Applying for a Mortgage - Part 2
During the process of chasing your dream of homeownership, a smart consumer would make every effort to gain knowledge and insight into the various aspects of the process. This effort not only involves developing an understanding of the mortgage loan application process, but also recognizing what you can do through preparation to increase the likelihood of a positive outcome. Nothing would be more discouraging than having your dream rejected or postponed due to an issue you could have resolved in advance with a little special attention.
As you know from our last visit, the underwriter makes a recommendation on your application through an evaluation process that attempts to determine the risk involved for the lender. There are two types of risk factors that the underwriter will review to develop the recommendation: credit report factors and non-credit report factors. Previously, we discussed the credit report factors and what an assessment indicating low risk would find displayed on your credit report. Today, we’ll review the non-credit report factors and examine why these factors are also considered important the lender.
Equity is the difference between the value of the home and the amount owed by the homeowner to a lender. Customarily, if your application shows you will be making a large down payment, the lender’s underwriter will associate this with lower risk, as this investment in your home is interpreted to indicate less likelihood that you would default or not pay back the loan. In the future, after purchase, making your payments and maintaining and improving your home’s condition often increases the home value and, as a result, the amount of equity you have in the home.
Loan-to-Value Ratio (or LTV) is the total loan amount divided by the value. For example, if the value of the home you choose to purchase is $80,000 and you get a loan for $64,000 (with a down payment of $16,000), your loan-to-value ratio is 80 percent. A lower LTV may indicate lower risk to the lender and may balance other higher risk factors identified during the underwriting process.
Liquid Reserves are the funds you have remaining after the purchase of your home, such as savings accounts, 401(k) vested amounts, IRAs, net stock value, bonds, or mutual funds. The greater your liquid reserves, the lower perceived risk. The key point of your application preparation is to spotlight saving in your budget. Of course, as a smart consumer, you know that the more you save, the better. An ideal goal is a minimum of 6 months worth of expenses in your liquid reserve accounts.
Debt-to-Income Ratio is determined by dividing your total monthly debt (don’t forget your current housing payment, installment loans and revolving - credit card - minimum payments) by gross (before taxes and other deductions) monthly income. Remember, for some, monthly income would include more than your paycheck. If you choose to include it, your lender may take into account interest earnings, tips, commissions, bonuses, child support, or alimony.
Typically, the lower the ratio, the lower the risk. This is where the discipline you’ve developed in avoiding credit overextension comes into play. Lenders are interested in this calculation to determine what potential financial consequences would be in store for you with loan approval.
Loan Purpose, or “the why” of your mortgage application, will also be considered by the lender. While this may seem obvious, there truly are many different reasons consumers apply for mortgage loans, and just as many levels of risk associated with those reasons. Usually, purchasing a home in which you intend to reside would result in the lowest risk rating, with a refinance of a rental property having highest risk.
** A word about the consolidation loan to payoff other (revolving) debts by refinancing your home: A smart consumer who follows this route, will recognize the necessity of examining financial behaviors in an effort to make better choices and enhance their smart spending habits.
Why? Sixty-eight percent of those who consolidate their debt in this manner are back to the same level of revolving debt within 18 months of the refinance. Now, however, they also have a higher mortgage payment. This is one reason a refinance mortgage is considered higher risk than the original purchase loan.
Loan Type is also a risk consideration. There are three basic types – balloon, fixed-rate, and adjustable-rate. Many mortgage lenders offer products that combine elements from two or all three. The most common type of loan for a mortgage is the fixed-rate mortgage. As you would expect from the name, the interest rate charged on this type of mortgage remains the same for the life of the loan.
The balloon mortgage is usually set with a fixed-rate for a short term (7 to 10 years), at which time the remaining balance of the loan would be due in a lump sum. Some folks choose this type intending to refinance or sell the home prior to the time the ‘balloon’ payoff payment is due.
The adjustable-rate mortgage or ARM will also, ordinarily, begin with a fixed-rate for a period of time (5 to 10 years). After that, at specified intervals, the rate would be reviewed and adjusted (up or down) as conditions modify in financial markets. ARMs will often have limits on the breadth of adjustments at each interval as well as overall for the loan. As the rate changes, the monthly payment of the loan is increased or decreased accordingly. Mortgage lenders are increasingly offering adjustable-rate mortgage products to consumers.
It is important to note that, although balloon and ARMs routinely offer lower rates initially than the fixed variety mortgage, statistics show that the more frequent the rate adjustment intervals are, the greater the default risk.
Loan Term for most mortgage loans is the standard 30 years, or 360 months. Shorter terms are available, and while the monthly payment may be higher, these loans can work to more quickly build equity and save thousands in interest charges over a longer-term loan. If you were thinking a shorter-term loan would be considered lower risk, you are correct. (Lender’s thinking? Shorter-term means less time for something to go wrong.)
Credit Advisors hopes that awareness of the factors assessed during the underwriting process will assist you in preparing to fulfill your dream of homeownership. The time and attention you take now in examining your position in relation to the various credit report and non-credit report factors will undoubtedly pay dividends to your efforts. If at any time you need assistance in your application preparation please contact one of the Credit Advisors certified housing counselors for additional information. After all, accomplishing your vision of becoming a homeowner will most likely be the most important financial transaction of your life.
credit advisors | foundation