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The process of determining whether a prospective borrower has the ability to repay
a loan. Qualification Versus Approval: To be approved for a loan, a prospective borrower must
demonstrate both the ability to repay and the willingness to repay. The borrower's willingness to
repay is assessed largely by the applicant's past credit history. Qualified borrowers may ultimately
be turned down because, while they have demonstrated the capacity to repay, a poor credit history
suggests that they may be unwilling to pay. Meeting Income Requirements: Lenders ask two basic
questions about the borrower's ability to pay. First, is the borrower's income large enough to
service the new expenses associated with the loan, plus any existing debt obligations that will
continue in the future? Second, does the borrower have enough cash to meet the upfront cash
requirements of the transaction? The lender must be satisfied on both counts. Expense Ratios: Lenders
assess the adequacy of the borrower's income in terms of two ratios that have become standard in the
trade. The 'housing expense ratio' is the sum of the monthly mortgage payment including mortgage
insurance, property taxes, and hazard insurance, divided by the borrower's monthly income. The 'total
expense ratio' is the same except that the numerator includes the borrower's existing debt service
obligations. For each of their loan programs, lenders set maximums for these ratios, such as, e.g.,
28% and 36%, which the actual ratios must not exceed. Debt Service: The debt service portion of total
expenses includes alimony but not income taxes, which doesn't make a lot of sense. It also does not
include student loans if repayment is deferred for a year or longer, although the underwriter can
elect to include it if the amount involved is very large or the borrower's credit is weak. If there
are co-borrowers, the debts of both must be included. Variations in the Ratios Among Loan Programs:
Maximum expense ratios may vary from one loan program to another. Hence, an applicant only marginally
over the limit may need to do nothing more than find another program with higher maximum ratios.
Variations in Ratios with Other Transaction Characteristics: Within any program, maximum expense
ratios may vary with other characteristics of the transaction. For example, the maximum ratios are
often lower (more restrictive) if the property is two- to four-family, co-op, condominium, second
home, manufactured, or acquired for investment rather than occupancy. On the other hand, if the
applicant makes a down payment larger than the minimum, the maximum expense ratios may be higher.
Applicant's Ability to Get the Maximum Ratios Raised: The
maximum ratios are not carved in stone. The following are illustrative of circumstances where the
limits may be waived: The borrower is just marginally over the housing expense ratio but well below
the total expense ratio 29% and 30%, for example, when the maximums are 28% and 36%. The borrower
has an impeccable credit record. The borrower is a first-time home buyer who has been paying rent
equal to 40% of income for three years and has an unblemished payment record. Reducing Expense Ratios
by Reducing the Term: If expense ratios exceed the maximums, one possible option is to reduce the
mortgage payment by extending the term. If the term is already 30 years, however, there is very
little that can be done. Few lenders offer 40-year loans, and extending the loan to 40 years doesn't
reduce the mortgage payment much anyway. Income Used to Qualify: Lenders disregard income that is
viewed as temporary, such as overtime or bonuses. But sometimes income from such sources can be
expected to continue. The burden of proof is on the applicant to demonstrate this. The best way to do
this is to show that they have in fact persisted over a considerable period in the past. Borrowers
who intend to share their house with another party can also consider making that party a co-borrower.
In such case, the income used in the qualification process would include that of the co-borrower. Of
course, the co-borrower would be equally responsible for repaying the loan. This works best when the
relationship between the borrower and the co-borrower is permanent.
Lenders will not take account of anticipated growth in income, even if it is highly probable, such as
in the case of a physician just out of medical school. They are not going to base a loan on
anticipated income that may or may not materialize. And they will not include income from a job the
borrower is confident of getting but doesn't have. Lenders include investment income, if it can be
documented as relatively stable. This includes income from property, as when a home buyer elects to
rent rather than sell an existing home. The lender in this situation will assume that some part of
rental income (usually 75%) will remain after paying for utilities, maintenance, etc. From this, they
subtract the mortgage payment, taxes, and insurance. If the difference is positive, they add it to
income, but if it is negative, they add it to debt service payments.
Getting Fired Before the Loan Closes: If this happens, the applicant should tell the lender
immediately because the lender will get the bad news anyway when they send out an employment
verification request. If they hadn't been told, they will be annoyed at having their time wasted and
probably won't be as helpful as they might have been otherwise. Being helpful means exploring the
possibility of recasting the loan so that the borrower's income can be disregarded. However, this
could require a substantial increase in down payment or interest rate, which could make the loan
unworkable. Meeting Cash Requirements: More borrowers are limited in the amount they can spend on a
house by the cash requirements than by the income requirements. Cash is needed for the down payment,
and also for points and other fees charged by the lender, title insurance, escrows, and a variety of
other charges. Settlement costs vary from one part of the country to another and, to some degree,
from deal to deal. Down Payment Requirements: Down payment requirements range from 30% to zero and
below in some cases, lenders will lend more than the value of the property. The requirements depend
on the type of program, loan amount, property characteristics, and the borrower's credit rating.
VA-guaranteed loans (available only to veterans) require no down payment on loans up to $203,000.
FHA-insured loans require only 1% down. Loan limits in 2003 ranged from $154,896 to $280,749. On
conventional (non-VA, non-FHA) prime loans, the lowest down payment requirement is generally 5% on
loans up to $400,000. It notches up quickly after that and is generally 40% on a $1,000,000 loan.
Some special affordability programs are available from Fannie Mae and Freddie Mac with 3% down. The
loan limit on these in 2003 was $322,700. On sub-prime loans, which carry higher interest rates, some
lenders will advance up to 125% of property value to borrowers with good credit ratings. Down payment
requirements will be higher whenever a transaction has characteristics that lenders view as risky.
The million-dollar loan has a high requirement, for example, because it is secured by an expensive
house that may have unique features that appeal to a limited number of potential buyers and is
therefore subject to much greater price variability than a less expensive house. For similar reasons,
lenders will usually require a larger down payment if the borrower has a poor credit record, is
purchasing a house as an investment rather than for occupancy, wants to refinance for an amount
significantly larger than the existing balance, and so on. Sources of Funds for Down Payment: In
general, lenders prefer that borrowers meet the down payment requirement with funds they have saved.
This indicates that the borrower has the discipline to save, which bodes well for the repayment of
the loan. Other sources of funds may be problematic. Gifts and secured loans are acceptable but only
within limits. On conventional loans having down payments of less than 20% of property value, at
least 5% of the down payment must come from the applicant's own funds. The balance can come from a
gift or a secured loan. With a 20% down payment, the entire amount can come from gifts or secured
loans. Secured loans must be reported as existing debt and the payments on them are included in total
housing expenses. If this total as a percent of income exceeds the lender's guidelines, a secured
loan may not work where a gift would work. Lenders want to be sure that an alleged gift is really a
gift. If it comes from a family member, they may ask that member to sign a gift affidavit. The
concern is that the 'gift' is really an unsecured loan and that if the borrower gets into financial
difficulty, he or she will give first priority to paying off the family member. If the 'gift' is from
the home seller, the concern is that the sale price has been correspondingly inflated. This would
mean that the equity in the property is less than it appears. For this reason, lenders tend to set a
limit on 'gifts' by sellers, which are typically referred to (more accurately) as 'seller
contributions.' Qualifying Self-Employed Borrowers: The system is somewhat more complicated and
onerous for self-employed borrowers, but it does work. The major problem with lending to the
self-employed is documenting an applicant's income to the lender's satisfaction. Applicants with jobs
can provide lenders with pay stubs, and lenders can verify the information by contacting the
employer. With self-employed applicants, there are no third parties to verify such information.
Consequently, lenders fall back on income tax returns, which they typically require for two years.
They feel safe in relying on income tax data because any errors will be in the direction of
understating rather than overstating income. Of course, they don't necessarily feel safe that the
W-2s given them are authentic rather than concocted for the purpose of defrauding them. For this
reason, they will require that the applicant authorize them to obtain copies directly from the IRS.
The support it provides to self-employed loan applicants is an unappreciated benefit of our income
tax system. It may not be fully appreciated, of course, by applicants who have understated their
income. In countries where virtually no one pays income taxes because cheating is endemic, tax
returns are useless for qualifying borrowers.
The second problem with lending to the self-employed is determining the stability of reported income.
For this purpose, the lender wants to see an income statement for the period since the last tax
return and in some cases a current balance sheet for the business. The two government-sponsored
enterprises, Fannie Mae and Freddie Mac, have developed detailed guidelines for qualifying
self-employed borrowers. Lenders looking to sell such loans to the agencies must follow the
guidelines. The problem is that implementation can be complicated and time-consuming, especially when
the declared income comes from a corporation or a partnership. If you own 25% or more, you are
considered as 'self-employed.'
Most lenders offer reduced documentation loans to self-employed applicants who cannot demonstrate two
years of sufficient income from their tax returns. These programs vary from lender to lender, but
they all provide less favorable pricing and/or tougher underwriting requirements of other types.
Lenders invariably require larger down payments and may also require a better credit score or higher
cash reserves. In addition, they may limit the types of properties or types of loans that are