How do banks calculate whether you are eligible for a mortgage or not?
The answer is easier and less complicated than many people seem to think.
I’m answering from the perspective of mortgage lending in the U.S., specifically for “conforming” loans—those following Fannie Mae and Freddie Mac’s guidelines. Those two investors purchase the majority of home loans in the U.S.
The most critical component of mortgage underwriting is the debt-to-income ratio (DTI). Lenders calculate this number by adding up the total house payment, including taxes and insurance, and all monthly debt payments appearing on the credit report, then dividing the total by the borrower’s gross monthly income. Lenders can approve conventional loans up to a DTI of 50%.
Example: A borrower earns $6,000 per month. Their credit report has a $400 car payment and $100 in credit card minimum payments. They are buying a home with a total monthly payment of $2,200. Their DTI is 45%, so their loan would pass that test.
The second component is the borrower’s credit score. When prospective clients or their realtors call me asking about preapproval, the first words out their mouths are invariably, “My credit score is such-and-such.” The truth is, I don’t care about their credit score—as long as they meet the minimum requirement for the loan they want.
For conventional loans, the minimum FICO score is 620. If they meet that criterion, they’re qualified from a creditworthiness standpoint.
Lenders use risk-based pricing on conventional loans. They apply loan-level pricing adjustments (LLPAs) on conventional loans to determine what rate they can get based on their credit score and the loan-to-value ratio. A borrower with a lower score will pay a higher rate because the LLPAs are higher. They’ll get the best rate with a FICO score of 740 or higher. Someone sporting an 850 FICO score will not get a lower rate than someone with a 740 score.
The lender will also look at the source of the borrower’s cash needed to close. Specifically, they will look for money that they can paper-trail. If they see “large” deposits—those for more than 50% of the borrower’s income—they’ll want to know where the money came from.
Years ago, I had a client hoping to buy a home. I saw a $20,000 ATM deposit in their bank statement. When I asked them where the money came from, they told me they’d taken a cash advance on their credit card—at 24% interest. They did not get their loan, as unsecured funds are not an acceptable source of money for a down payment.
Finally, the lender will look at the stability of the borrower’s income. Have they been in the same line of work for at least two years? If they receive overtime pay or bonuses, have they received it for at least two years? Lenders refer to the income they use for qualifying as stable income. It may be lower than what the borrower is currently earning. If they receive substantial overtime but have only gotten it for 18 months, that income won’t be admissible.
If a borrower is self-employed, the lender will evaluate their tax returns. A sole proprietor will file Schedule C, which is a summary of their gross income and fewer expenses. The underwriter will apply adjustments to the self-employed borrower’s reported net income to determine their stable income.
Many self-employed people take great (and legal) liberties with their Schedule C to minimize their tax liability. A real estate salesperson who drives many miles each year can claim $0.57 per mile. If they routinely drive 15,000 miles doing their job, they’ll be able to claim $11,400 in car expenses, thus reducing their taxable income.
However, this is a two-edged sword as the lender will use the reduced taxable income to qualify them for the loan.
When a loan officer originates a new loan, they’ll gather all the necessary documents, enter the information into the loan application, pull a credit report, and submit the loan package electronically to the automated underwriting system (AUS). Fannie Mae’s AUS is called Desktop Underwriter. Freddie Mac is a Loan Product Advisor. If the AUS approves the loan based on the data submitted, the package will go to the underwriter. Their job is to verify that the information submitted to the AUS is accurate. If it is, the chances are excellent that the loan will be approved.
The days of the “loan committee”—designated people working for the lender reviewed each application to decide on its fate—are thankfully gone. Today, technology drives most of the process, with the underwriter acting as part of the quality control mechanism.
Suppose a borrower meets the credit score and DTI criteria. In that case, if their income is stable and any cash needed is from acceptable sources, their chances of getting their approval are nearly assured.