Before Applying for a Home Loan, You Need to Understand This Situation

What's Going on Behind the Mortgage Scene and How it Affects Your Ability to Qualify for a Home Loan

Humor me. Allow me to vent for just one moment. If there is one thing I hated hearing more than any other during my loan officer days, it was the inevitable client declaration that because they had one good qualifying aspect, the bank should ignore the other bad qualifying aspects. It would go something like this: “Who cares that I make no money and have a bad credit score, there is plenty of equity in my house! Just give me this loan!” 

Ha, as if the bank has the ability to just loan money to whoever they think deserves to qualify for a home loan!

           Wait, what?

           Yes, you read that right.

It used to be—it seems so long ago now—that a bank would take a loan application, underwrite to standards they deemed appropriate, and make judgement call credit decisions about who should be approved. Well, thanks to abuse of that freedom, extreme greed by some powerful banks, ignorance and stupidity by other parties, and an overreaction by the government, those days are over. Most people have no idea.

It’s not your fault. The “news” isn’t big on details, and what’s really going on in the regulatory environment isn’t exactly attention grabbing headline material (or it wasn't until recently), but it affects millions of Americans whether or not they are aware. (If you want a quick recap, go watch The Big Short.)

Don’t worry, this article is not a political dissertation on how things should be, I just want you to understand the way things are. As much as you—and I—hate to hear it, our opinion on what the CFPB (the Government organization that regulates the financial industries) decides doesn't really matter, as they operate independently. Many things have changed because of this—many things that needed to and many things that didn’t—and what you need to know in order to be a prepared borrower is different now than it once was.

Which is why I hated hearing that complaint so much! Yes, it represented the way things used to be. Yes, it may actually makes sense, logically. But what many Americans don’t know and what few banks (if any) would admit is this: 

Lenders aren’t just worried about you defaulting on your $200,000 mortgage anymore. They are worried about being sued for unlimited millions more for giving you the loan in the first place!

That’s right, the real risk to banks is no longer (and maybe never was) individual loan defaults, it’s now the massive penalties assessed regularly by the CFPB for giving loans to people that the bank decided to lend to but the CFPB independently decides was not appropriate. 

Now, this is a dramatically simplified description of an increasingly complex regulatory and compliance driven landscape, but that's the only way to get to the most important point quickly:

What does this mean for you, the consumer? Well, it means that by and large most lenders no longer make decisions about who qualifies for a loan—regulators, investors, government agencies and sometimes even MI companies do that—the lender simply makes the decision on whether or not your loan application meets the guidelines laid out by the other parties. It doesn’t matter what they think of you as a borrower or whether they feel you qualify overall, it simply matters whether you fit the criteria of “ATR” (Ability to Repay) and “QM” (Qualified Mortgage) and honestly they want no part of making any decisions in gray area, because any decision they make opens them up to unlimited risk way beyond the potential loss of one foreclosure. 

So why do I want you to know this so bad?

Well, for starters, maybe you’ll go a little easier on your loan officer when he has to make that awkward decline call because your Costco credit card is over its limit (real example). She isn’t judging you. Or maybe she is, but that’s not the point. The rules are the rules.

More importantly, you need to know what those rules are so that you can get your house in order, so to speak, before applying for a mortgage. I can’t teach you all of them now, because there are literally thousands of them (and I literally mean literally, not literally figuratively). However, they are organized into four buckets that I call the “Four C’s”…but I’m just a guy, so call them what you want. To me, they are Credit, Collateral, Cash and Checks. To normal Loan Officers, it’s Credit, Collateral, Assets and Income. CCAI is a crappy acronym, so I’m sticking with the Four C’s.

Credit:

Probably the criterion that we write about most here at VA Finances, it’s the one you can most easily control. Know your FICO score. It matters. Most lenders are going to use the middle of the three scores that are reported by the three Credit Reporting Agencies, Equifax, Transunion and Experian. If there are two or more of you on an application, then it’s the lowest of all middle scores. We'll have 3-4 articles up soon if you’d like to know more about what affects your credit score and how you can nurse back to health an injured FICO.

Collateral:

Probably the criterion you have the least control over, the value of the property you are collateralizing matters greatly for a number of reasons: it determines how much you can borrow, your rate, and how much or little Cash you can put as a down payment to name a few. The value—and just as importantly to the lender, the condition—of the property is determined by using a third party appraisal. The use of “third party” is very important to understand. In most cases, your lender cannot pick the individual appraiser. They contract through a company called an AMC or Appraisal Management Company which then outsources to the end appraiser. This is done to maintain a separation between lender and appraiser. The thing I hated second most when I was a Loan Officer was any sentence starting with “Your appraiser…”. He’s not my appraiser any more than he is your appraiser. We are both his clients, in a way, and we both have to live with the results of his work without being able to influence it. 

If you are buying a house, an appraisal is done after you have a signed sales contract, and the agreed upon sales price is taken into consideration but ultimately not the determining factor. Just like in a refinance, it’s the comparable sales in the area that determine the appraised value of a given property.

Your loan amount divided by your appraised value equals a ratio known as your LTV, or loan to value. This ratio drives not only qualification, but also pricing, since rates are “risk-based”. Ask your loan officer if it makes financial sense to put more or less money down to get better pricing given your individual scenario.

Cash:

One of my famous sayings as a sales manager was in response to complaints my loan officers raised --when a client of their's would get declined for a loan, and I would subsequently find out they had $27 in their bank accounts. I would retort, ad nausea, “It takes money to buy a house!” Commence eye rolls, but come on, it does. $27 at a time wasn't even enough to get Bernie Sanders the Democratic nomination, so it’s not usually going to qualify you for a $400,000 home loan! Even if you are a veteran and have access to a zero down-payment loan, there are still cash considerations—such as earnest money deposits on sales contracts, closing costs, prepaids (non-fee closing costs like your own property taxes or insurance), HOA dues, potential reserves and many more. How much money you have in the bank matters, and so does the source of those funds. If the bank finds out that the money in your account is from untraceable funds, unsecured debt, or any illegal activity, you could be declined for that reason. (Then you’ll complain to me, “but I’m putting 50% down, who cares that the money is from mom’s credit card?!?” And I’ll…just….face + palm + tears). 

Checks:

Well, it’s 2017, so hopefully it’s more like Direct Deposits. I’m talking about your income. More specifically, your debt to income ratio. When you divide your total monthly credit obligations (including the loan in question) by your monthly qualifying income, you get a “DTI” percentage, or Debt to Income ratio. Different loan programs have different monthly DTI maximums that they allow. Many portfolio programs are capped at a 41% DTI, other conventional programs want you to be under 45%, and so on.

Notice I casually threw the word qualifying in that sentence above? That’s right, your “income” as you calculate it is not always the same as the “qualifying income” the bank must use for this ratio. What’s the difference? Well, if you are a strict base salary and W2 toting member of a corporation, not a whole lot. If you are self-employed, get over 25% of your income as commissions, own rental properties, named Madoff, new at your line of work or just super artsy and creative with your tax returns, it could be quite different.

So how do you measure up? 

Remember, these are separate and individual buckets. Strength in one doesn’t always overflow into another, you have to fill them each up to qualify for most loan programs these days. Super high debt matched with super high income can still equal a super high DTI, and you might be declined, even if you have a low LTV. And keeping up with Kardashians financially only gets you so far if the ink is still wet on your bankruptcy.

The CFPB likes to say “Know Before You Owe”, and I’m adding “Know Before You Go…and apply for a loan that could get declined and then you end up mad at someone who is not at fault because your cell phone company threw a $49 collection on your credit report and your score plummeted 60 points and now your dream house is going to get scooped up by your arch-nemesis because you never checked”. It’s less catchy, but you get the point.