Chapter 13
Qualifying the Buyer: Before and After He Shops
In This Chapter
• Preapproval for a mortgage makes buying easier
• Taking the “guesstimate” out of how much a client can afford
• Understanding income, assets, and liabilities
• The good, the bad, and the downright ugly about credit
“Getting your ducks lined up in a row” is an old adage, but actually makes a lot of sense for buyers in a hot housing market. Mortgage brokers can prequalify shoppers to give them a nonbinding idea of how much of a loan they can expect a lender to approve. The mortgage broker will need to review information on the client’s income and debt load, but the client doesn’t provide any documentation to verify the data. It’s an informal process, but gives the buyer a realistic idea of what he can spend for a house. It’s good for you as a mortgage broker because it starts to establish a relationship with a client. He’ll be more comfortable using you when he finds a home and needs to secure a mortgage.
Even better is the decision by some clients to go a step further and get preapproval for a mortgage. This process is similar to a real loan application without being tied to a specific property. Full documentation is needed to verify the information the client provides. For your purposes as a mortgage broker, it’s good because it is a commitment by a client to use your services to secure a loan once they find a house.
Whether it’s prequalification or preapproval, the focus is on the applicant’s credentials as a borrower and is not tied to any specific property.
In this chapter, we’ll review what is needed to preapprove a client for a mortgage. When the client has skipped the preapproval step (which is a purely voluntary stage), and has gone directly to applying for a mortgage for a specific property, then the lender requires information not only on the applicant, but on the value of the property as well. We’ll cover those issues in Chapter 15.
The Value of Preapproval
As a mortgage broker, you want to advise clients to seek preapproval for a mortgage before they begin to shop for a home. Here’s why:
• By getting preapproved for a mortgage, the buyer has a firm figure he can offer on a property. He avoids wasting time looking at homes he can’t afford.
• A buyer with a preapproved mortgage may be more attractive to a seller, especially if there is a bidding war on a property. The seller knows that financing will not be an issue in the deal.
For the mortgage broker, preapproval means the customer has filled out the paperwork and provided documentation to verify the information he has provided, as if he were applying for a mortgage. He has paid for a credit report. At this point, it’s unlikely that you will lose him as a client once he finds a property he wants to buy. This is an excellent way to build your client base.
When you first meet a client, you can prequalify him for a mortgage. This is an informal, nonbinding estimate of how much he can afford based on his current income and debt load. It’s an opening gambit, but to lock in a firm offer, the client will have to provide documentation and authorize a credit report.
On the Plus Side of a Financial Profile: Income and Assets
Lenders want to know that their risk in lending money is minimal. The industry has developed formulas that calculate risk. Loan applicants must provide documentation to prove that the information they give is accurate. You will review the data and tell the client what documents they need to provide in order to substantiate it. You’ll also pull a credit report to verify the applicant’s history in paying their debts. We’ll review each category that creates the financial profile of a loan applicant.
Income
It’s all about the risk. To determine it, lenders need to know how much money the applicant earns and how much he owes. If the loan is to be in more than one name, then both parties must submit the necessary information and documentation.
For income, lenders want …
• to know how much the applicant has earned over a two-year period.
• to be able to verify that figure from a reliable source.
We’ll talk about debt load in a few pages, but there is a rough ratio of income to debt that lenders use to determine how much money the applicant can spend to repay the mortgage.
For some of your clients, it’s easy. They are salaried and can easily provide pay stubs and W-2 forms that verify their income. But other loan applicants will present a more challenging case to prove their income stream. You will need to advise them of how to build their argument to the lender that they are good risks.
Income can be:
• earned from a salaried job
• earned as a self-employed worker
Heads Up!
When evaluating the income level of an applicant, for salaried employees, lenders are interested in gross income (before taxes); for self-employed individuals, lenders are interested in net income (after taxes).
• earned by commission
• payments earned from a pension, retirement fund, or Social Security
• alimony and child support payments
• payments from an annuity or trust fund
• dividends or interest from bank accounts or stock
• royalties from a book or other intellectual property
• income from investment real estate the applicant owns
But in all cases, the lender wants to verify the income and see that it will likely continue:
• Income tax returns from up to three years can verify how much income has been earned from nontraditional sources and for how long.
• Awards statements from Social Security or pension funds should be attached (or if deposited directly into the bank account, a copy of the bank statement).
• Royalty or residual statements should be included.
This gives the lender an insight into the strength and durability of the income stream. The lender wants reassurance that the income from outside sources will continue for at least 12 to 36 months.
Bottom line? You need to make sure that your clients provide a complete picture of all their income sources. You may need to ask specific questions about possible income lest they forget or don’t think it’s pertinent.
Documentation for the Salaried Employee
The income documentation required of a salaried employee is:
• a month’s worth of pay stubs showing year-to-date earnings
• most recent two years’ W-2 forms
If the applicant has lost his pay stubs and W-2 forms, tell him to request duplicates from either his employer or from the IRS.
If the applicant has changed jobs within that time frame, ask him to provide all salary information and an explanation of why he switched positions. The lender wants to see a reliable job history. Certainly switching jobs for a higher-level job and increased compensation is a good sign for a lender. Changing jobs every few months, even for better pay and title, may trip a warning signal to the underwriter of the loan.
If the applicant has been a student for part of that time period, have him include his transcript and or a copy of his diploma.
Anticipate and then help your clients explain any potential problems.
Documentation for the Non-Salaried Worker
The income documentation required of a non-salaried worker is:
• two years’ worth of income tax returns with full schedules
• a year-to-date profit/loss statement and balance sheet
Lenders understand that income for a non-salaried worker may vary from month to month, but the applicant should explain any discrepancies. For example, if the year-to-date income is significantly lower than the previous year’s, the applicant might explain that his most profitable season occurs in the latter half of the year (if that’s true). Lenders are looking for consistency of annual income.
Trickier is when it’s difficult to verify income—for example, workers who earn much of their income from tips. In that case, some lenders will accept as verification bank statements that reflect regular monthly deposits.
Lenders are interested in the full unadjusted amount of income (before any payroll deductions), and that includes overtime pay, commissions, fees, tips and bonuses, and compensation for personal services.
• Personal Services Income. According to the IRS, personal services includes payments for contract labor; payments for professional services, such as fees to an attorney, physician, or accountant, if the payments are made directly to the person performing the services; consulting fees; honoraria paid to visiting professors, teachers, researchers, scientists, and prominent speakers; and generally, payments for performances by public entertainers.
• Dependent Personal Service Income. Dependent personal services are services performed as an employee in the United States by a nonresident alien. Dependent personal services include compensatory scholarship or fellowship income. Compensation for such services includes payments for wages, salaries, fees, bonuses, commissions, and similar designations for amounts paid to an employee.
Assets
What else does the applicant bring to the table? The lender wants to know the applicant’s assets—what else he owns. An asset is an item of value; a liquid asset is something that can be quickly converted to cash.
While an asset would theoretically include the ugly vase from Aunt Dora, unless it’s a vase from the Ming dynasty and worth thousands of dollars, the lender is more interested in the applicant’s bank accounts, stocks, bonds, and mutual funds. Other assets include real estate, personal property, and debts owed to the applicant by others.
A liquid asset would be money in a checking, savings, or money market account. Non-liquid assets would include stocks, savings bonds, certificates of deposit, mutual funds, and certain retirement accounts. Access to their value is restricted. While the lender will consider the non-liquid assets in determining a borrower’s financial circumstances , non-liquid assets won’t be considered in terms of how much the applicant can repay on a monthly basis.
def·i·ni·tion
An asset is an item of value. A liquid asset is something that can be converted quickly to cash.
Again, the lender will demand verification of the applicant’s assets. Advise your client to provide a paper trail of what he owns.
Bank, Savings & Loans, and Credit Union Accounts
These are liquid assets. The applicant needs to list his accounts and provide the current cash or market value of each. He should also provide up to three months of his current bank statements. Again, advise your client to explain any significant discrepancies or changes to his accounts. If there are significant deposits or withdrawals that are different from his usual exchange of business, have the applicant include an explanation. For example, if the applicant sells his vintage comic book collection, including Superman Number One, and deposits the sale proceeds into his account, he should include a copy of the bill of sale and a page from a reputable price guide for vintage comics verifying the value.
Stocks, Bonds, and Mutual Funds
The applicant will list all stocks and bonds (company names/number), a description of each, and their current market value. Advise your client to provide a brokerage statement verifying the amount and current value of these assets.
Heads Up!
Remind your clients that when providing documentation of bank accounts, they need to submit all the pages of their bank statements, even those that are primarily advertisements. Lenders often question missing pages and become concerned that the applicant is trying to hide something—for example, a major withdrawal. Bottom line: if the bank statement has seven pages, send in all seven.
Life Insurance
The applicant will need to provide the net cash value of any life insurance policies he carries.
Real Estate Owned
This is considered a non-liquid asset. It will include any real estate (for example, the applicant’s current home if owned, as well as any investment property). The applicant should include the market value of the property(ies), as well as the carrying costs, for example, the taxes, insurance, and maintenance. If this is rental property, the client should enclose Schedule E of his tax return as verification of this info.
Retirement Funds
This is a non-liquid asset. The applicant will be asked to provide any vested interest in a retirement fund. Individual Retirement Accounts (IRAs) and Roth retirement plans are not considered liquid assets (there is a considerable penalty for withdrawing funds from these accounts). However, lenders do consider them in qualifying borrowers. Again, advise your clients to provide verification of these accounts.
If your client has a 401(k) account (a retirement plan made available by a company to its employees), he may be able to borrow against his vested amount. The borrower may wish to do that in order to get additional funds for a down payment; however, he should discuss this decision with his plan administrator. Some plans have limitations and restrictions on borrowing. Again, advise your client to provide verification of his 401(k) with his most recent statement.
Did You Know?
Banks will consider retirement funds in evaluating a client, but only at 70 percent of their value. That’s because of the substantial early withdrawal penalty that would have to be paid in order to access the funds.
Businesses Owned
A non-liquid asset, the applicant should list the net worth of business(es) he owns and attach financial statements for each.
Automobiles
A non-liquid asset, the applicant should list the make and year for each automobile he owns and the current market value. Advise him to check the Kelley Blue Book, www.kbb.com, for value of cars.
Other Assets
The applicant should itemize any other assets of value. This would include significant artwork, jewelry, and hobby collections like baseball cards. Include documentation of a recent appraisal of market value for any item listed.
On the Minus Side of a Financial Profile: Liabilities
Just as lenders want to know all of your client’s assets and income, clearly they need to know their liabilities: how much they owe. This includes monthly payments, for example rent, but also debt obligations, for example, credit card debt, car loans, and student loans. The applicant must provide the lender with complete information about all ongoing payment obligations, short- and long-term. As the mortgage broker, you will order a credit report that will verify much of this information, as well as give a rating of the individual’s credit history.
def·i·ni·tion
A liability is a recurrent payment that the applicant owes. It includes monthly obligations like rent and utilities, but also credit-card debt, student loans, car loans, and child support.
On the loan application, the client must provide information on the name, address, and account number of each loan, the amount of the monthly payment, how many months are left to pay on the loan, and the unpaid balance. The applicant must also list alimony/child support/separate maintenance obligations, as well as job-related expenses such as child care and union dues.
Remind your clients that they must also list any other names under which credit has been previously received; for example, a woman might have credit cards using her maiden name. They must list creditor name(s) and account number(s).
In the Case of Divorce
The client should include a copy of his divorce decree, as well as any documents that pertain to child support, alimony, or separate maintenance.
Check with your client about any property previously co-owned with a former spouse. If the client has given the property to his former spouse, there’s a potential problem. If his name is still on the mortgage loan, should it go into default, the lender may pursue your client for payment. He must take two steps: file a quitclaim deed to remove his name from ownership, and insist that the former spouse refinance the loan to remove him from any debt liability.
def·i·ni·tion
A quitclaim deed is a legal document that transfers all interests a person—for example, a former spouse—has in a property.
In the Case of Bankruptcy
If your client has ever filed for bankruptcy, finding a mortgage is more complicated, but still possible. The client will need to offer a detailed explanation of the bankruptcy circumstances. He’ll also need copies of the bankruptcy schedules and the Discharge of Debtor.
For a conforming mortgage, the bankruptcy needs to have been settled between three and five years earlier. There are exceptions to this rule which shorten the time period, such as a catastrophic event that created financial havoc, such as the death of the primary wage earner in the family.
Make sure that the client has re-established his credit successfully. Explain that he needs to show he is a good credit risk again. New credit needs to be repaid as agreed.
Heads Up!
Some nonconforming lenders will fund mortgages to applicants one month after discharge of their bankruptcy. There’s a higher price to be paid, but loans of this sort are available.
You should discuss lending options with your client. He may need to accept a higher-interest loan in order to qualify for a mortgage. However, should he be successful in re-establishing his credit, he could then refinance in a few years for better terms.
It Figures: Front End and Back End Ratios
Now that you have an idea of your client’s assets and liabilities, you can begin to get a clear picture of what the lender is going to see when presented with a loan application. Lenders will verify the information presented by the client in the credit report you pull (refer to the section “The Credit Report”). But a very gross analysis will permit you to draw some quick conclusions on the type of loans for which your client will qualify.
Front End Ratio
The front end ratio determines what portion of the applicant’s income will be used for monthly housing expenses. Typically, they want to see a front end ratio of no more than 28 percent. It is calculated as an individual’s monthly housing expenses divided by his monthly gross income (pre-tax).
For example, if the client has an annual gross income of $48,000, his monthly income is $4,000 ($48,000/12 = $4,000). If his proposed mortgage payments, PITI (principal, interest, taxes, and insurance), will be $1,100 per month, the front end ratio would be 27.5 percent.
def·i·ni·tion
The front end ratio is calculated as an individual’s monthly housing expenses divided by his monthly gross income. It is used to determine the percentage of an individual’s income to be used for mortgage payments. PITI refers to the components of a mortgage payment: principal, interest, taxes, and insurance.
Back End Ratio
The back end ratio, also known as the debt to income ratio, is the percentage of an individual’s monthly income that is used to pay debts. It is calculated as the individual’s total monthly debt divided by his gross monthly income. It includes mortgage payments (PITI), credit card payments, child support, auto loans, student loans, and so on. Some lenders only consider the back end ratio when considering a mortgage.
For example, if a client has a monthly income of $4,000, and spends $1,150 on monthly payments (including mortgage payments), his debt to income ratio would be 29 percent.
$1,150/$4,000 = 29 percent
Lenders consider a good ratio as one between 20 percent and 36 percent because it means the consumer has a better capacity to repay debts. Coupled with a good credit report, the consumer would likely qualify for a loan at the best interest rates, possibly even requiring less collateral.
def·i·ni·tion
The back end ratio, also known as the debt to income ratio, is the percentage of the individual’s monthly income used to pay debt.
Let’s Put It All Together
Here’s a case study as an example, using Freddie Mac calculators:
• John Walden’s annual salary, before taxes or deductions, is $48,000.
• He pays $300 a month on a car loan, and $100 per month on his student loan.
• He pays off his credit card debt each month and owes neither alimony or child support.
• His credit score is 724.
• He’s hoping to get a 30-year fixed mortgage at 6.5 percent.
• In the community where he’s looking, yearly property taxes are about $2,000, and yearly home insurance is about $200.
In order to have monthly mortgage payments of $1,040, which would be 26 percent of his gross monthly income (which is considered a good ratio), here’s what works:
To have the monthly mortgage payment he can afford, at the rate he prefers:
Down Payment Percentage: 20%
Down Payment Amount: $33,883
Loan Amount: $135,534
House Price: $169,417
Principal and Interest: $857
Taxes and Insurance: $183
Total Monthly Payment: $1,040
Down Payment Amount: $33,883
Loan Amount: $135,534
House Price: $169,417
Principal and Interest: $857
Taxes and Insurance: $183
Total Monthly Payment: $1,040
If John puts down 10 percent, to have the same monthly mortgage payment:
Down Payment Amount: $14,269
Loan Amount: $128,423
House Price: $142,692
Principal and Interest: $812
Taxes and Insurance: $183
Mortgage Insurance: $45*
Total Monthly Payment: $1,040
Loan Amount: $128,423
House Price: $142,692
Principal and Interest: $812
Taxes and Insurance: $183
Mortgage Insurance: $45*
Total Monthly Payment: $1,040
*Because he is only putting down 10 percent, John will probably have to pay mortgage insurance (insurance protecting the lender against loss from a mortgage default). It is generally required of borrowers who put down less than 20 percent down payment. PMI premiums are based on the down payment amount and the terms of the mortgage.
But the ratios are only a rough estimate of creditworthiness.
You’ll need to see the applicant’s credit report and see his credit score to get a better idea of how a lender will respond to the client’s loan application.
The Reality of Ratios
I’ll give you the rule of thumb for ratios—and then tell you how it’s often irrelevant.
Lenders traditionally use three different rules; the first number is the front end ratio and the second refers to the back end ratio:
• 5 percent down, the ratio is 25-33
• 10 percent down, the ratio is 28-36
• 20 percent down, the ratio is 33-38
Did You Know?
If your client has an installment loan, for example for a car, and is having trouble qualifying for a mortgage, it may be worth it to him to pay down his car debt. If an installment loan is down to 10 months or less, the lender won’t include it when calculating his debt load.
The whole point of ratios is to limit risk by funding mortgages with applicants who are likely to be able to repay the loan in a timely basis.
But now that computerized approval engines, such as Desktop Originator and Loan Prospector, have replaced adding machines, lenders don’t adhere as closely to the standard ratios. The approval engines take into account other elements, such as an applicant’s credit and assets, when evaluating a loan application. For example, I had a client whose ratio was a whopping 65-70, but he was easily approved for a mortgage. Why? He was retired, had outstanding credit, and had a hoard of cash in his account. The approval engine could incorporate those facts into the evaluation process.
Why bother to learn about ratios? Because they’re a quick assessment tool when meeting new clients.
The Credit Report
As part of the loan process, you will pull a credit report on each applicant. You will need their permission to do so. Credit reports track an individual’s credit history.
There are three nationwide consumer reporting companies: Equifax (1-800-685-1111) www.equifax.com; Experian (1-888-EXPERIAN [1-888-397-3742]) www.experian.com; TransUnion (1-800-916-8800) www.transunion.com.
Each company gets their information from different sources, so the reports may differ from each other. It’s not a question of accuracy, but of which data is being reported. You should pull all three reports on a client. If you submit only two reports, lenders will use the lower credit score number; if you submit all three, the lender uses the middle number.
What’s in the Report? What’s Not?
Depending on the age and credit history of the client, a credit report can be quite large. It includes:
• Personal information: name, current and recent addresses, Social Security number, date of birth, and current and previous employers.
• Credit history: the details of all credit accounts that the client has opened, or that list the client as an authorized user. Even if the client has closed an account or not used it recently, depending on the manner in which the account was paid, the information can stay on the report for 7 to 11 years from their last activity. The credit report will detail the date each account was opened, the credit limit or amount of the loan, the payment terms, the balance, and a history of whether the client paid or time.
• Inquiries: There will be a record of each time the credit report is shown to another party, such as a lender, landlord, or insurer. Inquiries remain on the credit report for up to two years.
• Public information: Matters of public record from government sources remain on the credit report for seven years. This includes liens, bankruptcies, and overdue child support.
What’s not included are checking or savings accounts, bankruptcies that are more than 10 years old, charged-off debts or debts that are more than seven years old, gender, ethnicity, religion, political affiliation, and medical history.
If the Client Disputes an Item
Make sure that the client reviews the reports to check for accounts he didn’t open, charges he didn’t make or disputed, or delinquencies he didn’t cause. If there are any inaccuracies, the client should immediately take steps to correct them. Here’s what happens.
• In writing, the client should tell the consumer reporting company what information that he believes is inaccurate. He should also tell the creditor, in writing, that he disputes the item.
• By law, the consumer reporting companies must investigate the items in question, usually within 30 days. The consumer reporting companies must forward all relevant data the client has provided to the organization or company that provided the original, allegedly inaccurate, information.
• Once the information provider receives notice of a dispute from the consumer reporting company, it must investigate, review the relevant information, and report the results back to the consumer reporting company.
• If the information provider finds that the disputed information is inaccurate, it must notify all three consumer reporting companies so they can correct the file.
• Once the investigation is complete, the consumer reporting company must give the individual the written results and, if the investigation results in a change, a free copy of his credit report.
• If an investigation does not resolve the dispute or your client does not accept the results, he can ask that a statement of the dispute be included in the file and in future reports. The client will have to pay a fee for this service.
Negative information can remain in a credit report for years. Most consumer reporting companies include accurate negative information for seven years and bankruptcy information for 10 years. There is no time limit on reporting information about criminal convictions, information reported in response to an application for a job that pays more than $75,000 a year, and information reported because the client applied for more than $150,000 worth of credit or life insurance. Information about a lawsuit or unpaid judgment can be reported for seven years or until the statute of limitations runs out, whichever is longer.
What’s the Score?
From all the information gathered, the consumer reporting companies develop a credit score, which is shorthand for how much of a credit risk they deem an individual to be: specifically, how likely is the person to make payments on a loan over the following two to three years? It’s based on a complex mathematical model that evaluates the information. The scores range from 300 to 850, with most consumers landing somewhere between 600 and 800.
The top factors influencing a credit report are:
• How effectively the client uses credit. If a consumer’s average balance of retail accounts is too high, it suggests to the lender that the individual is living beyond his means. If the client doesn’t use his credit cards, the lender is concerned because there’s no clear record to evaluate for creditworthiness. The best-case scenario is the client who has low balances on revolving accounts (credit cards), plus some installment accounts (mortgages, car loans), and pays off his debts in a timely fashion.
• How long the credit history extends. Credit reports that are less than three years old are usually determined to be inadequate. If your client has a limited credit history, he may need to increase his down payment, accept a higher interest rate, include a co-signer on the loan, or provide other documentation to prove his creditworthiness.
def·i·ni·tion
A revolving account is an account, like a credit card, that requires at least a specified minimum payment each month plus a service charge on the balance. An installment account is an account, like a mortgage or auto loan, in which the amount of the payment and the number of payments is prefixed.
• Asking for too much credit, too fast. Consumers who apply for too much credit at the same time (for example, multiple credit cards), may trip an alarm on the credit report. Each application for credit is noted on the credit report under “inquiries.” While the consumer may just be shopping around for a good rate, all the credit report knows is that there have been multiple inquiries to the file. Multiple inquiries could also signal that the consumer has become financially unstable. A spike in the number of inquiries could result in a lower score.
Putting It All Together
All the numbers, ratios, and calculations give you a rough estimate about how much of a loan for which a client will qualify. But it’s not that simple.
Mortgage loan software is complex and takes into account more than just the numbers plugged in. Plus, as the mortgage broker, you can help a client put his financial situation into perspective. A loan is dependent on good credit, the client’s total financial picture, his job, down payment size, and more.
To prequalify a client, a quick calculation of front- and back end ratios, will give you enough to steer your client in the right direction in terms of what they can afford to buy. If a client is seeking preapproval of a mortgage, then the process is more complicated and may result in a higher or lower figure than the prequalification figures provide.
The Least You Need to Know
• Prequalifying a client for a mortgage gives the buyer a better idea of what he can afford to spend on a house. It’s also an opportunity for you to establish a good working relationship so that when he seeks a mortgage, he comes to you.
• Preapproval for a mortgage is similar to a real loan application without being tied to a specific property. Full documentation is needed to verify the information the client provides. It’s a commitment by the client to use your services to secure a loan once they find a house.
• Your client’s credit report and credit score will play a significant role in their qualification for a mortgage. You can advise them if there are problems with their credit report.
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