Qualifying For a Mortgage

December 12, 2000, Revised November 14, 2006, August 1, 2007
A "good loan" is one to a borrower who has both the ability and the willingness to repay it. Determining the borrower's ability to repay is called "qualification". The borrower's willingness to repay is determined largely by the applicant's credit history. "Underwriting" is the process of making a final determination on approval or rejection. It involves verifying the information obtained from the borrower and other sources, and assessing information on the applicant's credit worthiness.

Borrowers Are in the Drivers Seat

Most potential borrowers are nervous about getting a mortgage loan because they share a widespread misperception: the misperception is that they have no bargaining power relative to lenders, and therefore must approach them hat in hand. That was the way things were for much of our history, and the way things still are in much of the world, but it has not been true in the US for many years. Today lenders compete fiercely among themselves for good loans.

A "good loan" is one to a borrower who has both the ability and the willingness to repay it. If you can demonstrate both the ability and the willingness to repay, lenders will be anxious for your business. You are in the driver’s seat. If your position is weak on either score, you will be limited to lenders who specialize in weak applicants and are prepared to take larger risks. These lenders are fewer in number, and their interest rates and other terms will be less favorable than those available to stronger applicants.

Qualification, Approval and Underwriting

Determining the borrower's ability to repay is what "qualification" is all about; it is the subject of this article. The borrower's willingness to repay is determined largely by the applicant's past credit history. (See Mortgage Credit Issues). For a loan to be approved, the lender must be satisfied on both scores. This is the difference between "qualification" and "approval".

The process of making a final determination on approval or rejection is called "underwriting". Underwriting involves verifying the information that has been obtained from the borrower and that served as the basis for qualification, as well as assessing information on the applicant's credit worthiness.

Qualification and Affordability

On a purchase transaction, qualification is always relative to property value. A borrower who is well qualified to purchase a $200,000 house may not qualify to buy a $400,000 house.

The property value for which you can qualify depends on your own personal financial condition, and it also depends on the mortgage terms available in the market at the time you are shopping. The table below shows some ballpark estimates of affordability based on the availability of a 7% 30-year mortgage. For each of 7 sale prices, the table shows the total cash required to meet down payment requirements and settlement costs, the total monthly housing expense, the minimum income required to cover housing expenses, and the maximum amount of debt service allowable on the minimum income.

To afford a $400,000 house, for example, you need about $54,400 in cash if you put 10% down. With a 7% mortgage your monthly income should be at least $11,200 and (if this is your income) your monthly payments on existing debt should not exceed $895. To develop a table tailored to your own situation, use my calculator 5a, Housing Affordability Calculator.

How Much House Can You Afford With a 7% 30-Year Mortgage?

To Spend This Amount on a House… You Need At Least This Monthly Income… To Cover This Monthly Housing Expense… Other Monthly Debt Payments Should Not Exceed… And You Need at Least This Much Cash… To Meet a Down Payment Requirement.. And Closing Costs

$400,000

$11,200

$3,133

$895

$54,400

$40,000

$14,400

350,000

9,800

2,741

785

47,600

35,000

12,600

300,000

8,400

2,350

670

40,800

30,000

10,800

250,000

7,000

1,958

560

34,000

25,000

9,000

200,000

5,970

1,671

475

17,600

10,000

7,600

150,000

4,480

1,253

355

13,200

7,500

5,700

100,000

3,040

850

240

6,880

3,000

3,880

Notes: Minimum monthly income is based on a ratio of monthly housing expense to income of 28%. Closing costs include points and are assumed to total 4% of the loan. The maximum monthly debt service payment is assumed to be 8% of minimum monthly income. Monthly housing expense includes principal and interest, mortgage insurance, taxes and hazard insurance. Taxes and hazard insurance are assumed to be 1.825% of sale price. The down payment requirement is assumed to be 10% on prices of $250,000-400,000, 5% on $150,000-200,000, and 3% on $100,000. Mortgage insurance premium rates are .79% with 3% and 5% down payments, and .53% with a 10% down payment.

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 up-front cash requirements of the transaction? The lender must be satisfied on both counts.

Expense Ratios: In general, the lender assesses the adequacy of the borrower's income in terms of two ratios that have become standard in the trade. The first is called the "housing expense ratio" and is the sum of the monthly mortgage payment including mortgage insurance, property taxes and hazard insurance divided by the borrower's monthly income. The second is called the "total expense ratio" and it 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.

Variations in the Ratios: Maximum expense ratios actually vary somewhat from one loan program to another. Hence, if you are only marginally over the limit, nothing more may be required than to find another program with higher maximum ratios. This is a situation where it is handy to be dealing with a mortgage broker who has access to loan programs of many lenders.

But even within one program, maximum expense ratios may vary with other characteristics of the transaction, and this can work against you. For example, the maximum ratios are often lower (more restrictive) for any of a long list of program "modifications", such as, e.g., the property is 2-4 family, co-op, condominium, second home, manufactured, designed for investment rather than owner occupancy, the borrower is self-employed, the loan is a cash-out refinance, and combinations of any of these.

Borrowers' Ability to Raise the Maximum Ratios: The maximum ratios are not carved in stone if the borrower can make a persuasive case for raising them. The following are illustrative of circumstances where the limits may be raised.

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 home buyer who has been paying rent equal to 40% of income for 3 years and has an unblemished payment record.

The borrower is making a large down payment.

Remember, lenders want to make loans!

Reducing Expense Ratios by Changing the Instrument: If expense ratios exceed the maximums, one possible option is to reduce the mortgage payment by changing the instrument. If the term is 30 years, you can extends it to 40 years, you can select an interest-only version, or you can switch to an option ARM. The first lowers the payment a little by extending the term; the second reduces it further by eliminating the principal payment for 5-10 years; the third reduces it even more by adding part of the interest due to the balance. See:

40-Year Loan, or Modify the 30 and 15?

Interest-Only Mortgage Tutorial

Tutorial on Option ARMs

Using Excess Cash to Reduce Your Expense Ratios: If you have planned to make a down payment larger than the absolute minimum, you can use the cash that would otherwise have gone to the down payment to reduce your expense ratios by paying off debt, paying points to reduce the interest rate, or funding a temporary buydown.

The first two approaches will work only in a small percentage of cases, however. For example, paying an extra 2.625 points to reduce the rate from 7% to 6.375% will reduce your housing expense ratio by only about 1 percentage point.

This assumes, furthermore, that the reduced down payment does not push you into a higher mortgage insurance premium category, which would offset most of the benefit. For this to happen, the smaller down payment must bring the ratio of down payment to property value into a higher insurance premium category. These categories are 5 to 9.99%, 10 to 14.99% and 15 to 19.99%. For example, a reduction in down payment from 9% to 6% wouldn't raise the insurance premium, but a reduction from 11% to 8% would.

Using the extra cash to pay off debt will work only if a) you exceed the maximum total expense ratio but not the maximum housing expense ratio (your ratios are 27% and 38%, for example, when the maximums are 28% and 36%); and b) your existing debts have short terms and high rates. For example, if you increase your loan by 2.6% and use the increase to repay debt, and if the debt has an average rate of 15% and is being repaid over 5 years, you would reduce your total expense ratio by about 2 1/2 percentage points.

Much the most effective way to reduce both 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. For example, on a 2-1 buydown, the mortgage payment in years one and two are calculated at rates 2% and 1%, respectively, below the rate on the loan. The borrower makes these lower payments in the early years, which are supplemented by withdrawals from the escrow account. The expense ratios are lower because the payment used is the "bought down" payment in the first month rather than the total payment received by the lender.

For example, assuming a market interest rate of 7% on a 30-year FRM, cash equal to 2.5% of the loan amount will fund a 2-1 buydown, where the payment is calculated in year one at 5% and in year 2 at 6%. This would reduce the expense ratio in year one by about 4 1/2 percentage points.

It is relatively easy for lenders to overcharge for temporary buydowns, and some do so. Read What Is a Temporary Buydown?

Getting Third Parties to Contribute: Borrowers sometimes can obtain the additional cash required to reduce their expense ratios from family members, friends, and employers, but the most frequent contributors in the US are home sellers including builders. If the borrower is willing to pay the seller's price but cannot qualify, the cost to the seller of paying the points or the buydown escrow the buyer needs to qualify may be less than the price reduction that would otherwise be needed to make the house saleable. Read Are House Seller Contributions Kosher?

Income Is Not Necessarily Immutable: While borrowers can't change their current income, there may be circumstances where they can change the income that the lender uses to qualify them for the loan. Lenders count only income which can be expected to continue, and they therefore tend to disregard overtime, bonuses and the like. The burden of proof is on the applicant to demonstrate that these other sources of income can indeed be expected to continue. 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 the feasibility of making that party a co-borrower. In such case, the income used in the qualification process would include that of the co-borrower. The co-borrower’s credit should be as good as that of the borrower, because lenders use the lower of their credit scores. This works best when the relationship between the borrower and the co-borrower is permanent.

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 settlement costs including points, 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.

Down Payment Requirements: In 2006, VA-guaranteed loans (available only to veterans) required no down payment on loans up to $417,000. FHA-insured loans required down payments of 3%, with loan limits that vary by area, topping out at $362,790 in the highest cost areas. On conforming conventional loans, which are loans eligible for purchase by Fannie Mae and Freddie Mac, the down payment was 3-5% on loans up to $417,000. On other conventional loans, down payments as low as zero were available on amounts up to $650,000 or thereabouts.

Down payment requirements will be higher whenever a transaction has characteristics that lenders view as risky. Very large loans have a high requirement, for example, because they are secured by expensive houses which may have unique features which appeal to a limited number of potential buyers, and are therefore subject to much greater price variability than less expensive houses. 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.

Source of Funds For Down Payment: In general, lenders want borrowers to meet the down payment requirement with funds they have saved because this indicates that the borrower has the discipline to save, which bodes well for the repayment of the loan. For this reason, they may restrict the amount of the down payment that is provided by gifts from family and friends. (Borrowers looking to parents for a major chunk of the down payment should make sure the money is in their own account several months before they apply for a loan). Borrowed funds will raise lender concerns even more, since they impose an additional repayment obligation on the borrower.

Copyright Jack Guttentag 2007