financing residential real estate lesson 8: qualifying the buyer

Financing Residential Real Estate

Lesson 8:

Qualifying the Buyer

Introduction

In this lesson we will cover: the underwriting process, automated underwriting, credit reports and credit scores, income analysis, net worth, other factors in underwriting, subprime lending, and risk-based loan pricing.

Introduction

Loan underwriting involves evaluation of:

1. Loan applicant’s overall financial situation.

Is buyer likely to make the payments on time?

2. Value of the property (collateral).

If buyer did default, would foreclosure sale proceeds cover the debt?

The Underwriting Process

Underwriting involves:

reviewing loan application;




obtaining additional information about applicant from other sources;





verifying information applicant provided;






applying lender’s qualifying standards;







evaluating property appraisal; and







evaluating property appraisal; and

making recommendation.


Qualifying standards: minimum standards used in underwriting.

Draw line between acceptable and unacceptable risks.

Qualifying standards


Although lenders can set their own standards, most use Fannie Mae/Freddie Mac standards for conventional loans.

FHA and VA standards must be used for FHA and VA loans.

Qualifying standards


Automated underwriting system (AUS): computer program that analyzes loan applications.

Used in conjunction with traditional underwriting.

Traditional underwriting now called manual underwriting.

Automated underwriting

Automated Underwriting

Most widely used AU systems:

Desktop Underwriter® (Fannie Mae)

Loan Prospector® (Freddie Mac)

Either may be used to underwrite conventional, FHA, or VA loans.

AU and secondary market

Automated Underwriting

Most widely used AU systems:

Desktop Underwriter® (Fannie Mae)

Loan Prospector® (Freddie Mac)

Either may be used to underwrite conventional, FHA, or VA loans.

Although Fannie Mae and Freddie Mac encourage lenders to use AU, they will still buy manually underwritten loans.

AU and secondary market


Programming of secondary market agency AU systems based on performance of millions of loans.

Loan performance: whether payments are made as agreed.

Analysis of performance statistics highlights factors that make default either more likely or less likely.

AU programming


Fannie Mae/Freddie Mac computer analysis of loan performance is ongoing.

Both agencies use latest information to adjust their AU systems and underwriting standards.

Adjustments have nationwide impact on underwriting practices.

AU programming


Information from loan application entered into AU system.

AUS obtains applicant’s credit information from credit reporting agencies.

AUS issues report with recommendations.

How AU works


Three main categories of recommendations in AU report:

Risk classification

Level of documentation

Property appraisal or inspection

How AU works


Risk classification

AU report indicates level of scrutiny application should receive.

Approve/Accept = meets all qualifying standards.

Approve/Ineligible = meets credit risk standards, but other aspects of loan make it ineligible for purchase by agency.

Refer/Caution = doesn’t meet all standards, should be reviewed.

How AU works


Risk classification

If application requires further review, underwriter looks at application in traditional way (manual underwriting).

How AU works


Risk classification


Some lenders reject Refer/Caution loans without further review.

How AU works


Risk classification


Some lenders reject Refer/Caution loans without further review.

Fannie Mae or Freddie Mac may buy manually underwritten Refer/Caution loan, but it will be treated as A-minus loan.

How AU works



AU report indicates how much documentation is needed to verify information on application.

How AU works




Before mortgage crisis, three basic levels:standardstreamlined (“low-doc”)minimal (“no doc” )

How AU works




Before mortgage crisis, three basic levels:standardstreamlined (“low-doc”)minimal (“no doc” )

Now just standard or streamlined; “no doc” loans no longer widely available.

How AU works



Refer/Caution loans:

Standard documentation (and manual underwriting) generally required.

Approve/Accept loans:

Streamlined documentation permitted.

How AU works


Appraisal recommendation

AU report also indicates which of these is appropriate:

full appraisal

drive-by inspection

report on property’s likely value (with no inspection)

How AU works


Advantages of automated underwriting over manual underwriting:

streamlines process;

Advantages of AU




increases objectivity; and

Advantages of AU




increases objectivity; and

improves underwriting accuracy.

Advantages of AU

Summary


Underwriting standards Automated underwriting Manual underwriting Loan performance Risk classification Standard documentation Streamlined documentation (low-doc) Minimal documentation (no doc) Drive-by inspection

Evaluating Creditworthiness

Buyer considered creditworthy if overall financial situation indicates she can be expected to make payments on time.



Qualification of buyer involves evaluation of three main components of creditworthiness:

Credit reputation




Credit reputation

Income




Credit reputation

Income

Net worth (assets)


Of the three main components of creditworthiness, many consider credit reputation most important.

To evaluate loan applicant’s credit reputation, lender relies on credit reports prepared by national credit rating agencies.

Credit reputation

Credit Reputation

A personal credit report covers 7 years of information about an individual’s:

revolving credit accounts,

installment debts, and

previous mortgages.

Utility bills, medical bills, etc., aren’t listed unless turned over to collection agency.

Credit reports

Credit Reputation

Credit reporting agencies are private companies.

Three major credit agencies in U.S.:

Equifax

Experian (formerly TRW)

TransUnion

Credit reports

Credit Reputation

Reports prepared by the three agencies don’t always match.

Lender may use reports from all three, or“tri-merge” report that combines them.

Credit reports

Credit Reputation

Credit information important in underwriting:

length of credit history

payment record

derogatory credit incidents

credit scores

Credit reports

Credit Reputation

“Credit history” widely used as synonym for “credit reputation.” Narrower definition used in underwriting.

Credit history = duration of applicant’s experience with credit.

Length of credit history

Credit Reputation

General requirements:

credit history at least one year in duration

with three or more active accounts

Alternative for applicant without established credit history: provide records of utility bill payments, rent payments.

Length of credit history

Credit Reputation

For each account listed, credit report gives detailed payment record showing whether payments have been made on time.

Late payments shown as 30 days, 60 days, or 90 days overdue.

Payment record

Credit Reputation

Underwriters view chronic late payments as sign applicant is financially overextended and/or irresponsible.

But spotless payment record not essential.

Payment record

Credit Reputation

Negative information on credit report may include:

charge-offs

collections

repossessions

judgments

foreclosures

bankruptcies

Major derogatory incidents

Credit Reputation

Charge-off: Uncollected debt treated as loss for tax purposes.

Tax code allows creditor to write off debt after no payment in 6 months.

Doesn’t relieve debtor of liability.


Credit Reputation

Collections

Creditor may turn delinquent bill over to collection agency that presses debtor for payment.

Debt held by collection agency appears on credit report, even if original bill did not.


Credit Reputation

Repossessions

If someone buys personal property on credit and fails to make the payments, creditor may have right to repossess the collateral property.


Credit Reputation

Judgments

When someone loses a lawsuit, court may order her to pay money (damages) to the person who sued.


Credit Reputation

Foreclosures

Not surprisingly, foreclosure on applicant’s credit report is a matter of special concern to mortgage lender.


Credit Reputation

Bankruptcy

Bankruptcy on applicant’s credit report also taken very seriously.


Credit Reputation

Under Fair Credit Reporting Act, derogatory incidents can remain on individual’s credit report for no more than seven years.

Exception: Bankruptcy – ten years.

Mortgage loan underwriters focus mainly on previous two years.

Foreclosures and bankruptcies are serious concerns for longer.


Credit Reputation

Credit score: Figure calculated by credit reporting agency using established scoring model.

Takes into account all information on credit report.

Indicates individual’s likelihood of default.

Three main credit reporting agencies may calculate different scores for same person.

Credit scores

Credit Reputation

Scoring models are based on statistical analysis of large numbers of mortgages.

Most widely used: FICO scores.

Range from under 400 to over 800.

High FICO score = unlikely to default

Credit scores

Credit Reputation

Underwriters use credit scores to determine level of review applied to applicant’s credit history.

Good scores: basic review

Mediocre or poor scores: in-depth review

Credit scores

Credit Reputation

Aside from major derogatory incidents, other factors that have negative impact on credit scores:

Chronic late payments

Maintaining high balance on credit card, even if payments on time

Applying for too much credit

Credit scores

Credit Reputation

Prospective buyers should look at their credit reports and scores before applying for mortgage.

Some information may be incorrect.

Fair Credit Reporting Act requires credit reporting agencies to investigate in response to complaint and correct errors.

Obtaining credit information

Credit Reputation

If underwriter is convinced that past problems don’t reflect applicant’s attitude towards credit, loan may be approved.

Explaining credit problems

Credit Reputation

Letter to lender explaining negative credit report should:

state reason for problem;

point out that it occurred during specific period;

show problem no longer exists;

highlight good credit before and since;

provide documentation from third parties; and

not blame creditors.

Explaining credit problems

Summary

Credit Reputation

Creditworthiness Credit report Credit history Charge-offs Collections Foreclosure Bankruptcy Credit scores (FICO scores) Fair Credit Reporting Act


Second main component of creditworthiness: income.

Even if buyer has excellent credit reputation, loan won’t be approved unless buyer can afford payments.

Buyer’s income is starting point in determining:

maximum loan amount

price range for houses

Income analysis

Income Analysis

Income has three dimensions:

Quantity Enough monthly income to afford

monthly mortgage payment

Quality From dependable sources

Durability Likely to continue for at least

three years

Characteristics of income

Income Analysis

wages or salary

bonuses

commissions

overtime

part-time earnings

self-employment income

retirement income

alimony

child support

public assistance

investment income

Stable monthly income

Income that meets tests of quality and durability is stable monthly income. May include:

Stable Monthly Income

Permanent employment is major income source for most home buyers.

Positive employment history:

consistency (usually 2 years in same job or field)

opportunities for advancement

special training or education

Employment income


Commissions, overtime and bonuses

Considered stable if consistent part of applicant’s overall earnings pattern.

Employment income


Part-time work

Considered stable if applicant has held job for at least two years.

Seasonal work

Considered stable if established earnings pattern exists.

Employment income


Self-employment income

Includes income from personal business, freelance work, or consulting work.

Underwriters consider earnings trend, training and experience, and nature of business.

Generally regarded as risky income source:

amount of income unpredictable

small businesses often fail

Employment income


Employment verification:

Verification form sent to employer, or

W-2 forms for 2 years plus pay stubs for 30 days, with phone call to employer.

Lender may also request income tax returns for previous two years to verify earnings.

Employment income


Pension and social security payments are usually dependable and durable.

Lenders can’t discriminate on basis of age.

Life expectancy can be considered.

Retirement income


Dividends or interest may be counted as part of stable monthly income.

Underwriter calculates average investment income for previous two years.

Investment income


If a stable pattern can be verified, rental income is considered stable monthly income.

Applicant may have to show gross earnings and operating expenses for previous two years.

Rental income


Many unpredictable factors affect rental income:

Emergency repairs

Vacancies

Tenants who don’t pay

Underwriter includes only a percentage of verified income to leave a margin for error.

Negative rental income treated as liability.

Rental income


Considered stable income sources if it appears payments will be made reliably.

Depends on:

whether payments required by court decree

how long payments have been made

financial/credit status of ex-spouse

ability to compel payment

Maintenance, alimony, child support


Lenders usually require:

copy of court decree

proof of receipt of payments

Child support no longer counts when child reaches mid-teens.



Applicants may not want to list these as sources of income if ex-spouse is hostile or uncooperative.

Equal Credit Opportunity Act prohibits lenders from asking if applicants are divorced or requiring them to disclose alimony or child support.

Income won’t be counted if not listed, of course.



Equal Credit Opportunity Act also prohibits lenders from discriminating against an applicant because part or all of his income is from a public assistance program.

But public assistance won’t count if eligibility will terminate in near future.

Public assistance


These usually don’t count as stable monthly income:

Wages from temporary job

Unemployment compensation

Contributions from family members

Unacceptable types of income


Income from temporary work not durable by definition.

But steady series of temporary jobs may be treated as freelance work (self-employment income).

Temporary employment


Unemployment benefits end after a specified number of weeks (ordinarily 26 weeks).

But unemployment benefits paid to seasonal worker for a certain number of weeks everyyear could be considered stable monthly income.

Unemployment compensation


Usually only earnings of head of household are counted in underwriting.

But if borrower’s family member is listed as a co-borrower, that person’s income is also considered.

Income from family members

Calculating Stable Monthly Income

All income payments must be converted into monthly figures.

Example:

Gwen is paid $14.50/hour. She works 40 hours per week.

$14.50 × 40 = $580

$580 × 52 = $30,160

$30,160 ÷ 12 = $2,513

Monthly figures


Gross income figures are used when calculating stable monthly income.

Payroll taxes aren’t subtracted.

Gross income


Gross income figures are used when calculating stable monthly income.

Payroll taxes aren’t subtracted.

Qualifying standards take into account that:

buyer will have to pay taxes, and

only after-tax amount will be available for expenses.

Gross income


Certain types of income are exempt from taxation:

Child support

Disability payments

Some public assistance

Full amount of payments available for expenses.

Nontaxable income


Certain types of income are exempt from taxation:

Child support

Disability payments

Some public assistance

Full amount of payments available for expenses.

Underwriter may “gross up” nontaxable income.

For example, might add 25% to child support payments received.

Nontaxable income

Income Analysis

To measure adequacy of applicant’s monthly income, underwriters use income ratios.

Rationale:

Borrower may have difficulty making payments if:

Monthly Expenses > X% of Monthly Income

Income ratios

Income Analysis

Two types of income ratios:

Debt to income ratio

Measures proposed monthly mortgage payment and any other regular debt payments against monthly income.

Income ratios

Income Ratios

Two types of income ratios:

Debt to income ratio

Measures proposed monthly mortgage payment and any other regular debt payments against monthly income.

Housing expense to income ratio

Measures monthly mortgage payment alone against monthly income.

Two types of ratios

Income Ratios

Proposed monthly mortgage payment used in calculating income ratios is PITI payment.

Includes impounds for property taxes and hazard insurance.

Also mortgage insurance and/or homeowners association dues, if applicable.

PITI

Income Ratios

Qualifying standards set maximum income ratios.

Example: Borrower’s monthly housing expense should not exceed 31% of stable monthly income.

Maximum ratios

Income Ratios

Qualifying standards set maximum income ratios.

Example: Borrower’s monthly housing expense should not exceed 31% of stable monthly income.

Maximum ratios are generally treated as guidelines, not hard-and-fast limits.

Lender may approve loan if sufficient compensating factors make up for weakness in income.

Maximum ratios

Income Analysis

Cosigner helps borrower qualify by sharing responsibility for loan.

Primary borrower and cosigner have joint and several liability for loan.

Court can order either one of them to payloan balance.

Cosigners

Income Analysis

Cosigner must have acceptable income, assets, and credit reputation.

Cosigners

Income Analysis


Cosigner’s stable monthly income added to applicant’s.

Cosigner’s monthly debts and housing expense combined with applicant’s.

Then income ratios are calculated.

Cosigners

Income Analysis


Cosigner’s stable monthly income added to applicant’s.

Cosigner’s monthly debts and housing expense combined with applicant’s.

Then income ratios are calculated.

Applicant’s separate income ratios are also calculated; shouldn’t be too far over limits.

Cosigners

Summary

Income Analysis Quantity, quality, and durability of income Stable monthly income Income ratios Debt to income ratio Housing expense to income ratio Cosigner Joint and several liability


Net Worth = Assets – Liabilities

Net worth



Significance of net worth in underwriting:

Substantial net worth indicates ability to manage financial affairs.

Net worth



Significance of net worth in underwriting:

Substantial net worth indicates ability to manage financial affairs.

Also, buyer must have enough liquid assets to close transaction.

Net worth

Net Worth

Liquid assets: cash and assets that can be easily converted into cash.

Applicant must have enough to cover:

downpayment

closing costs

Funds for closing

Net Worth

Also, desirable for buyer to have reserves left over after closing.

In case of financial emergency, can draw on reserves to keep paying mortgage.

Reserves

Net Worth



In some cases, lender may require applicant to have enough reserves to cover a certain number of mortgage payments.

Reserves

Net Worth



In some cases, lender may require applicant to have enough reserves to cover a certain number of mortgage payments.

Even if not required, reserves strengthen application.

Reserves

Net Worth

Almost any assets may help a loan applicant:

real estate

automobiles

furniture

jewelry

stocks/bonds

life insurance policy

Assets

Assets

To verify funds applicant has in bank accounts:

verification of deposit form sent to bank(s), or

applicant provides bank statements for 2 or 3 months.

Bank accounts

Assets

Reviewing verification information:

Does it match statements in loan application?

Does applicant have enough cash for closing?

Has bank account been opened only recently (last 3 months)?

Is present balance much higher than average balance?

If account is supposed to be source of good faith deposit, is balance high enough?

Bank accounts

Assets

Underwriter’s concern: Did applicant borrow funds?

Lenders generally want borrower to use own funds for downpayment and reserves.

Bank accounts

Assets



Borrowed funds would defeat purpose of lender’s requirements.

Bank accounts

Assets




Exception: loan secured by asset (other than home being purchased)

Bank accounts

Assets




Exception: loan secured by asset (other than home being purchased)

Affordable housing programs more flexible about borrowed funds.

Bank accounts

Assets

If applicant selling another property to raise cash, net equity in property can count as liquid asset.

Net Equity =

Market Value – (Liens + Selling Expenses)

Real estate for sale

Assets

If equity is main source of money for purchase of new home, lender won’t fund loan until old home sold.

Copy of settlement statement usually required as verification.


Assets

If equity is main source of money for purchase of new home, lender won’t fund loan until old home sold.

Copy of settlement statement usually required as verification.

If new home ready to close before old home sold, buyers may apply for swing loan.


Assets

Some applicants own real estate they aren’t planning on selling.

Should be listed as asset in loan application.

But only equity contributes to net worth.

Other real estate

Net Worth

Applicant’s personal liabilities are subtracted from total value of assets to calculate net worth.

Liabilities include:

credit card and charge account balances

installment debts

taxes owed

liens against real estate owned

Liabilities

Net Worth

Rules regarding gift funds usually limit how much of downpayment and closing costs may be covered by gift funds.

Borrower must invest some of her own funds.

Gift funds

Net Worth

Rules regarding gift funds usually limit how much of downpayment and closing costs may be covered by gift funds.

Borrower must invest some of her own funds.

Donor must sign letter stating that the gift funds don’t have to be repaid.

Funds must be deposited into applicant’s bank account for verification.

Gift funds

Other Factors in Underwriting

Type of loan (fixed-rate, adjustable-rate, partially amortized, etc.) affects underwriting.

Borrowers default more on ARMs and other loans that involve changes in payment amount.

Loan type


Length of repayment period affects size of monthly payment.

Shorter repayment period, larger payment.

More difficult to qualify for larger payment.

Repayment period


Length of repayment period affects size of monthly payment.

Shorter repayment period, larger payment.

More difficult to qualify for larger payment.

But lender may be slightly more inclined to approve loan with shorter repayment period.

Lender’s funds are tied up for less time.

Repayment period


Investor loans have much higher default rate than loans to owner-occupants.

Because of additional risk, investor loans are subject to stricter LTV requirements, additional fees, and higher interest rates.

Owner-occupancy


Regular single-family homes appreciate much more, and more reliably, than:

manufactured homes

condominium units

some other types of residential property

Nontraditional property type is treated as additional risk factor in underwriting.

Property type

Summary

Net Worth and Other Factors

Liquid assets Reserves Assets Liabilities Net equity Swing loan Gift funds Owner-occupant Investor loan

financing residential real estate lesson 8: qualifying the buyer

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