Finance_08 Instructor Materials.docx

8. Qualifying the Buyer Learning Objectives After completing this lesson, students should be able to… Describe the basic steps in the underwriting process Understand the purpose of underwriting (qualifying) standards Define the different classifications used in an automated underwriting report Discuss an underwriter’s main considerations: credit reputation, income, and net worth Define quantity, quality, and durability of income List the types of income that qualify as stable monthly income Explain how to use income ratios to measure the adequacy of income Calculate net worth using an applicant’s assets and liabilities Understand credit history and credit scores Explain other underwriting considerations, such as LTV, repayment period, and property type Suggested Lesson Plan 1. Give students Exercise 8.1 to review the previous chapter, “The Financing Process.” 2. Provide a brief overview of Chapter 8, “Qualifying the Buyer,” and review the learning objectives for the chapter. 3. Present lesson content: The Underwriting Process – Qualifying standards – Automated underwriting EXERCISE 8.2 The underwriting process Evaluating Creditworthiness Credit Reputation – Credit reports – Length of credit history – Major derogatory incidents – Credit scores EXERCISE 8.3 Credit reputation Income Analysis – Characteristics of income – Stable monthly income – Income ratios EXERCISE 8.4 Income analysis Net Worth – Funds for closing – Assets – Liabilities – Gift funds – Delayed financing EXERCISE 8.5 Net worth Other Factors in Underwriting Subprime Lending Risk-based Loan Pricing 4. End lesson with Chapter 8 Quiz. Chapter 8 Outline: Qualifying the Buyer I. The Underwriting Process A. Underwriting is the process of evaluating a proposed loan to assess whether the buyer and the property meet the lender’s minimum standards B. Qualifying standards 1. Qualifying standards (also called underwriting standards) establish what a lender considers to be acceptable and unacceptable loan risks 2. Because most loans will be sold on the secondary market, most lenders use underwriting standards established by Fannie Mae, Freddie Mac, the FHA, or the VA C. Automated underwriting 1. Most underwriting is done using software that generates a preliminary analysis of information provided on the loan application 2. Automated underwriting programs are based on the performance of millions of existing mortgage loans, analyzed to determine which factors make default more or less likely 3. An automated underwriting decision takes the form of a risk classification; an application classified as “Accept” can be approved, while one classified as “Refer” won’t necessarily be denied but will require further scrutiny by an underwriter 4. The automated underwriting report will also indicate the level of documentation required, and whether an exterior-only inspection is enough, instead of a full on-site appraisal EXERCISE 8.2 The underwriting process II. Evaluating Creditworthiness A. Creditworthiness can be divided into three basic categories: credit reputation, income, and net worth B. Strength in one area can offset weakness in another aspect of creditworthiness III. Credit Reputation A. Credit reports 1. A credit report will contain information about an individual’s loans, credit purchases, and repayments for the previous seven years 2. There are three credit reporting agencies, each of which can issue a separate credit report on an applicant B. Credit history 1. Credit history refers to how long an individual has been borrowing money and paying it back 2. Applicants should have at least a one-year credit history, but lending options are available for applicants who don’t C. Major derogatory incidents that will be listed on a credit report include charge-offs, collections, repossessions, foreclosures, and bankruptcies D. Credit scores 1. Credit scores predict the likelihood that an individual will default on a loan, given her previous credit history 2. The most widely used credit scores are FICO® scores EXERCISE 8.3 Credit reputation IV. Income Analysis A. Characteristics of income 1. Income has three dimensions: quantity, quality (how dependable the source of income is), and durability (the likelihood the income will continue in the future) 2. Income that meets tests for quality and durability is considered stable monthly income B. Stable monthly income 1. If an applicant has held the same employment position for two years or more, it won’t be necessary to investigate previous work history 2. Continuity of earnings is more important than job continuity, and education or training that will enhance earning power can substitute for a two-year work history 3. Commissions, overtime, bonuses, and seasonal work can be considered durable income if they have been earned consistently for two years or more 4. Self-employment income adds an extra level of risk; lenders will generally expect to see that the business has been operated profitably for at least two years 5. A lender may send a Request for Verification of Employment to the applicant’s employer, or the applicant may be able to provide W-2 forms and payroll stubs 6. Retirement income (such as pensions and social security) is dependable, so it is considered stable monthly income 7. Dividends or interest from investment income may be counted as stable monthly income if it is earned reliably 8. Income from an investment rental property may count as stable monthly income if the loan applicant has owned the property for at least two years 9. Alimony, maintenance, and child support count as stable monthly income if it appears payments have been made reliably and will continue for at least three years 10. Unacceptable income includes income from temporary employment, unemployment benefits, and income from unobligated family members C. Calculating stable monthly income 1. All income payments paid on a weekly or biweekly basis must be converted to monthly income 2. Qualifying standards assume that income will be taxed, so if some income is nontaxable (such as child support), it may be “grossed up” D. Income ratios 1. Debt to income ratio: the relationship between the proposed monthly mortgage payment and all other regular installment debt payments, and the pre-tax monthly income 2. Housing expense to income ratio: the relationship between the proposed monthly mortgage payment and the pre-tax monthly income 3. The income of a co-borrower, who will accept joint liability for the debt but will not be occupying the property, may be added to the applicant’s income to increase the likelihood a loan will be approved EXERCISE 8.4 Income analysis V. Net Worth A. Funds for closing 1. An applicant must have adequate liquid assets to cover the downpayment, closing costs, and other associated expenses 2. The applicant may also be required to have two or three months’ reserves leftover after making the downpayment, to cover unexpected expenses without defaulting on the loan B. Assets 1. An underwriter will send a Request for Verification of Deposit to the applicant’s bank to verify funds 2. An underwriter will be suspicious of recently opened accounts or higher-than-normal balances, which may mean funds for the downpayment were borrowed 3. If the borrower is selling property to generate cash to buy a new property, the lender will be concerned with the net equity in the property (market value minus liens and selling expenses) 4. If a buyer is unable to sell an old home in time to use the funds for the purchase of the new home, the buyer may use a temporary swing loan C. Liabilities: credit card and charge account balances, student loans, car loans, other installment debts, and other obligations (such as unpaid taxes) are subtracted from assets to arrive at net worth D. Gift funds 1. An underwriter will usually accept gift funds from friends or relatives; the donor should provide a gift letter stating that the funds given do not need to be repaid E. Delayed financing 1. In a highly competitive market, buyer may offer and pay with cash, and obtain mortgage loan after transaction closes. EXERCISE 8.5 Net worth VI. Other Factors in Underwriting A. Loan type: an ARM is riskier than a fixed-rate loan and may require closer scrutiny B. Loan term: a 15-year loan is less risky to a lender than a 30-year loan C. Owner-occupancy: if a borrower doesn’t plan to live in the property being purchased, it is considered an investor loan and a higher risk D. Property type: loans for certain property types that don’t appreciate as quickly, such as condos and mobile homes, might be considered riskier VII. Subprime Lending A. Subprime lenders make loans with higher degrees of risk, either to borrowers with lower credit scores or borrowers with good credit scores who have additional risk factors B. Subprime lenders apply more flexible underwriting standards and charge higher interest rates and fees C. The boom and bust in subprime lending played an important role in the most recent mortgage foreclosure crisis VIII. Risk-based Loan Pricing A. Subprime lenders use risk-based pricing; they make loans to borrowers with poor credit scores and charge them higher rates and fees to cover the added risk B. Prime lenders traditionally charged all borrowers who met their standards similar rates, and turned away loan applicants who didn’t meet their standards C. Now prime lenders generally use risk-based pricing, blurring the line between prime and subprime lending D. Lenders who use risk-based pricing to extend credit to consumers must provide a written risk-based pricing notice if the borrower receives a higher priced loan because of her credit standing Exercises EXERCISE 8.1 Review exercise To review Chapter 7, “The Financing Process,” have students answer the following questions. 1. Would a buyer seek prequalification or preapproval if she wanted a firm loan commitment? 2. What loan fee covers the administrative expenses associated with making the loan? 3. What loan fee adds to the lender’s upfront yield (usually in exchange for a reduced interest rate)? 4. What are two key disclosures required by the Truth in Lending Act? 5. To give home buyers a chance to recover from the financial strain of closing the transaction, mortgage lenders generally don’t require a loan payment for the month that follows closing. Instead, the first loan payment is due the month after that. What charge do the buyers have to pay at closing as a consequence of this policy? Answers: 1. Preapproval 2. Origination fee 3. Discount points 4. Finance charge and annual percentage rate 5. Interim interest EXERCISE 8.2 The Underwriting Process Answer the following multiple choice questions. 1. Which one of the following pairs describes an underwriter’s primary concerns? A. Buyer’s financial condition and property value B. Seller’s net profit and property value C. Lender’s margin and buyer’s financial condition D. Discount points and loan fees 2. Even when not required to, lenders often use Fannie Mae and Freddie Mac qualifying standards because those standards: A. have been proven to predict default better than any other standards B. facilitate sale of loans on the secondary market C. allow a lender to make more loans than any other standards D. reassure borrowers about the affordability of their loans 3. Automated underwriting: A. cannot be used for loan amounts in excess of $300,000 B. has completely replaced manual underwriting C. is used in conjunction with manual underwriting D. is approved by Fannie Mae, but not by Freddie Mac 4. The criteria that an automated underwriting system uses for its underwriting recommendations are based on analysis of the performance of: A. many existing mortgage loans made by many different lenders B. model loans designed by the major credit reporting agencies C. the secondary market D. similar loans previously made by the same lender 5. Automated underwriting reports include recommendations in the following three categories: A. risk, documentation, and appraisal B. margin, discount, appraisal C. risk, default, margin D. profitability, security, margin 6. Automated underwriting is: A. required by law B. disfavored by reputable lenders C. more error-prone than manual underwriting D. more objective than manual underwriting Answers: 1. A. An underwriter must make sure not only that the buyer is unlikely to default, but also that the property has sufficient value to provide adequate collateral for the loan. 2. B. Loans made using Fannie Mae and Freddie Mac’s standards are more easily sold on the secondary market, either to those entities themselves or to other investors. 3. C. Manual underwriting is used in conjunction with automated underwriting. An AU system may refer an application to a human underwriter for closer scrutiny. 4. A. Automated underwriting systems use statistical analysis of the performance of existing loans made by many different lenders to determine which factors make default more likely. 5. A. The three main categories in an automated underwriting report are the risk classification, the documentation classification, and the appraisal classification. 6. D. By decreasing reliance on the judgment of individual (human) underwriters, automated underwriting increases the likelihood that lending decisions will be fair and unbiased. EXERCISE 8.3 Credit reputation Discussion Questions: 1. What’s the difference between credit reputation and credit history? 2. List some of the types of major derogatory incidents that might appear on an individual’s credit report. 3. Andrew pays his bills on time; he always has. Does that mean he has a perfect credit score, or are there other factors besides late payments and defaults that can have a negative impact on an individual’s credit score? Answers: 1. Credit reputation is a general term for a borrower’s overall record of handling credit. Credit history is a component of credit reputation, referring to how many years the borrower has been borrowing money and paying it back. (In common usage, however, “credit history” is frequently used to mean the same thing as credit reputation.) 2. Major derogatory incidents that might appear on a credit report include charge-offs, collections, repossessions, foreclosures, and bankruptcy. 3. Credit scores may be lowered by a variety of other factors besides delinquency, such as having too much credit available (dozens of credit cards, for example); revolving accounts at or near their credit limits (“maxed out”); and too many credit inquiries (suggesting that the individual is applying for too much credit). EXERCISE 8.4 Income analysis Discussion Prompts: Jennifer earns $4,000 per month. She’s been employed at her current job for four years. She earned a $5,000 bonus at the end of last year, but it was the first time she received a bonus. She also earns money selling handicrafts at flea markets; she’s been doing that for five years and, on average, has made $500 per month from it. Her ex-husband sends her $800 per month in child support for their son, 14, and their daughter, 10; he’s made the payments reliably for many years. Jennifer’s son earned $1,200 last year doing yard work in the neighborhood. What is Jennifer’s stable monthly income? Would it make a difference if her son were 16 instead of 14? If so, why? Jennifer is applying for a mortgage loan that will have payments of $1,590 per month. She also pays $102 per month for a student loan and $163 per month for a car loan. What is her housing expense to income ratio? What is her debt to income ratio? Analysis: Jennifer’s salary and the child support are included in her stable monthly income. So is the income from selling handicrafts, since she’s been doing it for more than two years. The bonus doesn’t count because she’s received it only once, so it hasn’t been established as a reliable payment yet. The money earned by her teenage son also doesn’t count; income earned by family members isn’t considered part of a loan applicant’s stable monthly income. $4,000 + $800 + $500 = $5,300 (stable monthly income) If Jennifer’s son were 16, then his share of the child support wouldn’t count toward his mother’s stable monthly income. Support paid on behalf of a child who is 15 or older isn’t regarded as durable, since it will typically be discontinued when the child turns 18. With the payments required for the proposed loan, Jennifer’s housing expense to income ratio is 30%. Her debt to income ratio is 35%. $1,590 ÷ $5,300 = 30% (housing expense to income ratio) $1,590 + $102 + $163 = $1,855 (total monthly obligations) $1,855 ÷ $5,300 = 35% (debt to income ratio) EXERCISE 8.5 Net worth Discussion Prompts: The Jeffersons own a house with a market value of $600,000. The liens against it total $200,000, and they expect selling expenses of $60,000. What is their net equity in their house? In addition to their home equity, the Jeffersons also have $150,000 in savings accounts and retirement accounts. They own two automobiles worth $50,000. They own stocks worth $20,000. They owe $15,000 on one of the automobiles, and $25,000 in student loans. What is their net worth? Analysis: The Jeffersons’ net equity in their home is $340,000: $600,000 value – $260,000 (liens and selling expenses) = $340,000 (net equity) Their net worth is $520,000: $340,000 + $150,000 + $50,000 + $20,000 = $560,000 (assets) $560,000 – $40,000 (liabilities) = $520,000 (net worth) Chapter 8 Quiz 1. All of the following are among the tasks an underwriter will perform when evaluating a mortgage loan, EXCEPT: A. verifying information provided by the loan applicant B. evaluating the appraisal of the property C. making a recommendation for or against loan approval D. arranging for title insurance 2. A report generated by an automated underwriting system will include recommendations in all of the following categories, EXCEPT: A. risk classification B. document classification C. property classification D. appraisal classification 3. All of the following are primary aspects of a borrower’s financial situation, EXCEPT: A. income B. net worth C. credit reputation D. earnings potential 4. The dependability of the sources of an applicant’s income is known as its: A. quantity B. quality C. durability D. transferability 5. All of the following would be considered stable monthly income, EXCEPT: A. full-time permanent employment income B. income from bonuses received reliably for five years C. self-employment income from a business profitably operated for three years D. unemployment compensation 6. Which of the following sources of income is likely to be considered stable monthly income? A. Seasonal employment as a commercial fisherman over several decades B. A temporary job with a major company with no definite termination date C. Overtime earned only during the previous year D. Alimony payments where the ex-husband has frequently skipped payments 7. In which of the following instances are child support payments likely to be excluded from stable monthly income? A. One of the payments within the last year was never received B. The child in question is 16 years old C. The noncustodial parent lives out-of-state D. Both A and B 8. Larry, who has been a freelance writer for one year, and Sara, who has been employed as a chef for eight years, are applying for a loan. Larry’s dad, who receives Social Security, will be living with them but not cosigning the loan. Whose income will be considered stable monthly income? A. Larry only B. Sara only C. Larry and Sara D. Larry, Sara, and Larry’s dad 9. Theo receives $3,000 every two weeks from his employer. What is his monthly income? A. $3,000 B. $6,000 C. $6,500 D. $13,000 10. The ratio that measures the borrower’s proposed mortgage payment and all other regular monthly installment debt payments against monthly income is the: A. debt to income ratio B. housing expense to income ratio C. debt-to-housing gap ratio D. income to debt ratio 11. With regards to a loan, a primary borrower and a co-borrower each have: A. vicarious liability B. joint and several liability C. sole liability D. imputed knowledge 12. To calculate net worth, subtract: A. assets from liabilities B. liabilities from assets C. liabilities from reserves D. income from assets 13. The Mayers own a house that has been appraised at $400,000. There is a mortgage for $325,000 against the house. They anticipate selling expenses of 10%, or $40,000. What is their net equity in the house? A. $35,000 B. $60,000 C. $75,000 D. $125,000 14. Sheila received her first credit card in college nine years ago, and she has used credit consistently since then. This describes her: A. credit history B. credit report C. credit score D. payment record 15. Which of the following would not be an additional consideration that might increase the risk of default, according to a lender? A. A borrower applies for a 15-year loan, rather than a 30-year loan B. A borrower intends to lease out the property rather than live there C. A borrower intends to buy a manufactured home, rather than a site-built home D. A borrower receives her income from public assistance, rather than employment Answer Key 1. D. Title insurance is obtained during the closing process. All of the other options are part of the underwriting process. 2. C. The three categories of recommendations in an AU report are risk classification, document classification, and appraisal classification. 3. D. The three primary categories in evaluating creditworthiness are credit reputation, income, and net worth. 4. B. Quality of income refers to the dependability of the source of income. By contrast, durability refers to the likelihood the income will continue in the future. 5. D. Income from unemployment compensation is necessarily expected to run out, so it is not stable monthly income. 6. A. Seasonal employment income may be considered stable monthly income if it has been earned reliably for several years. 7. D. Child support payments may be excluded from stable monthly income if any payments in the last 6 to 12 months were late or missing, or if the child is 15 or older (since the payments will usually end in several years). 8. B. Only Sara, who has been permanently employed for more than two years, may have her income considered as stable monthly income. Larry’s dad’s income would count if he were a cosigner to the loan. 9. C. To calculate monthly income when a salary is paid every other week, multiply the payment by 26 for the annual total ($3,000 × 26 = $78,000) and divide the annual total by 12 for the monthly income ($78,000 ÷ 12 = $6,500). 10. A. The debt to income ratio compares the buyer’s monthly income against the proposed monthly mortgage and all other regular debt payments. 11. B. A primary borrower and a co-borrower each have joint and several liability, meaning that a court may order either one responsible for paying the entire loan balance. 12. B. A person’s net worth equals his assets minus his liabilities. 13. A. To determine net equity, subtract the value of all liens and selling expenses from the property’s appraised value ($400,000 – $325,000 – $40,000 = $35,000). 14. A. A person’s credit history, in its narrower sense, describes how many years that person has been borrowing and repaying money. 15. D. The Equal Credit Opportunity Act prohibits discrimination against loan applicants on the basis of receipt of income from public assistance, so long as the income has sufficient durability. Most lenders view a loan for a vacation home, a rental property, or a manufactured home as a greater risk.

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