© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 8: Qualifying the Buyer.

© 2012 Rockwell Publishing

Financing Residential Real Estate

Lesson 8:

Qualifying the Buyer


Introduction

This lesson will cover: underwriting processautomated underwritingcredit reports and credit scoresincome analysisnet worthother factors in underwritingsubprime lendingrisk-based loan pricing


Introduction

Loan underwriting is evaluation of: Loan applicant’s overall financial

situation. Is buyer likely to make payments

on time? Value of the property (collateral).

If buyer defaults, will foreclosure sale proceeds cover debt?


Underwriting Process

Underwriting involves:reviewing loan applicationobtaining additional information about

applicantverifying applicant informationapplying lender’s qualifying standardsevaluating property appraisalmaking recommendation



Qualifying standards: minimum standards used in underwriting.

Draw line between acceptable and unacceptable risks.

Qualifying standards



Most lenders use Fannie Mae/Freddie Mac standards for conventional loans.

FHA and VA standards must be used for FHA and VA loans.

Qualifying standards



Automated underwriting system (AUS): computer program that analyzes loan applications.

Used in conjunction with traditionalunderwriting.

Traditional underwriting now called manual underwriting.

Automated underwriting


Automated Underwriting

Most widely used AU systems:Desktop Underwriter® (Fannie Mae)Loan Prospector® (Freddie Mac)

Either may be used to underwrite conventional, FHA, or VA loans.

Fannie Mae/Freddie Mac will still buy manually underwritten loans.

AU and secondary market



Programming of secondary market agency AU systems based on performance of millions of loans.

Loan performance: whether payments are made as agreed.

Analysis of performance statistics highlights factors that make default either more likely or less likely.

AU programming



Information from loan application entered into AU system.

AU obtains applicant’s credit information from credit reporting agencies.

AU issues report with recommendations.

How AU works



Three main categories of recommendations in AU report:

risk classificationlevel of documentationproperty appraisal or inspection

How AU works


AU Recommendations

AU report indicates level of scrutiny that application should receive.

Approve/Accept: meets all qualifying standards.

Approve/Ineligible: meets credit risk standards, but ineligible for purchase by agency for other reasons.

Refer/Caution: doesn’t meet all standards, should be reviewed.

Risk classification


AU Recommendations

If further review required, underwriter uses traditional method (manual underwriting).

Some lenders reject Refer/Caution loans without further review.

Fannie Mae/Freddie Mac may buy manually underwritten Refer/Caution loan, but will treat as A-minus loan.

Risk classification


AU Recommendations

AU report indicates documentation level needed to verify information on application.

Before mortgage crisis, three basic levels:standardstreamlined (“low-doc”)minimal (“no doc” )

Now just standard or streamlined; “no doc” loans not available.

Level of documentation


AU Recommendations

Refer/Caution loans:standard documentation (and manual

underwriting) generally required

Approve/Accept loans:streamlined documentation permitted

Level of documentation


AU Recommendations

AU report also indicates which of these is appropriate:

full appraisaldrive-by inspectionreport on property’s likely value (no

inspection)

Appraisal recommendation



Advantages of automated underwriting over manual underwriting:

streamlines processincreases objectivityimproves underwriting accuracy

Advantages of AU


SummaryUnderwriting Process

• Underwriting standards

• Automated underwriting

• Manual underwriting

• Risk classification

• Standard documentation

• Streamlined documentation (low-doc)

• Minimal documentation (no doc)

• Drive-by inspection


Evaluating Creditworthiness

Qualification of buyer involves evaluation of three main components of creditworthiness:

credit reputationincomenet worth (assets)



To evaluate applicant’s credit reputation, lender relies on credit reports prepared by 3 national credit rating agencies:

EquifaxExperian (formerly TRW)TransUnion

All are private companies.

Credit reputation


Credit Reputation

Personal credit report covers 7 years of information about individual’s:

revolving credit accountsinstallment debtsprevious mortgages

Credit reports


Credit Reputation

Credit information important in underwriting:length of credit historypayment recordderogatory credit incidentscredit scores

Credit reports


Credit Reputation

“Credit history” widely used as synonym for “credit reputation.” Narrower definition used in underwriting.

Credit history: duration of applicant’s experience with credit.

Length of credit history


Credit Reputation

General requirements:credit history at least one year in durationwith three or more active accounts

Length of credit history


Credit Reputation

For each account, credit report gives detailed payment record.

Underwriters view chronic late payments as sign of irresponsibility, overextended finances.

Late payments shown as 30, 60, or 90 days overdue.

Payment record


Credit Reputation

Negative information on credit report may include:

charge-offscollectionsrepossessionsjudgmentsforeclosuresbankruptcies

Major derogatory incidents


Credit Reputation

Charge-off: uncollected debt treated as loss for creditor’s tax purposes.

Collections: creditor may turn delinquent bill over to collection agency that presses debtor for payment.



Credit Reputation

Repossessions: if personal property purchased on credit and payments delinquent, creditor may repossess collateral property.

Judgments: when someone loses lawsuit, court may order her to pay money (damages) to person who sued.



Credit Reputation

Foreclosures: foreclosure on applicant’s credit report is matter of special concern to mortgage lender.

Bankruptcy: bankruptcy on applicant’s credit report also taken very seriously.



Credit Reputation

Fair Credit Reporting Act limits time derogatory incidents can remain on record to 7 years.

Exception: Bankruptcy – 10 years



Credit Reputation

Credit score: figure calculated by credit reporting agency using established scoring model.

Evaluates all information on credit report.Indicates individual’s likelihood of default.Three main reporting agencies may have

different scores for same person.

Credit scores


Credit Reputation

Scoring models based on statistical analysis of large numbers of mortgages.

Most widely used: FICO® scores.Range from under 400 to over 800.

Credit scores


Credit Reputation

Underwriters use credit scores to determine level of review applied to applicant’s credit history.

Good scores: basic review.Mediocre or poor scores: in-depth review.

Credit scores


Credit Reputation

Buyers should look at their credit reports before applying for mortgage.

Some information may be incorrect.Fair Credit Reporting Act requires

agencies to investigate complaints, correct errors.

Obtaining credit information


Credit Reputation

Letter to lender explaining negative credit report should:

state reason for problemshow problem no longer existshighlight good credit before and sinceprovide documentation from third partiesnot blame creditors

Explaining credit problems


SummaryCredit Reputation

• Creditworthiness

• Credit report

• Credit history

• Charge-offs

• Collections

• Foreclosure

• Bankruptcy

• Credit scores (FICO® scores)

• Fair Credit Reporting Act



Income is second main component of creditworthiness.

Buyer who can’t afford payments won’t be approved for loan regardless of credit reputation.

Buyer’s income is starting point in determining loan amount, price range.

Income analysis


Income Analysis

Quantity: enough monthly income to affordmonthly mortgage payment.

Quality: from dependable sources.

Durability: likely to continue for at least 3 years.

3 characteristics of income


Income Analysis

wages or salarybonusescommissionsovertimeself-employment

income

retirement incomealimonychild supportpublic assistance investment

income

Stable monthly income

Stable monthly income: meets tests of quality and durability. May include:


Stable Monthly Income

Permanent employment: main income source for most buyers.

Positive employment history:consistency (2+ years in same job or

field)opportunities for advancementspecial training or education

Employment income



Commissions, overtime and bonuses: considered stable if consistent part of

applicant’s overall earnings pattern

Seasonal work:considered stable if established earnings

pattern exists

Employment income



Self-employment income:includes income from personal business,

freelance work, or consulting workgenerally regarded as risky income

sourceamount of income unpredictablesmall businesses often fail

Employment income



Employment verification:verification form sent to employer, orW-2 forms and/or tax returns for 2 years

plus pay stubs for 30 days, with phone call to employer

Employment income



Pension and social security payments are usually dependable and durable.

Lenders can’t discriminate on basis of age.

Life expectancy can be considered.

Retirement income



Dividends or interest may be counted as part of stable monthly income.

Underwriter calculates average investment income for previous two years.

Investment income



Whether considered stable depends on many factors, including past reliability of payments. Lenders usually require:

copy of court decreeproof of receipt of payments

Child support no longer counts when child reaches mid-teens.

Maintenance, alimony, child support



Equal Credit Opportunity Act prohibits lenders from discriminating against applicant because income is from public assistance program.

But income won’t count if eligibility terminates in near future.

Public assistance



These usually don’t count as stable monthly income:

wages from temporary jobunemployment compensationcontributions from family members

Unacceptable types of income


Calculating Income

All income payments must be converted into monthly figures.

Gross income figures used when calculating stable monthly income.

Payroll taxes not subtracted.Qualifying standards take this into

account.

Stable monthly income


Calculating Income

Certain types of income exempt from taxation:child supportdisability, public assistance

Full amount of payments available for expenses, so underwriter will “gross up” this income.

Nontaxable income


Income Analysis

To measure adequacy of applicant’s monthly income, underwriters use income ratios.

Borrower will have difficulty making payments if:

Monthly Expenses > X% of Monthly Income

Income ratios


Income Ratios

Debt to income ratio: measures proposed mortgage payment plus other regular debt payments against monthly income.

Housing expense to income ratio: measures monthly mortgage payment alone against monthly income.

Two types of ratios


Income Ratios

Proposed monthly mortgage payment used in calculating income ratios is PITI payment.

Includes impounds for property taxes, assessments, hazard insurance.

Also mortgage insurance and/or homeowners association dues, if applicable.

PITI


Income Ratios

Qualifying standards set maximum income ratios.

Ratios generally treated as guidelines, not hard-and-fast limits.

Lender may approve loan if sufficient compensating factors make up forweakness in income.

Maximum ratios


Income Analysis

Cosigner: helps borrower qualify by sharing responsibility for loan.

Must have acceptable income, assets, and credit reputation.

Primary borrower and cosigner have joint and several liability for loan.

Cosigners


SummaryIncome Analysis

• Quantity, quality, and durability of income

• Stable monthly income• Income ratios• Debt to income ratio• Housing expense to income

ratio• Cosigner• Joint and several liability



Net worth: assets minus liabilities.Substantial net worth indicates ability

to manage financial affairs.Buyer must also have enough liquid

assets to close transaction.

Net worth


Net Worth

Liquid assets: cash and assets that can be easily converted into cash.

Applicant must have enough to cover:downpaymentclosing costs

Funds for closing


Net Worth

Best for buyer to have reserves left over after closing.

Certain number of mortgage payments worth of reserves sometimes required by lender.

Even if not required, reserves strengthen application.

Reserves


Net Worth

Most assets will help loan applicant: real estateautomobilesfurniturejewelrystocks/bondslife insurance policy

Assets


Assets

Verification of applicant’s funds in bank account:

Do amounts match statements in loan application?

Does applicant have enough cash for closing?

Has account been opened only recently?Is present balance much higher than

average balance?

Bank accounts


Assets

Underwriter’s concern: did applicant borrow funds?

Lenders want borrower to use own funds for downpayment, reserves.

Borrowed funds would defeat purpose of lender’s requirements.

Affordable housing programs more flexible about borrowed funds.

Bank accounts


Assets

If applicant selling another property to raise cash, net equity counts as liquid asset.

Net Equity = Market Value – (Liens + Selling Expenses)

If equity main source of money for purchase, lender won’t fund loan until old home sold.

Buyer may apply for swing loan.

Real estate for sale


Net Worth

Applicant’s personal liabilities subtracted from total value of assets to calculate net worth.

Liabilities include:credit card account balancesinstallment debtstaxes owedliens against real estate owned

Liabilities


Net Worth

Rules limit how much of downpayment and closing costs may be covered by gift funds.

Borrower must invest some of own funds.

Donor must sign letter stating that funds need not be repaid.

May be transferred to closing agent or deposited into applicant’s bank account prior to closing.

Gift funds


Other Factors in Underwriting

Type of loan affects underwriting.Borrowers default more often on ARMs

and other loans with changing payment amount.

Loan type



Repayment period affects size of monthly payment.

Shorter repayment period, larger payment, harder to qualify.

But lender more inclined to approve loan with shorter repayment period.

Repayment period



Investor loans have much higher default rate than loans to owner-occupants.

Owner-occupancy



Regular single-family homes appreciate much more, and more reliably, than:

manufactured homescondominium units

Nontraditional property type treated as risk factor in underwriting.

Property type


SummaryNet Worth & Other Factors

• Liquid assets• Reserves• Assets• Liabilities• Net equity• Swing loan• Gift funds• Owner-occupant• Investor loan


Subprime Lending

Subprime lending: lending to riskier borrowers.

A credit: prime or standard financing.

A- to B, C, D credit: subprime financing.


Subprime Lending

Subprime financing may also be needed by buyers who can’t meet prime lender’s requirements in:

income & asset documentationacceptable debt levelssize of downpayment

Subprime borrowers


Subprime Lending

A-minus borrowers have:good credit rating, application with additional risk factor(s)

A-minus loans somewhere between prime and subprime.

A-minus loans


Subprime Lending

Subprime lenders charge higher interest rates and loan fees in exchange for more flexible underwriting.

More likely to have features such as:prepayment penaltyballoon paymentnegative amortization

Characteristics of subprime loans


Subprime Lending

Annual volume of subprime loans:

1994: $35 billion

2003: $332 billion

2007: $1.3 trillion (peak)

Subprime boom


Subprime Lending

Subprime boom fueled by growth of secondary market for subprime loans during 1990s.

Wall Street investors bought and securitized subprime loans.

Issued private-label mortgage-backed securities.

Secondary market for subprime loans


Subprime Lending

HUD encouraged Fannie Mae and Freddie Mac to enter subprime market to meet affordable housing goals.

GSEs at first purchased only very top layer of subprime market (A-minus loans).

Secondary market for subprime loans


Subprime Lending

Subprime boom led to loosening of underwriting standards throughout industry, even in prime market.

Eventually led to skyrocketing default rates.Many subprime lenders failed.Prominent Wall Street investment banks

collapsed.Prime lenders also affected.

End of boom


Subprime Lending

As mortgage crisis unfolded, subprime share of market shrank.

Far fewer subprime lenders now.Most lenders have tightened

underwriting standards and won’t make risky loans.

Dodd-Frank Act adds new restrictions on prepayment penalties, balloon payments, negative amortization

End of boom


Risk-based Loan Pricing

Risk-based pricing: charging borrowers different interest rates and loan fees depending on their credit risk.

Poor credit risk = higher rate and/or fees.Good credit risk = lower rate and/or fees.



Prime lenders have traditionally used average cost pricing or par rate pricing.

All approved borrowers charged same interest rate and fees.

Those who don’t meet lender standards are denied loan.



Now risk-based pricing taking hold in prime lending.

Advantages:Fewer applicants are denied financing.Fairer, because good credit risks don’t

subsidize poor credit risks.



Disadvantages:May make loan shopping more confusing,

since lenders can’t advertise just one interest rate or APR.


SummarySubprime Loans & Risk Pricing

• Subprime loan

• Prime loan

• A, B, C, D credit ratings

• A-minus loan

• Private-label MBS

• Risk-based pricing

• Average cost pricing

© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 8: Qualifying the Buyer.

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Transcript of © 2012 Rockwell Publishing Financing Residential Real Estate Lesson 8: Qualifying the Buyer.