As consumers, we're all used to being the one with the power to judge the products and services we purchase and the companies that offer them. But when it comes to financing our new home or refinancing the one we already own, we hand that power over to the mortgage lenders and, more specifically, the underwriters whose sole task is to crunch the numbers based on every bit of information the loan officer asks you to provide as part of the loan application process as well as the collection of documents that you send in later to substantiate the information you've already provided. In general, it's the underwriter that you'll have to suck up to to secure you that loan (if you even find them!). These underwriters attempt to verify two primary things about you in order to meet the bank's criteria for offering you a loan: general creditworthiness and debt-to-income ratio.
The first thing the underwriter is concerned with is your general creditworthiness. This will give the lender an idea of your general willingness to repay your debts. There are many ways to determine this, but the most common way is to use a mortgage credit score. This score is based on an analysis of your various credit files. The most popular score is the FICO score offered by Fair Isaac Corporation, but there are others in use as well. The mortgage credit score uses consumer data stored by the three major credit repositories, Experian, TransUnion and Equifax. Remember, your income is generally not part of this calculation, but it is important, as you'll see shortly.
Early in the loan origination process, the lender will request your permission to pull your credit scores and then purchase a credit score as part of the underwriting process. This number is used to determine how much risk you pose and, in some cases, to match you with the right mortgage loan product. The cost of these reports is generally passed back to you, as a minimal part of your closing costs.
The second thing the underwriter will want to know is how the new mortgage payment will impact your ability to repay. The traditional calculation for this is the debt-to-income ratio, or DTI. The DTI is a comparison of your monthly gross income (before taxes) and your monthly debts.
For example, if you pay $400 on credit cards, $200 on car loans and $1,400 a month in rent, your total monthly debt commitment is $2,000. If you make $60,000 a year, your monthly gross income is $60,000 divided by 12 months for a total of $5,000 a month. Your debt-to-income ratio is $2,000 divided by $5,000, which works out to .4 or 40%.
The debts in question include any consumer debt that would appear on your credit report, such as car loans, credit card debt and installment loans, as well as additional debt such as and if applicable, alimony or child support payments. Debt-to-income requirements vary by loan program, but typically underwriters are looking to see if the ratio of debt to income -- after the cost of your mortgage principal, interest, real estate taxes, insurance and private mortgage insurance (if required) are all added in -- is lower than about 40 percent. Some lenders require it to be even lower that than.
There are many other considerations that go into the underwriting of a new mortgage loan, but these areas are generally where underwriters focus their attention. If you know that you're going house hunting soon, it'll be wise to also get your finances in order. How, you ask? There are certainly proven effective ways to mitigate "bad credit", and effectively raise the chances of you securing that first-time homeowner's loan, such as:
- Increasing the amount you pay monthly to service your debts - extra payments can be applied directly to the principle, lowering your overall debt more quickly.
- Avoid taking on more debt - you can do this by reducing how much you charge on your credit cards, and by not applying for loans.
- Postpone large purchases until you have more savings - if you make a larger down payment, you'll have to fund less of the purchase with credit, which will help keep your DTI low.
- Recalculate your debt-to-income ratio monthly to see where you stand - watching your DTi ratio fall can help you stay motivated to keep your debt manageable, inching you closer to getting a golden parachute of a loan for that perfect piece of property.
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