The Four C's of Mortgage Underwriting

With Spring upon us, and new buyers out looking for houses, I thought today might be a good time to review the basics of what lenders look for as they decide to approve (or deny) mortgage applications. For at least 25 years, I have heard them called “The 4 C’s of Underwriting”- Capacity, Credit, Cash, and Collateral. Guidelines and risk tolerances change, but the core criteria do not.

CAPACITY

CAPACITY is the analysis of comparing a borrower’s income to their proposed debt. It considers the borrower’s ability to repay the mortgage. Lenders look at two calculations (we call ratios). The first is your Housing Ratio. It simply is the percentage of your proposed total mortgage payment (principal & interest, real estate taxes, homeowner’s insurance and, if applicable, flood insurance and mortgage insurance – like PMI or the FHA MIP) divided by your monthly, pre-tax income. A solid Housing Ratio (often called the front end ratio) would be 28% or less; although, many times loans are approved at a significantly higher number. That’s because your front end ratio is looked at in conjunction with your back end ratio.

The back end ratio (referred to as your Debt Ratio) starts with that mortgage payment calculation from the Housing Ratio and adds to it your recurring debts that would show up on your credit report (auto loans, student loans, minimum credit card payments, etc.) without taking into consideration some other debts (phone bills, utility bills, cable TV). A good back ratio would be 40% or less. However, many loans are granted with higher debt ratios. Understand that every application is different. Income can be impacted by overtime, night differential, bonuses, job history, unreimbursed expenses, commission, as well as other factors. Similarly, how your debts are considered can vary. Consult an experienced loan officer to determine how the underwriter will calculate your numbers.

CREDIT

CREDIT is the statistical prediction of a borrower’s future payment likelihood. By reviewing the past factors (payment history, total debt compared to total available debt, the types of monies: revolving credit vs. installment debt outstanding) a credit score is assigned each borrower which reflects the anticipated repayment. The higher your score, the lower the risk to the lender which usually results in better loan terms for the borrower. Scores below 620 are difficult (though not impossible); scores from 620-660 are mediocre; those from 660-720 are considered good; and above 720 are very good. Your loan officer will look to run your credit early on to see what challenges may (or may not) present themselves.

CASH

CASH is a review of your asset picture after you close. There are really two components – cash in the deal and cash in reserves. Simply put, the bigger your down payment (the more of your own money at risk) the stronger the loan application. At the same time, the more money you have in reserve after closing the less likely you are to default. Two borrowers with the same profile as far as income ratios and credit scores have different risk levels if one has $50,000 in the bank after closing and the other has $50. There is logic here. The source of your assets will be examined. Is it savings? Was it a gift? Was it a one-time settlement/lottery victory/bonus? Discuss how much money you have and its origins with your loan officer.

COLLATERAL

COLLATERAL refers to the appraisal of your home. It considers many factors – sales of comparable homes, location of the home, size of the home, condition of the home, cost to rebuild the home, and even rental income options. Understand the lender does not want to foreclose (they aren’t in the real estate business), but they do need to have something to secure the loan against, in case of default. In today’s market, appraisers tend to be conservative in their evaluations. Appraisals are really the only one of the 4 C’s that can’t be determined ahead of time in most cases.

Now, each of the 4 C’s are important, but it’s really the combination of them that is key. Strong income ratios and a large down payment with strong reserves can offset some credit issues. Similarly, long and strong credit histories help higher ratios….and good credit and income can overcome lesser down payments. Talk openly and freely with your loan officer. They are on your side, advocating for you and looking to structure your file as favorably as possible.

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Three Steps to a More Powerful Self Image

What does it mean to act “out of character?” In Hollywood, when an actor breaks character, it means they are acting in a way that isn’t consistent with the character they are portraying. Sometimes an actor will get so enmeshed in their role that they argue with the writers and directors proclaiming, “My character wouldn’t do this!” You may not be an actor, but I can assure you that you also have a character that you cling to and defend. If you’ve ever said, “That’s not me!” or “I could never do that,” it may be time to re-write your character so you can start to live your best life without limits and without fear.

Last week a good friend of mine couldn’t wait to tell me how proud she was for getting up early and going to the gym. “I don’t know what came over me,” she gushed, “it’s so out of character for me.” This innocuous comment illustrates both a tragedy — when you cling to a less than optimal version of yourself — and an opportunity — when you can recognize that you have the ability to break free from your own limits.

Who you have been doesn’t have to be who you are. You are not computer code, which once programmed, cannot change, grow or adapt. Your life is shaped significantly by the character you create and the story you tell yourself about the kind of person you are, what you’re capable of achieving and how you should behave.

But what happens when we desperately want a leading role, but our character has a bit part? What happens when your view of who you are actually holds you back? Is there something that would propel your life forward, but that you just can’t bring yourself to do? If so, it’s time for you to create a different story and character that embrace what you’ve been resisting.

Here are three steps to help you create a more powerful self-image:

1) Who do you think you are? You are who you think you are, so let’s find out what you think about yourself. Write down everything you can about how you think about yourself, especially any negative labels you use, such as shy, dumb, guilty, angry, etc.
2) Get real. Focus on the characteristics that are holding you back and think about them rationally. Are you really a terrible public speaker? Really? What proof do you have? Are you’re not the kind of person to get up early and exercise? Really? Are you a vampire? Do you have a medical condition that prevents you from getting your butt out of bed at 6 a.m.? Excuses often turn into habits that then create our character.
3) Create a better character. Stop being half the person you could be by creating a new character — one that does what you’re afraid to do or wouldn’t do.

What would be “out of character” for you? Standing up for yourself? Taking a risk at work? Saying no? Trusting? Questioning? Speaking up? Starting? Finishing? Becoming healthy? Staying sober? Showing up on time? Starting a company? Sticking to your guns? Reading a book? Writing a book?

The next time you find yourself saying, “I couldn’t do that, that’s just not me!” Yell, “Cut!” and re-write yourself a better character.

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Ok. You Win. Stop Listening to Real Estate Agents.

Each day we attempt to give truthful insight on the current housing market. If we report what is perceived as negative news, some in the real estate community come down on us hard. However, when we explain that we think now is a great time to buy, we get an avalanche of feedback from the general public attacking us for being nothing more than puppets for real estate agents across the country. Today, we don’t want you to listen to what we think about the opportunities that exist for buyers in this market. Instead, we want to report on what some members of the investment community are saying.

The Wall Street Journal

Jim Woods wrote an article earlier this year for Market Watch, part of the Wall Street Journal’s digital network. Its title: Why your best investment is a house. Mr. Woods compared the investment potential of real estate against other asset classes such as stocks and precious metals. Here was his conclusion.

One reason your best investment right now could be a home has to do with the relative upside of getting in on an asset class while it’s at the bottom versus buying into other asset classes that could be near a top. Consider for a moment the tremendous upside we’ve seen in stocks, precious metals and agricultural commodities over the past 12 months…

If you’re a long-term investor looking to put money to work, now is not really the best time to get into any of these three asset classes. However, with home sales starting to improve, and with prices now possibly forming a bottom, real estate could well be the asset class that represents the best low-risk buying opportunity out there today…

Mr. Woods went on to talk about the financing portion of the purchase:

Yes, mortgage rates still are near historical lows, but if we see these rates rise, then the cost of a new home could climb significantly. So, now could really be the best time to pull the trigger on that home purchase — and it could also be your best investment right now.

Fortune Magazine

Shawn Tully, senior editor at large for Fortune penned an article last week which was titled: Real estate: It’s time to buy again. In the article, Mr. Tully explained:

Forget stocks. Don’t bet on gold. After four years of plunging home prices, the most attractive asset class in America is housing.

Let’s state it simply and forcibly: Housing is back. Two basic factors are laying the foundation for dramatic recovery in residential real estate. The first is the historic drop in new construction … The second is a steep decline in prices, on the order of 30% nationwide since 2006, and as much as 55% in the hardest-hit markets. The story of this downturn has been an astonishing flight from the traditional American approach of buying new houses to an embrace of renting. But the new affordability will gradually lure Americans back to buying homes. And the return of the homeowner will start raising prices in many markets this year.

Bottom Line

Neither of the two media sources mentioned above has ever been accused of cuddling up to the National Association of Realtors. However, both have come to the same conclusion. It’s time to buy real estate. Perhaps we should listen to them.

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Double Dip or Double Your Money?

Last week, MacroMarkets LLC announced the results of the March 2011 Home Price Expectations Survey, compiled from 111 responses of a diverse group of economists, real estate experts and investment and market strategists. Many media sources reported on the survey’s comment about a projected ‘double dip’ in prices. What the media didn’t aggressively cover was the other projection in this same report. Today we want to shed light on both portions.

Double Dip

There is no doubt the survey looked negatively on house prices through the rest of 2011. Robert Shiller, MacroMarkets co-founder and chief economist said:

“Overall, the sentiment among our expert panel regarding the U.S. housing market outlook continues to deteriorate. Now they are expecting only a weak recovery, and even that is not until 2013. This uninspiring view must be influenced by the persistently weak market fundamentals – high unemployment, supply overhang, an unabated foreclosure crisis, and constrained mortgage credit.”

Terry Loebs, MacroMarkets managing director commented on the dreaded ‘double dip’.

“Many more experts are now projecting a double-dip after witnessing the double-dead cat bounce that came in the wake of expired government stimulus programs. In December, only 15% of our panelists were projecting that a new post-crash low would materialize for national home prices. Now, just three months later, almost 50% foresee a double-dip happening this year, and not a single panelist expects national home prices to recover to the pre-bubble trend in the coming 5 years.”

However, the longer term view of home prices was much more optimistic.

Double Your Money

The experts projected that by the end of 2015 home prices would attain a cumulative level of appreciation of almost 10% (see chart below from the report).

This means, if you purchased a house today with a 10% cash down payment, you could double your cash in five years; even taking the projected double dip into consideration.

Shiller also noted that there continues to be significant dispersion among the panelists regarding their individual home price forecasts:

“A few respondents do see a real recovery, predicting prices up 20% or so by 2015.”

If that happens, you would have TRIPLED your cash.

Bottom Line

If you are thinking of selling in the next 12 months, you should do it before the projected ‘double dip’. If you are thinking of buying and you plan to live in the home for at least five years, your financial investment will be fine.

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Did Modification Programs Work?

The government decided early on that the market would not be able to absorb the number of foreclosures that the financial crisis was creating without crushing house values. This was one reason that they funded the Troubled Asset Relief Program (TARP). This past week, the Congressional Oversight Panel (COP) weighed in with their opinion on TARP’s success.

Today we want to concentrate on the parts of the report that pertain to real estate. TARP funds were to be used:

…in a manner that protects home values, college funds, retirement accounts, and life savings; preserves homeownership and promotes jobs and economic growth; maximizes overall returns to the taxpayers of the United States.

Did TARP Accomplish Its Housing Goals?

One way TARP was to accomplish ‘protecting home values and preserving homeownership’ was through the Home Affordable Modification Program (HAMP). According to the COP report:

…when the President announced the Home Affordable Modification Program in early 2009, he asserted that it would prevent three to four million foreclosures. The program now appears on track to help only 700,000 to 800,000 homeowners.

We want to say that, if hundreds of thousands of families averted the devastation foreclosure can bring, we consider the program as worthwhile. Successful? That’s a different story.

Another program initiated to help was HOPE for Homeowners. It was established by Congress in July 2008 to permit the FHA to insure refinanced distressed mortgages. However, as the report explains:

HOPE for Homeowners was initially expected to help 400,000 homeowners, but it managed to refinance only a handful of loans. This was likely due to the program‘s poor initial design, lack of flexibility, and its reliance on voluntary principal write-downs, which lenders were very reluctant to make.

The Only Good News?

The only silver lining is that TARP didn’t cost the taxpayer as much as was originally estimated. At what expense to troubled homeowners? In discussing the falling cost of the program COP stated:

… a separate reason for the TARP‘s falling cost is that Treasury‘s foreclosure prevention programs, which could have cost $50 billion, have largely failed to get off the ground. Viewed from this perspective, the TARP will cost less than expected in part because it will accomplish far less than envisioned for American homeowners.

Bottom Line

TARP was set up to avoid home values being crushed under the weight of foreclosures. To that regard, it seems to have done nothing but delay the inevitable.

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