Applying for a Mortgage – Part 2
Chasing the dream of homeownership for yourself? A smart consumer will make every effort to gain knowledge and insight into the steps needed to achieve that goal. This effort not only involves developing an understanding of the mortgage loan process, but also recognizing what you can do in advance to increase the likelihood of a positive outcome. Having your dream of homeownership rejected or postponed, due to an issue you could have resolved beforehand with a little time and focus, can be discouraging and could potentially derail the dream entirely.
As you know from Applying for a Mortgage – Part 1, the underwriter’s job is to make a recommendation on your application through an evaluation process that attempts to determine just how risky it is for a lender to approve your loan application and how likely you are to repay the debt according to the terms of the agreement. There are four elements under review for any loan application including a mortgage: credit history, capital, capacity and collateral. In Part 1 we considered the credit report or credit history portion of the review. The non-credit report portion of the underwriter’s review would include an examination of your available capital, your capacity, and the collateral. Today, we’ll review the non-credit report factors and examine why these factors are also considered important the lender.
Collateral is something pledged as security to encourage repayment of a loan, to be forfeited in the event of non-payment. In the case of a mortgage loan the collateral is the home/property. Prior to being submitted to underwriting, a mortgage loan application package will require an appraisal. An appraisal is a professional review of the value of the property (often referred to as the Fair Market Value or FMV). The FMV will limit the amount the buyer may borrow as the lender is unlikely to lend more than the value of the property. In today’s market, where bidding wars still occur on certain properties the buyer would need to make up the difference between the purchase price and the FMV.
Also during a review of the collateral Loan-to-Value Ratio (or LTV) is calculated. The LTV is the total loan amount divided by the value. For example, if the value of the home you choose to purchase is $80,000 and you get a loan for $64,000 (with a down payment of $16,000), your loan-to-value ratio is 80 percent. A lower LTV may indicate lower risk to the lender and may balance other higher risk factors identified during the underwriting process. Speaking of down payments…
Capital is assets available to a borrower to be used to fund the mortgage loan application process through loan closing. Capital is available to make the down payment, pay for any application fees, the appraisal, the home inspection… any expense the borrower would incur before taking possession of the property.
Equity is the difference between the value of the home and the amount owed by the homeowner to a lender. The amount of equity during the home purchase process generally occurs due to the amount of the down payment provided by the borrower. Customarily, if your application shows you will be making a large down payment (industry standard still targets 20% of the purchase price), the lender’s underwriter will associate this with lower risk, as this investment in your home is interpreted to indicate a lower likelihood that you would default or not pay back the loan. In the future, after purchase, making your payments and maintaining and improving your home’s condition often increases the home value and, as a result, the amount of equity you have in the home.
Liquid Reserves are the funds you have remaining after the purchase of your home, such as savings accounts, 401(k) vested amounts, IRAs, net stock value, bonds, or mutual funds. The greater your liquid reserves, the lower perceived risk. A key point of your application preparation is to spotlight saving in your budget. Of course, as a smart consumer, you know that the more you save, the better. An ideal goal is a minimum of 6 months’ worth of expenses in your liquid reserve accounts.
Capacity reviews ratios and refers to the borrower’s ability to make the scheduled payments on a loan.
Housing Ratio is the calculation of the housing expense in comparison to monthly gross income. Generally, the housing ratio should not be more than 30% of the gross monthly income to maintain affordability.
Debt-to-Income Ratio is determined by dividing your total monthly debt (don’t forget your current housing payment, installment loans and revolving – credit card – minimum payments) by gross (before taxes and other deductions) monthly income. Remember, for some, monthly income would include more than your paycheck. If you choose to include it, your lender may take into account interest earnings, tips, commissions, bonuses, child support, or alimony. There are generally two debt-to income ratios calculated during a home purchase, the ‘front-end’ ratio and the ‘back-end’ ratio.
The ‘front-end’ ratio is the calculation of monthly debt payments to gross income ratio. The ‘back-end’ ratio is the calculation of monthly debt payment – including the anticipated new housing payment – compared to gross income ratio. Target for the ‘back-end’ ratio is to not go above 43% of the gross monthly income, in order to remain affordable.
Typically, the lower the ratio, the lower the risk. This is where the discipline you’ve developed in avoiding credit overextension comes into play. Lenders are interested in this calculation to determine what potential financial consequences would be in store for you with loan approval.
Loan Characteristics vary from loan product to loan product and lender to lender. Loan characteristics can include loan type, loan term, loan rates and loan fees for example.
Loan Type is also a risk consideration. There are three basic types – balloon, fixed-rate, and adjustable-rate. Many mortgage lenders offer products that combine elements from two or all three. The most common type of loan for a mortgage is the fixed-rate mortgage. As you would expect from the name, the interest rate charged on this type of mortgage remains the same for the life of the loan.
The balloon mortgage is usually set with a fixed-rate for a short term (7 to 10 years), at which time the remaining balance of the loan would be due in a lump sum. Some folks choose this type intending to refinance or sell the home prior to the time the ‘balloon’ payoff payment is due.
The adjustable-rate mortgage or ARM will also, ordinarily, begin with a fixed-rate for a period of time (5 to 10 years). After that, at specified intervals, the rate would be reviewed and adjusted (up or down) as conditions modify in financial markets. ARMs will often have limits on the breadth of adjustments at each interval, as well as overall, for the loan. For example, the current average annual cap allows for a rise of 2% yearly, and the current average life-time cap of 6% increase over the life of the loan. As the rate changes, the monthly payment of the loan is increased or decreased accordingly. Mortgage lenders are increasingly offering adjustable-rate mortgage products to consumers.
It is important to note that, although balloon and ARMs routinely offer lower rates initially than the fixed variety mortgage, statistics show that the more frequent the rate adjustment intervals are, the greater the default risk.
Loan Term for most mortgage loans is the standard 30 years, or 360 months. Shorter terms are available, and while the monthly payment may be higher, these loans can work to more quickly build equity and save thousands in interest charges over a longer-term loan. If you were thinking a shorter-term loan would be considered lower risk, you are correct. (Lender’s thinking? Shorter-term means less time for something to go wrong.)
Credit Advisors hopes that awareness of the factors assessed during the underwriting process will assist you in preparing to fulfill your dream of homeownership. The time and attention you take now in examining your position in relation to the various credit report and non-credit report factors will undoubtedly pay dividends to your efforts. If at any time you need assistance in your application preparation please contact one of the Credit Advisors Foundation’s certified housing counselors for additional information. After all, accomplishing your vision of becoming a homeowner will most likely be the most important financial transaction of your life.
