FIN 182 Real Estate Practice - Pre-approval

10.4.2.2 Credit analysis
The credit analysis begins with a credit report from one or more of the three major credit reporting agencies: Equifax, Trans Union, and Experian. A credit report can be downloaded immediately on-line and costs around $25.

The three credit bureaus track information on your place of residence, jobs, income, debts and debt payments, credit card usage and payments, and even utility and rental payments. This information is used to compute a credit score based on a proprietary formula. The most popular credit scoring formula is the FICO (from the Fair Isaac Company) score. FICO scores range from 100 to 900 and the higher the score the better the credit. To obtain the best or “prime” mortgage interest rates, a credit score of 660 to 700 and higher is required. Below 660, the mortgagor is considered a sub-prime borrower and will pay a premium in the form of a higher interest rate, maybe up to 100 basis points over the prime lending rate, or pay additional mortgage points.

FICO scores are used for mortgage, student, auto, and personal underwriting, and also used in setting auto insurance rates and screening job applicants. The theory behind using FICO scores in these fringe areas is that a high FICO score indicates that a person has their financial affairs in order and will therefore be a good insurance risk or an above average employee. Fair or unfair, this is how your FICO score is being used.

Because the FICO score is so important, it is recommended that you monitor your credit reports for any mistakes. The credit bureaus have a tremendous task in tracking all the information for basically every credit using US resident. There are mistakes and oversights made.

The credit reporting bureaus are periodically, every three to seven years, required by law to issue a free credit report to consumers for review. If you find an error on your credit report, you should report this mistake to the credit bureaus. The credit bureaus are also required by law to address your inquiry. Your credit report has a section for you to provide an explanation should you find a problem. A mortgagee will read consider your explanation. If you have a valid reason, such as a temporary job loss or unexpected health problem, the mortgagee will consider this information in the underwriting process. Your explanation could be the difference between receiving the loan and being rejected. With you credit evaluated, the next step in the underwriting process is to evaluate your income and expenses.

10.4.2.3 Income and housing expense analysis
For a typical owner occupied residential loan, the mortgagor’s personal income is the primary source for the monthly mortgage payments. Therefore, the quality and quantity of the mortgagor’s current and expected future income is very important component in the underwriting process.

Your employment history, current employment, and future earning power are considered in the evaluation of your income generating capacity. Applicants employed in relatively ‘hot’ areas of the economy such as healthcare and education may make better risks than contracting areas of the economy, such as manufacturing.

The most critical time period in the evaluation of your credit and your credit score is the past two years. Therefore, if you are planning to borrow money within the next two years you want to make sure you pay all your existing debts, rental payments, credit card payments, utility bills, and rental payments on-time and in full. If you have a credit problem such as a default, bankruptcy, or foreclosure, this credit ‘ding’ will stay on your credit report and be considered in your credit score evaluation for a period of seven years. After seven years, the credit problem will be removed from the credit report and credit score. During the seven-year period, however, it is very difficult or expensive to borrow money with a default, bankruptcy, or foreclosure on your credit record.

The underwriter considers your prior work experience and history. Several decades ago, it was common for people to work for the same company for an entire career. For example, an author’s grandfather was an accountant in World War II, stationed in Europe. Upon returning to the US, he worked for the same accounting firm for 40-years. Today, this situation is relatively rare and underwriters expect to see job and career changes on a resume. However, there are good and not so good job changes.

An underwriter looks for vertical job changes rather than horizontal changes. An example of vertical job change would be as follows:
• Accounting major lands a bookkeeping job right out of college.
• After six months as a bookkeeper, an auditing position is taken.
• After three years as an auditor, the person becomes a partner in the accounting firm.

An example of horizontal job changes would be as follows:
• A bookkeeper takes another bookkeeping job after six months, then
• another bookkeeping job after three months, then
• another bookkeeping job after three more months.

In the later case, the mortgagor is not moving up the career ladder and it is even beginning to appear that he or she is having issues with keeping a long-term employment arrangement. Also note that a college degree will help to convince an underwriting of your future earnings potential and help you qualify for a loan. Underwriters acknowledge that college graduates have greater income producing potential. Just a little credit related motivation to keep up the good work at school. See box.
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Box: Underwriting and the self-employed
The self-employed have a bit more difficulty in demonstrating their income to the underwriting. Self-employed income is typically more volatile than income from a salary. Also, the self-employed report their own income on the Federal Income Tax Schedule C, so there can be additional concerns by the underwriter in income verification. However, because the ranks of the self-employed and small business owners are growing, self-employed income is becoming a common source of income. Self-employment income is less of an issue that it was decades ago.
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Your income sources are verified with documentation and contact with your employer. The underwriter will request two years worth of income tax and W-2 forms and at least three months of your paycheck receipts. In addition to the documentation, the underwriting will verify this information by directly contacting your employer.

Your salary or self-employed income is used to determine your stable monthly income or SMI. The underwriter evaluates your income and expenses on a monthly basis because mortgage payments are typically paid monthly.

The underwriter may also consider some secondary income sources as part of your SMI. Realizable secondary income may include income from the following:
• Part-time employment. However, the part time job must be view as stable and permanent employment. Also, the income from the part-time job must be reported to the IRS. Working at your Uncle restaurant on weekends for an under-the-table payment, will not count at realizable secondary income.
• Bonuses, commissions, and overtime pay. Again, these secondary sources must be viewed as stable and continuing income. Therefore, a onetime bonus would not count but an end of the year bonus that has been paid the past three years would likely be included as SMI. Similarly, if commissions and overtime income sources have a track record and are expected to continue, this income would also be considered in SMI.
• Positive cash flow from rental property. If the applicant has a rental property with positive after tax income, a portion of this income could be used as SMI.
• Income from other investment sources. The underwriter will also consider stable investment income from other sources such as stocks, bonds, and partnerships, assuming that these investments will continue and not be liquidated to provide for the down payment.
• Payments of alimony, palimony, and/or child support. These payments must be expected to continued long-term and be ordered by a court to be considered recognizable.

In summary, stable monthly income (SMI) equals,
• Monthly salary and/or expected self-employment income, and
• Recognizable secondary income. Secondary income may include,
o Part-time employment
o Commissions
o Bonuses
o Overtime
o Positive rental property cash flow
o Investment income
o Court decreed alimony, palimony, and/or child support payment received

With SMI determined, the next step in the underwriting process is to evaluate the monthly housing expense that the mortgagor is proposing to take on. Monthly housing expense, or MHE, consist of the following:
• PITI which stands for principal, interest, taxes and insurance based on the term of the proposed mortgage. ‘P’ and ‘I’ is the loan’s debt service as demonstrated by equation 5 or computed on your financial calculator. ‘T’ represents property taxes and not income or sale taxes. ‘I’ stands for the property insurance sometime referred to as hazard insurance or fire insurance. Do not confuse property insurance with health, auto, mortgage, or other insurances.
• MI or PMI if applicable. If the LTV ratio is below 80%, mortgage insurance or private mortgage insurance is paid and included in the MHE.
• Homeowner’s association dues. If the property is located within a homeowner’s association, the monthly dues are included in the MHE.
• Ground rent. If the land the building occupies is leased rather than owned, any monthly ground rent payments are included in MHE. Ground rent maybe found in mobile and modular home communities.

Please note the following items are NOT included in MHE:
• utilities; such as electric, gas, water, sewer, trash, and cable,
• maintenance and repairs; and,
• federal and state income and sales taxes.

Next, the total monthly debt, or TMD, is considered. The total monthly debt includes the MHE but adds other on-going monthly financial obligations. To calculate TMD start with the MHE and adding the following:
• installment (credit card for example) debt with more than 10 payments,
• alimony, palimony, and child support payments,
• negative cash flow from rental properties.

10.4.2.4 Underwriting ratios
Now with SMI, MHE, and TMD calculated, we are ready to discuss the traditional underwriting ratios, housing expense ratio (HER) and the total debt ratio (TDR). HER and TDR are used as threshold screens. If the applicant qualifies with traditional ratio cut offs, the analyst will proceed with the underwriting process, order the appraisal, etc. These ratios are simply a measure of cash out flows over cash inflows and are calculated as follows:

HER = MHE / SMI with underwriters looking for a ratio of 28% or lower, and

TDR = TMD / SMI with underwriters looking for a ratio of 36% or lower.

Note that both ratios use SMI in the denominator and that the lower the ratio the better. Underwriting have determined through experience that applicants who spend 28% and 36% or less of their monthly income on monthly housing expenses and monthly debt payments, respectively, are generally good mortgagors. With ratios higher than these rules-of-thumb, the applicant maybe stretching their monthly budget and many not have enough income for either housing expense or other necessities of life.The 28% and 36% ratio limits are rule-of-thumb and some underwrites will go higher or lower than these benchmarks. Higher ratios maybe justifiable in the following situations:
• The applicant has a good track record and or reputation with the mortgagee and has the ability to manage their finances with the higher ratios.
• The applicant is paying a large down payment.
• The applicant has a large (liquid) net worth. This is the catch-22 of lending. When you have a lot of money, people want to lend you money. When you need the money, it is hard to get a loan.
• The applicant has good future earnings potential.
• The property has ‘green’ or energy efficient features that will lower the monthly utility bills so more monthly income is left to pay housing expenses.

For investment properties, higher ratios maybe justified in the following situations:
• The property has strong positive cash flow to cover the debt service.
• The mortgagor has experience and a proven track record in property management.
• The mortgagor has a reserve accounting with funds for repairs or mortgage payments, if needed in an emergency.

To get some practice and a better feel for these underwriting ratios, let’s consider the following two examples. For both example, you are the mortgage underwriting and it is your job to determine if the loan should be made or rejected.

10.4.2.5 Qualifying the buyer example 1
Based on the information below, calculate the HER and TDR and determine if the loan should be originated.
• Proposed loan information: $70,000 principal at 10% interest rate for 30 years with monthly payments.
• Income: $3,200 per month salary with $240 per month in recognizable secondary income.
• Outstanding debts and monthly expenses:
o Auto loan 1 - $380 per month with 30 payments remaining
o Auto loan 2 - $120 per month with 6 payments remaining
o Bank credit card balance of $1,200 and the applicant is paying $65 per month on this card.
o Gas credit card with no balance and the applicant is paying about $35 per month for gas
o Property (hazard) insurance of $21 per month
o Auto insurance of $75 per month
o Property tax of $84 per month
o Utilities of $130 per month
o Private mortgage insurance (PMI) premiums of $24 per month

What is the HER and TDR? Should you recommend that the loan be originated?

10.4.2.6 Qualifying the buyer example 2
Based on the information below, calculate the HER and TDR and determine if the loan should be originated.
• Proposed loan information: $57,000 principal at 9.5% interest rate for 30 years with monthly payments.
• Income: $26,000 per year salary with no recognizable secondary income.
• Outstanding debts and monthly expenses:
o Property tax of $83 per month
o Installment debt (auto loan) - $550 per month with 30 payments remaining
o Property insurance of $36 per month
o PMI of $17 per month
o Student loan payment of $50 per month with 7 payments remaining

What is the HER and TDR? Should you recommend that the loan be originated?

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Try this! Qualifying yourself
Well, how much would you qualify to borrow under that HER and TDR limits? Collect your personal information on your income and existing debts? Pick a mortgage amount that you think you might qualify for and research current mortgage terms. Use the steps presented in examples 1 and 2 to see if you qualify for this amount.

Step 1 – calculate your SMI.

Step 2 – calculate MHE, starting with PITI and add any PMI, homeowner association fees, or ground rent.

Step 3 – calculate TMD by adding any personal on-going debt payments or obligations to MHE

Step 4 – calculate HER and TDR and make the underwriting decision.

If you qualify under both ratios, raise the mortgage amount until your ratios are very close to the limits. This mortgage amount represents the maximum about that you can borrow. Divide this about by the LTV ratio that you intend to use and this will give you the maximum property purchase price that you can afford. Note that this doesn’t mean that you have to purchase a property of this about. This is just the maximum.

If you do not qualify under one or both ratios, try dropping the proposed mortgage amount and keep trying until you do qualify. Keep at it and you should know how much you could borrow, even before speaking to a mortgage originator.
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