You've found the house. You think you can afford it. You just need a loan. No loan means no house, so you're understandably nervous.
Don't be overcome by the fear of rejection. Instead, walk with me behind the veil of the mortgage application process so you can understand exactly what it takes to get your loan approved.
The big picture
Most mortgage loans are not actually owned by the bank that signs the papers with you at the closing table. Most mortgage loans are sold as part of large investment securities to Fannie Mae (NASDAQOTCBB: FNMA) or Freddie Mac (NASDAQOTCBB: FMCC), the much maligned government-sponsored entities made famous by the subprime mortgage crisis.
Because of this, the banks that originate the loans typically will only approve loans that fit certain investor-defined criteria. Assessing these criteria is what mortgage bankers call "underwriting" the loan.
The criteria vary by program, with factors like down payment and credit score ranging widely between programs. Government-sponsored programs like USDA or FHA loans typically have more relaxed standards.
The easiest way to understand these criteria is to view the application from the bank's perspective.
Bank's are unique in that they sell a product (a loan) that they must get back. When you buy a pair of shoes, the shoe store doesn't care what you do with the shoes after you've paid. Run in the mud, give them to Fido to chew on, or use them as an improvised fly swatter. It doesn't matter.
For banks, though, what you do with their product matters. A lot. They not only want to know how you'll pay them back, they want you to have a solid backup plan. And then they want you to have a third plan, you know, just in case.
Plan A: Pay the loan back with cash flow
The plan at the start of every loan is that you pay back the loan with cash flow. This is based on the assumption that the borrower (you) has good character, and is willing to repay the debt. Banks don't want to lend to deadbeats, so they check your credit report to see if you've ever failed to pay back a debt on time. In general, past behaviors tend to repeat themselves, and that starts with character.
The borrower (you) has a certain level of income, and a certain level of expenses (taxes, food, utilities, etc). The bank needs to make sure that the ratio between your income and expenses is such that you have the cash flow available to make the payment.
In essence, they are assessing your budget. They'll divide your self reported debts into your income -- cross-checked with your credit report and tax returns -- to calculate your "debt-to-income ratio" (commonly abbreviated as "DTI").
BankRate.com offers a calculator you can use to calculate your DTI ratio. Lower is better, with 40%-50% generally set as the upper threshold.
Plan B: Your assets and net worth
Every borrower and banker hopes that plan B will never be needed. If it is, that means the borrower has lost his or her job, has taken on too much debt, or some other negative event has interrupted the monthly cash flow used to make the payment.
When this happens, the bank still expects to be repaid, and they expect the borrower to do it with other assets. That's why the bank asks each applicant to complete a "Personal Financial Statement."
They are interested in your liquid assets, like cash and non-retirement investments. These assets can be used to make the payments immediately or, in the case of stocks, within a few days or weeks. Having sufficient liquidity provides a margin of safety for short-term problems like an unanticipated expense.
After the liquid assets, the bank wants to understand your net worth, which is your total assets minus all your debts. Your net worth represents cash that you could generate by selling things you own. How much do you have in retirement savings? Do you own any other real estate? A vehicle?
The bank realizes that selling your other assets won't happen overnight. But the equity that these assets provide gives the bank comfort for the long term. If net worth is positive, then if everything is sold off, at the end of the day, there's money left over.
Plan C: Collateral
Even though foreclosure is the worst-case scenario, the bank still underwrites for this eventuality. That is why they require an appraisal and, oftentimes, an inspection of the property by a professional home inspector.
The primary collateral ratio banks use is the loan-to-value ratio (LTV). This is just the simple division of the loan amount into the market value of the house. Traditional mortgages typically require LTV to be 80% or lower. That translates to what can be a sizable 20% down payment.
There are ways around the 20% down-payment requirement. Government backed programs from the USDA and FHA are one route or, alternatively, so banks will make loans with higher LTVs so long as the borrower purchases mortgage insurance.
The home inspection is also critical for both the bank and borrower. The inspector is a trained expert who will climb on the roof, into the attic, and under the house looking for water damage, rot, termites, or any structural issues hiding just beneath the surface.
For the borrower, it's an opportunity to get any issues found and fixed before ownership actually transfers. If the home is in disrepair, its also an opportunity to get out of the deal.
For the banks, it fundamentally provides the same value. It ensures that the house has no significant problems that could hinder a sale in the event of foreclosure.
What this means for getting your loan approved
How can you ensure that your loan application will be approved? First, talk to your mortgage banker, and ask what the bank's typical standards are. Very quickly you can determine if your financial picture fits.
And if you don't meet the standards, you can take steps to get there. Pay down some debts to improve your DTI ratio. Save up for a few more months to increase your down payment. Work with a financial advisor to improve your credit report.
Once you are able to meet the standard, you're just one beat away from home ownership.
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