After successfully completing this topic, you will be able to explain the process of qualifying for a loan and how to calculate qualifying ratios.
Determining the customer’s real property needs and economic capabilities is called qualifying.
FHA, VA, and conventional lenders all use the Uniform Residential Loan Application.
Lenders are most interested in the
• quantity and quality of a borrower’s income (ability to pay),
• credit score (willingness to pay), and
• other assets of value.
Quantity and quality of a borrower’s income—The lender wants to know first about the quantity of the borrower’s income so the appropriate qualifying ratios can be calculated. The quantity alone is not enough for a complete evaluation, however. The lender also wants some certainty that the gross income is likely to continue—that the borrower has been in the same line of work for a reasonable period. If the borrower’s income comes from commissions or other transactional sources, the lender will want to see at least two years of the income.
Credit Score—The lender will order a credit report that will show the borrower’s payment history and credit score. Credit scoring uses statistical samples to predict how likely it is that a borrower will pay back a loan. Credit scores disregard demographic or cultural differences.
Most mortgage lenders use the FICO score, developed by the Fair Isaac Corporation. FICO scores range from 400 to 900. Low scores predict that the borrower is more likely to default on a loan.
A person’s FICO score consists of the following components:
• Payment history is the most important component. Recent payment history is weighted a bit more heavily.
• Debt utilization is the second most important. It is the percentage of debt outstanding to the total available credit limit.
• Credit history shows how long the borrower has been a credit user—the longer the better.
• Recent credit searches shows whether the borrower has been getting loans or credit lines in the past months.
• Types of credit shows the mix of credit held, including installment loans (like car loans), leases, mortgages, or credit cards.
Other Assets—This study indicates whether the borrower has the necessary funds to close the transaction. A large cash reserve is very helpful.
Conventional lenders do not use a housing expense ratio nor a total obligations ratio. Conventional lenders use a debt-to-income ratio to evaluate the borrower’s ability to make the payments. Most lenders want this ratio to be 43% or lower. The ratio is calculated as follows:
|(Proposed housing payment + Monthly liabilities) ÷ Gross monthly income = Debt to Income Ratio|
The lender will order an appraisal for the property that will show the estimate of value as well as the condition of the property. The lender will check the loan-to-value ratio of the property to determine that the loan will not be higher than the maximum LTV.
The loan will be contingent on a title inspection to show that the seller has marketable title to the property and that the property will be free of liens and encumbrances at the time title is transferred.
In order to be prequalified, a borrower contacts a lender in person or by phone and answers questions posed by the lender relating to income and debt. If the answers seem to meet the loan requirements, the lender will issue a prequalification letter to the borrower. The borrower may submit this letter with offers on properties.
A much stronger letter is a preapproval letter. Preapproval indicates that the lender has not only gotten information from the borrower, but has ordered a credit report and has verified the borrower’s income and assets. The preapproval letter shows the loan amount the borrower is approved to obtain and is effective for 120 days.
You can find out more about FICO credit scores in this optional video.