Financing Residential Real Estate
Lesson 8:
Qualifying the Buyer
Introduction
In this lesson we will cover:
the underwriting process,
automated underwriting,
credit reports and credit scores,
income analysis,
net worth,
other factors in underwriting,
subprime lending, and
risk-based loan pricing.
Introduction
Loan underwriting involves evaluation of:
1. Loan applicant’s overall financial situation.
 Is buyer likely to make the payments
on time?
2. Value of the property (collateral).
 If buyer did default, would foreclosure
sale proceeds cover the debt?
The Underwriting Process
Underwriting involves:
 reviewing loan application;
The Underwriting Process
Underwriting involves:
 reviewing loan application;
 obtaining additional information about
applicant from other sources;
The Underwriting Process
Underwriting involves:
 reviewing loan application;
 obtaining additional information about
applicant from other sources;
 verifying information applicant provided;
The Underwriting Process
Underwriting involves:
 reviewing loan application;
 obtaining additional information about
applicant from other sources;
 verifying information applicant provided;
 applying lender’s qualifying standards;
The Underwriting Process
Underwriting involves:
 reviewing loan application;
 obtaining additional information about
applicant from other sources;
 verifying information applicant provided;
 applying lender’s qualifying standards;
 evaluating property appraisal; and
The Underwriting Process
Underwriting involves:
 reviewing loan application;
 obtaining additional information about
applicant from other sources;
 verifying information applicant provided;
 applying lender’s qualifying standards;
 evaluating property appraisal; and
 making recommendation.
The Underwriting Process
Qualifying standards
Qualifying standards: minimum standards used in
underwriting.
Draw line between acceptable and
unacceptable risks.
The Underwriting Process
Qualifying standards
Although lenders can set their own standards, most
use Fannie Mae/Freddie Mac standards for
conventional loans.
FHA and VA standards must be
used for FHA and VA loans.
The Underwriting Process
Automated underwriting
Automated underwriting system (AUS): computer
program that analyzes loan applications.
Used in conjunction with traditional
underwriting.
Traditional underwriting now called
manual underwriting.
Automated Underwriting
AU and secondary market
Most widely used AU systems:
Desktop Underwriter® (Fannie Mae)
Loan Prospector® (Freddie Mac)
Either may be used to underwrite conventional,
FHA, or VA loans.
Automated Underwriting
AU and secondary market
Most widely used AU systems:
Desktop Underwriter® (Fannie Mae)
Loan Prospector® (Freddie Mac)
Either may be used to underwrite conventional,
FHA, or VA loans.
Although Fannie Mae and Freddie Mac encourage
lenders to use AU, they will still buy manually
underwritten loans.
The Underwriting Process
AU programming
Programming of secondary market agency AU
systems based on performance of millions of loans.
Loan performance: whether payments are
made as agreed.
Analysis of performance statistics highlights
factors that make default either more likely or
less likely.
The Underwriting Process
AU programming
Fannie Mae/Freddie Mac computer analysis of loan
performance is ongoing.
Both agencies use latest information to adjust
their AU systems and underwriting standards.
Adjustments have nationwide impact on
underwriting practices.
The Underwriting Process
How AU works
Information from loan application entered into AU
system.
AUS obtains applicant’s credit information from
credit reporting agencies.
AUS issues report with recommendations.
The Underwriting Process
How AU works
Three main categories of recommendations in AU
report:
Risk classification
Level of documentation
Property appraisal or inspection
The Underwriting Process
How AU works
Risk classification
AU report indicates level of scrutiny application
should receive.
Approve/Accept = meets all qualifying
standards.
Approve/Ineligible = meets credit risk
standards, but other aspects of loan make
it ineligible for purchase by agency.
Refer/Caution = doesn’t meet all
standards, should be reviewed.
The Underwriting Process
How AU works
Risk classification
If application requires further review, underwriter
looks at application in traditional way (manual
underwriting).
The Underwriting Process
How AU works
Risk classification
If application requires further review, underwriter
looks at application in traditional way (manual
underwriting).
Some lenders reject Refer/Caution loans
without further review.
The Underwriting Process
How AU works
Risk classification
If application requires further review, underwriter
looks at application in traditional way (manual
underwriting).
Some lenders reject Refer/Caution loans
without further review.
Fannie Mae or Freddie Mac may buy manually
underwritten Refer/Caution loan, but it will be
treated as A-minus loan.
The Underwriting Process
How AU works
Level of documentation
AU report indicates how much documentation is
needed to verify information on application.
The Underwriting Process
How AU works
Level of documentation
AU report indicates how much documentation is
needed to verify information on application.
Before mortgage crisis, three basic levels:
 standard
 streamlined (“low-doc”)
 minimal (“no doc” )
The Underwriting Process
How AU works
Level of documentation
AU report indicates how much documentation is
needed to verify information on application.
Before mortgage crisis, three basic levels:
 standard
 streamlined (“low-doc”)
 minimal (“no doc” )
Now just standard or streamlined; “no doc”
loans no longer widely available.
The Underwriting Process
How AU works
Level of documentation
Refer/Caution loans:
Standard documentation (and manual
underwriting) generally required.
Approve/Accept loans:
Streamlined documentation permitted.
The Underwriting Process
How AU works
Appraisal recommendation
AU report also indicates which of these is
appropriate:
full appraisal
drive-by inspection
report on property’s likely value (with
no inspection)
The Underwriting Process
Advantages of AU
Advantages of automated underwriting over manual
underwriting:
 streamlines process;
The Underwriting Process
Advantages of AU
Advantages of automated underwriting over manual
underwriting:
 streamlines process;
 increases objectivity; and
The Underwriting Process
Advantages of AU
Advantages of automated underwriting over manual
underwriting:
 streamlines process;
 increases objectivity; and
 improves underwriting accuracy.
Summary
The Underwriting Process
Underwriting standards
Automated underwriting
Manual underwriting
Loan performance
Risk classification
Standard documentation
Streamlined documentation (low-doc)
Minimal documentation (no doc)
Drive-by inspection
Evaluating Creditworthiness
Buyer considered creditworthy if overall financial
situation indicates she can be expected to make
payments on time.
Evaluating Creditworthiness
Buyer considered creditworthy if overall financial
situation indicates she can be expected to make
payments on time.
Qualification of buyer involves evaluation of three
main components of creditworthiness:
 Credit reputation
Evaluating Creditworthiness
Buyer considered creditworthy if overall financial
situation indicates she can be expected to make
payments on time.
Qualification of buyer involves evaluation of three
main components of creditworthiness:
 Credit reputation
 Income
Evaluating Creditworthiness
Buyer considered creditworthy if overall financial
situation indicates she can be expected to make
payments on time.
Qualification of buyer involves evaluation of three
main components of creditworthiness:
 Credit reputation
 Income
 Net worth (assets)
Evaluating Creditworthiness
Credit reputation
Of the three main components of creditworthiness,
many consider credit reputation most important.
To evaluate loan applicant’s credit reputation,
lender relies on credit reports prepared by national
credit rating agencies.
Credit Reputation
Credit reports
A personal credit report covers 7 years of
information about an individual’s:
 revolving credit accounts,
 installment debts, and
 previous mortgages.
Utility bills, medical bills, etc., aren’t listed unless
turned over to collection agency.
Credit Reputation
Credit reports
Credit reporting agencies are private companies.
Three major credit agencies in U.S.:
 Equifax
 Experian (formerly TRW)
 TransUnion
Credit Reputation
Credit reports
Reports prepared by the three agencies don’t
always match.
Lender may use reports from all three, or
“tri-merge” report that combines them.
Credit Reputation
Credit reports
Credit information important in underwriting:
 length of credit history
 payment record
 derogatory credit incidents
 credit scores
Credit Reputation
Length of credit history
“Credit history” widely used as synonym for
“credit reputation.” Narrower definition used in
underwriting.
Credit history = duration of applicant’s
experience with credit.
Credit Reputation
Length of credit history
General requirements:
credit history at least one year in duration
with three or more active accounts
Alternative for applicant without established credit
history: provide records of utility bill payments, rent
payments.
Credit Reputation
Payment record
For each account listed, credit report gives detailed
payment record showing whether payments have
been made on time.
Late payments shown as 30 days,
60 days, or 90 days overdue.
Credit Reputation
Payment record
Underwriters view chronic late payments as sign
applicant is financially overextended and/or
irresponsible.
But spotless payment record not essential.
Credit Reputation
Major derogatory incidents
Negative information on credit report may include:
 charge-offs
 collections
 repossessions
 judgments
 foreclosures
 bankruptcies
Credit Reputation
Major derogatory incidents
Charge-off: Uncollected debt treated as loss for tax
purposes.
Tax code allows creditor to write off debt after
no payment in 6 months.
Doesn’t relieve debtor of liability.
Credit Reputation
Major derogatory incidents
Collections
Creditor may turn delinquent bill over to collection
agency that presses debtor for payment.
Debt held by collection agency appears on
credit report, even if original bill did not.
Credit Reputation
Major derogatory incidents
Repossessions
If someone buys personal property on credit and
fails to make the payments, creditor may have right
to repossess the collateral property.
Credit Reputation
Major derogatory incidents
Judgments
When someone loses a lawsuit, court may order her
to pay money (damages) to the person who sued.
Credit Reputation
Major derogatory incidents
Foreclosures
Not surprisingly, foreclosure on applicant’s credit
report is a matter of special concern to mortgage
lender.
Credit Reputation
Major derogatory incidents
Bankruptcy
Bankruptcy on applicant’s credit report also taken
very seriously.
Credit Reputation
Major derogatory incidents
Under Fair Credit Reporting Act, derogatory
incidents can remain on individual’s credit report
for no more than seven years.
Exception: Bankruptcy – ten years.
Mortgage loan underwriters focus mainly on
previous two years.
Foreclosures and bankruptcies are
serious concerns for longer.
Credit Reputation
Credit scores
Credit score: Figure calculated by credit reporting
agency using established scoring model.
Takes into account all information on credit
report.
Indicates individual’s likelihood of default.
Three main credit reporting agencies may
calculate different scores for same person.
Credit Reputation
Credit scores
Scoring models are based on statistical analysis of
large numbers of mortgages.
Most widely used: FICO scores.
Range from under 400 to over 800.
High FICO score = unlikely to default
Credit Reputation
Credit scores
Underwriters use credit scores to determine level of
review applied to applicant’s credit history.
Good scores: basic review
Mediocre or poor scores: in-depth review
Credit Reputation
Credit scores
Aside from major derogatory incidents, other factors
that have negative impact on credit scores:
 Chronic late payments
 Maintaining high balance on credit card,
even if payments on time
 Applying for too much credit
Credit Reputation
Obtaining credit information
Prospective buyers should look at their credit
reports and scores before applying for mortgage.
Some information may be incorrect.
Fair Credit Reporting Act requires credit
reporting agencies to investigate in
response to complaint and correct errors.
Credit Reputation
Explaining credit problems
If underwriter is convinced that past problems don’t
reflect applicant’s attitude towards credit, loan may
be approved.
Credit Reputation
Explaining credit problems
Letter to lender explaining negative credit report
should:
state reason for problem;
point out that it occurred during specific period;
show problem no longer exists;
highlight good credit before and since;
provide documentation from third parties; and
not blame creditors.
Summary
Credit Reputation
Creditworthiness
Credit report
Credit history
Charge-offs
Collections
Foreclosure
Bankruptcy
Credit scores (FICO scores)
Fair Credit Reporting Act
Evaluating Creditworthiness
Income analysis
Second main component of creditworthiness:
income.
Even if buyer has excellent credit reputation,
loan won’t be approved unless buyer can afford
payments.
Buyer’s income is starting point in determining:
maximum loan amount
price range for houses
Income Analysis
Characteristics of income
Income has three dimensions:
Quantity
Enough monthly income to afford
monthly mortgage payment
Quality
From dependable sources
Durability
Likely to continue for at least
three years
Income Analysis
Stable monthly income
Income that meets tests of quality and durability is
stable monthly income. May include:
wages or salary
retirement income
bonuses
alimony
commissions
child support
overtime
public assistance
part-time earnings
self-employment
income
investment income
Stable Monthly Income
Employment income
Permanent employment is major income source for
most home buyers.
Positive employment history:
consistency (usually 2 years in same
job or field)
opportunities for advancement
special training or education
Stable Monthly Income
Employment income
Commissions, overtime and bonuses
Considered stable if consistent part of
applicant’s overall earnings pattern.
Stable Monthly Income
Employment income
Part-time work
Considered stable if applicant has held
job for at least two years.
Seasonal work
Considered stable if established earnings
pattern exists.
Stable Monthly Income
Employment income
Self-employment income
Includes income from personal business,
freelance work, or consulting work.
Underwriters consider earnings trend, training
and experience, and nature of business.
Generally regarded as risky income source:
amount of income unpredictable
small businesses often fail
Stable Monthly Income
Employment income
Employment verification:
Verification form sent to employer, or
W-2 forms for 2 years plus pay stubs for 30
days, with phone call to employer.
Lender may also request income tax returns for
previous two years to verify earnings.
Stable Monthly Income
Retirement income
Pension and social security payments are usually
dependable and durable.
Lenders can’t discriminate on basis of age.
Life expectancy can be considered.
Stable Monthly Income
Investment income
Dividends or interest may be counted as part of
stable monthly income.
Underwriter calculates average investment
income for previous two years.
Stable Monthly Income
Rental income
If a stable pattern can be verified, rental income is
considered stable monthly income.
Applicant may have to show gross earnings and
operating expenses for previous two years.
Stable Monthly Income
Rental income
Many unpredictable factors affect rental income:
 Emergency repairs
 Vacancies
 Tenants who don’t pay
Underwriter includes only a percentage of
verified income to leave a margin for error.
Negative rental income treated as liability.
Stable Monthly Income
Maintenance, alimony, child support
Considered stable income sources if it appears
payments will be made reliably.
Depends on:
whether payments required by court
decree
how long payments have been made
financial/credit status of ex-spouse
ability to compel payment
Stable Monthly Income
Maintenance, alimony, child support
Lenders usually require:
copy of court decree
proof of receipt of payments
Child support no longer counts when child reaches
mid-teens.
Stable Monthly Income
Maintenance, alimony, child support
Applicants may not want to list these as sources of
income if ex-spouse is hostile or uncooperative.
Equal Credit Opportunity Act prohibits lenders
from asking if applicants are divorced or
requiring them to disclose alimony or child
support.
Income won’t be counted if not listed, of course.
Stable Monthly Income
Public assistance
Equal Credit Opportunity Act also prohibits lenders
from discriminating against an applicant because
part or all of his income is from a public assistance
program.
But public assistance won’t count if eligibility
will terminate in near future.
Stable Monthly Income
Unacceptable types of income
These usually don’t count as stable monthly income:
 Wages from temporary job
 Unemployment compensation
 Contributions from family members
Stable Monthly Income
Temporary employment
Income from temporary work not durable by
definition.
But steady series of temporary jobs may be
treated as freelance work (self-employment
income).
Stable Monthly Income
Unemployment compensation
Unemployment benefits end after a specified
number of weeks (ordinarily 26 weeks).
But unemployment benefits paid to seasonal
worker for a certain number of weeks every
year could be considered stable monthly
income.
Stable Monthly Income
Income from family members
Usually only earnings of head of household are
counted in underwriting.
But if borrower’s family member is listed as a
co-borrower, that person’s income is also
considered.
Calculating Stable Monthly Income
Monthly figures
All income payments must be converted into
monthly figures.
Example:
Gwen is paid $14.50/hour. She works 40
hours per week.
$14.50 × 40 = $580
$580 × 52 = $30,160
$30,160 ÷ 12 = $2,513
Calculating Stable Monthly Income
Gross income
Gross income figures are used when calculating
stable monthly income.
Payroll taxes aren’t subtracted.
Calculating Stable Monthly Income
Gross income
Gross income figures are used when calculating
stable monthly income.
Payroll taxes aren’t subtracted.
Qualifying standards take into account that:
buyer will have to pay taxes, and
only after-tax amount will be available
for expenses.
Calculating Stable Monthly Income
Nontaxable income
Certain types of income are exempt from taxation:
 Child support
 Disability payments
 Some public assistance
Full amount of payments available for expenses.
Calculating Stable Monthly Income
Nontaxable income
Certain types of income are exempt from taxation:
 Child support
 Disability payments
 Some public assistance
Full amount of payments available for expenses.
Underwriter may “gross up” nontaxable income.
For example, might add 25% to
child support payments received.
Income Analysis
Income ratios
To measure adequacy of applicant’s monthly
income, underwriters use income ratios.
Rationale:
Borrower may have difficulty making payments if:
Monthly Expenses > X% of Monthly Income
Income Analysis
Income ratios
Two types of income ratios:
Debt to income ratio
Measures proposed monthly mortgage
payment and any other regular debt
payments against monthly income.
Income Ratios
Two types of ratios
Two types of income ratios:
Debt to income ratio
Measures proposed monthly mortgage
payment and any other regular debt
payments against monthly income.
Housing expense to income ratio
Measures monthly mortgage payment
alone against monthly income.
Income Ratios
PITI
Proposed monthly mortgage payment used in
calculating income ratios is PITI payment.
Includes impounds for property taxes and
hazard insurance.
Also mortgage insurance and/or
homeowners association dues, if
applicable.
Income Ratios
Maximum ratios
Qualifying standards set maximum income ratios.
Example: Borrower’s monthly housing
expense should not exceed 31% of
stable monthly income.
Income Ratios
Maximum ratios
Qualifying standards set maximum income ratios.
Example: Borrower’s monthly housing
expense should not exceed 31% of
stable monthly income.
Maximum ratios are generally treated as guidelines,
not hard-and-fast limits.
Lender may approve loan if sufficient
compensating factors make up for
weakness in income.
Income Analysis
Cosigners
Cosigner helps borrower qualify by sharing
responsibility for loan.
Primary borrower and cosigner have joint and
several liability for loan.
Court can order either one of them to pay
loan balance.
Income Analysis
Cosigners
Cosigner must have acceptable income, assets,
and credit reputation.
Income Analysis
Cosigners
Cosigner must have acceptable income, assets,
and credit reputation.
Cosigner’s stable monthly income added
to applicant’s.
Cosigner’s monthly debts and housing expense
combined with applicant’s.
Then income ratios are calculated.
Income Analysis
Cosigners
Cosigner must have acceptable income, assets,
and credit reputation.
Cosigner’s stable monthly income added
to applicant’s.
Cosigner’s monthly debts and housing expense
combined with applicant’s.
Then income ratios are calculated.
Applicant’s separate income ratios are also
calculated; shouldn’t be too far over
limits.
Summary
Income Analysis
Quantity, quality, and durability of income
Stable monthly income
Income ratios
Debt to income ratio
Housing expense to income ratio
Cosigner
Joint and several liability
Evaluating Creditworthiness
Net worth
Net Worth = Assets – Liabilities
Evaluating Creditworthiness
Net worth
Net Worth = Assets – Liabilities
Significance of net worth in underwriting:
Substantial net worth indicates ability
to manage financial affairs.
Evaluating Creditworthiness
Net worth
Net Worth = Assets – Liabilities
Significance of net worth in underwriting:
Substantial net worth indicates ability
to manage financial affairs.
Also, buyer must have enough liquid
assets to close transaction.
Net Worth
Funds for closing
Liquid assets: cash and assets that can be easily
converted into cash.
Applicant must have enough to cover:
 downpayment
 closing costs
Net Worth
Reserves
Also, desirable for buyer to have reserves left over
after closing.
In case of financial emergency, can draw on
reserves to keep paying mortgage.
Net Worth
Reserves
Also, desirable for buyer to have reserves left over
after closing.
In case of financial emergency, can draw on
reserves to keep paying mortgage.
In some cases, lender may require applicant to
have enough reserves to cover a certain
number of mortgage payments.
Net Worth
Reserves
Also, desirable for buyer to have reserves left over
after closing.
In case of financial emergency, can draw on
reserves to keep paying mortgage.
In some cases, lender may require applicant to
have enough reserves to cover a certain
number of mortgage payments.
Even if not required, reserves strengthen
application.
Net Worth
Assets
Almost any assets may help a loan applicant:
 real estate
 automobiles
 furniture
 jewelry
 stocks/bonds
 life insurance policy
Assets
Bank accounts
To verify funds applicant has in bank accounts:
verification of deposit form sent to bank(s), or
applicant provides bank statements for 2 or 3
months.
Assets
Bank accounts
Reviewing verification information:
Does it match statements in loan application?
Does applicant have enough cash for closing?
Has bank account been opened only recently
(last 3 months)?
Is present balance much higher than average
balance?
If account is supposed to be source of good
faith deposit, is balance high enough?
Assets
Bank accounts
Underwriter’s concern: Did applicant borrow funds?
Lenders generally want borrower to use own
funds for downpayment and reserves.
Assets
Bank accounts
Underwriter’s concern: Did applicant borrow funds?
Lenders generally want borrower to use own
funds for downpayment and reserves.
Borrowed funds would defeat purpose of
lender’s requirements.
Assets
Bank accounts
Underwriter’s concern: Did applicant borrow funds?
Lenders generally want borrower to use own
funds for downpayment and reserves.
Borrowed funds would defeat purpose of
lender’s requirements.
Exception: loan secured by asset (other
than home being purchased)
Assets
Bank accounts
Underwriter’s concern: Did applicant borrow funds?
Lenders generally want borrower to use own
funds for downpayment and reserves.
Borrowed funds would defeat purpose of
lender’s requirements.
Exception: loan secured by asset (other
than home being purchased)
Affordable housing programs more
flexible about borrowed funds.
Assets
Real estate for sale
If applicant selling another property to raise cash,
net equity in property can count as liquid asset.
Net Equity =
Market Value – (Liens + Selling Expenses)
Assets
Real estate for sale
If equity is main source of money for purchase of
new home, lender won’t fund loan until old home
sold.
Copy of settlement statement usually
required as verification.
Assets
Real estate for sale
If equity is main source of money for purchase of
new home, lender won’t fund loan until old home
sold.
Copy of settlement statement usually
required as verification.
If new home ready to close before old home
sold, buyers may apply for swing loan.
Assets
Other real estate
Some applicants own real estate they aren’t
planning on selling.
Should be listed as asset in loan application.
But only equity contributes to net worth.
Net Worth
Liabilities
Applicant’s personal liabilities are subtracted from
total value of assets to calculate net worth.
Liabilities include:
 credit card and charge account balances
 installment debts
 taxes owed
 liens against real estate owned
Net Worth
Gift funds
Rules regarding gift funds usually limit how much of
downpayment and closing costs may be covered by
gift funds.
Borrower must invest some of her own
funds.
Net Worth
Gift funds
Rules regarding gift funds usually limit how much of
downpayment and closing costs may be covered by
gift funds.
Borrower must invest some of her own
funds.
Donor must sign letter stating that the gift
funds don’t have to be repaid.
Funds must be deposited into
applicant’s bank account for
verification.
Other Factors in Underwriting
Loan type
Type of loan (fixed-rate, adjustable-rate, partially
amortized, etc.) affects underwriting.
Borrowers default more on ARMs and other
loans that involve changes in payment amount.
Other Factors in Underwriting
Repayment period
Length of repayment period affects size of monthly
payment.
Shorter repayment period, larger payment.
More difficult to qualify for larger payment.
Other Factors in Underwriting
Repayment period
Length of repayment period affects size of monthly
payment.
Shorter repayment period, larger payment.
More difficult to qualify for larger payment.
But lender may be slightly more inclined to
approve loan with shorter repayment period.
Lender’s funds are tied up for less time.
Other Factors in Underwriting
Owner-occupancy
Investor loans have much higher default rate than
loans to owner-occupants.
Because of additional risk, investor loans are
subject to stricter LTV requirements, additional
fees, and higher interest rates.
Other Factors in Underwriting
Property type
Regular single-family homes appreciate much
more, and more reliably, than:
 manufactured homes
 condominium units
 some other types of residential property
Nontraditional property type is treated as additional
risk factor in underwriting.
Summary
Net Worth and Other Factors
Liquid assets
Reserves
Assets
Liabilities
Net equity
Swing loan
Gift funds
Owner-occupant
Investor loan