HOW DO YOU LOOK TO A LENDER?

Looking at six factors, through the eyes of a lender, helps you see yourself better in terms of your credit worthiness.

A combination of factors is evaluated before a mortgage loan can be approved and funded. They include: collateral, credit (or character), capacity, commitment, capital (or cash) reserves, and compensating factors. We call these factors collectively “The Six C’s” of mortgage financing. The following is an outline of how these six factors shape a lender’s decision making process of whether or not to extend mortgage credit.

 1. Collateral

What is your property worth? What is the condition of your property?

In mortgage lending, the collateral is the condition and value of the property you are borrowing against. The loan amount, equaling a percentage of the value of the property, is expressed as the Loan-to-Value ratio (or LTV). For example, a loan in the amount of $80,000 secured against a property with a market value of $100,000 would have an LTV of 80%. Sometimes, such as in refinance transactions where the borrower will not be bringing in any cash at closing, the LTV is paramount and serves not only as a representation of collateral, but can also reflect a borrower’s commitment to the new loan by indicating the amount of equity as risk.

There are certain types of property, and property in poor condition, that a lender may not want to accept as collateral to secure a loan. To determine the suitability of the collateral, and that it meets a lender’s criteria, an appraisal by an approved appraiser is required. This appraisal will give a lender all the information needed to ensure that the property being financed is an acceptable form of collateral.

2. Credit (or Character)

How trustworthy are you? How prompt are you at paying your credit obligations?  Have you demonstrated a willingness to pay your obligations as agreed?

Your credit report is a snapshot revealing the way you have paid your debts in the past and is considered a good indication of your willingness to pay your debts in the future. If you have a history of not making your payments on time, it is considered likely that you won’t pay a new lender on time either. Likewise, if you have a history of collections, judgments, charge offs, bankruptcy, or foreclosure, a new lender considers it a significant risk that similar behavior may be expected in the future. The converse is also true. If you have a history of making your payments on time, and repaying your debts as agreed, a lender will probably conclude that this will continue and that the risk of a new loan not being repaid is minimal.

Most loan originations involve the use of credit scores. Although there are several types and models of credit scores available to lenders, the most common is available from Fair Isaac and Company and has become known as the FICO Score. Under the FICO model scores can range from 400 to over 800 and are based on the following factors:

▪     35% of the score is based on payment history.

▪     30% of the score is based on the amount owed.

▪     15% of the score is based on the length of time credit has been established.

▪     20% is based on whether the person is taking on new loans and if they have a “healthy mix of loans”

How does your credit score compare with others? The chart below shows the distribution of FICO scores nationally. Any score above 680 is considered to be “A” credit. Those from 620 to 679 are “A-” credit. Below 620 is considered to be “Sub-Prime” credit.

3. Capacity

Will you be able to meet your credit obligations now and in the future?  Is there a good probability that your income will continue?

Your ability to repay a new loan is something the lender must consider. This ability (or capacity) stems from a combination of factors, such as the amount of existing debt, the amount of residual income remaining each month after all debts are serviced, and the probability that there will be a continuity of income to service debts in the future.

To determine your ability to repay a debt, a lender will first consider your employment stability or job history including the time on your present job and the amount of time you have spent in the same line of work. If you derive income from a source other than employment, that source will also be scrutinized to ensure that there is a good probability that income will continue.

After verifying the sources of income, a lender will determine the amount of monthly income and the total of monthly payments required to service your debt, including the new mortgage payment. Two ratio calculations involving your monthly income will be used. They will determine the mortgage debt ratio which is the percentage of your income that will be required to make the mortgage payment each month; and the total debt ratio which is the percentage of your income that will be required monthly to service all of your debts, including your new mortgage. If 30% of your income will be required to make the payment on a new mortgage loan; and 45% of your monthly income will be required to make the payment for all of your debt, including your new mortgage payment; your debt ratios would be expressed as 30/45.

Many variables contribute to the effect a borrower’s debt ratios will have in credit decisions, but as a general rule, higher debt ratios will be allowed in cases where there is a good credit rating, a stable work history, and a reasonable amount of residual income remaining each month after all of the debts have been serviced. Some loan programs such those allowing “No Doc”, and “No Ratio” qualifying disregard debt ratios altogether in favor of other factors.

4. Commitment

What are you risking?  What motivation will you have to repay the loan as agreed?

As far as the lender is concerned, your commitment is usually demonstrated by having your own money or equity at risk. If you are buying a $100,000 home and put down $20,000 you have made a big commitment and will probably not want walk away from your new obligation. If you are refinancing, this commitment is measured by the amount of equity you are risking. For example, if your home is worth $100,000 and you are borrowing $80,000, the equity remaining in your home is $20,000. The more cash or equity you are willing to risk the more secure the lender will be in your commitment to a new mortgage loan. For loans requiring cash at closing, it is best if the required funds come from the borrower’s own source of funds such as a checking, savings or other cash equivalent account. However, a lender may, in some cases, allow funds for down payment and closing costs to be obtained from a gift, grant, or loan.

Borrowers with excellent credit are thought to have a heightened commitment to repay their obligations. Because of their conscientious attention to credit concerns, their willingness to risk their credit denotes a certain level of commitment in the view of most lenders and can be a deciding factor in credit decisions.

5. Capital (or Cash) in Reserve

How much cash will you have after the loan is funded? Are you financially stable, or are you living from paycheck to paycheck?

The amount of capital you will have left over after a new loan funds will be a factor a lender uses to determine your credit worthiness. Even if you are not required to use your liquid assets as down payment, a lender may prefer that you have assets other than income that could be used to repay the loan if necessary. The availability of liquid assets indicates that you are financially stable. The verification of such reserves is a common requirement by many lenders. In certain instances liquid reserves may be obtained by borrowing against a non-liquid asset or as a gift from a relative.

6. Compensating Factors

If you have weaknesses in some areas, do you have strengths in others to compensate for them?

With a host of lending programs available, a lender may be able to find solutions that overcome deficiencies in your overall ability to qualify. Such programs focus on certain strengths such as employment stability, credit, large down payment, low LTV, notable cash reserves, etc. Even the program guidelines themselves may be stretched to allow for some weakness where there is sufficient strength in other areas. This concept of compensating factors brings a great deal of flexibility to the decision making process and enables a lender to approve more applications.