When I wrote the first version of this article in 2000, I
felt it necessary to emphasize to potential borrowers that
they were not beggars who had to approach lenders hat in
hand. There are multiple hundreds of lenders in this market
who compete fiercely among themselves for good loans, I told
readers. That remains the case today, although the financial
crisis has changed some of the rules.
Qualification and Approval
A "good loan" is one to a
borrower who has the ability to pay, the willingness to pay,
and the capacity to make a down payment. Lenders base
judgments of borrower ability to repay mainly on their
income relative to their mortgage and other recurring
obligations. They assess the willingness to repay
mainly by the applicant's credit history. They assess the
capacity to make a down payment from the borrower’s current
financial statements.
The term “qualification” is used in two ways. In a narrow
sense, a qualified borrower is one with the ability to pay.
Real estate agents qualify borrowers in this sense to make
sure they will look at houses in the right price range. But
qualification is also used in a broader sense to mean that
the applicant meets all the requirements for approval.
Approval requires that an applicant have the ability to pay,
the willingness to pay, and an adequate down payment. Which
meaning is intended is usually clear from the context.
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 on the mortgage terms
available in the market at the time you are shopping. To
afford a $400,000 house, for example, you need about $55,600
in cash if you put 10% down. With a 4.25% 30-year mortgage,
your monthly income should be at least $8178 and (if your
income is $8178) your monthly payments on existing debt
should not exceed $981. To develop the data tailored to your
own situation, use calculator 5a, Housing
Affordability Calculator.
Meeting Income/Expense Requirements
In
general, lenders assess the adequacy of borrower income in
terms of two ratios that have become standard in the trade.
The first is the "housing expense ratio" (also known as the
“front-end ratio”) and is the sum of the monthly mortgage
payment including mortgage insurance, property taxes, hazard
insurance, and condo fees if applicable, divided by the
borrower's monthly income. The second is called the "total
expense ratio" (also known as the “back-end ratio” or DTI)
and it is the same except that the numerator includes the
borrower's existing debt service obligations, such as credit
card or student loan payments. For each of their loan
programs, lenders set maximums for these ratios, which the
actual ratios must not exceed. Following the financial
crisis, these ratios were increased, from 28/36 with
exceptions to 31/43 with exceptions. Emphasis also shifted
to placing greater weight on the more inclusive measure.
Lower Maximum Ratios on
Riskier Transactions: Maximum
expense ratios are not carved in stone. They are lower (more
restrictive) for any of a long list of program
"modifications" that are considered riskier. For example,
the property is 2-4 family, co-op, condominium, second home,
or manufactured, the transaction is for investment rather
than owner occupancy, the borrower is self-employed, or the
loan is a cash-out refinance.
Higher Maximum Ratios on Less
Risky Transactions: The
following are circumstances where the limits may be raised:
* The borrower’s high housing expense ratio is offset by
exceptionally high disposable income.
* 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 down payment well above the
amount required.
Reducing Expense Ratios by
Changing the Instrument: Before
the financial crisis, expense ratios could be reduced by
extending the term to 40 years, selecting an interest-only
option, switching to an option ARM on which the initial
payment did not cover the interest, switching to an ARM with
an exceptionally low interest rate for the first 6 or 12
months, or taking a temporary buydown where cash placed in
an escrow account was used to supplement the borrower's
payments in the early years of the loan. None of these
options exist today.
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 non-mortgage debt, or by paying points to
reduce the interest rate. Just make sure that the reduced
down payment does not push you into a higher mortgage
insurance premium category, which would offset most of the
benefit. This happens when the smaller down payment brings
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 9% to 4 % would. See
Shrewd Mortgage Borrowers Know Their PNPs.
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 the buyer needs to qualify
may be less than the price reduction that would otherwise be
needed to make the house saleable. See
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 that is expected to continue and they therefore tend
to disregard overtime, bonuses and the like. They will
include overtime or bonuses only if the borrower has
received them for the last 2 years, and the employer states
on the written verification-of-employment form that they
expect the payments to continue.
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. The co-borrower’s credit
should be as good as that of the borrower, however, because
lenders use the lower of the credit scores of co-borrowers.
The co-borrower must also be on the title and reside in the
house. This works best when the relationship between the
borrower and the co-borrower is permanent.
Meeting Cash Requirements
More homebuyers are limited
in the amount they can borrow by the cash requirements than
by the income requirements. They need cash for the down
payment, and 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.
FHA requires 3.5% down on the loans it insures. Fannie Mae
and Freddie Mac require 5% down on most of the loans they
purchase, though lenders may raise it to 10% on larger
loans. On jumbo loans that are too large to be purchased by
the agencies, lenders generally require 20% down, though
some lenders will accept 10% if the loan is not too large.
Qualification Tool
Prospective borrowers can find out whether they will qualify, and if they can't the reasons they can't, by using my qualification tool. Click on "Shop For a Mortgage" in the margin.
