© 2013 rockwell publishing washington real estate practices lesson 9: loan qualifying

Washington Real Estate Practices

Lesson 9:

Loan Qualifying

Introduction

Topics in this lesson: standards lenders use to evaluate loan

applicationswhat buyers should look for when

choosing loan

Preapproval

Preapproval: buyer submits loan application and information to lender, who analyzes credit reputation, income, and net worth.

Preapproval Preapproval letter

If buyer is approved, lender issues letter stating it will lend buyer up to certain amount (assuming property meets lender’s standards).

Preapproval letter typically valid only for stated period.Preapproval streamlines closing process

and makes buyers more attractive to sellers.

Preapproval Preapproval letter

Potential drawback: preapproval letter lets seller know how much buyer could spend. Buyer can ask lender for preapproval

letter for particular transaction, simply stating that buyer is approved for amount of offer.

Prequalifying vs. Preapproval

Prequalifying: much more informal process, though not very common anymore.Agent asks questions about income,

assets, debts, and credit history to help determine what financing buyers would qualify for.

Buyers can do this online themselves.

SummaryPrequalifying and Preapproval

PreapprovalPrequalification

The Underwriting Process

Loan underwriting: process lender uses to evaluate mortgage loan applicant and security property, to determine whether proposed loan is good risk.

The Underwriting ProcessLender’s risks

In making mortgage loans, lender assumes two risks:

1. that borrower will fail to repay loan as agreed

2. if borrower does default, security property will be worth less than what borrower owes lender

The Underwriting ProcessUnderwriting standards

Lender evaluates property based on appraisal.

Most lenders evaluate applicants using uniform underwriting standards established by Fannie Mae and Freddie Mac. Otherwise loan is nonconforming and

lender might not be able to sell it on secondary market.

Lenders use underwriting standards to weed out riskier loan applicants. If applicant doesn’t meet underwriting

standards, lender won’t make loan.

Underwriting standards applied to both applicant and property.

Underwriting StandardsAutomated underwriting

Automated underwriting: many aspects of underwriting now handled by computer.

Fannie Mae, Freddie Mac, and large lenders each have own automated underwriting system (AUS).

Underwriting StandardsAutomated underwriting

AUS analyzes loan application and credit report, and makes recommendation for or against approval.Generally, underwriter must review

software’s recommendation.

Underwriter evaluates information in loan application, credit report, and verification forms.

Three categories: incomenet worthcredit reputation

The Underwriting ProcessIncome

Lender uses two-step process to evaluate loan applicant’s income:First, lender determines applicant’s

stable monthly income.Then, lender decides if stable monthly

income is sufficient to make proposed loan’s monthly payments.

IncomeStable monthly income

Before lender can judge whether applicant’s income is sufficient, lender must look at income’s quality and durability.Stable monthly income requires certain

level of quality and durability.

Stable Monthly IncomeQuality

Income quality refers to reliability or dependability of source. Reasonably reliable sources of income

include established private employers and government agencies. The less dependable the source of the

income, the lower the quality of the income.

Stable Monthly IncomeDurability

To be stable, income must also be durable—expected to continue for reasonable period of time.

Examples of durable income include:wages from permanent employment permanent disability benefitsinterest on established investments

Stable Monthly IncomeDurability

In contrast, unemployment benefits aren’t considered durable because they aren’t expected to continue for a long period of time.

Stable Monthly IncomeAcceptable types of income

Lenders have general rules of thumb for determining what is and what is not stable monthly income.

Acceptable IncomePermanent employment

Permanent employment is most common source of stable monthly income.Generally, loan applicant must have

history of continuous, stable employment—typically at least two years in same field.

But extenuating circumstances may warrant loan approval without two-year work history.Example: applicant recently finished

college or just left armed services. Special education or training can make

up for minor weaknesses in job history.

Lenders look favorably upon applicant changing jobs to advance within same line of work.But changing jobs persistently without

any advancement is viewed as a problem.

Acceptable IncomeSelf-employment

Self-employment income is considered less durable and less reliable than income from permanent job. Applicant who has been self-employed

for short time must show employment history in same field and reasonable chance of success on her own.

Acceptable IncomeOther employment income

Secondary employment income—bonuses, commissions, part-time earnings, etc.—may sometimes be included if established in applicant’s earnings history.

Overtime pay is not considered stable income unless regular part of applicant’s earnings.

Acceptable IncomeSecondary sources

Income from pensions and social security is acceptable as stable monthly income.

Alimony or spousal support is acceptable if payments are reliable. Applicant must give lender copy of court

decree ordering payments.

Child support is considered stable monthly income only if required by court decree, and proof is provided of regular payment.

The closer child is to age of majority (when payments will stop), the less likely lender will include child support. If child is over 15, lender probably won’t

count child support.

Income from public assistance programs acceptable as long as payments are expected to continue for sufficient period of time.Payments from welfare or food stamps

may be counted as stable monthly income, depending on prospects for continued eligibility.

Equal Credit Opportunity Act prohibits lenders from discriminating against loan applicants because income is from public assistance.

Acceptable IncomeInvestment income

Income from investments can be considered stable monthly income. Unless applicant must sell investment for

downpayment or closing costs.

Acceptable IncomeRental income

Income from loan applicant’s rental properties can count as stable monthly income. Applicant must prove rental payments

are made regularly.Lender generally bases allowable

amount on property’s past net income.

Acceptable IncomeCo-mortgagors

Lender may be willing to use income of co-mortgagor in qualifying loan applicant.

Co-mortgagor: signs mortgage and note along with primary borrower and has same legal obligation to pay off loan.

Acceptable IncomeCo-mortgagors

Parents frequently act as co-mortgagors to help children purchase first home. Co-mortgagors help loan application only

if their income is enough to support both their own mortgage payment and new mortgage payment.

Stable Monthly IncomeUnacceptable types of income

Types of income usually NOT acceptable to lender (either because not reliable or not durable):unemployment benefits earnings of family members other than

spouseincome from temporary employment

(either part-time or full-time) unless steady work

SummaryStable Monthly Income

IncomeStable monthly incomeAcceptable incomeUnacceptable income

IncomeVerifying income

Two main methods of verifying employment income:

1. Lender sends income verification form directly to applicant’s employer, who fills it out and sends it back directly to lender.

2. Applicant gives lender W-2 forms for previous two years and payroll stubs or vouchers for previous 30-day period.

Lender confirms information in documents by calling employer.

Commission income: verified with copies of applicant’s federal income tax returns for previous two years.

Self-employment income: verified with audited financial statements and federal income tax returns for previous two years.

Alimony or child support: verified with copy of court decree and proof that payments have actually been received.

Rental income: verified with recent income tax returns; usually other documentation too, such as leases.

IncomeCalculating monthly income

After verifying applicant’s income, next step is to calculate monthly income.

IncomeCalculating monthly income

Convert hourly wages to monthly income by multiplying by 173.33.

If a buyer gets paid twice a month, multiply paycheck amount by two.

If buyer gets paid every two weeks, multiply by 26 to get annual income. Then divide that by 12 to get monthly income.

IncomeRatios

Lender sets maximum income ratios to ensure mortgage and other monthly debt payments don’t eat up too much monthly income. Two types of income ratios: debt to

income ratio and housing expense to income ratio.

IncomeRatios

Debt to income ratio: measures monthly mortgage payment plus other regular installment debt payments against monthly income.

Housing expense to income ratio: measures monthly mortgage payment against monthly income.

IncomeRatios

Monthly mortgage payment includes principal, interest, taxes, and insurance (PITI).

Income ratio is expressed as a percentage.

Each type of loan program has its own maximum income ratios.

SummaryIncome Analysis

Income verificationCalculating monthly income Income ratios

The Underwriting ProcessNet worth

Lender calculates applicant’s net worth by subtracting liabilities from assets.

The Underwriting ProcessFinancial management skills

Lenders feel applicant with significant net worth probably has good financial management skills and is good credit risk. If applicant’s income is marginal, above-

average net worth could help approval.

Net WorthCash for closing

Lender also investigates net worth to ensure applicant has enough cash to complete purchase (downpayment, closing costs, and other incidental expenses).

Net WorthReserves

Buyers often required to have reserves left after downpayment and closing costs. Typically, reserves must be enough to

cover two or three mortgage payments. Means buyer could likely handle short

emergency without defaulting.

Net WorthAssets

Loan applicant lists assets on loan application, and lender does whatever it can to verify information. Encourage buyers to include anything of

financial value, such as real estate, cars, furniture, jewelry, stocks, bonds, or cash value in life insurance policy.

AssetsLiquid assets

Liquid assets generally more important to lender than non-liquid assets.

Liquid assets: cash and any other assets that can be quickly converted to cash.

AssetsAccount verification

Lender will need buyer’s bank name, account number, and balance. Lender sends “Request for Verification of

Deposit” form directly to bank, who returns it directly to lender.

Or applicant may submit original bank statements for previous three months to verify sufficient cash for closing.

Lender looks at four issues when verifying deposits:

1. Does verified information conform to loan application?

2. Does applicant have enough money in bank for expenses of purchasing property?

3. Has bank account been opened only recently (within last couple of months)?

4. Is present balance notably higher than average balance?

If account was recently opened or has higher than normal balance, lender may become suspicious. Strong indications that loan applicant

borrowed funds to pay downpayment and closing costs—generally not allowed.

AssetsReal estate

If buyer is selling one home to buy another, she can use net equity in current home as liquid asset.

Net equity: difference between market value of property and sum of liens against property, plus selling expenses.

AssetsReal estate

To estimate net equity available, take current home’s appraised value (or sales price if it’s in escrow), subtract outstanding mortgage and other liens, and then subtract estimated selling costs.

AssetsReal estate

If equity in other property will be main source of cash used to buy new property, lender will probably require proof property has been sold and buyer has received proceeds.

AssetsReal estate

If property won’t sell in time for closing, lender may provide swing loan (or bridge loan), which provides cash for closing on new home. When old home sells, swing loan is paid

off from sale proceeds.

Net WorthLiabilities

Applicant also lists all liabilities, including credit card balances, charge accounts, student loans, car loans, and other debts. If applicant owns real estate, remaining

principal balance on mortgage and amount of any other liens are considered liabilities.

Net WorthGift funds

If buyer has income to qualify for loan, but not enough cash for downpayment and closing, his family may be willing to help. Generally allowed, as long as money is

gift and not loan.

Net WorthGift funds

Relative’s gift of money must be confirmed with “gift letter” signed by donor, stating money is gift and does not have to be repaid. Lenders often have specific forms for gift

letters, and may require them to be used.

SummaryNet Worth

Net worthAssetsLiabilitiesGift funds

The Underwriting ProcessCredit reputation

Next, lender analyzes loan applicant's credit reputation by obtaining credit report.Applicant ordinarily pays credit report

The Underwriting ProcessCredit reputation

Report covers debt and repayment history for preceding seven years (primarily credit cards and loans). Other bills usually aren’t listed unless

they were turned over to collection agency.

Credit Reputation Derogatory information

If credit report shows history of credit trouble, loan may be declined. Derogatory credit information includes:

slow payments, debt consolidations, collections, repossessions, foreclosures or short sales, judgments, and bankruptcies.

Credit ReputationDerogatory information

Slow payments: buyer with chronic late payments may be seen as financially overextended or not taking debt seriously.

Debt consolidation: pattern of periodic “bailouts” through refinancing and debt consolidation suggests applicant has tendency to live beyond his means.

Collections: if creditor turns bill over to collection agency, this appears on credit report for seven years.

Repossession: if someone buys personal property on credit and fails to make payments, creditor may be able to repossess it.Appears on credit report for seven years.

Foreclosure: real estate foreclosure stays on debtor’s credit report for seven years. Previous foreclosure viewed very

seriously.Similar weight given to short sales, etc.

Judgment: listed on credit report for seven years after it’s entered in public record.

Bankruptcy: appears on debtor’s credit report for ten years, rather than seven.

Three different types of bankruptcy: Chapter 7: total discharge of debtsChapter 11: reorganization of businessChapter 13: reorganization of personal

finances

Credit ReputationCredit scores

Credit scores are designed to measure likelihood someone will default on loan.

Most commonly used is FICO (also called Fair Isaac). FICO scores range around 300 to 850.Higher score (over 700) = relative

creditworthiness.

Credit ScoresHow credit scores are used

If applicant has good credit score, the underwriter typically won't investigate further. But mediocre credit score will prompt

underwriter to look more closely at circumstances of credit problems.

Credit ScoresHow credit scores are used

If credit score is mediocre, lender might approve loan but charge higher interest rate to make up for increased risk. Sometimes called subprime loan.

Credit ScoresMaintaining a good score

Previous two years are most important to applicant’s score.

Other factors with negative impact on score:constantly carrying credit card balance

near maximum amountapplying for too much credit

Credit ScoresMaintaining a good score

Several credit inquiries made within certain period (ranging from14 to 45 days) are treated as single inquiry in calculating credit score. Loan applicant was probably

comparison-shopping for mortgage or car loan.

Credit ReputationObtaining credit information

Before house-hunting, buyer should check credit report for any errors or discrepancies (doesn’t count as credit inquiry). Get report from all three major agencies

—Equifax, Experian, and TransUnion.Specifically ask for credit scores.

Credit ReputationObtaining credit information

If buyer finds any errors, he should contact credit agencies. Federal Fair Credit Reporting Act

requires agencies to investigate any complaints and correct errors.

Credit Reputation Explaining credit problems

If report has a few derogatory items, see if: they occurred during specific period for

valid reason, and credit report before and after is

acceptable.

If problems can be explained and lender believes circumstances were only temporary, loan might be approved.

Buyer shouldn’t blame problems on creditors.

Lender won’t look favorably on buyer not taking responsibility for previous credit problems.

Buyer should go to lender and explain situation honestly.

If payments were late for several months because borrow was laid off, he should tell lender.

Lender is likely to be sympathetic, especially if borrower can show he's now steadily employed and paying bills on time.

Subprime Lending

Buyer who doesn’t qualify for loan under standard underwriting requirements might be able to get a subprime loan.

Subprime mortgages: riskier loans made using more flexible underwriting standards.

Subprime Lending

Subprime borrowers often have poor or limited credit histories. Or may be borrowers who:can’t meet standard income and asset

documentation requirementshave good credit but carry a lot of debtwant to purchase nonstandard properties

Subprime Lending

In exchange for the added risk, subprime lenders usually charge higher interest rates and fees.Subprime loans also more likely to have

prepayment penalties, balloon payments, and negative amortization.

Subprime Lending

Late 1990s and early 2000s boom in subprime lending led to many defaults.Mortgage foreclosure epidemic affected

entire economy.Subprime mortgages now much less

common.

SummaryCredit Reputation

Credit reputationCredit reportCredit scoresSubprime lending

Choosing a Loan

Buyers should look at several lenders and types of loans offered by each lender.

In addition to interest rates, other important criteria: loan’s overall cost (APR), lender’s lock-in policies, and lender’s competence.

Choosing a LoanLoan costs

Along with interest, borrower pays loan origination fee and possibly discount points. Loan origination fee: for administrative

cost of processing loan—typically ranges from 1% to 3% of loan amount.

Discount points: increase lender's upfront yield or profit—range from 1% to 6% of loan amount (one to six points).

Lenders quoting low interest rates usually charge more points to compensate. Variation in loan fees between lenders

and between loans could make it difficult to accurately compare loan costs.

Choosing a LoanLoan costs

Loan CostsTruth in Lending Act

Truth in Lending Act (TILA): federal law requiring lenders to disclose cost of loans in same manner, to enable borrowers to compare costs and shop around for best rate. Implemented through Federal Reserve's

Regulation Z.

TILA’s most important disclosure is loan's annual percentage rate (APR).APR takes into account interest, points

paid by borrower, loan origination fee, and mortgage insurance or guaranty fees.

To accurately compare cost of two loans, buyer should compare APRs.

Under TILA, lender must give loan applicant disclosure statement with good faith estimate of financing charges within three business days after receiving application. Disclosure statement typically provided

when application is submitted.

Choosing a LoanLock-ins

If interest rate isn’t locked in, lender can change it at any time before closing. When lender quotes rate, buyer should

ask if rate will be locked in, and for how long.

Choosing a LoanLock-ins

Unless lender will let buyer take advantage of rates dropping, buyer shouldn’t lock in rate if market rates appear likely to fall.

Lender usually charges fee (.25% of loan amount, for example) to lock in interest rate.Fee may be applied to buyer's closing

costs if transaction closes.

Choosing a LoanLender competence

Competent lenders will ensure loan process goes smoothly and no costly errors are made. Easiest way to judge good lender: ask

experienced agents for advice.

Choosing a LoanOther considerations

Encourage buyers to think about financial and home ownership plans in long-term fashion. Buyers must choose type of loan based

on their unique financial circumstances and goals.

Other Considerations

In addition to APR and overall loan costs, buyers should consider the following:How much money will be left in savings

after closing?How much money will be left over after

the monthly loan payment?How long does the buyer plan to stay in

this home?

Buyer planning to stay in the home for a short time wants to minimize the short-term cost of the property.

Buyer who wants to retire early may be concerned with building equity and paying off the loan quickly.

First-time buyers with limited buying power typically want to purchase the most expensive home they can afford.

Other buyers may want to invest their money elsewhere.

SummaryChoosing a Loan

Truth in Lending ActAnnual percentage rateLock-insOther considerations

Predatory Lending

Predatory lending: mortgage practices used to take advantage of unsophisticated borrowers.

Predatory lenders tend to target elderly or minority borrowers.Especially those with limited income or

limited English skills.

Predatory LendingPredatory lending practices

Predatory steering: directing buyer toward a more expensive loan than the buyer could otherwise obtain.

Fee packing: charging interest rates, points, or other fees that far exceed market rates and aren’t justified by service provided.

Loan flipping: eating into homeowner’s equity by charging fees on repeat refinances.

Disregarding buyer’s ability to pay: making loan based only on property’s value, without considering whether buyer will be able to afford payments.

Balloon payment abuses: making low monthly payment loan that is either partially amortized or interest-only, without disclosing existence of large balloon payment.

Fraud: misrepresenting or concealing unfavorable loan terms or excessive fees, or using other fraudulent means to get borrower to agree to loan.

Predatory LendingMortgage Broker Practices Act

Mortgage Broker Practices Act (MBPA):Washington’s anti-predatory lending actregulates mortgage brokers

MBPA prohibits mortgage brokers from:defrauding or misleading borrowers,

lenders, or third partiescontracting with borrower to receive fees

even when borrower doesn’t actually obtain loan

misrepresenting available rates, points, or financing terms

failing to make required disclosures to loan applicants and other parties

bribing an appraiser

advertising interest rate without disclosing APR

failing to pay third-party service providers within 30 days of recording loan closing documents

acting as mortgage broker in own transaction or transaction handled by licensee working for same real estate brokerage

Mortgage Broker Practices Act Penalties

Violation of the MBPA is misdemeanor.Individual harmed by violation can bring

civil suit against mortgage broker’s bond.

Mortgage Broker Practices Act Penalties

Violation of MBPA is also violation of Consumer Protection Act (CPA).Individuals can bring actions under CPA

for 3x actual damages (up to $25,000).

SummaryPredatory Lending

Predatory lendingMortgage Broker Practices

© 2013 rockwell publishing washington real estate practices lesson 9: loan qualifying

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