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Washington Real Estate Practices
Lesson 9:
Loan Qualifying
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Introduction
Topics in this lesson: standards lenders use to evaluate loan
applicationswhat buyers should look for when
choosing loan
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Preapproval
Preapproval: buyer submits loan application and information to lender, who analyzes credit reputation, income, and net worth.
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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.
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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.
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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
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The Underwriting Process
Loan underwriting: process lender uses to evaluate mortgage loan applicant and security property, to determine whether proposed loan is good risk.
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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
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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.
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The Underwriting ProcessUnderwriting standards
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.
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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).
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Underwriting StandardsAutomated underwriting
AUS analyzes loan application and credit report, and makes recommendation for or against approval.Generally, underwriter must review
software’s recommendation.
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The Underwriting ProcessUnderwriting standards
Underwriter evaluates information in loan application, credit report, and verification forms.
Three categories: incomenet worthcredit reputation
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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.
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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.
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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.
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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
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Stable Monthly IncomeDurability
In contrast, unemployment benefits aren’t considered durable because they aren’t expected to continue for a long period of time.
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Stable Monthly IncomeAcceptable types of income
Lenders have general rules of thumb for determining what is and what is not stable monthly income.
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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.
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Acceptable IncomePermanent employment
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.
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Acceptable IncomePermanent employment
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.
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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.
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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.
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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.
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Acceptable IncomeSecondary sources
Child support is considered stable monthly income only if required by court decree, and proof is provided of regular payment.
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Acceptable IncomeSecondary sources
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.
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Acceptable IncomeSecondary sources
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.
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Acceptable IncomeSecondary sources
Equal Credit Opportunity Act prohibits lenders from discriminating against loan applicants because income is from public assistance.
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Acceptable IncomeInvestment income
Income from investments can be considered stable monthly income. Unless applicant must sell investment for
downpayment or closing costs.
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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.
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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.
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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.
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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
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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.
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IncomeVerifying income
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.
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IncomeVerifying income
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.
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IncomeVerifying income
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.
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IncomeCalculating monthly income
After verifying applicant’s income, next step is to calculate monthly income.
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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.
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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.
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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.
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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
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The Underwriting ProcessNet worth
Lender calculates applicant’s net worth by subtracting liabilities from assets.
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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.
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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).
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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.
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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.
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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.
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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.
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AssetsAccount verification
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?
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AssetsAccount verification
3. Has bank account been opened only recently (within last couple of months)?
4. Is present balance notably higher than average balance?
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AssetsAccount verification
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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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The Underwriting ProcessCredit reputation
Next, lender analyzes loan applicant's credit reputation by obtaining credit report.Applicant ordinarily pays credit report
fee.
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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.
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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.
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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.
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Credit ReputationDerogatory information
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.
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Credit ReputationDerogatory information
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.
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Credit ReputationDerogatory information
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
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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Credit Reputation Explaining credit problems
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.
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Credit Reputation Explaining credit problems
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.
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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.
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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
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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.
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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
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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.
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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).
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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
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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.
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Loan CostsTruth in Lending Act
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.
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Loan CostsTruth in Lending Act
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.
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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.
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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.
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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.
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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.
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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?
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Other Considerations
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.
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Other Considerations
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
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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.
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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.
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Predatory LendingPredatory lending practices
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.
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Predatory LendingPredatory lending practices
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.
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Predatory LendingMortgage Broker Practices Act
Mortgage Broker Practices Act (MBPA):Washington’s anti-predatory lending actregulates mortgage brokers
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Predatory LendingMortgage Broker Practices Act
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
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Predatory LendingMortgage Broker Practices Act
misrepresenting available rates, points, or financing terms
failing to make required disclosures to loan applicants and other parties
bribing an appraiser
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Predatory LendingMortgage Broker Practices Act
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
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Mortgage Broker Practices Act Penalties
Violation of the MBPA is misdemeanor.Individual harmed by violation can bring
civil suit against mortgage broker’s bond.
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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
Act
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