RF_08 Instructor Materials PDF

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 diff...

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. © 2018 Rockwell Publishing  Financing Residential Real Estate Instructor Materials 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. 2  Chapter 8: Qualifying the Buyer 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 un- derwriting 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 ap- plication 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 pur- chases, and repayments for the previous seven years 2. There are three credit reporting agencies, each of which can issue a separate cred- it report on an applicant B. Credit history 1. Credit history refers to how long an individual has been borrowing money and paying it back 3  Financing Residential Real Estate Instructor Materials 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 ap- pears payments have been made reliably and will continue for at least three years 10. Unacceptable income includes income from temporary employment, unemploy- ment 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 4  Chapter 8: Qualifying the Buyer 2. Qualifying standards assume that income will be taxed, so if some income is non- taxable (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 5  Financing Residential Real Estate Instructor Materials 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 low- er credit scores or borrowers with good credit scores who have additional risk factors B. Subprime lenders apply more flexible underwriting standards and charge higher inter- est 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 cred- it 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)? 6  Chapter 8: Qualifying the Buyer 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 qualify- ing 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 7  Financing Residential Real Estate Instructor Materials 4. The criteria that an automated underwriting system uses for its underwriting recom- mendations 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 clas- sification, 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. 8  Chapter 8: Qualifying the Buyer 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. Jen- nifer’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? 9  Financing Residential Real Estate Instructor Materials 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 ac- counts 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) 10  Chapter 8: Qualifying the Buyer Chapter 8 Quiz 1. All of the following are among the tasks an 6. Which of the following sources of income is underwriter will perform when evaluating a likely to be considered stable monthly income? mortgage loan, EXCEPT: A. Seasonal employment as a commercial A. verifying information provided by the loan fisherman over several decades applicant B. A temporary job with a major company B. evaluating the appraisal of the property with no definite termination date C. making a recommendation for or against C. Overtime earned only during the previous loan approval year D. arranging for title insurance D. Alimony payments where the ex-husband has frequently skipped payments 2. A report generated by an automated underwrit- ing system will include recommendations in all 7. In which of the following instances are child of the following categories, EXCEPT: support payments likely to be excluded from A. risk classification stable monthly income? B. document classification A. One of the payments within the last year C. property classification was never received D. appraisal classification B. The child in question is 16 years old C. The noncustodial parent lives out-of-state D. Both A and B 3. All of the following are primary aspects of a borrower’s financial situation, EXCEPT: A. income 8. Larry, who has been a freelance writer for one B. net worth year, and Sara, who has been employed as a C. credit reputation chef for eight years, are applying for a loan. D. earnings potential Larry’s dad, who receives Social Security, will be living with them but not cosigning the loan. Whose income will be considered stable 4. The dependability of the sources of an appli- monthly income? cant’s income is known as its: A. Larry only A. quantity B. Sara only B. quality C. Larry and Sara C. durability D. Larry, Sara, and Larry’s dad D. transferability 9. Theo receives $3,000 every two weeks from 5. All of the following would be considered stable his employer. What is his monthly income? monthly income, EXCEPT: A. $3,000 A. full-time permanent employment income B. $6,000 B. income from bonuses received reliably for C. $6,500 five years D. $13,000 C. self-employment income from a business profitably operated for three years D. unemployment compensation 11  Financing Residential Real Estate Instructor Materials 10. The ratio that measures the borrower’s pro- 15. Which of the following would not be an ad- posed mortgage payment and all other regular ditional consideration that might increase the monthly installment debt payments against risk of default, according to a lender? monthly income is the: A. A borrower applies for a 15-year loan, A. debt to income ratio rather than a 30-year loan B. housing expense to income ratio B. A borrower intends to lease out the property C. debt-to-housing gap ratio rather than live there D. income to debt ratio C. A borrower intends to buy a manufactured home, rather than a site-built home D. A borrower receives her income from pub- 11. With regards to a loan, a primary borrower and lic assistance, rather than employment 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 ap- praised 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 consis- tently since then. This describes her: A. credit history B. credit report C. credit score D. payment record 12  Chapter 8: Qualifying the Buyer Answer Key 1. D. Title insurance is obtained during 9. C. To calculate monthly income when a the closing process. All of the other salary is paid every other week, multiply options are part of the underwriting the payment by 26 for the annual total process. ($3,000 × 26 = $78,000) and divide the annual total by 12 for the monthly in- 2. C. The three categories of recommen- come ($78,000 ÷ 12 = $6,500). dations in an AU report are risk classification, document classification, 10. A. The debt to income ratio compares the and appraisal classification. buyer’s monthly income against the proposed monthly mortgage and all 3. D. The three primary categories in other regular debt payments. evaluating creditworthiness are credit reputation, income, and net worth. 11. B. A primary borrower and a co-borrower each have joint and several liability, 4. B. Quality of income refers to the de- meaning that a court may order either pendability of the source of income. one responsible for paying the entire By contrast, durability refers to the loan balance. likelihood the income will continue in the future. 12. B. A person’s net worth equals his assets minus his liabilities. 5. D. Income from unemployment compen- sation is necessarily expected to run 13. A. To determine net equity, subtract the out, so it is not stable monthly income. value of all liens and selling expenses from the property’s appraised value 6. A. Seasonal employment income may be ($400,000 – $325,000 – $40,000 = considered stable monthly income if $35,000). it has been earned reliably for several years. 14. A. A person’s credit history, in its nar- rower sense, describes how many 7. D. Child support payments may be ex- years that person has been borrowing cluded from stable monthly income and repaying money. if any payments in the last 6 to 12 months were late or missing, or if the 15. D. The Equal Credit Opportunity Act child is 15 or older (since the payments prohibits discrimination against loan will usually end in several years). applicants on the basis of receipt of income from public assistance, so long 8. B. Only Sara, who has been permanently as the income has sufficient durabil- employed for more than two years, ity. Most lenders view a loan for a may have her income considered as vacation home, a rental property, or a stable monthly income. Larry’s dad’s manufactured home as a greater risk. income would count if he were a co- signer to the loan. 13  Financing Residential Real Estate Instructor Materials PowerPoint Thumbnails Use the following thumbnails of our PowerPoint presentation to make your lecture notes. Financing Residential Real Estate Lesson 8: Qualifying the Buyer © 2018 Rockwell Publishing Introduction This lesson covers: ⚫ underwriting process ⚫ automated underwriting ⚫ credit reports and credit scores ⚫ income analysis ⚫ net worth ⚫ other factors in underwriting ⚫ subprime lending ⚫ risk-based loan pricing © 2018 Rockwell Publishing Introduction Loan underwriting is evaluation of: ⚫ Loan applicant’s overall financial situation ⚫ Is buyer likely to make payments on time? ⚫ Value of the property (collateral) ⚫ If buyer defaults, will foreclosure sale proceeds cover debt? © 2018 Rockwell Publishing 14  Chapter 8: Qualifying the Buyer Underwriting Process Underwriting involves: ⚫ reviewing loan application ⚫ obtaining additional information about applicant ⚫ verifying applicant information ⚫ applying lender’s qualifying standards ⚫ evaluating property appraisal ⚫ making recommendation © 2018 Rockwell Publishing Underwriting Process Qualifying standards Qualifying standards: minimum standards used in underwriting. ⚫ Draw line between acceptable and unacceptable risks. © 2018 Rockwell Publishing Underwriting Process Qualifying standards Most lenders use Fannie Mae/Freddie Mac standards for conventional loans. ⚫ FHA and VA standards must be used for FHA and VA loans. © 2018 Rockwell Publishing 15  Financing Residential Real Estate Instructor Materials Underwriting Process Automated underwriting Automated underwriting system (AUS): computer program that analyzes loan applications. ⚫ Used in conjunction with traditional underwriting. ⚫ Traditional underwriting now called manual underwriting. © 2018 Rockwell Publishing Automated Underwriting AU and secondary market Most widely used AU systems: ⚫ Desktop Underwriter® (Fannie Mae) ⚫ Loan Product Advisor® (Freddie Mac) Either may be used to underwrite conventional, FHA, or VA loans. ⚫ Fannie Mae/Freddie Mac will still buy manually underwritten loans. © 2018 Rockwell Publishing Underwriting Process AU programming Programming of secondary market entities’ AU systems based on performance of millions of loans. ⚫ Loan performance: whether payments are made as agreed. ⚫ Analysis of performance statistics highlights factors that make default either more likely or less likely. © 2018 Rockwell Publishing 16  Chapter 8: Qualifying the Buyer Underwriting Process How AU works Information from loan application is entered into AU system. ⚫ AU obtains applicant’s credit information from credit reporting agencies. ⚫ AU issues report with recommendations. © 2018 Rockwell Publishing Underwriting Process How AU works Three main categories of recommendations in AU report: ⚫ risk classification ⚫ level of documentation ⚫ property appraisal or inspection © 2018 Rockwell Publishing AU Recommendations Risk classification AU report indicates level of scrutiny that application should receive. ⚫ Approve/Accept: meets all qualifying standards. ⚫ Approve/Ineligible (or Out of Scope): meets credit risk standards, but ineligible for purchase by GSE for other reasons. ⚫ Refer/Caution: doesn’t meet all standards, should be reviewed. © 2018 Rockwell Publishing 17  Financing Residential Real Estate Instructor Materials AU Recommendations Risk classification If further review required, underwriter uses traditional method (manual underwriting). ⚫ Some lenders reject Refer/Caution loans without further review. ⚫ Fannie Mae/Freddie Mac may buy manually underwritten Refer/Caution loan, but will treat as A-minus loan. © 2018 Rockwell Publishing AU Recommendations Level of documentation AU report indicates documentation level needed to verify information on application. Before mortgage crisis, three basic levels: ⚫ standard ⚫ streamlined (“low-doc”) ⚫ minimal (“no doc”) Now mostly standard or streamlined; “no doc” loans much less common. © 2018 Rockwell Publishing AU Recommendations Level of documentation Refer/Caution loans: ⚫ standard documentation (and manual underwriting) generally required Approve/Accept loans: ⚫ streamlined documentation permitted © 2018 Rockwell Publishing 18  Chapter 8: Qualifying the Buyer AU Recommendations Appraisal recommendation AU report also indicates which of these is appropriate: ⚫ full appraisal ⚫ exterior-only inspection © 2018 Rockwell Publishing Underwriting Process Advantages of AU Advantages of automated underwriting over manual underwriting: ⚫ streamlines process ⚫ increases objectivity ⚫ improves underwriting accuracy © 2018 Rockwell Publishing Summary Underwriting Process Underwriting standards Automated underwriting Manual underwriting Risk classification Standard documentation Streamlined documentation (low-doc) Minimal documentation (no doc) Exterior-only inspection © 2018 Rockwell Publishing 19  Financing Residential Real Estate Instructor Materials Evaluating Creditworthiness Qualification of buyer involves evaluation of three main components of creditworthiness: ⚫ credit reputation ⚫ income ⚫ net worth (assets) © 2018 Rockwell Publishing Evaluating Creditworthiness Credit reputation To evaluate applicant’s credit reputation, lender relies on credit reports prepared by 3 national credit rating agencies: ⚫ Equifax ⚫ Experian ⚫ TransUnion All are private companies. © 2018 Rockwell Publishing Credit Reputation Credit reports Personal credit report covers 7 years of information about individual’s: ⚫ revolving credit accounts ⚫ installment debts ⚫ previous mortgages © 2018 Rockwell Publishing 20  Chapter 8: Qualifying the Buyer Credit Reputation Credit reports Credit information important in underwriting: ⚫ length of credit history ⚫ payment record ⚫ derogatory credit incidents ⚫ credit scores © 2018 Rockwell Publishing Credit Reputation Length of credit history “Credit history” widely used as synonym for “credit reputation.” Narrower definition used in underwriting, though. Credit history: duration of applicant’s experience with credit. © 2018 Rockwell Publishing Credit Reputation Length of credit history General requirements: ⚫ credit history at least one year in duration ⚫ with three or more active accounts © 2018 Rockwell Publishing 21  Financing Residential Real Estate Instructor Materials Credit Reputation Payment record For each account, credit report gives detailed payment record. ⚫ Underwriters view chronic late payments as sign of irresponsibility, overextended finances. ⚫ Late payments shown as 30, 60, or 90 or more days overdue. © 2018 Rockwell Publishing Credit Reputation Major derogatory incidents Negative information on credit report may include: ⚫ charge-offs ⚫ collections ⚫ repossessions ⚫ foreclosures ⚫ bankruptcies © 2018 Rockwell Publishing Credit Reputation Major derogatory incidents Charge-off: uncollected debt treated as loss for creditor’s tax purposes. Collections: creditor may turn delinquent bill over to collection agency that presses debtor for payment. © 2018 Rockwell Publishing 22  Chapter 8: Qualifying the Buyer Credit Reputation Major derogatory incidents Repossessions: if personal property purchased on credit and payments delinquent, creditor may repossess collateral property. Foreclosures: foreclosure on credit report is matter of special concern to mortgage lender. Bankruptcy: bankruptcy on applicant’s credit report also taken very seriously. © 2018 Rockwell Publishing Credit Reputation Major derogatory incidents Fair Credit Reporting Act limits time derogatory incidents can remain on record to 7 years. ⚫ Exception: Bankruptcy – 10 years © 2018 Rockwell Publishing Credit Reputation Credit scores Credit score: figure calculated by credit reporting agency using established scoring model. ⚫ Evaluates all information on credit report. ⚫ Indicates individual’s likelihood of default. ⚫ Three main reporting agencies may have different scores for same person. © 2018 Rockwell Publishing 23  Financing Residential Real Estate Instructor Materials Credit Reputation Credit scores Scoring models based on statistical analysis of large numbers of mortgages. ⚫ Most widely used: FICO scores. ® ⚫ Range from around 300 to 850. © 2018 Rockwell Publishing Credit Reputation Credit scores Underwriters use credit scores to determine level of review applied to applicant’s credit history. ⚫ Good scores: basic review. ⚫ Mediocre or poor scores: in-depth review. © 2018 Rockwell Publishing Credit Reputation Obtaining credit information Buyers should look at their credit reports before applying for mortgage. ⚫ Some information may be incorrect. ⚫ Fair Credit Reporting Act requires agencies to investigate complaints, correct errors. © 2018 Rockwell Publishing 24  Chapter 8: Qualifying the Buyer Credit Reputation Explaining credit problems Letter to lender explaining negative credit report should: ⚫ state reason for problem ⚫ show problem no longer exists ⚫ highlight good credit before and since ⚫ provide documentation from third parties ⚫ not blame creditors © 2018 Rockwell Publishing Summary Credit Reputation Creditworthiness Credit report Credit history Charge-offs Collections Foreclosure Bankruptcy Credit scores (FICO® scores) Fair Credit Reporting Act © 2018 Rockwell Publishing Evaluating Creditworthiness Income analysis Income is second main component of creditworthiness. ⚫ Buyer who can’t afford payments won’t be approved for loan regardless of credit reputation. ⚫ Buyer’s income is starting point in determining loan amount, price range. © 2018 Rockwell Publishing 25  Financing Residential Real Estate Instructor Materials Income Analysis 3 characteristics of income Quantity: enough monthly income to afford monthly mortgage payment. Quality: from dependable sources. Durability: likely to continue for at least 3 years. © 2018 Rockwell Publishing Income Analysis Stable monthly income Stable monthly income: meets tests of quality and durability. May include: ⚫ wages or salary ⚫ retirement income ⚫ bonuses ⚫ alimony ⚫ commissions ⚫ child support ⚫ overtime ⚫ public assistance ⚫ self-employment ⚫ investment income income © 2018 Rockwell Publishing Stable Monthly Income Employment income Permanent employment: main income source for most buyers. Positive employment history: ⚫ consistency (2+ years in same job or field) ⚫ opportunities for advancement ⚫ special training or education © 2018 Rockwell Publishing 26  Chapter 8: Qualifying the Buyer Stable Monthly Income Employment income Commissions, overtime, and bonuses: ⚫ considered stable if consistent part of applicant’s overall earnings pattern Seasonal work: ⚫ considered stable if established earnings pattern exists © 2018 Rockwell Publishing Stable Monthly Income Employment income Self-employment income: ⚫ includes income from personal business or consistent income from freelance or consulting work ⚫ generally regarded as risky income source ⚫ amount of income unpredictable ⚫ small businesses often fail © 2018 Rockwell Publishing Stable Monthly Income Employment income Employment verification: ⚫ verification form sent to employer, or ⚫ W-2 forms and/or tax returns for 2 years plus pay stubs for 30 days, with phone call to employer © 2018 Rockwell Publishing 27  Financing Residential Real Estate Instructor Materials Stable Monthly Income Retirement income Pension and social security payments are usually dependable and durable. ⚫ Lenders can’t discriminate on basis of age. ⚫ Life expectancy can be considered. © 2018 Rockwell Publishing Stable Monthly Income Investment income Dividends or interest may be counted as part of stable monthly income. ⚫ Underwriter calculates average investment income for previous two years. © 2018 Rockwell Publishing Stable Monthly Income Rental income Rental from investment property can be counted as stable monthly income. ⚫ Lender may use only specific percentage of anticipated income, to account for vacancies or unexpected expenses. Rental from non-investment property (primary residence or second home) cannot be used. © 2018 Rockwell Publishing 28  Chapter 8: Qualifying the Buyer Stable Monthly Income Maintenance, alimony, child support Whether considered stable depends on many factors, including past reliability of payments. Lenders usually require: ⚫ copy of court decree ⚫ proof of receipt of payments Child support no longer counts when child reaches mid-teens. © 2018 Rockwell Publishing Stable Monthly Income Public assistance Equal Credit Opportunity Act prohibits lenders from discriminating against applicant because income is from public assistance program. ⚫ But income won’t count if eligibility terminates in near future. © 2018 Rockwell Publishing Stable Monthly Income Unacceptable types of income These usually don’t count as stable monthly income: ⚫ wages from temporary job ⚫ unemployment compensation ⚫ contributions from family members © 2018 Rockwell Publishing 29  Financing Residential Real Estate Instructor Materials Calculating Income Stable monthly income All income payments must be converted into monthly figures. Gross income figures used when calculating stable monthly income. ⚫ Payroll taxes not subtracted. ⚫ Qualifying standards take this into account. © 2018 Rockwell Publishing Calculating Income Nontaxable income Certain types of income exempt from taxation: ⚫ child support ⚫ disability, public assistance Full amount of payments available for expenses, so underwriter will “gross up” this income. © 2018 Rockwell Publishing Income Analysis Income ratios To measure adequacy of applicant’s monthly income, underwriters use income ratios. Borrower will have difficulty making payments if: Monthly Expenses > X% of Monthly Income © 2018 Rockwell Publishing 30  Chapter 8: Qualifying the Buyer Income Ratios Two types of ratios Debt to income ratio: measures proposed mortgage payment plus other regular debt payments against pre-tax monthly income. Housing expense to income ratio: measures monthly mortgage payment alone against pre-tax monthly income. © 2018 Rockwell Publishing Income Ratios PITI Proposed monthly mortgage payment used in calculating income ratios is PITI payment. ⚫ Includes impounds for property taxes, assessments, hazard insurance. ⚫ Also mortgage insurance and/or homeowners association dues, if applicable. © 2018 Rockwell Publishing Income Ratios Maximum ratios Qualifying standards set maximum income ratios. ⚫ Ratios generally treated as guidelines, not hard-and-fast limits. ⚫ Lender may approve loan if sufficient compensating factors make up for weakness in income. © 2018 Rockwell Publishing 31  Financing Residential Real Estate Instructor Materials Income Analysis Co-borrowers and cosigners Co-borrower: helps borrower qualify by sharing responsibility for loan. ⚫ Must have acceptable income, assets, and credit reputation. ⚫ Primary borrower and co-borrower have joint and several liability for loan. Cosigner: Non-occupant co-borrower with no ownership interest in property. © 2018 Rockwell Publishing Summary Income Analysis Quantity, quality, and durability of income Stable monthly income Income ratios Debt to income ratio Housing expense to income ratio Cosigner Joint and several liability © 2018 Rockwell Publishing Evaluating Creditworthiness Net worth Net worth: assets minus liabilities. ⚫ Substantial net worth indicates ability to manage financial affairs. ⚫ Buyer must also have enough liquid assets to close transaction. © 2018 Rockwell Publishing 32  Chapter 8: Qualifying the Buyer Net Worth Funds for closing Liquid assets: cash and assets that can be easily converted into cash. Applicant must have enough to cover: ⚫ downpayment ⚫ closing costs © 2018 Rockwell Publishing Net Worth Reserves Best for buyer to have reserves left over after closing. ⚫ Certain number of mortgage payments worth of reserves sometimes required by lender. ⚫ Even if not required, reserves strengthen application. © 2018 Rockwell Publishing Net Worth Assets Most assets will help loan applicant: ⚫ real estate ⚫ automobiles ⚫ furniture ⚫ jewelry ⚫ stocks/bonds ⚫ life insurance policy © 2018 Rockwell Publishing 33  Financing Residential Real Estate Instructor Materials Assets Bank accounts Verification of applicant’s funds in bank account: ⚫ Do amounts match statements in loan application? ⚫ Does applicant have enough cash for closing? ⚫ Has account been opened only recently? ⚫ Is present balance much higher than average balance? © 2018 Rockwell Publishing Assets Bank accounts Underwriter’s concern: did applicant borrow funds? ⚫ Lenders want borrower to use own funds for downpayment, reserves. ⚫ Borrowed funds would defeat purpose of lender’s requirements. ⚫ Affordable housing programs more flexible about borrowed funds. © 2018 Rockwell Publishing Assets Real estate for sale If applicant selling another property to raise cash, net equity counts as liquid asset. Net Equity = Market Value – (Liens + Selling Expenses) If equity main source of money for purchase, lender won’t fund loan until old home sold. ⚫ Buyer may apply for swing loan. © 2018 Rockwell Publishing 34  Chapter 8: Qualifying the Buyer Net Worth Liabilities Applicant’s personal liabilities subtracted from total value of assets to calculate net worth. Liabilities include: ⚫ credit card account balances ⚫ installment debts ⚫ taxes owed ⚫ liens against real estate owned © 2018 Rockwell Publishing Net Worth Gift funds Rules limit how much of downpayment and closing costs may be covered by gift funds. ⚫ Borrower must invest some of own funds. ⚫ Donor must sign letter stating that funds need not be repaid. ⚫ May be transferred to closing agent or deposited into applicant’s bank account prior to closing. © 2018 Rockwell Publishing Net Worth Delayed financing In highly competitive market, some buyers may want to make all-cash offer, pay cash, and obtain mortgage loan after closing © 2018 Rockwell Publishing 35  Financing Residential Real Estate Instructor Materials Other Factors in Underwriting Loan type Type of loan affects underwriting. ⚫ Borrowers default more often on ARMs and other loans with changing payment amount. © 2018 Rockwell Publishing Other Factors in Underwriting Repayment period Repayment period affects size of monthly payment. ⚫ Shorter repayment period, larger payment, harder to qualify. ⚫ But lender more inclined to approve loan with shorter repayment period. © 2018 Rockwell Publishing Other Factors in Underwriting Owner-occupancy Investor loans have much higher default rate than loans to owner-occupants. © 2018 Rockwell Publishing 36  Chapter 8: Qualifying the Buyer Other Factors in Underwriting Property type Regular single-family homes appreciate more, and more reliably, than: ⚫ manufactured homes ⚫ condominium units Nontraditional property type treated as risk factor in underwriting. © 2018 Rockwell Publishing Summary Net Worth & Other Factors Liquid assets Reserves Assets Liabilities Net equity Swing loan Gift funds Owner-occupant Investor loan © 2018 Rockwell Publishing Subprime Lending Subprime lending: lending to riskier borrowers. A credit: prime or standard financing. A- to B, C, D credit: subprime financing. © 2018 Rockwell Publishing 37  Financing Residential Real Estate Instructor Materials Subprime Lending Subprime borrowers Subprime financing may also be needed by buyers who can’t meet prime lender’s requirements in: ⚫ income & asset documentation ⚫ acceptable debt levels ⚫ size of downpayment © 2018 Rockwell Publishing Subprime Lending A-minus loans A-minus borrowers have: ⚫ good credit rating, ⚫ application with additional risk factor(s) A-minus loans somewhere between prime and subprime. © 2018 Rockwell Publishing Subprime Lending Characteristics of subprime loans Subprime lenders charge higher interest rates and loan fees in exchange for more flexible underwriting. More likely to have features such as: ⚫ prepayment penalty ⚫ balloon payment ⚫ negative amortization © 2018 Rockwell Publishing 38  Chapter 8: Qualifying the Buyer Subprime Lending Subprime boom Annual volume of subprime loans: 1994: $35 billion 2003: $332 billion 2007: $1.3 trillion (peak) © 2018 Rockwell Publishing Subprime Lending Secondary market for subprime loans Subprime boom fueled by growth of secondary market for subprime loans during 1990s. ⚫ Wall Street investors bought and securitized subprime loans. ⚫ Issued private-label mortgage-backed securities. © 2018 Rockwell Publishing Subprime Lending Secondary market for subprime loans HUD encouraged Fannie Mae and Freddie Mac to enter subprime market to meet affordable housing goals. ⚫ GSEs at first purchased only very top layer of subprime market (A-minus loans). © 2018 Rockwell Publishing 39  Financing Residential Real Estate Instructor Materials Subprime Lending End of boom Subprime boom led to loosening of underwriting standards throughout industry, even in prime market. Eventually led to skyrocketing default rates. ⚫ Many subprime lenders failed. ⚫ Prominent Wall Street investment banks collapsed. ⚫ Prime lenders also affected. © 2018 Rockwell Publishing Subprime Lending End of boom As mortgage crisis unfolded, subprime share of market shrank. ⚫ Far fewer subprime lenders now. ⚫ Most lenders have tightened underwriting standards. ⚫ Dodd-Frank Act added restrictions on prepayment penalties, balloon payments, negative amortization. © 2018 Rockwell Publishing Risk-based Loan Pricing Risk-based pricing: charging borrowers different interest rates and loan fees depending on their credit risk. ⚫ Poor credit risk = higher rate and/or fees. ⚫ Good credit risk = lower rate and/or fees. © 2018 Rockwell Publishing 40  Chapter 8: Qualifying the Buyer Risk-based Loan Pricing Risk-based pricing is used in most lending. Advantages: ⚫ Fewer applicants are denied financing. ⚫ Fairer, because good credit risks don’t subsidize poor credit risks. © 2018 Rockwell Publishing Risk-based Loan Pricing Disadvantages: ⚫ May make loan shopping more confusing, since lenders can’t advertise just one interest rate or APR. © 2018 Rockwell Publishing Summary Subprime Loans & Risk Pricing Subprime loan Prime loan A, B, C, D credit ratings A-minus loan Private-label MBS Risk-based pricing © 2018 Rockwell Publishing 41