Getting Approved For a Loan: 4 Key Criteria

A common question most borrowers have is, "how is my loan application evaluated", or "what is an underwriter looking for?" There are 4 main criteria by which an underwriter evaluates a loan: capital, capacity, character, and collateral. The first three relate to the borrower, and the fourth refers to the evaluation of the property. Most of the documentation that must be provided in the loan application is for the verification and validation of these 4 parameters. The following is a discussion of each parameter:

*Capital*
Capital refers to whether you have enough money for the down payment and closing costs. If it's a purchase, and you're putting down 10%, the underwriter will want to know where this money is coming from.

For example, do you have this 10% in a bank account, a retirement account, or is it a gift from a relative? Gift money from other is certainly permitted, but there are restrictions with gift money.

The underwriter will also want to know if you have enough cash for emergencies. An underwriter will generally require 2 months (sometimes more) of PITI (principal, interest, taxes, and insurance) in a bank account or retirement fund, in case you come upon financially hard times and have trouble paying the mortgage.

*Capacity*
Capacity refers to your ability to repay the debt. Based upon the income indicated on your loan application, the underwriter will calculate your debt-to-income ratio (DTI ratio).

The DTI ratio is calculated by adding the minimum monthly payments of all your revolving (ie credit card) and installment (ie car loan) debt, plus your new mortgage payment (including taxes and insurance), and dividing by the monthly income indicated on your loan application.

For example, if you have $200 in monthly credit card payments, $400 in monthly card payments, and your new mortgage (principal, interest, taxes, and insurance all included) will be $3000, then the total of your new monthly debts will be $3600. If your monthly income before taxes is $8000, your DTI ratio will be $3600/$8000= 45%. Fifty percent (50%) is generally the maximum DTI a lender will allow.

*Character*
Whereas capacity refers to your ability to repay the debt, character refers to your past history in paying back your creditors. An underwriter will review your credit report and examine how you're handling current debt obligations, and how you've handled past debt obligations. Particularly, the lender will want to know if you've ever been late on a mortgage payment, ever declared bankruptcy, or ever been foreclosed upon.

Additionally, the lender will evaluate your tri-merged credit score. When you apply for a credit card or car loan, your credit is pulled from only one of the 3 bureaus (Equifax, Transunion, and Experian ). However, when you apply for a mortgage loan, your credit is pulled from all 3 bureaus; hence the term, tri-merged credit report.

Your score can vary widely with each of these bureaus, and the underwriter will only use one of these scores to make an approval decision. Specifically, the underwriter will take the median of the 3 scores, ie the middle score. So if a borrower has scores of 650, 690, and 740 reporting, the lender will use 690.

*Collateral*
The evaluation of capital, capacity, and character is specific to the borrower. However, since the borrower is pledging his/her property as collateral for the loan, the underwriter wants to know the value of that collateral.

To assess this value, a professional, certified appraiser that is a neutral third party to the transaction (ie not an employee of the lender and not a close friend or relative of the borrower) will be sent to the property. The appraiser will determine the fair market value of the property, ie the price that would be agreed upon in a sale between a willing buyer and seller.

If the property is a purchase, an appraiser will make sure the sales price is justified. In the event the sales price and appraised value are not the same, the lender will use the lesser of the sales price and appraised value.

There are several specific documents the borrower may be required to provide, such as proof of homeowner's insurance, W2s, paystubs, bank statements, etc. However each of these items serves the purpose of evaluating one of the 4 criteria listed above.

Copyright 2008 Jared Martin.

Fixed Rate Mortgage Reviews

This payment amount is independent of the additional costs on a home sometimes handled in escrow, such as property taxes and property insurance. Consequently, payments made by the borrower may change over time with the changing escrow amount, but the payments handling the principal and interest on the loan will remain the same.

Fixed rate mortgages are characterized by their interest rate (including compounding frequency, amount of loan, and term of the mortgage). With these three values, the calculation of the monthly payment can then be done.

Fixed rate mortgages are the most classic form of loan for home and product purchasing in the United States. The most common terms are 15-year and 30-year mortgages, but shorter terms are available, and 40-year and 50-year mortgages are now available (common in areas with high priced housing, where even a 30-year term leaves the mortgage amount out of reach of the average family).

Outside the United States, fixed-rate mortgages are less popular, and in some countries, true fixed-rate mortgages are not available except for shorter-term loans. For example, in Canada the longest term for which a mortgage rate can be fixed is typically no more than ten years, while mortgage maturities are commonly 25 years. In Australia banks are unable to offer fixed rates for terms longer than 15 years due to funding constraints.

In finance, negative amortization, also known as Neg Am, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases. As an amortization method the shorted amount (difference between interest and repayment) is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment.

The fact that a fixed rate mortgage has a higher starting interest rate does not indicate that this is a worse form of borrowing compared to the adjustable rate mortgages. If interest rates rise, the ARM cost will be higher while the FRM will remain the same. In effect, the lender has agreed to take the interest rate risk on a fixed rate loan.

Some studies have shown that the majority of borrowers with adjustable rate mortgages save money in the long term, but that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate, and the likelihood that the rate will increase or decrease during the life of the loan.

The risk resulting from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond.Pension funds are also subject to reinvestment risk especially with the shorterm nature of cash investments there is always the risk that future proceeds will have to be reinvested at a lower interest rate.

In the case of a mortgage-backed security (MBS), prepayment is perceived as a risk, because mortgage debts are often paid off early in order to incur lower total interest payments through cheaper refinancing. The new financing may be cheaper because the borrower's credit rating has improved or because interest rates are lower, but in either case, the payments that would have been made to the MBS investor would be above market rates.

Redeeming such loans early through prepayment reduces the upside of credit & interest rate variance in an MBS. The downside of these variances (interest rates rises or creditworthiness declines) does not normally induce a refinancing (since the fixed mortgage payments are now at below-market rates). The fact that MBS-holders are exposed to downside prepayment risk, but rarely benefit from it, means that these bonds must pay a slightly higher interest rate than similar bonds without prepayment risk, to be attractive investments.

Joli Royal