The Fundamentals of Mortgage Banking

Below is an overview providing general information about mortgage loans. While specific guidelines vary from program to program, but the basic concepts of what is evaluated and how it is evaluate, in terms of whether or not a loan is made, can be generally summarized in the 4 C’s of mortgage lending. Please note that DHI Title is not a lender, and the information provided below consists only of basic concepts that may vary depending on a number of factors, including the lender you choose and the loan type. The following information is for educational purposes only.

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 many factors, such as 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. In addition to the repayment of the loan(s), housing costs include other expenses associated with owning property including monthly expenses for property taxes, homeowners insurance, homeowners association fees (in the event the property is located, for example, in a planned development) and in some cases mortgage insurance. The lender must determine what level of income the borrower has. Income that may be considered generally 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 (e.g. overtime, bonus, commissions) as well as self-employment income and non-guaranteed passive earnings (e.g. interest and dividend income, rental income) may be averaged to reflect the fluctuating nature of that income. Other passive earnings, such as receivables and child support, generally must also continue for a minimum period of time 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 participate 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 required minimum investment will depend on thinkgs like the mortgage loan program and while several program options may exist that offer small or no down payment, any upfront investment the borrower is making must be documented. These funds possibly may come from a number of sources (and permissibility may depend on the relevant loan program, among other things), such as: :
  • Bank Accounts
  • Net Equity in The Borrower's 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 largely two-fold. The first reason 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 history of good credit, such as for a period of two years. 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 evaluation borrowers. The three major national consumer reporting agencies – Experian, Equifax, and Trans-Union – all generally engage in scoring consumers. A credit score can be defined quite simply as a snapshot of someone’s credit information. The score may consider, amoung other things, negative credit like late payments, judgments, and 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 (which can sound like many people want to give the borrower credit), could 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 with a particular lender.

Because someone has had credit problems does not mean they can never qualify for a mortgage. What lenders often 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 may be able to qualify for a loan. The specific circumstances and the severity of the negative credit are factors that may be considered. For severe negative credit, including foreclosure or bankruptcy, the applicant will generally have to reestablish good credit and wait a period of time - such as two to three years before they will be able to obtain certain mortgage 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 applicants accurately. For example,  you mayneed to count payments on all installment debts that are ten months in duration or longer, and the minimum payments (e.g. use 5% of the outstanding balance if the minimum payment isn’t known) on all revolving (e.g. 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 may be approved for a specific period of time provided that the borrowers circumstances and the structure of the loan don’t change during that time period. In that instance, the loan approval letter will generally indicate conditions for the approval to remain valid. For example, 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

Mortgage lending may sound like a mysterious process, but it can be broken down into some simple core concepts. There are a couple of things to remember to help you understand the process. (Note that hte following information is for educational purposes only.)

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 often makes a mortgage loan with the intention of selling it into the secondary market. In such instances, they must make sure the loan meets those guidelines or they can’t sell the loan in this way.

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

The second concept is the steps involved in the process. The following is a summary of common steps in the mortgage lending process, but note that the process may vary depending on a number of factors, including the lender you choose and the loan type. The first step in the process is the application. At application, applicant information is gathered, the financial goals of the applicant(s) are discussed, and the mortgage loan originator completes an application based on the loan program or program that seem to best fit the applicant's needs. Next, the application is processed. This step typically involves verification of the information the applicant(s) provided to the lender/broker 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 the underwriting step. In this step, the underwriter evaluates the loan to confirm that it meets the appropriate guidelines, including those necessary so that the loan can be sold into the secondary market, if applicable. The underwriter is determining among other things, the suitability of the applicant(s) for the loan based on, for example, 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, amont other relevant such expenses).

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

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