1. © 2012 Rockwell Publishing Financing Residential Real Estate Lesson 8: Qualifying the Buyer

2. © 2012 Rockwell Publishing Introduction This lesson will cover: underwriting process automated underwriting credit reports and credit scores income analysis net worth other factors in underwriting subprime lending risk-based loan pricing

3. © 2012 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?

4. © 2012 Rockwell Publishing 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

5. © 2012 Rockwell Publishing Underwriting Process Qualifying standards: minimum standards used in underwriting. Draw line between acceptable and unacceptable risks. Qualifying standards

6. © 2012 Rockwell Publishing Underwriting Process Most lenders use Fannie Mae/Freddie Mac standards for conventional loans. FHA and VA standards must be used for FHA and VA loans. Qualifying standards

7. © 2012 Rockwell Publishing Underwriting Process Automated underwriting system (AUS): computer program that analyzes loan applications. Used in conjunction with traditional underwriting. Traditional underwriting now called manual underwriting. Automated underwriting

8. © 2012 Rockwell Publishing Automated Underwriting Most widely used AU systems: Desktop Underwriter® (Fannie Mae) Loan Prospector® (Freddie Mac) Either may be used to underwrite conventional, FHA, or VA loans. Fannie Mae/Freddie Mac will still buy manually underwritten loans. AU and secondary market

9. © 2012 Rockwell Publishing Underwriting Process Programming of secondary market agency 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. AU programming

10. © 2012 Rockwell Publishing Underwriting Process Information from loan application entered into AU system. AU obtains applicant’s credit information from credit reporting agencies. AU issues report with recommendations. How AU works

11. © 2012 Rockwell Publishing Underwriting Process Three main categories of recommendations in AU report: risk classification level of documentation property appraisal or inspection How AU works

12. © 2012 Rockwell Publishing AU Recommendations AU report indicates level of scrutiny that application should receive. Approve/Accept: meets all qualifying standards. Approve/Ineligible: meets credit risk standards, but ineligible for purchase by agency for other reasons. Refer/Caution: doesn’t meet all standards, should be reviewed. Risk classification

13. © 2012 Rockwell Publishing AU Recommendations 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. Risk classification

14. © 2012 Rockwell Publishing AU Recommendations 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 just standard or streamlined; “no doc” loans not available. Level of documentation

15. © 2012 Rockwell Publishing AU Recommendations Refer/Caution loans: standard documentation (and manual underwriting) generally required Approve/Accept loans: streamlined documentation permitted Level of documentation

16. © 2012 Rockwell Publishing AU Recommendations AU report also indicates which of these is appropriate: full appraisal drive-by inspection report on property’s likely value (no inspection) Appraisal recommendation

17. © 2012 Rockwell Publishing Underwriting Process Advantages of automated underwriting over manual underwriting: streamlines process increases objectivity improves underwriting accuracy Advantages of AU

18. © 2012 Rockwell Publishing Summary Underwriting Process Underwriting standards Automated underwriting Manual underwriting Risk classification Standard documentation Streamlined documentation (low-doc) Minimal documentation (no doc) Drive-by inspection

19. © 2012 Rockwell Publishing Evaluating Creditworthiness Qualification of buyer involves evaluation of three main components of creditworthiness: credit reputation income net worth (assets)

20. © 2012 Rockwell Publishing Evaluating Creditworthiness To evaluate applicant’s credit reputation, lender relies on credit reports prepared by 3 national credit rating agencies: Equifax Experian (formerly TRW) TransUnion All are private companies. Credit reputation

21. © 2012 Rockwell Publishing Credit Reputation Personal credit report covers 7 years of information about individual’s: revolving credit accounts installment debts previous mortgages Credit reports

22. © 2012 Rockwell Publishing Credit Reputation Credit information important in underwriting: length of credit history payment record derogatory credit incidents credit scores Credit reports

23. © 2012 Rockwell Publishing Credit Reputation “Credit history” widely used as synonym for “credit reputation.” Narrower definition used in underwriting. Credit history: duration of applicant’s experience with credit. Length of credit history

24. © 2012 Rockwell Publishing Credit Reputation General requirements: credit history at least one year in duration with three or more active accounts Length of credit history

25. © 2012 Rockwell Publishing Credit Reputation 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 days overdue. Payment record

26. © 2012 Rockwell Publishing Credit Reputation Negative information on credit report may include: charge-offs collections repossessions judgments foreclosures bankruptcies Major derogatory incidents

27. © 2012 Rockwell Publishing Credit Reputation 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. Major derogatory incidents

28. © 2012 Rockwell Publishing Credit Reputation Repossessions: if personal property purchased on credit and payments delinquent, creditor may repossess collateral property. Judgments: when someone loses lawsuit, court may order her to pay money (damages) to person who sued. Major derogatory incidents

29. © 2012 Rockwell Publishing Credit Reputation Foreclosures: foreclosure on applicant’s credit report is matter of special concern to mortgage lender. Bankruptcy: bankruptcy on applicant’s credit report also taken very seriously. Major derogatory incidents

30. © 2012 Rockwell Publishing Credit Reputation Fair Credit Reporting Act limits time derogatory incidents can remain on record to 7 years. Exception: Bankruptcy – 10 years Major derogatory incidents

31. © 2012 Rockwell Publishing Credit Reputation 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. Credit scores

32. © 2012 Rockwell Publishing Credit Reputation Scoring models based on statistical analysis of large numbers of mortgages. Most widely used: FICO ® scores. Range from under 400 to over 800. Credit scores

33. © 2012 Rockwell Publishing Credit Reputation 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. Credit scores

34. © 2012 Rockwell Publishing Credit Reputation 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. Obtaining credit information

35. © 2012 Rockwell Publishing Credit Reputation 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 Explaining credit problems

36. © 2012 Rockwell Publishing Summary Credit Reputation Creditworthiness Credit report Credit history Charge-offs Collections Foreclosure Bankruptcy Credit scores (FICO® scores) Fair Credit Reporting Act

37. © 2012 Rockwell Publishing Evaluating Creditworthiness 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. Income analysis

38. © 2012 Rockwell Publishing Income Analysis Quantity: enough monthly income to afford monthly mortgage payment. Quality: from dependable sources. Durability: likely to continue for at least 3 years. 3 characteristics of income

39. © 2012 Rockwell Publishing Income Analysis wages or salary bonuses commissions overtime self-employment income retirement income alimony child support public assistance investment income Stable monthly income Stable monthly income: meets tests of quality and durability. May include:

40. © 2012 Rockwell Publishing Stable Monthly 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 Employment income

41. © 2012 Rockwell Publishing Stable Monthly 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 Employment income

42. © 2012 Rockwell Publishing Stable Monthly Income Self-employment income: includes income from personal business, freelance work, or consulting work generally regarded as risky income source amount of income unpredictable small businesses often fail Employment income

43. © 2012 Rockwell Publishing Stable Monthly 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 Employment income

44. © 2012 Rockwell Publishing Stable Monthly Income Pension and social security payments are usually dependable and durable. Lenders can’t discriminate on basis of age. Life expectancy can be considered. Retirement income

45. © 2012 Rockwell Publishing Stable Monthly Income Dividends or interest may be counted as part of stable monthly income. Underwriter calculates average investment income for previous two years. Investment income

46. © 2012 Rockwell Publishing Stable Monthly Income 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. Maintenance, alimony, child support

47. © 2012 Rockwell Publishing Stable Monthly Income 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. Public assistance

48. © 2012 Rockwell Publishing Stable Monthly Income These usually don’t count as stable monthly income: wages from temporary job unemployment compensation contributions from family members Unacceptable types of income

49. © 2012 Rockwell Publishing Calculating 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. Stable monthly income

50. © 2012 Rockwell Publishing Calculating 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. Nontaxable income

51. © 2012 Rockwell Publishing Income Analysis 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 Income ratios

52. © 2012 Rockwell Publishing Income Ratios Debt to income ratio: measures proposed mortgage payment plus other regular debt payments against monthly income. Housing expense to income ratio: measures monthly mortgage payment alone against monthly income. Two types of ratios

53. © 2012 Rockwell Publishing Income Ratios 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. PITI

54. © 2012 Rockwell Publishing Income 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. Maximum ratios

55. © 2012 Rockwell Publishing Income Analysis Cosigner: helps borrower qualify by sharing responsibility for loan. Must have acceptable income, assets, and credit reputation. Primary borrower and cosigner have joint and several liability for loan. Cosigners

56. © 2012 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

57. © 2012 Rockwell Publishing Evaluating Creditworthiness Net worth: assets minus liabilities. Substantial net worth indicates ability to manage financial affairs. Buyer must also have enough liquid assets to close transaction. Net worth

58. © 2012 Rockwell Publishing Net Worth Liquid assets: cash and assets that can be easily converted into cash. Applicant must have enough to cover: downpayment closing costs Funds for closing

59. © 2012 Rockwell Publishing Net Worth 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. Reserves

60. © 2012 Rockwell Publishing Net Worth Most assets will help loan applicant: real estate automobiles furniture jewelry stocks/bonds life insurance policy Assets

61. © 2012 Rockwell Publishing Assets 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? Bank accounts

62. © 2012 Rockwell Publishing Assets 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. Bank accounts

63. © 2012 Rockwell Publishing Assets 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. Real estate for sale

64. © 2012 Rockwell Publishing Net Worth 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 Liabilities

65. © 2012 Rockwell Publishing Net Worth 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. Gift funds

66. © 2012 Rockwell Publishing Other Factors in Underwriting Type of loan affects underwriting. Borrowers default more often on ARMs and other loans with changing payment amount. Loan type

67. © 2012 Rockwell Publishing Other Factors in Underwriting 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. Repayment period

68. © 2012 Rockwell Publishing Other Factors in Underwriting Investor loans have much higher default rate than loans to owner-occupants. Owner-occupancy

69. © 2012 Rockwell Publishing Other Factors in Underwriting Regular single-family homes appreciate much more, and more reliably, than: manufactured homes condominium units Nontraditional property type treated as risk factor in underwriting. Property type

70. © 2012 Rockwell Publishing Summary Net Worth & Other Factors Liquid assets Reserves Assets Liabilities Net equity Swing loan Gift funds Owner-occupant Investor loan

71. © 2012 Rockwell Publishing Subprime Lending Subprime lending: lending to riskier borrowers. A credit: prime or standard financing. A- to B, C, D credit: subprime financing.

72. © 2012 Rockwell Publishing Subprime Lending 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 Subprime borrowers

73. © 2012 Rockwell Publishing Subprime Lending A-minus borrowers have: good credit rating, application with additional risk factor(s) A-minus loans somewhere between prime and subprime. A-minus loans

74. © 2012 Rockwell Publishing Subprime Lending 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 Characteristics of subprime loans

75. © 2012 Rockwell Publishing Subprime Lending Annual volume of subprime loans: 1994: $35 billion 2003: $332 billion 2007: $1.3 trillion (peak) Subprime boom

76. © 2012 Rockwell Publishing Subprime Lending 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. Secondary market for subprime loans

77. © 2012 Rockwell Publishing Subprime Lending 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). Secondary market for subprime loans

78. © 2012 Rockwell Publishing Subprime Lending 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. End of boom

79. © 2012 Rockwell Publishing Subprime Lending As mortgage crisis unfolded, subprime share of market shrank. Far fewer subprime lenders now. Most lenders have tightened underwriting standards and won’t make risky loans. Dodd-Frank Act adds new restrictions on prepayment penalties, balloon payments, negative amortization End of boom

80. © 2012 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.

81. © 2012 Rockwell Publishing Risk-based Loan Pricing Prime lenders have traditionally used average cost pricing or par rate pricing. All approved borrowers charged same interest rate and fees. Those who don’t meet lender standards are denied loan.

82. © 2012 Rockwell Publishing Risk-based Loan Pricing Now risk-based pricing taking hold in prime lending. Advantages: Fewer applicants are denied financing. Fairer, because good credit risks don’t subsidize poor credit risks.

83. © 2012 Rockwell Publishing Risk-based Loan Pricing Disadvantages: May make loan shopping more confusing, since lenders can’t advertise just one interest rate or APR.

84. © 2012 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 Average cost pricing