Home loans are my specialty, so of course I know what it takes to get a buyer approved but from my experience in dealing with first time buyers and even some repeat buyers, not everyone understands what the bank underwriters are looking for when deciding if you are qualified or not.  I spend a good amount of time in my initial conversations explaining what I call the three pillars of loan qualification which are: Pillar one: Credit, Pillar two: income compared against current credit obligations and Pillar three: Available assets to be used for the down payment and closing costs.  These are the three areas an underwriter is looking at to decide If the loan applicant is a good risk for the bank to extend credit for the loan that can range anywhere from 100k to a couple million dollars. Keep in mind that the mindset of the bank is all about risk.  The bank wants to know what is the risk that the potential borrower will have a problem making the payments on the new loan which increases the risk that the bank will have to incur costs to collect or even repossess and re-sell the home at a discount on the foreclosure market.  The banks had to come up with some way to look at a borrower and calculate the risk and these are the metrics they use.  How your scenario lines up within these three categories will determine how qualified you are and how complicated the loan process will be.  In this blog entry, I will discuss each of the three Pillars and explain why they are important as well as provide some examples of what would make the process smoother or more complicated to help you better understand how the process can vary from person to person.

Pillar one: Credit

Let’s tackle the credit pillar first.  Most of us know what a credit/fico score is and maybe you know what yours is.  Generally, they range from 300 to about 850 with most people falling into the 500 to 800 range depending on how you have managed your credit up to the date of pulling your score.  There are various ways of keeping track of your score via online apps, your bank, or maybe you had it run recently.  It’s good to know that your score is always in flux depending on your balances, payment history, seasoning of existing accounts and variety of open accounts etc. there are also a variety of credit scoring models, so a mortgage score may be different than an auto loan or credit card score.  For our purposes, let’s focus on mortgage credit.

When we pull a mortgage credit report, we pull all three bureaus (Trans Union, Experian, and Equifax) and we use the middle score of the three.  So, if your three scores are 700, 685, and 726, we would use the 700 score as the qualifying metric for your mortgage loan.   Why are they all different?  Each credit bureau uses a slightly different model and not all accounts report to all three bureaus, and if they do not all report at the same time, the information can vary.  That is why we throw out the high AND the low and use the middle score as your average.

Your credit score tells the bank underwriter a story about how you have paid your accounts in the past.  Have you had a spotless record since you started, or have you had some stumbles along the way?  How bad were the stumbles? Did you recover and get back on the right track, or maybe you recovered then stumbled again. Have you had a major negative credit event, like bankruptcy, foreclosure, or collection accounts?  Do you have a very limited credit history? Is that limited history good or bad?  All this shows up in your credit report and is intended to reflect in your score.  This is why your score is such a big factor.  The lower the score the more issues you may have had and the higher the score reflects better credit management.

Sometimes a score can be lower than it should be or higher than it should be given, what the details of the report show.  A higher score usually isn’t an issue, but a low score could present problems with the qualifying process.   There are ways to repair and re-score your credit that take time and sometimes money.  Any good lender will be able to review your credit and usually identify some accounts that could be addressed to potentially help improve the score.  Due to the variance of the three bureaus and the fluidity of the scoring model, it’s not always easy to predict with 100% certainty what the score can be improved to.  For someone with a low score and fairly clean credit, feeling like the system is being unfair to them, this can be frustrating and stressful.  There are always exceptions, and I would say that with time anyone’s score can be improved with proper guidance and diligent management of their accounts moving forward.   The fico scoring system isn’t always spot on, but no system is perfect, and the banks need some way of determining your credit history, for the sake of not making this blog a novel, let’s not get sidetracked in the “what if” or credit repair direction.  If you have specific questions, please contact me directly and we can discuss your situation.

These days perfect credit is considered anything above a fico score of 780.  I would say the minimum score you should shoot for to have access to a decent set of loan options is 620 or above.  There are some programs that allow for scores as low as 580, but there are some additional criteria that need to be present for these programs.  In general, any score in the mid-700s is solid and will get you access to any credit program you desire.  Assuming your score sits in the 620 to mid-700 zone, we would look at different loan options that will depend on how your scenario lines up under the other two Pillar categories.

Put simply, your credit score is your record of past performance on your credit obligations.  The bank is judging your credit worthiness for a sizable loan based on how you have paid your bills (that report to the credit bureaus) up to that point.   It’s important to remember that only the accounts that report to the bureaus are taken into consideration.   So, managing your credit is important.  Don’t think that because a bill is small that it doesn’t matter as much.  I have seen a missed 5-dollar gas card payment sink a borrower’s credit score.  It’s vital to pay attention to all your accounts that report to the credit bureaus.   You have 30 days passed the due date on an account before the late payment gets reported.   You may still get charged a late fee, but your credit report only shows late payments 30 days or more on an account.    If you have specific questions about credit, credit scores, how to manage your credit, please reach out to me directly and we can discuss.

So, pillar one supports your credit worthiness for a home loan.  It can be as simple as a score or maybe a more complicated scenario that needs time and effort to get to a level that will help you qualify for a home loan.  It’s also important to know that none of the three pillars stand alone and it’s a combination of how your pillars line up that helps you qualify.  For example, if you have below average credit (pillar one), say a 620 fico score but you have a lot of money for a down payment (pillar three) say 40% of the purchase price, and a solid job with a great salary and not a lot of debt (pillar two), you could qualify for a loan with a rate similar to someone with a great fico score, not a lot to put down and a good job with some debt.  My rule of thumb is that you want at least 2 of the 3 pillars to be stable and look good to an underwriter.  It’s preferable to have all 3 looking great, but with 2 of the 3 being stable I can usually get the loan approved.  Next, I want to continue and take a dive into the 2^nd pillar, so you understand how your income along with what your current credit obligations say about your capacity to take on a new mortgage payment.

Pillar Two: Income and current credit obligations

 All three pillars are important and, like I said earlier, you optimally want to have high marks in all three areas, but you can usually get a loan with at least two of the three being strong.  One of those two stronger pillars needs to be income as you absolutely need to show the ability to repay the new loan.   And the 2^nd part of pillar two is your current debt load.  Together your income and current debt load show the underwriter your “capacity” to take on or afford the new mortgage payment as well as any other obligations related to the house like property taxes, homeowners’ insurance, and when applicable: homeowners’ association dues.  When lenders talk about all these items, we refer to it as the Principal, Interest, Taxes and Insurance payment or PITI payment.  Always make sure you are quoted this full payment as these are real costs and will be used for your debt-to-income ratio or DTI when the underwriter is looking at the numbers for your file.

A debt-to-income ratio or DTI is just what it sounds like.  It’s the percentage of your income that is spent on your credit debt obligations.  For example:  if you make $5000 a month and are obligated to $2500 in monthly credit debt obligations, your DTI % would be 50%.  An easy way to check you current DTI is to add up all your credit report related monthly minimum payments (credit cards, auto loans, student loans, cosigned loans, department store cards etc.) and divide that number by your gross monthly income and you will have your Debt-to-income ratio.  Keep in mind you don’t need to add any payments that aren’t reported on your credit report. (Cell phone, insurance, utilities etc.).    For the purposes of a mortgage loan, the underwriter will do this same thing but add in the proposed PITI Mortgage payment and come up with your DTI % with the mortgage added in.   The goal is to keep this number as close to or under 45%.   There are cases where we can go to 50% but there needs to be other compensating factors so 45% and below is a good goal.

Now that you know the goal is to have an all-in 45% DTI (or lower) and how your current debt load affects how much of a mortgage expense you can take on, let’s circle back to the income part of Pillar two.  Not all income is looked at the same. I wrote a nice blog about this a couple weeks ago.  Keep in mind the points that blog makes so you know how your income will be looked at when calculating your total income number that will be used when determining your “capacity” to take on the new PITI mortgage payment.

The underwriter’s job is to look at your file and identify the risk level to the lending bank.  Pillar one is your credit or your history of how you have paid your bills up to that point. Pillar two is looking at your ability or “capacity” to afford the newly proposed PITI mortgage payment when added to your existing credit debt payments.  As your loan officer, it’s my job to let you know how much of a payment you can take on and still qualify with a DTI in an allowable range. (Optimally 45% DTI and below)

Let’s look at what makes up your PITI payment. I already said that PITI means Principal, Interest, Taxes, and Insurance.  The principal and interest are the loan payment portion of the PITI number.  Those amounts are your actual loan payment and are a factor of the loan amount (example 300K), the interest rate (example 6%) and the loan term (example 30 years) which for this example would mean a principal and interest payment of $1798.65.  The third part of a PITI payment is taxes, which are roughly calculated at 1.25% annually on the purchase price of the home (example $375K) and divided by 12 to get the monthly amount which would be $390.63. The last part would be homeowners’ insurance which can range anywhere from $80 to $200+ depending on what type of policy you attain.  For our example let’s assume it’s a policy with an annual premium of $1200 a year, so that would be $100 a month.  When you put all these parts together $1798.65 (PI)+ $390.63 (T)+$100 (I)= $2289.28 (PITI) is your all-in mortgage costs for a new home worth 375K and a loan for 300K at 6%.

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As your loan officer I would have had made sure that your Debt to income ratio (DTI) with that PITI payment and all your other monthly debt obligation was at or below 45% before we moved forward and found a house and submitted your loan to an underwriter, but that is what the underwriter is looking at when they crunch the numbers on your file to make sure you have the quantifiable income to afford the loan you are requesting.  This is all stuff I work on ahead of time and I wouldn’t submit your loan without knowing how the numbers look, but the underwriter double checks my math and occasionally makes minor adjustments which is why I always leave a little room under the cap to be safe.

You should now have a good understanding of how important Pillar two is to the underwriting process.  We don’t have stated income loans anymore, so you need to be able to show you have the capacity or ability to repay the newly proposed loan. Next, let’s dive into Pillar three and learn about how the assets you have available for a down payment affects your loan approvability.

Pillar Three: Assets available for a down payment

When I refer to funds available for a down payment, I am also referring to closing costs.   It is very common for a first-time buyer to assume that all they need is the funds for a down payment, but there are also closing costs associated with a loan.  They can range from 2% to 5% depending on the size of the loan, if points are paid or not, and how the purchase agreement is negotiated.  The best rule of thumb I like to use is 2% of the price of the house for houses over 600K and 3% for anything under 600K.  Rule of thumb meaning that it’s a rough estimated number.  The best way to know for sure what the closing costs will be is to complete a loan application and allow me to plug in more accurate numbers based on your specific scenario. For now, just assume that you will need an extra 2-3% over the down payment amount to cover costs like: appraisal, inspections, title and escrow fees, first year’s homeowners’ insurance premium, prorated property taxes, prepaid interest in the loan, funding your escrow/impound account, credit reports, any processing fees, recording fees etc.  (These fees will differ from lender to lender but generally are close assuming you don’t buy down your rate with additional origination points or fees)

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Put simply, your down payment funds are your skin in the game.  It’s the collateral you are putting up towards the transaction that affects the risk the lender is taking on.  For example, a larger down payment presents the bank with a lower risk and a smaller down payment increases the risk.   Someone putting 20% down on a house has more skin in the game and is sharing the risk with the bank, while someone looking for 100% financing (or 0% down) is asking the bank to take on all the risk.  Logic would dictate that any percentage of down payment in between 0% down and 20% will be on the spectrum of risk for the bank.

Pillar three is an important element especially when combined with the other two pillars.   The lower the down payment the stronger the bank will require the other pillars to be.    Example: for a conventional loan, someone putting 3% down (Pillar three) is going to be required to have a better credit score (pillar one) and a lower debt to income ratio (pillar two).  conversely, a buyer with a large down payment (pillar three) will still qualify with a less than perfect fico score (pillar one) and maybe a little more debt compared to their income (pillar two).  It’s always preferable to have all three pillars strong, but in the case of Pillar three (like pillar two), you can make up for weakness with a strong showing in the other two pillars.

Hopefully by now you are getting a feel for how the three pillars work together to help an underwriter assess your level of risk when it comes to loan qualification.  It’s not an exact science and there are exceptions to the rule, so it’s always best to discuss your specific scenario with me or another lender to see how you line up.

When I say “assets”, I mean documentable liquid assets.  What does this mean?

A documentable asset is one that is in an account that can be documented.  This excludes cash, as it cannot be traced back to a source.  The banking industry is always on alert for fraud, and cash is not traceable, so it lends itself to fraud more readily than an asset that has been sitting in an account for some time.  In general banks assume money that has been in an account for 2 months or more to be valid funds useable for the transaction.  Keep this in mind, as cash deposited into an account within that two-month period will be required to be sourced and it can be very problematic for your loan file process.

An asset can be from a variety of sources.  Allowable funds can be from: checking or savings accounts, stock accounts, retirement accounts like 401K or IRAs, a work bonus, sale proceeds of personal property, gift funds from a family member, annuities, life insurance cash value etc. …even Crypto currency if you can document it with a statement.    If it can be documented to be your funds (or the funds of a gift funds donor) for at least two months, it is allowable.

Not all loans require the same level of pillar three strength.  The required minimum down payment can vary depending on the type of loan you are applying for.  VA loans allow for 0% down, FHA loans require at least 3.5%, and Conventional loans generally require at least 5% if you don’t qualify for a low-income version which in those cases allows for a 3% down payment.  Typically, a Jumbo loan will require at least 10% down but the rates get better and there are more options the more you put down.  All loans will allow you to put more money down as it lowers the risk to the bank, but it is important to know the minimum amounts are for each option.

Glossary of mortgage terms

A popular misconception is that VA and FHA loans are for first-time buyers only, but I would say they are more geared towards buyers with a less than perfect fico score (pillar one), a higher debt to income ratio (pillar two) and less money for a down payment (pillar three). Conventional loans will allow for lower credit scores and lower down payments, but the rate and monthly private mortgage insurance (PMI) will be higher reflecting the increased risk to the bank, whereas the government backed loans (VA/FHA) allow for more risk without penalizing the buyer with a higher rate. So, in a sense they allow for less stable pillars.

When combined with the strength of your other two pillars, your available assets complete the picture for an underwriter assessing your files risk.  Not all loan types require the same dynamic of the three pillars.  A knowledgeable loan officer will examine and discuss your strengths and weaknesses of the three pillars and advise which loan option best fits your current situation.  A quality loan officer will be able to explain how these three pillars interact and why they are important.  Not everyone will qualify for the loan they want, but a good lender can explain your current pillar dynamics and what improvements can be made to strengthen your chances of getting your loan approved.  Sometimes the conclusion of the discussion is putting a plan in place to enable you to get to where you want to be.

I hope this has been helpful in explaining what an underwriter is focusing on when making the decision to approve or deny your loan. Knowledge is power and understanding this process is key to making good decisions moving forward to give yourself the best chance to secure the lending you need to make your home ownership goals a reality.  This should take some mystery out of the process for you, but also keep in mind that my job as a loan officer is to help you navigate this process.  It is my job to pre-asses your pillar strength and guide you to the right path so that by time your file hits an underwriter’s desk, there is no debate about whether it will be approved.

Thank you for reading all this. You are now more knowledgeable than most buyers (even some loan officers). If you have questions, feel free to reach out to me and we can discuss your specific situation.  Going down every possible path would have turned this article into a book and it’s already a bit long as is.  Please pass this information along to anyone you know that would benefit from it. My goal is to educate and enlighten so that the loan application process isn’t as intimidating as it can be for some. I look forward to helping you reach your homeownership goals.