With Spring upon us, and new buyers out looking for houses, I thought today might be a good time to review the basics of what lenders look for as they decide to approve (or deny) mortgage applications. They are known as the “The 4 C’s of Underwriting”:
"Capacity, Credit, Cash, and Collateral"
CAPACITY is the analysis of comparing a borrower’s income to their debt, and considers the borrower’s ability to repay the mortgage. Lenders look at two calculations (we call ratios), however understand that every application is different. Consult an experienced loan officer to determine how the underwriter will calculate your numbers.
- Housing Ratio - is simply is the percentage of your proposed total mortgage payment (principal & interest, real estate taxes, homeowner’s insurance) divided by your monthly, pre-tax income. A rule of thumb is you can afford 1 week (25%) of your monthly take home pay.
- Debt Ratio - this starts with the mortgage payment calculation from the Housing Ratio and adds to it your recurring debts that would show up on your credit report (auto loans, student loans, minimum credit card payments, etc.) without taking into consideration some other debts (phone bills, utility bills, cable TV). A good debt ratio would be 40% or less.
CREDIT is the statistical prediction of a borrower’s future payment likelihood. By reviewing the past factors (payment history, total debt compared to total available debt, & the types of monies) a credit score is assigned each borrower which reflects the anticipated repayment. The higher your score, the lower the risk to the lender which usually results in better loan terms for the borrower. Your loan officer will look to run your credit early on to see what challenges may (or may not) present themselves.
CASH is a review of your asset picture after you close. There are really two components – cash in the deal and cash in reserves. Simply put, the
Bigger down Payment = Stronger the loan application
More money in reserves after closing = Less likely you are to default
Two borrowers with the same profile as far as income ratios and credit scores have different risk levels if one has $50,000 in the bank after closing and the other has $50.
COLLATERAL refers to the appraisal of your home. It considers many factors – sales of comparable homes, location of the home, size of the home, condition of the home, cost to rebuild the home, and even rental income options. Understand the lender does not want to foreclose, but they do need to have something to secure the loan against, in case of default. Appraisals are really the only one of the 4 C’s that can’t be determined ahead of time in most cases.
Combination is key. Strong income ratios and a large down payment with strong reserves can offset some credit issues. Similarly, long and strong credit histories help higher ratios….and good credit and income can overcome lesser down payments. Talk openly and freely with your loan officer. They are on your side, advocating for you and looking to structure your file as favorably as possible.
Sean S. Williams
Licensed Broker, Realtor®, ABR®, e-Pro®
1st Time Buyer & Relocation Specialist
of Louisville, Kentucky
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