credit cards, retail accounts, installment loans, finance company accounts, mortgage, etc.)
• Presence of adverse public records (bankruptcy, judgements, suits, liens, wage attachments, etc.), collection items, and/or delinquency (past due items)
• Severity of delinquency (how long past due)
• Amount past due on delinquent accounts or collection items
• Time since (recency of) past due items (delinquency), adverse public records (if any), or collection items (if any)
• Number of past due items on file
• Number of accounts paid as agreed
  

Amounts Owed

• Amount owing on accounts
• Amount owing on specific types of accounts
• Lack of a specific type of balance, in some cases
• Number of accounts with balances
• Proportion of credit lines used (proportion of balances to total credit limits on certain types of revolving accounts)
• Proportion of installment loan amounts still owing (proportion of balance to original loan amount on certain types of installment loans)

Length of Credit History

• Time since accounts opened
• Time since accounts opened, by specific type of account
• Time since account activity

New Credit

Number of recently opened accounts, and proportion of accounts that are recently opened, by type of account

• Number of recent credit inquiries
• Time since recent account opening(s), by type of account
• Time since credit inquiry(s)
• Re-establishment of positive credit history following past payment problems

 Types of Credit Used

• Number of (presence, prevalence, and recent information on) various types of accounts (credit cards, retail accounts, installment loans, mortgage, consumer finance accounts, etc.)

Please note that:

• A score takes into consideration all these categories of information, not just one or two.
  No one piece of information or factor alone will determine your score.
• The importance of any factor depends on the overall information in your credit report.
  For some people, a given factor may be more important than for someone else with a different credit history. In addition, as the information in your credit report changes, so does the importance of any factor in determining your score. Thus, it's impossible to say exactly how important any single factor is in determining your score - even the levels of importance shown here are for the general population, and will be different for different credit profiles. What's important is the mix of information, which varies from person to person, and for any one person over time.
• Your FICO score only looks at information in your credit report.
  However, lenders look at many things when making a credit decision including your income, how long you have worked at your present job and the kind of credit you are requesting.
• Your score considers both positive and negative information in your credit report.
  Late payments will lower your score, but establishing or re-establishing a good track record of making payments on time will raise your score.

Qualifying the borrower - Collateral

What happens if the borrower doesn’t pay?  When a borrower does not pay his or her mortgage a lender has the right to accelerate the payment of the note.  This means they can demand repayment of the entire loan.  They have the right through the Deed of Trust to use the collateral to repay the debt.  This is commonly known as foreclosure.  Always assuming the worst, lenders review the collateral used to secure the loan before approving someone for a mortgage.  An appraisal is used to determine the quality of the collateral for a loan.

Loan-to-Value
The amount of the loan divided by the sales price or appraised value (whichever is lower)

Example 1:
$160,000 loan with a $200,000 sales price 
Loan to Value = 80%

Example 2:
$160,000 loan with a $200,000 sales price but the house appraises at $195,000  Loan to Value = 82%

Other items addressed when determining if sufficient collateral exists

• Does the house have hard to sell features?
• Will the property hold its value?
• Did the seller make concessions as an inducement to the buyer?
• Are there equivalent comparables nearby?
• Is the property too unique?  (Example: log cabin in downtown Washington D.C.)

When sufficient collateral does not exist a borrower has several options including a second mortgage or mortgage insurance.

High Loan-to-Value Options

Mortgage Insurance (MI)

There are three types of MI

• Lender Paid

No monthly premium but higher interest rate

• Monthly MI

Premium based on loan to value
Usually .8% per year spread over 12 months

• Up-front MI

Paid at closing
Little or no monthly insurance
Rarely used except for government loans

 ****MI may be tax deductible.

Removal of Mortgage Insurance

• When principle is paid down to 78% LTV (about 12 years)
• When new appraised value of home reduces Loan-to-Value below 80% - this varies dependent on appreciation rates and is subject the MI company approval.

Second Mortgage
A second mortgage is placed in second position behind the primary mortgage.  If a house were to go to foreclosure the second mortgage would receive payment only after the first mortgage is satisfied.  This is a higher risk investment and therefore is usually at a higher rate.

• Often referred to as 80/10/10 or 80/15/5 

***80% 1st Mortgage, 10% 2nd Mortgage, 10% down payment

• Up to 100% financing
• Relieves need for mortgage insurance
• Borrowers must meet strict credit criteria
• Interest is tax deductible unlike MI

****Second mortgages are essentially non-existent.  These options may return, but they are not viable options in the current market.