Mortgage Basics 101

There are three main components to mortgage lending and the qualification process.  These are commonly referred to as the three “C”s of mortgage lending; Capacity, Collateral, and Credit. 

• Capacity (Income)
• Collateral (Assets)
• Credit

Each  has a value given to it that represents the strength of the borrower.  But more importantly, it represents the level of risk to the lender.  The process of mortgage qualification and underwriting is really the bank determining what level of risk a transaction represents.   The following is a basic breakdown of how a bank looks at these criteria.

Each section in this graph represents a risk factor the bank considers when lending money. As shown by this graph, all three risk factors have equal weight in the underwriting process.   The lower the bank’s risk, the better your rate will be.  Here are some really basic scenarios and graphs that demonstrate how a mortgage is evaluated in the Underwriting process. Let’s take a minute to understand how the bank looks at each segment. 

For each category, the better the criteria you present, the better the program / rate you qualify for.   If one category is lacking in criteria, then the higher the risk, resulting in a higher interest rate and terms.

Capacity (Income):  Simply stated, this is how much you make.   Take your gross monthly income (GMI) and subtract your regular monthly installment bills (debt servicing).  What is left is what you have available to make your mortgage payment.   In very simple terms, the   greater your capacity, the more house you can afford. 

The lender is looking to see that you have enough available income (capacity) to pay for the loan, and that your ability to continue to earn that income is stable.    Lenders will usually want to see a good track record of employment or income from self-employment for a minimum of two years.   So make sure you bring your tax returns, W-2’s for two years, as well as your last two pay stubs.  Be prepared and your application through approval will go much smoother and quicker.

Collateral (Assets): This is a two meaning phrase. 
The first collateral, (house) is what the loan (mortgage) will be secured against.  The value (appraisal) of the home compared to the amount of the loan is known as the loan to value (LTV) ratio.  For example, if you want to buy a house that has an appraised value of $100,000 and you put down $20,000 the mortgage will be $80,000, or a Loan to Value (LTV) of 80%.  Therefore, in the mortgage underwriting decision process, the lower the LTV, the   lower the risk for the bank and the better your rate could be.
                The second “asset” definition is the accounting definition.  An asset is basically money in the bank, stock, or other commodity that has value (gold, equipment, tools, buildings etc.).  The more assets you have available (whether they are used for the mortgage or not) adds a positive note to the decision making process. 
There are programs that allow you to finance 100% of the purchase price and some closing costs.  However, you do need to have some money available   for this transaction.  A minimum of 1% will be needed.  Ask your loan consultant for more information.

Credit:  Credit is really your history of making payments to creditors.   It is usually given as a FICO score, or other type of score used by the three main repositories of credit history: Experian, Trans Union, and Equifax.  In very simple terms, the better your credit score, the better the rate and program you can qualify for.

Let’s look at a couple of scenarios and how it can affect your loan’s terms and conditions.

Scenario 1: Bad Credit

You are able to put some money down and lower your LTV ratio.  .  You also have cash for closing costs. Your credit scores are less than Prime (580-630) so the risk to the bank increases, and therefore the rate can increase.  If your credit was poor due to explainable and reasonable conditions, such as medical or other problems, we can work with the lender to show your scenario in more positive manner to help overcome lower scores.  Each case need to be analyzed and a game plan created to best present your loan to a lender. 

Scenario 2:  Reduced income

You need to refinance, but your company had a cut-back and you are making less money than when you bought the house.   Or your debts are a bit high in comparison to your income.   Again, here the risk gets higher for the bank, and the rate may as well.  This is when you need to keep under or around the 80% LTV, or have great credit.  There are banks that will allow a higher LTV without penalty depending on the other conditions of the loan. 

Scenario 3: Minimal Collateral

You found a great house, in your price range, but you do not have 20%, 10% or even 5% for a down payment.  This scenario is doable, but again, the higher the risk, the higher the rate.  There are programs for 1st time home buyers that will finance 100% of the purchase price, but you still need some money to cover some of the closing costs.   Other options like Piggyback loans can be used to reduce or eliminate PMI, and finance close to 100%, pending your qualification criteria. 

You DO need money to buy a home. You will have to put a deposit on the purchase contract, you will need application fees for the lender, appraisal fees, and most of these fees are paid up-front. It is in your best interest to pay these up front, so that you do not pay over time and pay 2-3 times more in interest payments. You’ve heard about buying a house with no money down, but you are not getting the whole story. There are costs, there are fees, they CAN be rolled into the mortgage, and that has costs associated with it as well. Many times it is smarter to pay one fee now, rather than pay for it over 30 years with interest.

To summarize, everyone’s scenario is different. We are here to help you determine which is best for you.

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