The Fundamentals of Mortgage Banking

Specific guidelines vary from program to program; but the basic concept of what is evaluated, and how, in terms of whether or not a loan is made, can be summarized in the 4 C’s of mortgage lending. Please note that DHI Title is not a lender, and the information below are basic concepts that can vary depending on the lender you choose.

The 4 C's of Mortgage Lending:

The first C is for Capacity. The lender wants to make sure the borrower has the ability to repay the loan. The lender considers the amount and the stability of the borrower’s income. Based on their experience with other borrowers, the lender assumes that the applicant can safely spend a certain percentage of his or her income for housing costs. Housing costs include not only the repayment of the loan(s), but other expenses associated with owning property including monthly expenses for property taxes, homeowners insurance, homeowners association fees (in the event the property is located in a planned development) and in some cases mortgage insurance. The lender must determine what level of income the borrower has. Income that can be considered can include:

  • Hourly or Salaried Wages
  • Overtime, Bonus, or Commissioned Income
  • Self-Employment Income
  • Interest and Dividend Income
  • Notes Receivable Income
  • Investment Property Income
  • Alimony and Child Support
  • Social Security / Retirement Pension / Disability Income
The industry generally considers a borrower's history as sufficient proof of the stability of the income. It is important to note that wages that are production-oriented (overtime, bonus, commissions) as well as self-employment income and non-guaranteed passive earnings (interest and dividend income, rental income) will be averaged to reflect the fluctuating nature of that income. Other passive earnings such as receivables and child support must also continue for a minimum of five years to be counted.

The second C is for Capital. The lender is going to be making a large, long-term investment and, as such, is going to be asking the borrower to share in that investment. The lender is looking to determine that the borrower has sufficient funds to cover the borrower’s down payment, settlement costs, and cash reserves. The minimum investment will depend on the program and while several program options exist that offer small or no down payment, any upfront investment the borrower is making must be documented. These funds can come from:
  • Bank Accounts
  • Net Equity in Their Current Home
  • Stocks and Bonds
  • Company Retirement/Savings Plans
  • Cash Value of Life Insurance
  • Collateralized Loans
  • Gifts
The third C is for Credit. The lender wants to determine the quantity and quality of the borrower’s credit obligations. The purpose is two-fold. The first is to use past credit history as a future predictor of how the buyer will handle their credit obligations. Generally, the lender is looking for a two-year history of good credit. Since 1996, the mortgage lending community has placed an increased amount of emphasis on credit scoring.

Credit scoring has been in use for decades by the consumer finance industry as a quick way of approving borrowers. The three major national credit repositories – Experian, Equifax, and Trans-Union – all score borrowers. A credit score can be defined quite simply as a snapshot of someone’s credit. The score considers negative credit like late payments, judgments, collections, as well as outstanding debt, how long accounts have been open and inquiries or applications for new credit. Research has found there is a strong correlation between credit scores and mortgage delinquencies. Many lenders now require a minimum credit score to qualify for certain loans. It is important to understand that some things that a borrower might consider a positive attribute, like several open accounts (everybody wants to give me credit), will actually lower credit scores. It is important that applicants check their credit early in the process, as it may be necessary for them to “heal” their credit before they can qualify for a mortgage.

Because someone has had credit problems does not mean they can never qualify for a mortgage. What lenders are looking for are patterns. If the applicant was generally responsible about their credit obligations, got into trouble for whatever reason, but then resolved it, got back on track, and hasn’t had any problems since, then they generally can qualify for a loan. The specific circumstances and the severity of the negative credit will of course be factors. For severe negative credit, including foreclosure or bankruptcy, the applicant will generally have to reestablish good credit and wait two to three years before they will be able to obtain traditional financing.

The second reason is to quantify the amount of other debt the applicant carries. Lenders assume based on their experience with other borrowers that an applicant can spend a certain percentage of their income for all of their debt (housing costs plus other payments). A complete picture of the liability payments is needed to qualify them accurately. Generally you will need to count payments on all installment debts that are ten months in duration or longer, and the minimum payments (use 5% of the outstanding balance if the minimum payment isn’t known) on all revolving (credit card) debts.

The following is a list of typical obligations:
  • Real Estate Loans
  • Car Loans
  • Personal Loans
  • Students Loans
  • Credit Cards
  • Alimony / Child Support
The fourth C is for Collateral. The lender will want to determine if the property is good collateral for the loan by requiring such things as an appraisal, an inspection, a survey, and title work. The goal is to determine whether or not the property could be sold to satisfy the obligation if the borrower were to default on the loan.

When the borrower’s circumstances are within the guidelines of the loan program for which they are applying, their loan is approved for a specific period of time provided the borrowers circumstance and the structure of the loan don’t change. The loan approval letter will generally indicate conditions for the approval to be valid. An example would be that if a loan was approved subject to the borrower selling a home and no longer being responsible for the mortgage on that home, a condition of the approval could be proof of the sale of that home and the satisfaction of that mortgage.

The Loan Process

Although mortgage lending may sound like a mysterious process; it is really quite simple. There are a couple of things to remember to help you understand the process. The first concept to understand is the concept of the secondary market. The vast majority of loans that are originated today are sold to one of three places; FNMA (Fannie Mae), FHLMC (Freddie Mac), and GNMA(Ginnie Mae). These primary players and a handful of smaller ones that act in a similar fashion make up the secondary market.

The secondary market packages loans in groups and sells them as investments to different types of investors. Because the investors are buying these securities, it is important to them that the underlying loans are sound. As a result, the secondary market entities set stringent guidelines for the quality of these loans.

A primary lender is making the loan with the intention of selling it to the secondary market, so they must make sure the loan meets those guidelines or they can’t sell the loan.

The process of making a lending decision is then quite simply comparing the loan to a set of quality guidelines and deciding if the loan fits or not.

The second concept is the steps involved in the process. The first step in the process is the application. At application, all the borrowers information is gathered, their financial goals are discussed, and the lender completes an application based on the loan program or programs that seems to best fit the customer’s needs. Next, the application is processed. This is simply the independent verification of the information the borrower provided us with regard to their financial status, as well as validation of the property as good collateral for the loan. The loan decision is formally made in underwriting. The underwriter evaluates the loan to confirm that it meets the appropriate guidelines so that it can be sold into the secondary market. The underwriter is determining among other things, the borrower’s suitability for the loan based on their ability to successfully pay the monthly housing expenses associated with the purchase (principal and interest payment on the loan(s), property taxes, homeowners insurance, and in some cases homeowner’s association dues and mortgage insurance).

Occasionally, the underwriter will require clarification or additional information, which will be one of the conditions of the approval. Once all the conditions are met, the loan is ready to go to closing, where the loan documents are drawn and sent to the settlement agent for execution.  

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