For most buyers, obtaining financing is the key to obtaining the home that they want. In order to determine whether they will consider issuing a loan, lenders look to the income and financial condition of the borrower as well as the value of the underlying property which secures the loan. Lenders want to make sure that the income stream of the buyer is sufficient to satisfy the loan as well as other financial obligations and also that the value of the property is sufficient to secure the loan.
If financing is going to be needed, a lender should be contacted prior to getting serious about purchasing a particular property and a pre-approval letter obtained.- The pre-approval letter indicates the amount the lender is willing to lend for a qualified property and that amount, plus the down payment sets the budget for the buyer.
A mortgage loan is consists of two parts, a Promissory Note which contains details of the loan and a mortgage document that encumbers the property legally until the note is fully paid off.
If the promissory note comes into default (as defined in the note) during the time it is active, the lender has the right to foreclose (repossess) the property and ultimately sell it to obtain funds to pay off the note. States differ in the specifics of how mortgages are foreclosed. In Florida, a foreclosure is a judicial process that involves the courts. In some other states, a Deed of Trust is executed to one or more Trustees who are empowered to sell the property if the loan is in default.
Lender requirements:
Lenders are looking for a stable income, a good credit history and a down payment, typically between 5-20 percent of the purchase price for a conventional, conforming mortgage, i.e., one that can be sold on the secondary market.
Lenders will also want documentation verifying the borrower’s income (W-2 forms, tax returns, employment), credit history and assets (such as bank statements to verify savings). Lenders are also going to look at the credit history and credit score as part of the decision-making process. Under Federal law, individuals are entitled to receive a free copy of their credit report from each of the national reporting agencies (Equifax, Experian and TransUnion) once a year. These reports are available at https://www.annualcreditreport.com/index.action. Some people pull each report once a year while others get one of the three each four months as a better way of tracking changes. There is some additional information on credit scores in the Advise for Buyers section of this website. There are a variety of different credit scores calculated and used by lenders. Some are available at no charge while others may require subscription to a paid service. Discover Card, for example, offers one of the FICO scores at no charge to their card members. Lenders will, of course, have access to the scores that they use for their decisions and should discuss this with the borrowers.
Late payments, judgments and other unpaid bills can lead to a lower credit score. If there is a legitimate dispute, each of the credit reporting agencies provides a mechanism to dispute erroneous entries. These days, an inferior credit report may result in a higher interest rate being charged or credit being denied altogether so investing the effort to clean up a marginal credit report will typically pay off.
There are various types of loans which have Federal government participation. The Federal Housing Administration (FHA) insures home loans meeting its criteria. The Veterans Administration (VA) guarantees loans for qualified veterans. Lesser known are Rural Development loans offered by the United States Department of Agriculture (USDA). Loans that aren’t issued under one of these programs are conventional loans but most conventional loans follow criteria set up by Fannie Mae and Freddie Mac, two government-chartered corporations that purchase and resell mortgage loans that conform to their criteria.
In determining how large a payment can be afforded, lenders typically use two formulas.
The Housing Expense Ratio (HER) is calculated by taking the projected monthly housing expense including principal, interest, property taxes and hazard insurance (PITI) divided by the applications monthly gross income (MGI).
HER = PITI / MGI
The Total Obligation Ratio (TOR) uses total monthly obligations (TMO). TMO includes monthly expenses reported on credit reports such as car payments, credit card payments, student loan payments and child support payments in addition to the PITI figure mentioned above. The TMO figure is divided by the same MGI figure as above.
TOR = TMO / MGI
FHA loans calculate an allowable payment as up to 31% (.31) for HER and 41% for TOR. The VA uses a TOR limit of 41% along with a Table of Residual Incomes which is calculated by region. Conventional loans marketable by Fannie Mae and Freddie Mac use their own similar criteria.
Lenders and loan types:
It is often a good idea to start with the bank or credit union that you already do business with. They will have some familiarity with your account and they may have special programs for existing customers. Of course, other banks or credit unions also offer loans as well as Internet lenders. Mortgage bankers are institutions that underwrite and issue loans while mortgage brokers work with borrowers and place loans with a mortgage banker. These days, most loans can and are sold in a secondary market. There is also a distinction between the owner of the note and the organization that services the loan, i.e., collects payments and issues statements.
The time over which the payments will fully pay the principal due on the loan is termed the amortization period. Most commercial lenders issue loans that are fully amortized, that is, the loan principle is fully paid over the life of the note. Private lenders, on the other hand, often offer shorter term “balloon” notes where the remaining principle is due and payment at a certain time. For example, a loan that is amortized over 20 years but due and payable in 5 is a balloon note. Some principle payments will be made during the term of the loan but the remaining balance (a large part of the original loan amount) will have to be paid in cash in 5 years of another loan obtained.
There are a variety of loan programs offered and the offerings have changed over time. Most common are fixed term, fixed rate loans. There are typically offered over a period of 15 or 30 years. The payment for a 15 year loan is a bit higher but the total amount paid in interest over the life of the loan is significantly less. Another option is an Adjustable Rate Mortgage (ARM). An ARM typically starts with a fixed rate for a period of time and then the rate changes based on a specified interest rate index. Changes can be annually and the loans sometimes limit the lifetime changes up or down. With interest rates fairly low now, ARMs are not as common as they once were. But it is important to get some idea of what the interest rate would be based on current conditions and the stated index. In theory, a low introductory rate can enable someone to buy a more expensive property but care needs to be taken that the potential increase in future payments is not excessive.
In previous years, some ARM loans were issued with low introductory rates such that the principle loan balance actually increased during the first part of the loan (before interest rate adjustment). If the buyer was unable to refinance within the initial period (typically 18 months), the interest rate would skyrocket, making payments unaffordable. Those negative amortization loans are no longer commonly offered.
Comparing loans of different types from different source is not a simple process. Each loan will always have a specified Annual Percentage Rate (APR) which is a rough-cut way of comparing loans. The APR will include stated interest but will also be adjusted for the effect of discount points and certain bank fees. Discount points have not been common in the past several years but are ciarged against the loan when issued in order to generate a higher return for the bank. Each discount point is 1% of the value of the loan. For example, if you have a $50,000 loan with 1 discount point, you will only receive $49,500 but will pay back the full $50,000. Discount fees are included in the APR calculation which is good. But some fees that a lender might require are not included in an APR. It is important to understand what fees are being charged, are required, e.g., survey, appraisal, etc. and which fees are included and not included in the stated APR.
Pre-approval:
Thinking back to the first part of this article, recall that the lenders are looking into both personal financial status and the value of the underlying property securing the note.
A pre-approval is the lender’s estimate of the principle balance that the borrower can handle given their current financial situation and assuming a property that appraises for the amount of the loan. Getting a preapproval is an important step for most home buyers these days. Purchase contracts for properties that have a financing contingency are less attractive to sellers than those that don’t. But if a financing contingency is present, providing a copy of a pre-approval letter can help convince a seller that the contract is not likely to drop out due to inability to meet a financing contingency.
A pre-approval letter will typically be issued for a specific period of time and will typically note that it is dependent upon no significant changes in the borrower’s financial situation, e.g., adding new financial obligations, and require that the property being financed meet the lender’s specification.
The Purchase and Closing
The more intense work begins once a property is selected and a contract negotiated. Contracts that include a financing contingency typically impose specific deadlines on buyers to apply for financing. If these deadlines are not met, the contract can be terminated by the sellers and the deposit forfeited. For buyers with a pre-approval letter, a fair amount of the work has already been done.