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Good lending institutions are very careful with their depositors' funds. They employ professional underwriters, who evaluate the degree of risk involved in loans that the lenders have been asked to make by prospective borrowers. Underwriters tell the lender how much risk is involved in lending money to you. If they determine that you're too risky, chances are you won't get the loan. Underwriting standards vary considerably from lender to lender.
- Most lenders comply with underwriting guidelines of two institutions, the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). These lenders sell their loans on the secondary mortgage market to Freddie Mac or Fannie Mae, who then resell the loans to investors such as insurance companies and pension funds.
- Portfolio lenders, who keep loans they originate rather than selling them in the secondary mortgage market, usually have more flexible underwriting standards.
 | Just because one lender turns you down doesn't mean that all lenders will. If you're having trouble getting a loan approved, head for a portfolio lender in your area. |
Underwriting standards vary from lender to lender because the underwriters who examine loan applications are human beings, not machines. Two underwriters can evaluate the same loan application and reach different conclusions (regarding the degree of risk involved in making the loan) because each interprets the traditional underwriting guidelines differently.
To get a mortgage, you must give a lender the right to take your home away from you and sell it to pay the balance due on your loan if you don't make your loan payments, fail to pay your property taxes, let your homeowners insurance policy lapse, or do anything else that financially endangers the property. The legal action taken by a lender to repossess property and sell it to satisfy mortgage debt is called a foreclosure. Lenders detest foreclosures. They're emotionally debilitating for everyone involved in the transaction, they generate awful public relations for the lender and, if a lending institution has too many foreclosures, state and federal bank regulators begin questioning the lender's judgment.
Lenders constantly fine-tune the way they evaluate mortgage applications in search of better screening techniques to keep borrowers — and themselves — out of foreclosure. Lenders traditionally rely on several factors to assess prospective borrowers' creditworthiness.
Integrity
Lenders look very closely at you when deciding whether or not to approve your loan request. They want to know whether you're a good player. Will you keep your word? How great an effort will you make to repay the loan?
One of the first things a loan processor does after you submit a loan application is order a credit report. Surprisingly, blemishes on your credit record aren't always the kiss of death. Contrary to what you may have heard, lenders are human. They understand that financial difficulties related to one-time situations, such as a divorce, job loss, or serious medical problems, can smite even the best of us.
All loan applications contain a "Declarations" section that is chock-full of red flag questions. For instance, this section asks whether you've ever had a property foreclosed upon.
If you answer "yes" to any of these questions, lenders will want all the details. Even with the blemish of a bankruptcy or foreclosure in your credit history, however, you'll get favorable consideration from lenders if you established a repayment plan for your creditors. That commitment demonstrates integrity.
Conversely, people who've skipped out on their financial obligations are treated like roadkill. Lenders know that if borrowers have cut and run once, they'll probably do it again.
Income and job stability
Lenders don't want you to overextend yourself. They know from experience that the number one cause of foreclosures is borrowers spreading themselves too thin financially. The loan processor will send your employer a verification of employment (VOE) letter to independently confirm the employment information on your loan application, including your income, find out how long you've had your present job, and determine your prospects for continued employment.
Some lenders are more lenient than others when they see that a prospective borrower has a history of job-hopping. All lenders, however, must be certain that you have a high likelihood of uninterrupted income. If you don't get paid, how will they?
Debt-to-income ratio
Lenders aren't as concerned about short-term loans that you'll pay off in less than ten months. They will, however, add 5 percent of any unpaid revolving credit charges to your monthly debt load.
For example, suppose that you earn $4,000 per month. If your current monthly long-term debt plus the projected home-ownership expenses total $1,200 a month, your debt-to-income ratio is 30 percent ($1,200 divided by $4,000).
If your debt-to-income ratio is on the high side, a lender will put your loan application under a microscope. Even if all your credit cards are current, the lender may insist as a condition of making the loan that you pay off and cancel some of your credit cards to reduce your potential borrowing power. Doing so reduces the risk of future default on your loan.
| If you want to increase the odds of having your loan approved and accomplishing your financial goals, here's one way to show lenders that you're a good money manager: Lower your debt-to-income ratio by paying off small loans and credit card debt and closing any unused open credit accounts prior to applying for a mortgage. An excessive number of open accounts reduces your credit rating. |
Property appraisal
Lenders must find out what the house you want to mortgage is currently worth, because the property will be used to secure your loan. They do this by getting an appraisal, a written report prepared by an appraiser (the person who evaluates property for lenders) that contains an estimate or opinion of fair market value. The reliability of an appraisal depends upon the competence and integrity of the appraiser.
A loan-to-value ratio, or LTV, is a quick way for lenders to guesstimate how risky a mortgage might be. LTV is simply the loan amount divided by the property's appraised value. If you're borrowing $150,000 to buy a home with an appraised value of $200,000, the loan-to-value ratio is 75 percent (your $150,000 loan divided by the $200,000 appraised value).
The more cash you put down, the lower your loan-to-value ratio and, from a lender's perspective, the lower the odds that you'll default on your loan. It stands to reason that you're less likely to default on a mortgage if you have a lot of money invested in your property.
Conversely, the higher the LTV, the greater a lender's risk if problems arise later with your loan. That's why most lenders charge higher interest rates and loan fees or require mortgage insurance whenever a loan-to-value ratio exceeds 80 percent of appraised value.
Cash reserves
As a condition of making your loan, some lenders insist that you have enough cash or other liquid assets, such as bonds, to provide a two- or three-month reserve to cover all your living expenses in the event of an emergency. Others lenders reduce their cash reserve requirements if you have a low debt-to-income ratio or a low LTV.
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