How to Find Creditworthy Buyers for Your Home
After you determine that you have spare cash to invest or lend, and you’re looking for taxable interest income, the hard work comes: putting on your detective hat and assessing the merits of lending your money to a prospective buyer who’s more than likely a complete stranger.
So how do you, someone who isn’t a mortgage lender by profession, become a savvy credit analyst? Perhaps you’ve heard the expression, “Imitation is the sincerest form of flattery.” Well, do what bankers do when deciding whether to lend someone money.
The first thing a lender does in her evaluation of the creditworthiness of a prospective borrower is to bury him in paperwork. As a lender, you absolutely, positively must gather financial facts from the borrower. You can’t accurately assess the risk of lending money to a buyer, even one whom you’ve known personally for a number of years, without going through the information-gathering exercise in this section.
Only agree to make a loan to the buyer of the property when he’s able to make at least a 20 percent down payment. Bankers normally require a down payment of that size for good reason: If the borrower defaults and the banker is forced to hold a foreclosure sale, the down payment provides a cushion against the expenses of sale and possible losses in property value if real estate prices have declined since the loan was made. If the buyer falls on hard times at the same time real estate prices go into the tank, you may find yourself in the unfortunate position of repossessing a house that’s worth less than the amount the borrower owes on it.
So, what documents should you request and what information should you look for?
The loan application
The best way we know to get data from a prospective borrower is to have him complete the Uniform Residential Loan Application, also known as Form 1003, which mortgage lenders almost always use. You can obtain one of these forms through mortgage lenders or mortgage brokers. If, because no profit is in it for them, they’re unwilling to send you a form for your personal use, you can pose as a prospective borrower and have them mail you their standard application package. You can also find the forms online for free. (Please note that the sample form here is the version set for release in July 2019.)
After you receive the completed application from the borrower, be sure it’s completely filled out. Ask for explanations for unanswered questions. The following list explains how to evaluate the information in various parts of the form:
- Borrower information: In this section, the borrowers tell you about themselves. If the borrower hasn’t lived in his most recent housing situation for at least two years, be sure he also lists his prior residence. If the borrower was renting in his recent housing situation(s), request a letter from the buyer’s landlord to verify that rent was paid on time. Alternatively, ask for both sides of canceled checks or checking account statements covering the most recent 12-month period evidencing timely rental payments. If the person moved frequently in recent years, check with more than the most recent landlord. Borrowers who’ve had trouble paying rent on time may well have trouble making regular mortgage payments. Ask for explanations of any red flags you find.
- Employment information: Even more important than a borrower’s recent housing record is the employment record. Here, you’re again looking for stability as well as an adequate income to make housing payments. If the borrower hasn’t been in the most recent position for at least two years, ask the person to list prior employment to cover the past two years. The borrower also lists his/her monthly income from the current job in this section of the application.
- Monthly income and income from other sources: In this important section, the borrower details monthly employment income as well as income from bank, brokerage, and mutual fund investments. In addition to income from bank accounts, stocks, bonds, or mutual funds, a borrower may have income from real estate rental properties. For most people, obviously, employment provides the lion’s share of their income.
The buyer’s expected monthly housing expenses (which include the mortgage payment, property taxes, and insurance) should be compared against (divided by) the borrower’s gross (before-tax) monthly income. Most mortgage lenders require that a homebuyer’s monthly expenses do not exceed about 33 percent of the homebuyer’s monthly income; we think that’s a good ratio for you to work with as well.
However, like a good banker, you don’t want to be rigid. If someone’s proposed monthly housing expenses come in at 34 percent or 35 percent of her monthly income and the borrower has a good job, large down payment, solid references, and so on, then you may decide to go ahead and make the loan, especially if the deal gets your house sold.
- Assets and liabilities: The borrower should also tell you about her personal assets and liabilities. (The next section lets the borrower do the same for other real estate if he owns any.) The mortgage application form divides the buyer’s assets between those that are liquid, and therefore available for a down payment or closing costs (for example, savings and money market account balances outside retirement accounts), and those that aren’t so liquid (retirement account investments or real estate).
In the liabilities section, the borrower should detail any and all outstanding loans or debts. Be wary of lending to someone who carries a great deal of high-interest consumer debt (such as credit cards or auto loans). If the borrower has the cash available to pay off consumer debts before closing, have her pay those balances.
- Type of mortgage and terms of loan: Asking the borrower to fill in these sections isn’t vital; the legal loan document that you both sign later contains information on the terms of the loan — the loan amount, interest rate, length of the loan, and the loan type (fixed-rate or adjustable-rate). Later in this chapter, we walk you through the steps for setting the terms of your loan and having a loan agreement prepared.
- Loan and property information: Although you know that the borrower is obviously buying, you may not know whether he’s going to use the property as a primary or secondary residence or as an investment property. If the buyer intends to rent the property for investment purposes, your loan is riskier, and you should charge a higher interest rate than you’d charge an “owner-occupied” buyer (see “Deciding what to charge” later in this chapter).
Verify the source of the buyer’s down payment and closing costs to ensure this money isn’t yet another loan that may handicap the buyer’s ability to repay the money you’re lending him. The down payment and closing costs should come from the buyer’s personal savings. Ask to see the last several months of the buyer’s bank and investment account statements to verify that the funds have been in the accounts during that time and didn’t arrive there recently as a loan, for example, from a relative.
- Declarations: In this section, the borrower should disclose any past financial or legal problems: foreclosures, bankruptcies, and so on. If the borrower answers any of these questions in the affirmative, ask for a detailed written explanation.
Documentation, documentation, documentation
If you borrow from a lender, the staff asks that you provide a raft of financial documents. If you’re the lender, you need to ask for the pile of papers, too. You may rightfully wonder why you need more paperwork after the buyer completes a detailed loan application.
Unfortunately, some people lie. Even though you may think you have the most financially stable, honest, and creditworthy buyers nibbling on your “house for sale” fishing line, don’t start reeling them in yet. You need to get the additional paperwork to prove and substantiate the borrower’s financial status. Pay stubs, tax returns, and bank and investment-account statements document the borrower’s income and assets. Just because someone tells you on an application form that he’s earning $5,000 per month doesn’t prove that he really is.
When verifying the information supplied on the mortgage application, ask the prospective borrower for the following documents:
- Federal income tax returns and W-2s for the past two years
- Original pay stubs for the past month or two (if the borrower is self-employed, request a year-to-date income statement and balance sheet)
- Award letter and copy of the most recent check if the borrower receives pension, Social Security, or disability income
- Past three months of account statements for money to be used for down payment, as well as copies of all other investment accounts (including retirement accounts)
- Most recent statement for all outstanding loans
- Divorce or separation papers if the borrower pays or receives alimony or child support
You also should obtain, at the borrower’s expense, a copy of his or her credit report(s) to check credit history and to ensure that you’re aware of all outstanding debts. The larger consumer credit reporting agencies include Experian, Trans Union, and Equifax.
Even when you request and receive all this documentation, some buyers still can falsify information, which is committing perjury and fraud. For example, some people, particularly those who are self-employed, may make up phony income tax returns with inflated incomes.
As you may know from your own personal experience, some people don’t have perfect financial and credit histories. In some cases, a prospective borrower may have enough problems for you to reject the application. In other situations, however, the problems may be minor and can be overcome by taking some simple steps and precautions.
Here are common problems likely to crop up with prospective borrowers, and our best advice on how to deal with each situation:
- Income appears too low to support monthly housing costs: The best way to protect your interests if you’re considering lending to someone who’s stretching (in terms of monthly income) to afford your house is to ask for a larger down payment. As we discuss in the next section, you can charge a higher rate of interest for lending to someone who’s a greater credit risk. Another strategy is having the borrower get a cosigner, such as a parent.
- Past credit problems: Just because someone has nicks on her credit report doesn’t mean you should immediately reject the loan application. Credit reporting agencies and creditors who report information to the agencies sometimes make mistakes. Someone who has a small number of infrequent late payments shouldn’t be as big a concern as someone who has reneged on a loan. Ask the borrower for a detailed explanation of any problems you see on the report and use your common sense to determine whether that person is simply human or irresponsible with credit. In the latter case, you may suggest that the borrower enlist a cosigner.
- Outstanding consumer debt: If the borrower has the cash available to pay off the debt, have him or her do so as a condition of making the loan. If the borrower lacks the cash to pay off consumer debt and lacks a 20-percent down payment, you’re probably better off not making the loan, unless the buyer’s income provides a great deal of breathing room. If you’re on the fence, consider having the borrower get a cosigner.