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This article provides an outline of the process and details of obtaining a mortgage as well as the basic residential loan products.

The steps in obtaining a mortgage loan are as follows:

1) Make an application either in person with a loan broker or over the Internet.

2) Sign a completed application and other disclosures including a Good Faith Estimate, which is an estimate of your closing costs and monthly payment. If purchasing a property, then submit the purchase contract.

3) Obtain loan approval after income disclosure and a credit check.

4) Provide required income, asset, and other documentation.

5) Obtain an appraisal and select a title company to close.

6) Go to the title company to sign the loan documents.

This entire process can take only a few hours of time.

Remember, one very important part of the Conventional loan process: Humans do not approve loans; computers approve loans. With a few exceptions, people do not make the fundamental underwriting decision. Your loan will be input into an automated system and either approved or denied by a computer program.

The computer program, often called DU/DO, will assess the overall credit risk of the applicants and make a decision based upon the perceived risk of the loan request. The three major risk factors taken into account as the loan is analyzed are: the applicant’s income ratios, credit history, and equity position in the property being financed.

THE APPLICATION PROCESS

There is a standard application called a Fannie Mae Form 1003. It requires basic information about the loan amount, term, and interest rate. It also asks about the applicant’s residence, income, assets, liabilities, and work history. This form can be very frustrating for someone who has never filled one out. It can easily take 40 minutes or longer. Experienced mortgage brokers will often interview the applicants and complete the 1003 for them.

The loan broker inputs the application into the DU/DO system. After input, the computer obtains the borrowers credit report and internally scores the application. This process of pulling credit, scoring the loan, and approving it rarely takes over 90 seconds. The approval is transmitted to the broker, and it stipulates certain conditions to be met and income documentation to be provided.

The applicants should be prepared to provide most, but not necessarily all, of the following documentation:

1) W-2's for the most recent 2 years. If self-employed, two years of Federal (not State) tax returns.

2) One complete month of the most recent pay stubs.

3) Two months of the most recent bank statements. (Bank statements and pay stubs should be dated within 30 days of loan closing.)

4) Homeowners Insurance agent’s name and phone number.

QUALIFYING RATIOS

Lenders want to feel confident that borrowers can meet the monthly repayment of principal, interest, taxes, and insurance on their loans. To insure the borrowers have enough income, qualifying ratios are computed. There are two ratios computed on each application and they are simply called the front and the back ratios.

The front ratio is computed as follows: Borrower's estimated monthly loan payment divided by the borrower's monthly income. The loan payment includes principal, interest, taxes, insurance and, if any, the mortgage insurance and homeowners association fees.

The back ratio is: the monthly loan payment plus all other installment and credit card payments divided by the borrower's monthly income. In addition to installment and credit card payments, also included are alimony and child support payments, as well as student loans.

An example will best serve as clarification. Borrower's monthly income is $5,000. The proposed total monthly loan payment is $1,500. The borrowers have monthly installment and credit card payments of $500.

Front Ratio $1500 / $5000 = 30%

Back Ratio $1500+$500 / $5000 = 40%

DU/DO is more critical of the back ratio than the front ratio.

CREDIT REPORTS

A very important aspect to obtaining a loan with a favorable interest rate is the applicant’s credit history.

There are three credit repositories in the United States. They are: Experian, TransUnion, and Equifax. Each of these companies computes its own unique credit score. The scoring systems are respectively called Fair Isaac Credit Organization (most commonly called FICO), Empirica, and Beacon respectively. These scoring systems are slightly different, and the scores can be as low as 400 or as high as 900. The DU/DO programs are based upon the borrower’s middle (of three) credit score. Generally, the DU/DO programs set the minimum score for a conventional loan to be 620.

General guidelines for interpreting FICO scores among conventional and portfolio lenders are as follows:

Scores Below 620 Subprime (or B, C, &D)

620 to 679 Average Score

680 to 719 Good Score

720+ Excellent

800+ Top 1%

Credit reports frequently contain errors and the scores can easily show spreads of 50 to 100 points between the high and low scores. The most common types of errors are duplicate accounts, open loans that have been paid, open collection items that have been paid, and judgments or charge offs that have been paid. There are procedures for correcting and updating individual scores and these methods will be discussed in a separate article.

APPRAISALS

There are four types of general residential appraisals. They range from a simple drive-by inspection with no value assigned to a full Uniform Residential Appraisal Report (URAR). The DU/DO program specifies the type of appraisal based upon its internally assigned risk assessment. For example, a purchase with 30% down payment and borrowers with excellent credit will likely require a drive-by inspection. But a cash-out refinance on a highly leveraged property to a person with an average credit score will likely require a full appraisal, if it is approved at all.

The four types of appraisals and their approximate costs are:

1) A drive-by inspection that is not an appraisal. This type generally costs $150 to $200.

2) A drive by appraisal where the appraiser provides comparable values for other properties in the neighborhood. This appraisal generally costs $150 to $225.

3) A Form 2055 that is much more detailed than the first two. This appraisal can be an exterior only appraisal or the DU/DO program can request an interior inspection. This appraisal generally costs $250 to $325.

4) A full URAR appraisal that generally costs $300 to $400.

A word of caution is appropriate. Do not order your own appraisal. There are several reasons for this. The lender may have its own list of approved appraisers or you may order from an appraiser who is not properly licensed. Furthermore, the lenders name, as well as the borrower's name, must be provided in the body of the appraisal report.

MORTGAGE INSURANCE

Mortgage insurance (MI) or private mortgage insurance (PMI) is not the same as homeowners insurance. Mortgage Insurance insures the lender in the event the borrower defaults and the lender is forced to foreclose and sell the property.

Mortgage insurance is required on any conventional loan where the loan to value exceeds 80%. FHA loans require PMI regardless of the loan to value and the amount is a fixed .5% in all cases. For conventional loans, the higher the loan to value, the higher the MI premium. There are many MI companies and they have slightly different rate schedules. Rates from one of the MI companies for standard coverages are as follows:

LTV 80.01 to 85% .32% of the loan amount

85.01 to 90% .52%

90.01 to 95% .78%

95.01 to 97% 1.04%

BASIC LOAN PRODUCTS

Conventional Loans

Conventional loans are the cornerstone of the mortgage industry. DU/DO is the underwriting system for conventional loans. Conventional loans specify high standards and require good credit scores. They generally provide the lowest rates available and they represent the bulk of the loans that are originated in the United States. Disadvantages of conventional loans are that they are heavily weighted to credit scores and limited to some extent by qualifying ratios. Solid loans to low risk borrowers are sometimes denied by DU/DO.

Federal Housing Administration - FHA Loans

FHA loans are the second most popular loans. They are frequently used for first time home buyers and for other purchasers who have good credit but for some reason have lower credit scores. The automated system for FHA loans is call Loan Prospector (LP) and it does not underwrite based upon FICO scores. This aspect of FHA loans is very significant. That is, many prospective borrowers have old/aged derogatory information on their credit bureau reports. Collection Agency items and Judgments, even though paid, still have very negative effects on credit scores.

The LP system will analyze the credit reports and if the derogatory items are sufficiently aged, will approve the borrower. DU/DO on the other hand, will deny the borrower based upon the score alone and not an analysis of the borrower's situation.

FHA loans can also be underwritten by a human. FHA gives the option to select lenders to manually underwrite loans where the circumstances dictate. The underwriter, however, is not allowed to approve an FHA loan that has been denied by the LP system.

Experienced brokers are able to preview an FHA application and determine if the automated system or a human underwriter should approve the loan.

FHA loans, regardless of the Loan to Value, require private mortgage insurance. (PMI) FHA loans are very popular and if used properly, can save the borrowers thousands of dollars and allow them to own a home that they might not be able to otherwise afford.

VA Loans

VA loans are for borrowers who have served in the armed forces of the United States. They represent low cost mortgages for current and previous servicemen and women. VA allows the borrowers to finance 100% of the purchase price of a new home. VA enforces high loan standards and will not approve borrowers who have much derogatory credit. VA loans have a one-time, up-front fee of 2% of the loan amount. This fee is called a funding fee, and it is 3% if a Veteran uses their benefits a second time. The funding fee is added to the loan amount. VA loans are generally used for first time home buyers or buyers who have no cash equity to contribute toward the purchase of a home. Once a homeowner has sufficient equity in a home, VA loans are not financially attractive.

Stated Income - No Ratio / No Asset Loans

Stated Income and No ratio/no asset loans (both are also called low doc loans) are unique products designed for specific situations. These loans were created for self employed borrowers who were very credit-worthy but who did not possess the necessary income documentation to qualify for a loan.

With stated income loans, the borrower "states" his income on page 2 of the loan application and the lender does not verify the amount or source of income. Instead, the lender relies on the borrowers high credit score and also on the equity in the real estate that is being purchased or refinance. Generally, borrower needs a minimum FICO of 680 and a minimum loan to value of 80%. Programs exist for greater than 80% LTV's but they come with higher interest rates.

Most stated income programs require six months of proposed monthly payments in the form of cash reserves in bank accounts.

Borrowers with high FICO scores and low LTV's can generally obtain more favorable interest rates. These stated income programs are priced based upon the assessed risk of the loan.

There are stated income programs also for salaried borrowers.

No ratio and no asset loans are programs in which the income is not stated and the assets listed on the loan application are not verified. These loans are perceived as being inherently more risky and are priced at higher interest rates than the stated income loans. Generally, the FICO scores and the LTV's are also more restrictive.

Subprime Loans

Subprime loans are also called "B, C and D" loans. These letter designations are similar to school grades. That is, conventional and VA loans would be A+ and A loans and FHA would be A+, A or A- loans. This grading of creditworthiness allows lender to make loans that are perceived to be of greater risk and which carry a higher interest rate.

Subprime loans are for borrowers with moderate to substantially impaired credit. Impaired credit can be in the form of Judgments or Collection Agency items on the credit report. Other examples of impaired credit are late payments of 30 to 90+ days past due, foreclosures, repossessions, settlements, and bankruptcies.

Subprime lenders enter the market for borrowers whose credit scores are below 620. However, Subprime lenders have loan products for those whose credit scores are 680 or higher. Subprime loans can go to borrowers whose scores are as low as 500, and there may be lenders in the marketplace who will approve borrowers whose scores are below 500.

SUMMARY

The preceding has been a detailed explanation of the process and methods employed in obtaining a mortgage. The process is very similar for either a purchase or refinance. We covered applications, qualifying ratios, credit reports, and appraisals.

While this information is not rocket science, it is very detailed and requires considerable management attention on the part of the mortgage broker. It is so detailed, that the borrower should not hesitate to ask his/her mortgage broker to repeat any of the information that is being disseminated to them.

The description of the basic loan products should help prospective loan applications decide what product might be best suited for them.

When shopping for a loan remember this, the mortgage broker's job is to first obtain a loan commitment and then to obtain the most favorable interest rate for the borrower.

Keywords: mortgage, refinance, home mortgage, home loan

About the Author
Mike Cotter, Lakewood, Coloraodo USA
<http://www.rocky-mountain-mortgage-rates.com>
Mike Cotter has been a professional lender for over 30 years. In 1982 he opened his own commercial bank and served as President and CEO. In 1992 he left commercial banking for the mortgage banking field. He has successfully completed over 5,000 “deals” in his career. Mike holds both a Master’s Degree in Business Administration and a Master’s Degree in Banking.