Broker Pre-License Flashcards (Unit 8)
Loan Processing
In order for you to counsel your buyers accurately, it's important for you to have some understanding of how lenders qualify buyers for loans. Lenders qualify buyers using what are called qualifying standards or loan underwriting standards. When a lender is processing a loan, there are four critical procedures involved. The lender must: -Determine the ability of the borrower to repay the loan. -Estimate the value of the property that is collateral for the loan. -Research and analyze the marketability of the title. -Prepare the documents necessary to approve the loan and close the transaction. On the following pages, we'll discuss how the lender determines the borrower's ability to repay the loan and estimates the value of the property. Lenders use loan underwriters to process the applications and decide whether to accept or reject the loan. All mortgage loans are risky for the lender. Lenders run the risk that: -The borrower will not be able to repay the loan. -If the borrower defaults on the loan, the property will be worth less than what is still owed on the loan.
Stable Income
Income is considered stable if it comes from a consistent and reliable source. Depending on who the employer is, the income might hold a lot of weight or not so much. For example, let's say the applicant works for the State of Indiana. Working for the state is considered to be a reliable and consistent source of income, so the underwriter is apt to give income from this source a high score. On the other hand, what if the applicant works for a new, small business that is just starting up in the area? Since the new company does not have an established track record in the area, the underwriter will probably give this income a lower score. Income is also judged on its permanence - in other words, how long it can be expected to continue. Income that comes from permanent employment, government benefits, or some types of investment interest or dividends is favorably viewed. On the other hand, income from temporary employment or unemployment benefits is not considered stable enough for major consideration.
Preapproval does have its advantages.
-Offers from buyers who have a preapproval letter are much more attractive to sellers. When sellers are dealing with multiple offers, a preapproval letter might be just the thing to help make their decision, since it shows that the financing contingency will not be a problem. Most sellers' agents will specifically ask for proof of the buyer having been preapproved. If the agent does not receive such proof, he or she may recommend that the seller not consider the offer until the seller gets notice of preapproval. -Closing goes more smoothly when buyers are preapproved. Since the evaluation of the buyers has already been done, the lender needs only to obtain an appraisal and start the title work. When buyers are certain they are ready to buy, preapproval is very valuable. It's a wise idea in an active market for buyers to get preapproved before they make an offer.
Income Analysis
An underwriter must do a careful analysis of the borrowers' income to determine if, in fact, the borrowers can afford the monthly payment for the property they want to buy. When an underwriter is looking at an applicant's income, he or she must decide: How much of the applicant's income is stable - Income that is not stable will not be used in the calculations for ability to repay the loan. If the applicant has enough stable income to make the monthly payment.
Assets
Assets can be financial, such as stocks or bonds; they can be tangible or intangible - an intangible asset would be the cash value of a life insurance policy; or they can be physical, such as jewelry, real estate, cars or furniture. Underwriters typically give more weight to assets that are liquid. Liquid assets are cash or anything that can be quickly converted to cash, such as stocks. When you are dealing with buyers who currently own a home, more than likely they will be counting on the proceeds from the sale of their current home to help finance the purchase of the new home. These proceeds are referred to as net equity. Lenders often treat the net equity of a home as a liquid asset.
Credit History
At the same time the underwriter is reviewing financial and employment information, the underwriter will also send a request for a borrower's credit reports. The credit report indicates the status of current and past accounts. The borrower's payment history is the most important part of the report. The credit reporting agencies use past payment history, the types of credit the borrower has used, outstanding debt, and other factors to evaluate and score a particular borrower. Lenders use these credit scores to decide whether or not to lend money to a borrower, and if so, under what terms.
Liabilities
Liabilities include everything a person owes, including credit card debt, charge accounts, student loans, car loans, other installment loans, medical bills, and outstanding taxes.
Qualifying Activities for Buyers
Most home buyers, especially those buying for the first time, have little idea of what they can really afford to pay for a home. Some buyers are certain that they know what they could afford in a monthly payment. However, what a buyer may be willing to pay per month on a mortgage loan may be too high a percentage of his or her monthly income to be acceptable to a lender. Making the payments on a mortgage falls squarely on the shoulders of the home buyers. However, it's the lender who will make the decision as to whether or not the buyers qualify for a loan and how much that loan will be. When working with buyers, it's critical for both you and them to have a solid idea of what they can afford before you start showing them homes in a particular price range. By having your buyers preapproved, you can avoid wasting a lot of time showing them homes that are outside of their price range - either too high or too low. More importantly, you can help the buyers avoid the embarrassment and disappointment of having their loan application rejected, if they make an offer on a home that it turns out is not within their means.
Preapproval
On the other hand, preapproval is a formal process that only a lender can do. When going through a preapproval process, the buyers fill out a loan application and give the lender all of the same documentation that's required when applying for a loan after finding a home. The lender takes all of the information and evaluates it just as if it were a regular loan application, except that the lender will not order an appraisal or a title search (since the buyers have not yet chosen a home they want). After checking the buyers' credit and finding it to be satisfactory, the lender will set a maximum loan amount based on the financial information the buyers provided. Then the lender will issue a preapproval letter, which says the lender will lend the buyers an amount up to their maximum approved amount - as long as the property they choose meets the lender's standards. The preapproval letter typically has an expiration date of about three to four months, but the buyers could ask for an extension if needed. Prequalification and preapproval have the same basic result - the buyers know how much of a home they can afford. But preapproval has some advantages. Let's take a look at that aspect.
Income Ratios
Once the lender has established the applicant's monthly income, it's time to determine if that income is enough to pay a loan. The lender will do this by establishing an income ratio and a debt ratio. The income ratio establishes the borrower's capacity to pay by limiting the percent of gross income a borrower may spend on housing costs. Housing costs include the principal, the interest, the taxes and homeowner's insurance, and also may include some monthly assessments for mortgage insurance and utilities. Conventional loans typically require this ratio to be under 28 percent, but FHA guidelines require the income ratio to be no more than 29 percent. A borrower's debt ratio is calculated based on all of the monthly obligations the borrower has, including those items or payments the borrower must make for other debts. These debts could be car payments, revolving charge accounts, etc. Conventional loans usually require the debt ratio be 36 percent or lower, but FHA guidelines state the debt ratio may not be greater than 41 percent.
Debt Ratio
The debt ratio considers all of the monthly obligations of the income ratio plus any additional monthly payments the applicant must make for other debts. The lender will look specifically at minimum monthly payments due on revolving credit debts and other consumer loans. The debt ratio formula is: monthly housing expenses + monthly debt obligations/ monthly gross income = debt ratio To identify the housing expenses plus the debt a debt ratio allows, modify the formula as follows: monthly gross income x debt ratio = monthly housing expense + monthly debt obligations Most conventional lenders require that this debt ratio be no greater than 36%. For an FHA-backed or VA-guaranteed loan, the debt ratio may not exceed 41%. The FHA and VA include in the debt figure any obligation costing more than $100 per month and any debt with a remaining term exceeding six months. Using the 36% debt ratio, the couple whose monthly income is $4,000 will be allowed to have monthly housing and debt obligations of $1,440: $4,000 gross income x 36% = $1,440 expenses and debt VA-guaranteed loans also require a borrower to meet certain qualifications based on net income after paying federal, state, and social security taxes, housing maintenance and utilities expenses. Such residual income requirements vary by family size, loan amount, and geographical region.
Underwriting
The evaluation process used to determine the borrower's ability to repay a loan and to estimate the value of the property being used as collateral is called underwriting. Underwriting will determine whether a borrower and property meet the minimum requirements established by the lender, the investor, or the secondary market (into which the lender will probably sell the loan). Underwriting Process Once the borrower has submitted a loan application to a lender, the actual underwriting process begins. The underwriter must evaluate the borrower's ability to repay the loan. As we said earlier, one of the principal risks a lender undertakes is the fact that the borrower might default on repayment of the loan and that the borrower will damage the value of the property as security. In addition, the lender runs the risk that, in the event of a foreclosure, the sales proceeds from the property will not be enough to cover the lender's loss. To qualify for a mortgage loan, a borrower must meet the lender's qualifications in terms of income, debt, cash, and net worth. In addition, the borrower must demonstrate sufficient creditworthiness to be an acceptable risk.
Other Underwriting Considerations
The underwriter will examine the assets and liabilities section of the borrower's application very carefully. The information about the borrower's net worth is important to the lender as it gives an indication of the borrower's ability to keep up the payments on the loan in the event that the borrower would lose his or her job. The lender determines a borrower's net worth by subtracting liabilities from assets.
Finding the Right Price Range
The upper limit of the buyers' price range consists of the maximum amount of the loan they can secure, plus whatever money they have available to make the down payment and pay the closing costs. Obviously, the buyers know for certain how much cash they have available for the down payment and closing costs. So to determine the upper limit of their price range, they need to know just how much of a loan they can qualify for. Buyers can find out how much of a loan they can qualify for in one of two ways: Prequalification Preapproval Let's examine the difference.
Prequalification
This process is informal. It can be done by a real estate agent or by a lender. A real estate agent can prequalify his or her buyers by meeting with them and asking a series of questions about their financial status - income, assets, debts and credit history. Once the agent has collected this information, he or she can establish the price range of homes the buyers can afford. Note: Prequalification by a lender is also an informal process in that the lender is not committing to making the loan. The lender is only saying how much the buyers would qualify for, based on the answers to the same kinds of questions regarding their financial status.
The Letter
When a lender does the prequalification of the buyers, the lender will issue a prequalification letter that is very similar to a preapproval letter. Be sure both you and your buyers know the difference. As we said earlier, with prequalification the lender does not commit to the loan. So the evaluation of the buyer will not take place until after the offer is accepted and the buyers complete a formal loan application. Sometimes lenders call their letter an approval letter just as a matter of course. But if in the body of the letter it states that loan approval is subject to "verification of the buyers' income and credit information," you can be sure that the letter is a prequalification letter rather than a preapproval letter.