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The process of determining whether a prospective borrower has the ability to repay a loan.
Qualification Versus Approval: To be approved for a loan, a prospective borrower must demonstrate both the ability to repay and the willingness to repay. The borrower's willingness to repay is assessed largely by the applicant's past credit history. Qualified borrowers may ultimately be turned down because, while they have demonstrated the capacity to repay, a poor credit history suggests that they may be unwilling to pay.
Meeting Income Requirements: Lenders ask two basic questions about the borrower's ability to pay. First, is the borrower's income large enough to service the new expenses associated with the loan, plus any existing debt obligations that will continue in the future? Second, does the borrower have enough cash to meet the upfront cash requirements of the transaction? The lender must be satisfied on both counts.
Expense Ratios: Lenders assess the adequacy of the borrower's income in terms of two ratios that have become standard in the trade. The “housing expense ratio” is the sum of the monthly mortgage payment including mortgage insurance, property taxes, and hazard insurance, divided by the borrower's monthly income. The “total expense ratio” is the same except that the numerator includes the borrower's existing debt service obligations. For each of their loan programs, lenders set maximums for these ratios, such as, e.g., 28% and 36%, which the actual ratios must not exceed.
Debt Service: The debt service portion of total expenses includes alimony but not income taxes, which doesn't make a lot of sense. It also does not include student loans if repayment is deferred for a year or longer, although the underwriter can elect to include it if the amount involved is very large or the borrower's credit is weak. If there are co-borrowers, the debts of both must be included.
Variations in the Ratios Among Loan Programs: Maximum expense ratios may vary from one loan program to another. Hence, an applicant only marginally over the limit may need to do nothing more than find another program with higher maximum ratios.
Variations in Ratios with Other Transaction Characteristics:
Within any program, maximum expense ratios may vary with other characteristics of the transaction. For example, the maximum ratios are often lower (more restrictive) if the property is two- to four-family, co-op, condominium, second home, manufactured, or acquired for investment rather than occupancy. On the other hand, if the applicant makes a down payment larger than the minimum, the maximum expense ratios may be higher.
Applicant's Ability to Get the Maximum Ratios Raised: The maximum ratios are not carved in stone. The following are illustrative of circumstances where the limits may be waived:
• The borrower is just marginally over the housing expense ratio but well below the total expense ratio—29% and 30%, for example, when the maximums are 28% and 36%.
• The borrower has an impeccable credit record.
• The borrower is a first-time homebuyer who has been paying rent equal to 40% of income for three years and has an unblemished payment record.
Reducing Expense Ratios by Reducing the Term: If expense ratios exceed the maximums, one possible option is to reduce the mortgage payment by extending the term. If the term is already 30 years, however, there is very little that can be done. Few lenders offer 40-year loans, and extending the loan to 40 years doesn't reduce the mortgage payment much anyway.
Using Excess Cash to Reduce Expense Ratios: Borrowers paying more than the minimum down can shift the excess over the minimum to reduce expense ratios. They can pay points to reduce the interest rate, pay off other debt, or fund a temporary buydown. Except for the last, however, the impacts are quite small. They won't work at all, furthermore, if the reduced down payment increases the mortgage insurance premium.
The mortgage insurance premium categories, defined in terms of the ratio of down payment to property value, are 5 to 9.99%, 10 to 14.99%, and 15 to 19.99%. An applicant putting down 10%, 15%, or 20% cannot reduce the down payment without moving into a higher mortgage insurance premium category. But an applicant putting down 7.5 %, 12.5%, 17.5%, or 22.5% can.
The most effective way to reduce expense ratios is to use a temporary buydown, which some lenders allow on some programs. With a temporary buydown, cash is placed in an escrow account and used to supplement the borrower's payments in the early years of the loan. See Temporary Buydown.
Income Used to Qualify: Lenders disregard income that is viewed as temporary, such as overtime or bonuses. But sometimes income from such sources can be expected to continue. The burden of proof is on the applicant to demonstrate this. The best way to do this is to show that they have in fact persisted over a considerable period in the past.
Borrowers who intend to share their house with another party can also consider making that party a co-borrower. In such case, the income used in the qualification process would include that of the co-borrower. Of course, the co-borrower would be equally responsible for repaying the loan. This works best when the relationship between the borrower and the co-borrower is permanent.
Lenders will not take account of anticipated growth in income, even if it is highly probable, such as in the case of a physician just
out of medical school. They are not going to base a loan on anticipated income that may or may not materialize. And they will not
include income from a job the borrower is confident of getting but doesn't have.
Lenders include investment income, if it can be documented as relatively stable. This includes income from property, as when a homebuyer elects to rent rather than sell an existing home. The lender in this situation will assume that some part of rental income (usually 75%) will remain after paying for utilities, maintenance, etc. From this, they subtract the mortgage payment, taxes, and insurance. If the difference is positive, they add it to income, but if it is negative, they add it to debt service payments.
Getting Fired Before the Loan Closes: If this happens, the applicant should tell the lender immediately because the lender will get the bad news anyway when they send out an employment verification request. If they hadn't been told, they will be annoyed at having their time wasted and probably won't be as helpful as they might have been otherwise.
Being helpful means exploring the possibility of recasting the loan so that the borrower's income can be disregarded. However, this could require a substantial increase in down payment or interest rate, which could make the loan unworkable.
Is an ARM Needed to Qualify? Because the interest rate used to qualify applicants is generally lower on an ARM than on a FRM, some borrowers need an ARM to qualify. Yet some borrowers who appear to require an ARM in fact could qualify with an FRM using one or more of the approaches discussed above. It just takes a little more work by the loan officer. If the loan officer is lazy or is primarily interested in selling ARMs, the effort may not be made.
Meeting Cash Requirements: More borrowers are limited in the amount they can spend on a house by the cash requirements than by the income requirements. Cash is needed for the down payment, and also for points and other fees charged by the lender, title insurance, escrows, and a variety of other charges. Settlement costs vary from one part of the country to another and, to some degree, from deal to deal. See Settlement Costs.
Down Payment Requirements: Down payment requirements range from 30% to zero and below—in some cases, lenders will lend more than the value of the property. The requirements depend on the type of program, loan amount, property characteristics, and the borrower's credit rating.
VA-guaranteed loans (available only to veterans) require no down payment on loans up to $203,000. FHA-insured loans require only 1% down. Loan limits in 2003 ranged from $154,896 to $280,749.
On conventional (non-VA, non-FHA) prime loans, the lowest down payment requirement is generally 5% on loans up to $400,000.
It notches up quickly after that and is generally 40% on a $1,000,000 loan. Some special affordability programs are available from Fannie Mae and Freddie Mac with 3% down. The loan limit on these in 2003 was $322,700.
On sub-prime loans, which carry higher interest rates, some lenders will advance up to 125% of property value to borrowers with good credit ratings.
Down payment requirements will be higher whenever a transaction has characteristics that lenders view as risky. The million-dollar loan has a high requirement, for example, because it is secured by an expensive house that may have unique features that appeal to a limited number of potential buyers and is therefore subject to much greater price variability than a less expensive house. For similar reasons, lenders will usually require a larger down payment if the borrower has a poor credit record, is purchasing a house as an investment rather than for occupancy, wants to refinance for an amount significantly larger than the existing balance, and so on.
Sources of Funds for Down Payment: In general, lenders prefer that borrowers meet the down payment requirement with funds they have saved. This indicates that the borrower has the discipline to save, which bodes well for the repayment of the loan. Other sources of funds may be problematic.
Gifts and secured loans are acceptable but only within limits. On conventional loans having down payments of less than 20% of property value, at least 5% of the down payment must come from the applicant's own funds. (There are some special programs for which the own-funds requirement is only 3%.) The balance can come from a gift or a secured loan. With a 20% down payment, the entire amount can come from gifts or secured loans.
Secured loans must be reported as existing debt and the payments on them are included in total housing expenses. If this total as a percent of income exceeds the lender's guidelines, a secured loan may not work where a gift would work.
Lenders want to be sure that an alleged gift is really a gift. If it comes from a family member, they may ask that member to sign a gift affidavit. The concern is that the “gift” is really an unsecured loan and that if the borrower gets into financial difficulty, he or she will give first priority to paying off the family member.
If the “gift” is from the home seller, the concern is that the sale price has been correspondingly inflated. This would mean that the equity in the property is less than it appears. For this reason, lenders tend to set a limit on “gifts” by sellers, which are typically referred to (more accurately) as “seller contributions.” See Down Payment/ Home Seller Contributions.
Qualifying Self-Employed Borrowers: The system is somewhat more complicated and onerous for self-employed borrowers, but it does work. I have been in countries where it is impossible for a self-employed person to obtain a mortgage loan from an institutional lender. The only sources of funding, other than family members, are money-lenders, who charge extortionate rates and break the borrowers' legs if they don't pay.
The major problem with lending to the self-employed is documenting an applicant's income to the lender's satisfaction. Applicants
with jobs can provide lenders with pay stubs, and lenders can verify the information by contacting the employer. With self-employed applicants, there are no third parties to verify such information.
Consequently, lenders fall back on income tax returns, which they typically require for two years. They feel safe in relying on income tax data because any errors will be in the direction of understating rather than overstating income. Of course, they don't necessarily feel safe that the W-2s given them are authentic rather than concocted for the purpose of defrauding them. For this reason, they will require that the applicant authorize them to obtain copies directly from the IRS.
The support it provides to self-employed loan applicants is an unappreciated benefit of our income tax system. It may not be fully
appreciated, of course, by applicants who have understated their income. In countries where virtually no one pays income taxes
because cheating is endemic, tax returns are useless for qualifying borrowers.
The second problem with lending to the self-employed is determining the stability of reported income. For this purpose, the lender
wants to see an income statement for the period since the last tax return and in some cases a current balance sheet for the business.
The two government-sponsored enterprises, Fannie Mae and Freddie Mac, have developed detailed guidelines for qualifying self-
employed borrowers. Lenders looking to sell such loans to the agencies must follow the guidelines. The problem is that implementation can be complicated and time-consuming, especially when the declared income comes from a corporation or a partnership. If you own 25% or more, you are considered as “self-employed.”
Most lenders offer reduced documentation loans to self-employed applicants who cannot demonstrate two years of sufficient income from their tax returns. (See Documentation Requirements.) These programs vary from lender to lender, but they all provide less favorable pricing and/or tougher underwriting requirements of other types. Lenders invariably require larger down payments and may also require a better credit score or higher cash reserves. In addition, they may limit the types of properties or types of loans that are eligible.