Scientists who study and measure human behavior find that buying a home is one of the most stressful experiences of our lives. Contributing significantly to this anxiety is waiting for the mortgage to be approved. Much of the homebuyers' unease results from not knowing what is going on. You know credit checks and verifications of employment are taking place-but what makes the difference between getting or not getting that loan, and how long does it take? This page can dispel at least some of that anxiety by detailing the steps the lender takes in making the loan decision-process called "underwriting."
Are You a Good Risk?
Just as wise stock market investors carefully research the companies in which they plan to buy stock, careful mortgage lenders investigate the financial background of each loan applicant. In lending the prospective homebuyer the money to buy the home, the lender assumes a long-term risk. The assumption is that the borrower is going to eventually repay the loan and in the meantime make the loan payments on time.
Once all the information is collected and eligibility is established, the lender decides whether to extend the homebuyer credit. In other words, lenders analyze the risk of lending (making the investment), and match it to an appropriate interest rate and loan term.
There are no established, industry-wide standards for underwriting, though most lenders follow standards set by government-related agencies, private mortgage insurers, private mortgage investors or institutional investors. The vast majority of mortgage lenders attempt to approve a loan application if at all prudently possible, but to approve a loan that will become delinquent serves no one's best interest. The burden falls on the lender to establish that an applicant is qualified.
The Initial Interview
The process usually begins with an interview where the prospective borrowers and a representative of the lender sit down to discuss the potential loan. Increasingly, however, lenders are not requiring a face-to-face meeting and accept a completed application by mail. Many lenders today will even qualify you for a loan before you begin to shop for a home. Many lenders advertise this service in the local newspaper, but any lender can provide it. Knowing approximately how much money you are qualified to borrow can save you time and prevent disappointment when you are looking at houses.When going to see a lender for an initial interview, you should take:
- Purchase contract for the house if you have one.
- Certificate of Eligibility from the Veterans Administration (VA) if you want a VA loan. (Note: If you do not have one, the lender will obtain the information for you from your service records.
- Bank account numbers and the address of your bank branch. This will save the lender time in checking your credit.
- Credit card bills for the past several billing periods.
- Pay stubs, W2 forms or other proof of employment and salary.
- If you are self-employed, you should be able to present balance sheets, tax returns and other information about your business.
The important document that gets the whole process rolling is the loan application. It asks in-depth questions concerning you, your income, assets and liabilities, your credit, and your legal history, as well as a description of the property you wish to buy. The lender will verify the information you provide on the application before making the decision whether to extend the loan.
Applicants usually will know after the initial interview if they are qualified for the type and size of loan they want. Lenders try to let the borrower know as quickly as possible if they really are not qualified for the size of loan that they request.
The initial interview sets in motion some important consumer safeguards. The Truth-in-Lending disclosure requirements provide the applicant with an estimated yearly cost for the loan - the Annual Percentage Rate (APR). The other important disclosure that follows from the Real Estate Settlement Procedures Act (RESPA), a federal law. This requires lenders to provide homebuyers with information on known and estimated closing costs.
The initial interview also starts a clock that will allow applicants to know whether or not they have been approved in about 30 to 60 days from the submission of a completed application. If the loan is denied, the lender must disclose the specific reason (s) for the rejection.
Is Your Income Sufficient?
Following the initial interview, or loan application, the first step the lender takes is to verify your employment or income. This is done by mailing employment and income forms to current and past employers, and it will help the lender determine how much debt you can successfully take on.
A general rule is that you can qualify for a loan of up to twice the family's income (i.e. a family with income of $30,000 a year usually can qualify for a mortgage of up to $60,000). Often, the amount you earn may not be as important as how you earn it. Bonuses and commissions can vary greatly from year to year, and lenders are reluctant to depend on them if they make up a large percentage of your income. There are similar problems when a large portion of your salary is based on overtime pay, and you rely on it to qualify for the loan. In the case of bonuses and commissions, the lender will want to verify your bonus and commission status back two or three years to get a better idea of what you earn from those sources on average. In the case of overtime, the lender will establish whether the work is expected to continue and whether or not the amount of overtime income is reasonable for the extra work. After establishing these points, the mortgage lender will make a decision as to how much to allow for these additional sources of income.
If you are self-employed, you should plan on producing a balance sheet, profit and loss statements and copies of your federal income tax returns for the past two or three years. Tax returns may also be required to verify other income claims, such as when income from securities is a major source for mortgage payments.
Income /Expense Standards
Lenders use a set of general standards (income/expense ratios which show how much income is used for various expenses) to test the application for qualification. These standards are based on what experience shows a homeowner can spend to own the home and also take care of other long-term financial obligations, though lenders use their own discretion in making the final decision.
Lenders generally say that housing expenses (including mortgage payments, insurance, taxes and special assessments) should not exceed 25 percent to 28 percent of the homeowner's gross monthly income. For Federal Housing Administration (FHA) loans, this figure is not to exceed 29 percent of the homebuyer's gross monthly income. With loans guaranteed by the Department of Veteran's Affairs (VA), lenders measure prospective homebuyers with Residual Income, or the monthly income minus expenses. The remainder is then measured against geographical and family size data to qualify the
borrower. Your lender will work out these figures for you when you sit down to discuss the mortgage you want.
Lenders usually define long-term debt as monthly expenses extending more than 10 months into the future. These expenses should not exceed 33 percent to 36 percent of the homeowner's gross monthly income. FHA-insured mortgage lenders define long-term debt as monthly expenses extending 12 months or more into the future, and look for these expenses plus housing expenses not to exceed 41 percent of the homeowner's gross monthly income.
Is Your Credit Good?Before extending credit, lenders will want to examine the risk of not getting the money back. To do this lenders will look at four crucial aspects of your credit history when you apply for a mortgage:
- History of past credit - what were the size and terms of past loans?
- Type of Credit - have you obtained real estate, auto, personal or other installment loans in the past?
- Attitude toward credit - are active accounts current. and is there any recent bankruptcy or judgment?
- Lapses in employment or debt repayment - how many unexplained lapses are there, and for how long?
From the information uncovered by these four questions, lenders can develop a fair idea of just how you will handle your responsibilities once you have signed the contract for repaying the loan. However, lenders cannot examine everything when putting together a credit history. They have two extremely important limitations on credit information gathering.
Credit Information Safeguards
The first limitation is the Fair Credit Reporting Act, which was designed to ensure fair and accurate consumer credit reporting. The Fair Credit Reporting Act stipulates that lenders must certify the purpose for which the information is sought and use it for no other purpose. The Act also prohibits reports based on subjective information from neighbors and others concerning character, general reputation and other personal aspects. Certain other credit information, such as bankruptcy more than seven years before, is also prohibited unless the principal involved in the action was $50,000 or more.
The second consumer safeguard limiting the credit information lenders can use to make a mortgage decision is the Equal Credit Opportunity Act (ECOA). ECOA prohibits discrimination in lending based on race, color, national origin, sex, marital status, age (provided the applicant may legally contract), and the fact that all or part of the applicant's income comes from a public assistance program.
Lender's are also prohibited by law from asking:
- questions concerning the applicant's spouse, unless
- questions concerning future parenting plans (although the lender may ask the ages and current number of children the applicant has).
Can You Make The Down Payment?
Lenders expect homebuyers to have enough money available to make the down payment of between 10 and 20 percent of the asking price for the house-though FHA and VA loans require smaller down payment (0 to 5 percent) and to pay their share of the closing costs (3 percent to 6 percent of the loan amount). If, however, you cannot come up with a 20 percent down payment, a lender can make you a loan for as little as 5 percent down. He will, however, require you to carry private mortgage insurance for conventional (not FHA or VA loans), for which you will pay a premium for the first year and an additional monthly fee in subsequent years.
Sources on which prospective homebuyers may draw for the down payment and the closing costs include savings, stocks/bonds, Individual Retirement Accounts (IRAs), pension funds, real state holdings, life insurance policies, mutual funds or employee savings plans.
Homebuyers may also rely on another source of funding for the down payment-a gift, or money given by a parent or other relative that need not be repaid. a person may give another person up to $10,000 per year without either party being taxed. A married couple, therefore, could give a child or spouse as much as $40,000 for a down payment tax-free. Remember, however, that if you use gift money for a down payment, you will need to present a letter so stating and signed by both the giver(s) and the receiver( s) to your lender.
Mortgage lenders send a form to the homebuyer's savings institution(s) to verify the amount available for purchasing the house, as well as the amount of outstanding loans with that institution.
Is The House You Are Buying Worth The Price?
Mortgage lenders also examine the real estate being purchased to make sure that, in case of foreclosure, the lender has a salable property. The property's acceptability is established by an independent appraisal.The appraiser looks not only at what the home is worth today, but how the neighborhood's dynamics will affect the property value in the future. The three main points the appraiser checks are:
- Physical security of the property: age, structural soundness, landscaping, etc.
- Location: the kind of neighborhood, surrounding houses, access to transportation, commercial development nearby, etc.
- Local government's plans for the area: how zoning and taxes will affect the property in the years to come.
Do I Get The Loan?
Your lender has made all the checks. Your income, credit, assets, property and all necessary documentation have been scrutinized. Now comes the big decision.
If the lender's decision is to extend the credit, you will be notified, usually through a commitment letter. The mortgage lender can approve the homebuyer for the entire amount asked for, or a lesser amount based on the borrower's qualifications. The commitment terms relating to interest rate and/or discount points may be firm at the time of commitment or conditioned on the market rate at the time of closing. If the decision is not to extend the credit, the lender has 30 days from the acceptance of the completed application to notify the prospective homebuyer. This notification must also include the reason(s) for the rejection.
If the loan is eligible for government insurance or guaranty, written agreements stating so are issued. These can be either an FHA or Firm Commitment or VA Certificate of Commitment. Conventional loans (not FHA or VA) receive an application for private mortgage insurance if the down payment is less than 20 percent of the purchase price.
By now you should feel a bit more at ease about what happens after you apply for a mortgage. If you have a good credit rating, it will speak for itself. Also, it is up to the lender to prevent homebuyers from over-extending themselves to the point of losing their homes. Prudent underwriters should prevent this from occurring.
Certainly there will always be some anxiety associated with applying for a mortgage, but if you understand the process, waiting for approval will be far less worrisome.