As the saying goes, it’s all about the financing, and that is absolutely right. Once we have properly planned for our home loan financing and determined the maximum home loan amount (and thus the purchase price we can afford), we are then in a great position to go find the house of our dreams.We can confidently write offers knowing we will be approved for home loan financing, and close on time.
Thus, the best way to buy a home is to have a sound, verified financial strategy. In other words, to be “pre-approved,” as we say. That is to have a mortgage lending underwriter review and verify our financial information, and ability to qualify for the home loan and close on time as per our offer contract.
Any experienced home loan officer will begin by asking about and pulling your credit report. That is our starting point. More loans are denied due to bad credit or poorly resolved credit issues than any other reason. Most people have a general feel for their credit history, but often do know specifically what their credit report tells the lender.
Use of Credit
Credit scoring models and underwriters not only consider credit history and scores, but look closely at the level of credit usage. Heavy users of credit, especially when younger, are a bad indicator to an underwriter even when scores are adequate. It tells them that the borrower is likely to get into trouble down the road when a mortgage payment is placed on top of a tendency to heavily rely on credit for purchases or living expenses. To put a number on that, if you have three or more credit cards, lines, payment plans, etc., it is critical to pay off, consolidate, and close the extra ones, even if the balances are low or zero. Underwrites know how easy it is to get additional credit.
Last, when it comes to credit usage, consider your credit activity “frozen” for three to six months prior to the time you want to get a loan pre-approved. Any new accounts are a red flag to the underwriter. Just go without until you close and move in before taking out credit of any kind including new credit cards, auto loans, or personal loans of any sort.
Credit history, or the line-by-line creditor report of balance, payments, and any late pay, is a direct reflection on a borrower’s ability to handle financial obligations responsibly. So, some credit is necessary to reflect a stable credit management history. As already discussed, too much credit is not good. We will discuss credit “derogs,” or bad credit, and what, if anything, you can do a little further along in this book.
What are scores? Mortgage scores, i.e.,“credit scores,” are comprised of collection and reporting activity of the three main national credit bureaus Experian, Equifax, and Transunion. These three bureaus collect and report an individual’s credit history, and have complex statistical models used to develop an individual’s credit score at any given time. Credit scoring for mortgage loan approval is different than that for auto loans, consumer credit, or credit cards.
How are Credit Scores Used?
Of the three scores received, the mortgage underwriting systems uniformly use the middle score (i.e., 680,693, 705; thusthe middle score of 693 is used), of the primary borrower to determine score eligibility. Some exceptions apply, but this is the general rule.
Raising Your Scores
Low credit scores from late payments, clerical errors, past B/K’s, etc., can be raised by contacting the individual bureau with a good dispute or data error plea. Because this is time consuming and requires strong knowledge of credit and reporting methods, it is best left to a credit clean-up company. Costs for credit cleanup can go from zero to thousands of dollars, depending on the complexity of the cleanup. These activities are best performed at least 6-12 months out from applying for a loan to be most effective.
Names on Report
Credit reports often contain multiple names, which confuse the underwriter and typically reduce scores. The most mixed names come from spouses, ex-spouses, and family members with similar names, like father and son with same first names.
Serious Credit Derogatory Events
Bankruptcies, prior short sales/foreclosures, credit charge-offs, IRS liens, and child support liens are examples of serious credit events that can stop a mortgage request immediately if not handled properly. Some of these events have actual timing benchmarks that must be met to proceed. Example, a bankruptcy generally requires two to three years from the discharge date to allow a mortgage.
Child liens can be complex, and can take two to three months to resolve. Each of these has its own need to be resolved. Again, the rule of thumb is to attack it early―at least 6-12 months prior to wanting to buy a home.
With the various types of income a home loan buyer may receive, each has its own effect on the qualifying and underwriting process. Generally, buyers will have one or several of these income payment types.
Hourly / Salary
The most common type of income is hourly or salary, in which case the underwriter will use the most recent paystubs to determine current income.He or she will also look at year-end W-2’s, and the most recent year’s tax return to determine consistency of income. Large changes or gaps in income or employment will be viewed negatively and can effect current income qualifying.
Commissions & Bonuses
Commissioned income and bonuses by nature are less consistent in both frequency and level. Therefore, the underwriter must average these income types over time. The typical time line is to use the most recent past two years of tax returns, plus any recent year-end income statements that may have been received. This two-year average evens out the ups and downs. Unfortunately, if the income trend has been downward or there was a large gap between amounts, that will reduce the qualifying income derived.
The self-employed borrower with a small or medium sized business is typically the hardest to qualify. The nature of self-employment is to minimize taxable income reporting. So while we often see adequate gross income levels reported, by the time all expenses and tax benefits are deducted, the net income before taxes has been reduced to a level that does not support the two-year average needed to qualify for the home loan and home desired. The only solution here is either to buy a smaller home with a larger down payment, or plan ahead and report higher taxable income that year and absorb a higher tax payment. This is the unfortunate Catch-22 of self- employed home buyers stuck between the IRS and mortgage underwriting.
1099s, Tax Returns, Schedule C, Gifts
There are an unlimited number of income and cash scenarios that one encounters when loan qualifying. The general rule is if the income source is a one time or rare event, not reported on tax returns, or from an undocumented or unreported source such as cash side jobs, gifts, etc., then it will NOT be included in your income for loan qualifying. It is still important to your household budget, but just can’t be used for the mortgage.
Income vs. Expense Reimbursement
Another area of concern for those with reportable business expenses, whether a direct employee or self-employed, is that most expense reimbursement amounts are either disregarded or discounted by the underwriter. While they show up in your pay, the underwriter correctly assumes most or all of the amount is an actual business related expense, and therefore not available for housing and debt service.
Job History and Consistency
As a home purchase and mortgage are considered a very long-term financial responsibility, underwriters are determining your likelihood of repaying the loan in a consistent manner. The best way is to look to recent job history over the past two to three years. Any gaps in employment, multiple job changes, or income variations will raise red flags and require detailed explanation or may cause your loan request to be declined.
All sources of income claimed will be verified by documentation such as recent paystubs, W-2 forms, tax returns, or 1099s for self-employment.
When contemplating a long distance move for job purposes, college graduation, military discharge, etc. and a home purchase is desired, you will need a new employment verification letter of acceptance, including pay level, start date, and job description.
New Employment Verification
This verification letter needs to come from the employing company, on its letterhead, signed by a contact person in HR or your new supervisor,with a phone number that is verifiable by the underwriter. In addition, in most cases you will need to be on the job,having received your first paycheck before being fully approved for the loan. Thus, planning ahead three to six months can be crucial to your move and home purchase timing.
Commuting Long Distances
Some jobs can be far from the home being purchased. This usually happens in order to maintain a previous job, or a buyer wants to be in a favorable home location, but the job is far away. Typically, a job within an hour commute is not an issue, but as the commute gets beyond that, an underwriter may need a full written explanation of the necessity of the long commute and the benefit of doing so. This letter must read well to be acceptable.
Veterans, Retired, Active Duty, Nearing Separation of Duty
Military persons who are either active, recently separated, or retired have unique situations, as their jobs are scheduled to end or they may be re-enlisted. When applying for a mortgage, the underwriter will want an explanation of the intent to separate, re-enlist, or of new job opportunities.
In the case of re-enlistment,for each four years, a letter from the command will likely be required. In the event of separation, the new job must be in place, and a first paycheck received for final qualification. Again, prior planning three to six months out is the way to ensure a successful home purchase.
College or Trade School Graduation
Expected or recent college or trade school graduates will need a job and first paystub in order to be ap-proved. The professional, medical, or trade employee, while very employable in most cases, still needs to be on the job to be loan acceptable. Student loans come into play in the debt consideration phase of under-writing, and have unique issues, which will be discussed later.
Ahh! Debts are the area that most often trip up home buyers. Credit, credit history, and derogatory items found on credit reports that decrease credit scores below acceptable levels kill more loan requests than all other issues combined, in my experience.
Types of Debt
General categories of debts are consumer debt such as credit cards, loans, lines of credit, auto debt for purchase or lease, student loans, and mortgage debt. These will all show up on the credit report.
Inclusion vs. Exclusion
Credit lines expected to be paid off within 12 months, and generally are not included for qualifying. Those over 12 months will be.
Student Loans, Deferment, Repayment Schedules, Consolidation
Most college students have loans these days. When the student graduates, there is typically a deferment period of 6-12 months. Once the payment begins, it is reported on the borrower’s credit report, and becomes a large item to build credit. Often these loans can be consolidated, and the payments reduced.
Loan or credit card purchase charge-offs for non-payment or disputed accounts are bad for lenders to see as it indicates a willingness on the applicant’s part to fully ignore his or her credit obligations. These can drop a credit score 50-80 points in one month and take one to two years to recover from.
New Debt during Loan Process
Underwriters do not want to see any new or increasing debts just prior to or during the loan process. So any new purchases must be deferred until after the close of the new home purchase.
Credit Cards, Use of, Closing, Excess
Credit cards and auto loans tend to be the backbone of credit in our country. Use of them is quite acceptable and encouraged, as they reflect good financial management. Where they become a problem for underwriters is when there is excessive use. That generally means more than three credit cards, an auto loan, and possible student loan debt, especially when the credit cards are maxed out with a history of high usage. The underwriter assumes the borrower is a high user of debt, which could lead to trouble when a mortgage and home ownership is added to the financial burden.
In addition, excessive debt loads tend to reduce credit scores by 20-40 points even when the payments have been timely. Also, closing of credit lines just prior to or during the mortgage process can reduce credit scores. Again, the best strategy is to manage these events three to six months or more before applying for a mortgage.
Liens, Tax Payments, Debt Counseling, Payment Plans
Additional but less frequent debt/lien problems that need close attention and active management well before the home purchase are lingering items from prior legal issues, child support payments, and debt counseling payment programs. While these can sometimes be worked around by a competent loan officer and cooperative underwriter, they tend to be difficult problems if not addressed until the loan is in process.
The purpose of financial analysis performed by underwriters is to derive qualifying ratios that meet set guidelines by their respective companies and national housing agencies such as FNMA, VA, and FHA. While there is a range of qualifying debt to income ratios for different loan programs and variables, ultimately there is a narrow range that most loans must adhere to be approved.
First, the underwriter determines the total debt loan and associated monthly payments, and adds the new assumed loan and housing cost payments to determine total debt level.
The monthly housing cost of the new purchase is typically the largest monthly recurring debt by far. It is broken into a couple of components.
Principal, interest, real estate taxes, and home insurance on a monthly prorated basis are the most common components on stand-alone home sales.
HOA / Mello Roos
In most major cities and communities, we now find homeowner associations, special tax pools for schools and local parks, and improvements known as Mello Roos. These fees are pro-rated monthly and added to the housing cost for a total monthly assumed housing cost.
Along with the new housing costs, the underwriter adds the monthly cost of other monthly scheduled debts for a Total Debt Ratio.
Income Calculation: Inclusion
To be included for reportable income we typically see:
The most common income payment for employees.
Added back from W-2s or tax returns. This amount is usually averaged from the past two years of reported tax returns.
For self-employed small business owners, the schedule C is a critical part of the income analysis.
Corporations, Ownership, Schedule K
Owners of incorporated businesses, partnerships, or those who may own portions of multiple businesses will require full reporting and analysis of each entity owned, which generates income or losses in some cases.
Existing rental property income can be used, but must be reported on tax returns, and generally in place for two years. Tax losses generated by rental property can cause problems by offsetting real income.
Total Debt to Income Ratio
The final result the underwriter is after is the total debt to income ratio, “TDI,” or “back end ratio,” as it is known.
Deciphering Debt Ratios
The ratios read something like 36/43, which means your housing debt PITI + HOA fees is 36% of your gross monthly income. Your total debts, which include housing plus other reported debts, credit cards, auto loans, student loans, etc., equals 43% of total monthly income. These two ratios in the industry are known as “front” and “back” end ratios, sometimes referred to as “housing” and “total” debt ratios.
Improving Debt vs. Income Changes
There are ways to improve these ratios; for example, by paying off consumer debts, small auto loans, consolidating student loans, etc. Income can be increased in some cases by getting pay raises prior to the loan request, second jobs as long as documented, reporting higher taxable income for the year prior to wanting to buy a home, etc. The thing to keep in mind is that due to the math leverage of the ratios, reducing debt is always more effective than trying to increase income. Obviously, amounts and reasons are important. As with all home and loan planning strategy, working on debts and income levels 6-12 months in advance substantially increases the likelihood of success.
Most people are familiar with interest rates on various consumer loans. While credit cards are typically interest only, auto loans tend to have principal and interest components in their payment plans, as do mortgage loans. Most mortgage rates are set by major lenders and bond market activity, which is generally derived from various US Treasury rates.
Fixed vs. Variable
Mortgage loan rates can be fixed, as the most common 30-year fixed rate loan is, and adjustable rate mortgages, or “ARMs,” which vary by periods from monthly to annual, reset at the prevailing market rates.
ARMs have reset parameters known as margins, with a floor and ceiling, or maximum rate it can charge at any reset point or over the life of the loan. These features contain the risk of rising interest rates, so as not to put the mortgage borrower at risk of too high a payment at sometime in future years.
There are “hybrid” loans that contain a fixed period of usually three, five, seven, or 10 years, where the rate and payment is fixed for that time frame, and then begins to adjust with regular scheduled resets, typically annually from then on.
Where do Mortgage Rates Begin?
Mortgage rates, as mentioned, are largely set by the mortgage banking industry participants as they derive them from bond and mortgage market activity on a daily basis under complex financial calculations lenders call daily “pricing.” Most fixed loan rates are derived initially from US Treasury bonds and bills found in the daily market guides available online or in financial papers like the Wall Street Journal.
Loan points, discount points, buy down points, etc. are just a form of interest earned by the lender or mortgage broker. The difference is points are paid at the time of loan closing to the lender, whereas loan interest is earned over time based on remaining balance.
Points can be increased or decreased depending on the borrower’s objectives to save money upfront by getting a zero point loan or even a point rebate to cover closing costs, or pay additional points to decrease the loan rate.This decreases the loan payment, and saves money over the life of the loan, at some point recouping the cost of paying the point(s). Generally, the most common option borrowers select is either zero points to save costs, or one point to get the best combination of points and rates without costing too much.
These fees are charged directly by the funding lender to add to its profit margins and offset origination costs. For disclosure purposes, these are treated the same as points.
Mortgage Interest Rate Buy Downs
Added or extra points to “buy down”are paid to decrease the interest rate and payments.
FHA, VA, Conventional, Conforming, High Balance, Jumbo.
There are a few general categories of home loans that are overseen and regulated by various government, or quasi-government, agencies. The purpose of these loans is to provide home loan credit to differing segments of consumers based on income, credit, down payment, and loan size variables.
High Cost Markets / Agency High Balance Loans
FNMA, the primary national housing agency, has designated an annual market analysis to determine what it calls “conforming” loan size. It can vary annually based on median home prices. The past five to seven years has seen it remain the same at $417,500.
However, in certain major cities and counties it has realized that higher home costs require special loan underwriting treatment, and has given a “high cost” or “agency high balance” loan designation to these costs,which allows more flexible underwriting at higher loan levels on a county-specific level. For example, San Francisco, Hawaii, and New York City tend to have the highest maximum loan amounts nationwide. These are viewable on FNMA’s website.
Income Verifying vs. “Stated Income”
There are numerous home loan programs that allow for non-traditional methods of proving income known as no income verifying, or stated income loans. Typically, they have more conservative guidelines as to down payments, cash reserves, self-employment, and other restrictions. They also tend to have much higher interest rates to compensate the lender for the higher risk of not requiring income documentation.
Now we get to the real strategy to be a successful home buyer.
Preparing for loan approval and making offers on homes starts 6-12 months or more before ever applying for loan approval and searching for homes.This is where we get our income (tax returns, paystubs, W-2s collected and reviewed, as well as considering our credit. If unsure of what our credit looks like, we should have our credit report pulled for review.
Most home buyers wait too long to see their credit, and many are surprised by what they see. The buyer should start budgeting if he has not been, and become fully aware of what his monthly costs and income are. Before searching for homes, it is important to start with the question “How much housing cost can I comfortably afford with my income and debts?” If this needs adjusting, 12 months beforehand is the time to start tweaking it by paying off debts, asking for pay raises, getting new jobs, etc.
Once the home buyer has collected his list of financial and credit related information, it is time to talk to the lender and get prequalified. Basically, this is using an experienced loan officer or automated underwriting system (AUS) like www.eprequal.com to ask relevant questions and provide answers about income, debts, assets, employment, etc. The answers are entered into the AUS, and quickly analyzed according to industry guidelines and loan product selection.
Assuming a positive result, we can move forward with a full loan underwriting and review of the documents needed by the lender. In the event of an initial decline, we can review the reasons to discover whether it was related to income, credit issues, cash needs, time on the job, etc. Most of the time, the motivated home buyer can find a way to adjust and move forward or he would likely not be this far along in the home buying search.
The second level of home loan approval is called pre-approval. This is typically the result of the underwriter actually reviewing all documents provided and confirming the AUS results.
The preapproval is also known as a conditional approval, as the result delivers long list of conditions that must be met and documents that may still need to be provided and reviewed to get to final approval.
Final approval is more of a process than an event. Once all borrower documents and loan product details have been reviewed and confirmed, and the buyer’s purchase contract has been accepted, the property appraised, and the homeowner association has checked the appraisal, the underwriter is ready to let the loan go to the final steps, including drawing up the loan documents to be sent to escrow for buyer signing.
When loan documents have been signed, notarized, and final figures and all parties’ documents received by escrow, the lender will send a wire or fund the home loan.
When this final day arrives, the escrow and title transfer is ready to be completed.The escrow or title company sends the signed grand deed to the county recorder’s office for recording as a public notice that the property has transferred ownership. This is the final event that solidifies the new owner’s right to occupy and move in.
Determining Maximum Home Loan Qualifying and Home Purchase Price Range
We are now ready to show a simple example of how qualifying ratios are calculated for a positive loan approval. We will assume a simple 20% down payment purchase loan on a home price of $300,000, for example. Using a conforming FNMA/conventional 30-year fixed rate, the qualifying analysis looks something like this:
Loan Prequalifying Analysis (Worksheet 1)
Thinking of Buying a Home soon?
Along with preparing yourself by reading my book and following the tips and guidelines, consider working with a top real estate company that has wide experience and knows home buying from A to Z.
We recommend Keller Williams Realty for nationwide access to all markets. Keller-Williams 80,000 agents nationwide receive the best training, tools, and support to help you whether you are a first time home buyer, seller, or experienced investor looking for great deals.
Be the next happy home buyer!
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