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Mortgage Basics

The 3 C’s Of Basic Mortgage Lending

There are three basic building blocks in mortgage lending. They are Credit, Capacity and Collateral, the “Three C’s.” When you think about it, it makes perfect sense. If you were considering lending a substantial amount of money to a perfect stranger, you’d probably want to know their track record on how they paid other lenders (Credit), you’d want to know if they had stable employment and that the income was sufficient (Capacity) and you’d want to know that the property securing the loan was worth what the borrower said it was (Collateral). Everything in mortgage lending is geared to establish and answer these three basic questions. Let’s look a little deeper into each.

1. Credit

Home buyer's credit score

Credit is the easiest of the three mortgage basic blocks to understand. How has a person managed past debt payments and what is the likelihood of them paying back the loan they applied for? Prior to the industry acceptance of credit scores, lenders would physically quantify and categorize the number of creditors, types of credit, and payment history. They had formulas in place given their appetite for risk that looked something like, “minimum 4 credit lines opened for at least 24 months with no more than 2 x 30 in last 12 months and 1 x 60 in last 24 months.”

The advent of credit scores greatly streamlined the procedure of determining credit strength and took the human element out. Different mortgage lenders have different levels of risk they will accept. For example, some won’t take credit scores below 660 and others will go as low as 580.

Your credit score is also used to partially determine the rate you’ll be offered. The lower scores are riskier and that means the return, or rate, will need to be higher to compensate for the additional risk. At some point, the risk will be too great and a lender will not be interested in the transaction at any rate.

Basically, the risk categories or tiers are in 20-point increments with 740+ being the highest. As credit deteriorates the access to lending products tightens and the rate starts to increase. The difference between any two adjacent tiers is usually negligible.

Lastly, your credit report is a snapshot in time. Mortgage lenders will only pull your credit report once and will use that report for 90-120 days. They will accept updates to credit but once you reach the 90 or 120-day mark they will request to re-pull to update a pre-approval letter (if purchasing). You should not go over 30-45 days on a refinance.

2. Capacity

Home buyer's capacity to repay debt

Capacity is the ability to repay the debt and consists of both job stability and the relationship between income and monthly debt obligations. This relationship is known as “debt-to-income” ratio of DTI.

Conventional mortgage lending guidelines (FNMA & FHLMC) and Government guidelines (FHA) require a two-year job history. There are some exceptions for recent college graduates. While the requirement is for at least a two-year history that doesn’t mean it needs to be with the same employer. However, while you don’t have to be employed by the same employer the type of work must be the same or similar. You made a job change doing the same type of work or started a management position in the same field, no problem. You went from clerical office work to commissioned sales, even with the same company, and haven’t been in that role for 2+ years? This basically won’t fly. Additionally, if you are self-employed the guidelines are different. Underwriting requires that you have at least 2 years of filed business and individual tax returns.

The second part of Capacity is the debt-to-income ratio. Mortgage lenders always think in terms of risk and return. When it comes to DTI, or debt-to-income ratio, the risk to the lender is in the ratio. The higher the DTI the greater the risk. Most lenders will not go over a 50% DTI, not even 50.01%. DTI is a basic calculation and I have included two examples below. Please remember that your DTI is calculated using your gross, pre-tax, income. Also, your DTI is only calculated for what actually shows on your credit report.

Example

01

Gross Monthly Income – $5,000

Monthly Payment Obligations

Principal and Interest on new loan $800
Taxes and Insurance on property $300
Mortgage Insurance $100 (when putting down <20%, PMI/MI required)
Combined minimum credit card payments $150 (only use minimum monthly payments)
Car payment $400
Student Loans $350 (actual payment or 0.5% of combined balances if in deferment)
Total $2,100

DTI = $2,100 / $5,000 = 0.42, or 42%

Example

02

Gross Monthly Income – $3,000

Monthly Payment Obligations

Principal and Interest on new loan $800
Taxes and Insurance on property $300
Mortgage Insurance $100 (when putting down <20%, PMI/MI required)
Combined minimum credit card payments $150 (only use minimum monthly payments)
Car payment $400
Student Loans $350 (actual payment or 0.5% of combined balances if in deferment)
Total $2,100

DTI = $2,100 / $3,000 = 0.7, or 70%

In Example 2 the DTI is well over 50% and the loan would be denied based on excessive obligations. Since we know that the DTI is over max by 20% ($600) we can look for ways to reduce by paying off monthly obligations, reducing purchase price of property, increasing down payment (lowers loan amount/payment) or a combination that totals $600+.

I have a spreadsheet available for download that will auto-calculate principal and interest payment as well as DTI if you input the variables.

3. Collateral

Home buyer's collateral to secure mortgage

Collateral is basically the property used to secure the mortgage loan. There are two components to a loan, the Note, or Promissory Note, and the Mortgage. The Note is your promise to repay, and the mortgage creates a legal interest for the lender in your property if you default. Technically, you don’t “get a mortgage,” you “give a mortgage” since you are giving the lender an interest in your property if you don’t fulfill your obligations of the Note.

While the note on a mortgage is the legal aspect of the loan, the collateral, or property, is also used to determine the LTV, or “loan-to-value ratio” of the transaction. This goes back to the lender’s risk and return assessment of the loan and will in part determine the rate offered. The higher the LTV the higher the risk.

Think of it this way, basically if you are purchasing a new property but only have 3% to put down the lender is 97% of the value of the property. When a borrower has very little at risk it is much easier for them to walk away if their employment or income slips. It’s easier to walk away when you have $6,000 in a property ($200,000 at 3% down) than when you have $20,000 invested ($200,000 at 10% down). Even with private mortgage insurance, the PMI does not insure the entire value of the property but only a percentage of it. Not including the revenue lost (monthly interest) when a borrower defaults, there are significant carrying costs and transaction costs for the lender to foreclose on a property. Lenders would much rather be paid back according to schedule and do not want to go through foreclosure. They are trying to break even and get their principle back or at least mitigate their losses.

The actual LTV calculation is simple and a downloadable spreadsheet will auto-calculate when you enter the variables. Here is the calculation:

(Purchase Price – Down Payment) / Purchase Price = LTV
($200,000 – 5%) / $200,000 = 95%

A free downloadable spreadsheet is available that will auto-calculate principle and interest payment as well as DTI if you input the variables. Fill out the short form to download this spreadsheet.