Introduction to Home Loan Qualifying
An aura of mystery
surrounds the mortgage lending industry. The vocabulary of loan officers
and underwriters is filled with acronyms like "LTV" and "FNMA" while the
payment calculations on a loan is enough to put a look of worry on any
high school algebra student. Compounding it all are the thousand and one
mortgage loan programs that are offered every day. You can get terms of
30 years, 15 years or less. There are fixed rate loans, adjustable rate
loans and combinations of the two. The whole point is that as an
advisor, a counselor, or a consumer, it is up to you to know which are
the right programs for you or for your clients. To help you make an
intelligent decision, this manual summarizes many of the financing
options as well as the pluses and minuses of each. In addition, you will
be informed as to the requirements of each to allow you and your clients
the greatest flexibility of financing options available.
Before deciding which
program best fits your needs, it is important to be able to understand
the basics behind each program. The key to understanding mortgage basics
lies into three areas: 1) What is the loan-to-value ratio? 2) What are
their income ratios? and 3) What is their credit score?
Loan-to-Value Ratios
The loan-to-value ratio
(LTV) is probably the most important of all the ratios when deciding to
approve a mortgage. The lower the LTV ratio the safer the loan is for a
lender. The reason is that the lower the LTV ratio, the higher the
equity investment the borrower will have in the property and thus the
more the borrower has to lose. Stated as a percentage, the LTV
essentially determines the level of risk in the repayment of the loan.
The LTV is calculated as follows:
Mortgage Amount divided by Lesser of Sales Price or Appraised Value =
LTV
LTV’s will vary from
program to program, depending upon other "risks" associated with the
program. Traditionally, guidelines have stated that the LTV should not
be any higher than 75 to 80%. With the advent of mortgage insurance,
LTV’s have been stretched as high as (and in some cases exceed) 95% of
the value of the property.
Income Ratios
Before a loan can be
approved, a mortgage underwriter is concerned with a borrower’s ability
to repay the mortgage debt. The most important test of whether an
applicant can afford a particular loan is by computing the various
income ratios. These ratios, often established by the secondary market,
have evolved through the years after reviewing millions of mortgage
loans and are used as realistic guidelines for making mortgages with a
low risk of default. Underwriters look at two income ratios: 1) the
monthly housing ratio (or front-end ratio, as it is sometimes called)
and 2) the debt-to-income ratio (or back-end ratio).
The monthly housing
ratio is calculated by determining what percentage the proposed mortgage
payment (PITI) would be in relation to the borrower(s) gross monthly
income as follows:
PITI ¸
Gross Monthly Income = Monthly Housing Ratio
PITI is an acronym that
stands for principal, interest, taxes and insurance and includes not
only the monthly principal and interest payment but also the hazard
insurance payment, mortgage insurance payment, flood insurance payment,
homeowner’s association dues and 1/12 of the annual property taxes.
However, individuals
often have other monthly debt obligations in addition to mortgage
payments. The ratio of these combined debts to gross monthly income must
be calculated separately. This ratio is called the debt-to-income ratio
and is calculated by dividing the sum of the PITI payment plus the
minimum monthly debt payments by the gross monthly income. Also stated
as a percentage, calculate it as follows:
(PITI +
Mthly Debt Pmts) ¸ Gross Monthly Income = Debt-to-Income Ratio
Other debt payments
include revolving charges (credit cards, department store cards, etc.),
payments on installment debts that have more than 10 remaining payments
(car loans, student loans, signature loans, etc.) and any alimony and/or
child support payments.
Credit Scoring
In the past 50 years,
American society has been radically altered by the "credit revolution."
Everyone has credit cards, uses credit to buy cars, furniture, clothing,
and even food. No longer are items bought with cash but rather on a line
a credit or some type of financing. How much you are worth is often tied
directly to how much you can borrow. Having a bad credit rating can
hinder your ability to buy, especially in regards to home ownership. Too
much debt can and has trapped people into a life without savings where
they are chained to scrapping by to just make the minimum payments on
their credit cards.
Within the last year or
two, creditors have become increasingly dependent upon credit scoring.
Credit scores (also known as risk scores) are a numerical interpretation
of your credit profile. The score predicts how likely consumers in a
specific score range will repay their debts. Experian, for example, uses
the Fair Isaac Model (FICO) to determine a risk score with a range from
200 to 900. The higher the number, the better the credit history.
With the advent of the
credit scoring revolution, many lenders require borrowers to have
acceptable credit scores to obtain a mortgage. In late 1996, for
example, the Federal National Mortgage Association (Fannie Mae)
instituted minimum acceptable credit scores for all loans they purchase.
Many people who once qualified for a mortgage under Fannie Mae
guidelines now have to turn to alternative sources for financing a home.
This translates into higher interest rates, prepayment penalties for
early retirement of the loan, and a larger down payment on a home
purchase.
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