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Mortgage: An Overview (Part 5 of 5)

Mortgages - An Overview (5): Qualifying for a Loan

by Joseph Hughes

With the collapse of the sub-prime market, the mortgage industry has returned to basics and has gone back to the way loans were processed years ago. Essentially, three basic categories are considered in order for a loan to be granted: income, the property, and credit.

The borrower needs to have sufficient, sustainable, regular income to qualify for the loan. To determine stability, the lender looks at income for the past two years. If the borrower has had a job for less than two years, the lender looks at the previous job. Ideally the borrower did the same type of work with only a short gap between jobs. If the new job is in a different line of work, the lender must be convinced that the new job is similar enough or the skills are similar or transferable to the new job.

If the borrower is self-employed, the lender is looking for at least two years of self –employed income and will average that income over a two year period. This can be difficult if a new business is involved, because the first year is start up time and the business may not make money. The income for a self- employed person is determined by the amount that is transferred from the federal Schedule E to the front of the 1040. This approach shows how much potential borrower nets from the business after expenses, but before taxes are paid.

Then the lender calculates the borrower’s monthly housing expenses including the mortgage payment, the projected monthly real estate tax, and the monthly hazard insurance payment, as derived from the annual or semi-annual bill. These items totaled are his monthly housing obligation. Once the housing obligation is determined, the lender adds in the borrower’s other monthly bills, including items such as credit card and car payments, to calculate the total monthly obligation. Life insurance and health insurance are not included. To qualify, the total of housing expenses and consumer debt should not exceed forty percent of the borrower’s gross monthly income before any federal or state withholding, or Social Security taxes are taken out. If the borrower has very good credit, a low loan to value ratio, and/or a large amount of savings, the ratio can easily to pushed to more liberal levels.

The Three Elements of Getting a Loan

The appraised value or the sales price, which ever is lower, is used for the loan process. The property has to appraise for an amount sufficient for the needs of the lender. For instance, if the borrower applies for an eighty percent loan, the value of the property must be sufficient to support that amount. In reality, having the property appraise for enough is rarely a problem, for, in the majority of cases, the appraisal comes in at the agreed upon sales price because the market has dictated a fair price for the property. The appraiser has a copy of the sales contract and knows what the price is, as well as any concessions that the seller has made. Occasionally a property can’t support the sales price because the property is unique and no comparable sales support the price. Sometimes a buyer has become enamored with an over-priced property. In that case, the lender expects the appraiser to provide a more accurate market value. If the buyer still wants the property because of its unique characteristics, the loan will be based on the appraised value, not the sales price. Then the buyer must either renegotiate for a lower price or, if that is not possible, make a larger down payment. In either case the loan is limited by the appraisal on the property. An appraisal can also be a problem during a refinance when a certain value is needed to get a specific loan amount. Owners often over-estimate the value of their homes and fail to understand the subtleties of the appraisal process. For instance, the houses that the owner thinks are comparables may have different features, such as a larger lot or updated kitchen and bathrooms that the borrower doesn’t recognize. The credit part of the trio is in some ways the most straightforward. A borrower either does or does not have good credit. Credit that is in the middle can be a problem. It is neither outstanding nor is it terrible. Before credit scores were introduced, credit reports were carefully examined to determine the likelihood that the borrower would repay the loan in a timely manner. This determination was done by looking at each derogatory item on the credit report and it was examined to see if there was a pattern that suggested the borrower would not meet his obligations. The severity of the infractions was considered. For example any late payment from Sears was disregarded because Sears was known to be overly strict about reporting late payments. Basically, these decisions were based on experience.

This approach changed with the initiation of credit scoring. The three major credit reporting firms each have a credit score based on the information in their data base. Lenders use the middle of the three scores, taking judgment and evaluation out of the process. Anyone with a credit score above a certain level is considered credit worthy. Judgment and an evaluation of the credit problems have disappeared. A logarithm is used that is supposed to be constantly adjusted to give the lender a score which tells the borrower’s probability of either paying on time or defaulting. Often the information in the credit report and the credit score seem so different that it is not clear how the score was derived, which may be one reason for the sub-prime meltdown. That number has replaced experience and judgment.

When the three elements of income, appraisal, and credit all pass the test, the loan is approved and the documents are ready to be drawn and signed.

Continue to the next article in the Mortgage: An Overview series