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Underwriting Guidelines for Mortgage Loans - Loan Requirements, Credit Review, Qualify for a Loan

Underwriting Guidelines for the Average Mortgage

Last Updated: September 25, 2014

Understanding mortgage underwriting guidelines will help you understand your loan options when purchasing or refinancing a home. Now that you have found your dream house, you are going to need to apply for a mortgage loan. Your realtor will either recommend a banking institution or you may already have one in mind. You will be dealing with a loan officer who will be compiling all the data on you to see if you qualify for a loan to pay for this house. All lending institutions have different Underwriting Guidelines set in place when reviewing a borrower's financial history to determine the likelihood of receiving on-time payments. The primary items reviewed are listed below.

Income

Income is one of the most important variables a lender will examine because it is used to repay the loan. Income is reviewed for the type of work, length of employment, educational training required, and opportunity for advancement. An underwriter will look at the source of income and the likelihood of its continuance to arrive at a gross monthly figure.

Salary and Hourly Wages - Calculated on a gross monthly basis, prior to income tax deductions.

Part-time and Second Job Income - Not usually considered unless it is in place for 12 to 24 straight months. Lenders view part-time income as a strong compensating factor.

Commission, Bonus and Overtime Income - Can only be used if received for two previous years. Further, an employer must verify that it is likely to continue. A 24-month average figure is used.

Retirement and Social Security Income - Must continue for at least three years into the future to be considered. If it is tax free, it can be grossed up to an equivalent gross monthly figure. Multiply the net amount by 1.20 percent.

Alimony and Child Support Income - Must be received for the 12 previous months and continue for the next 36 months. Lenders will require a divorce decree and a court printout to verify on-time payments.

Notes Receivable, Interest, Dividend and Trust Income - Proof of receiving funds for 12 previous months is required. Documentation showing income due for 3 more years is also necessary.

Rental Income - Cannot come from a Primary Residence roommate. The only acceptable source is from an investment property. A lender will use 75 percent of the monthly rent and subtract ownership expenses. The Schedule E of a tax return is used to verify the figures. If a home rented recently, a copy of a current month-to-month lease is acceptable.

Automobile Allowance and Expense Account Reimbursements - Verified with 2 years tax returns and reduced by actual expenses listed on the income tax return Schedule C.

Education Expense Reimbursements - Not considered income. Only viewed as slight compensating factor.

Self Employment Income - Lenders are very careful in reviewing self-employed borrowers. Two years minimum ownership is necessary because two years is considered a representative sample. Lenders use a 2-year average monthly income figure from the Adjusted Gross Income on the tax returns. A lender may also add back additional income for depreciation and one-time capital expenses. Self-employed borrowers often have difficulty qualifying for a mortgage due to large expense write offs. A good solution to this challenge used to be the No Income Verification Loan, but there are very few of these available any more given the tightened lending standards in the current economy. NIV loan programs can be studied in the Mortgage Program section of the library.

Debt and Liabilities

An applicant's liabilities are reviewed for cash flow. Lenders need to make sure there is enough income for the proposed mortgage payment, after other revolving and installment debts are paid.

Credit History

Most lenders require a residential merged credit report (RMCR) from the 3 main credit bureaus: Trans Union, Equifax, and Experian. They will order one report which is a blending of all three credit bureaus and is easier to read than the individual reports. This "blended" credit report also searches public records for liens, judgments, bankruptcies and foreclosures. See our credit report index.

Credit report in hand, an underwriter studies the applicant's credit to determine the likelihood of receiving an on-time mortgage payment. Many studies have shown that past performance is a reflection of future expectations. Hence, most lenders now use a national credit scoring system, typically the FICO score, to evaluate credit risk. If you're worried about credit scoring see our articles on it.

The mortgage lending process, once very forgiving, has tightened lending standards considerably. A person with excellent credit, good stability, and sufficient documentable income to make the payments comfortably will usually qualify for an "A" paper loan. "A Paper", or conforming loans, make up the majority of loans in the U.S. and are loans that must conform to the guidelines set by Fannie Mae or Freddie Mac in order to be sold by the lender. Such loans must meet established and strict requirements regarding maximum loan amount, downpayment amount, borrower income and credit requirements and suitable properties. Loans that do not meet the credit and/or income requirements of conforming "A-paper" loans are known as non-conforming loans and are often referred to as "B", "C" and "D" paper loans depending on the borrower's credit history and financial capacity.

Here are some rules of thumb most lenders follow:

Savings and Checking Accounts

Lenders evaluate checking and savings accounts for three reasons.

  1. The more money a borrower has after closing, the greater the probability of on-time payments.
  2. Most loan programs require a minimum borrower contribution.
  3. Lenders want to know that people have invested their own into the house, making it less likely that they will walk away from their life's savings. They analyze savings documents to insure the applicant did not borrow the funds or receive a gift.

Lenders look at the following types of accounts and assets for down payment funds:

Checking and Savings - 90 days seasoning in a bank account is required for these funds.

Gifts and Grants - After a borrower's minimum contribution, a gifts or grant is permitted.

Sale of Assets - Personal property can be sold for the required contribution. The property should be appraised and a bill of sale is required. Also, a copy of the received check and a deposit slip are needed.

Secured Loans - A loan secured by property is also an acceptable source of closing funds.

IRA, 401K, Keogh & SEP - Any amount that can be accessed is an acceptable source of funds.

Sweat Equity and Cash On Hand - Generally not acceptable. FHA programs allow it in special circumstances.

Sale Of Previous Home - Must close prior to new home for the funds to be used. A lender will ask for a listing contract, sales contract, or HUD 1 closing statement.

Debt vs Income Ratio

The percentage of one's debt to income is one of the most important factors when underwriting a loan. Lenders have determined that a house payment should not exceed approximately 30 percent of Gross Monthly Income. Gross Monthly Income is income before taxes are taken out. Furthermore, a house payment plus minimum monthly revolving and installment debt should be less than 40 percent of Gross Monthly Income.

Example

An applicant has $4,500 gross monthly income. The maximum mortgage payment is:

$4,500 X .30 = $1,350

Their total debts come to:

$500 Car
$20 Visa
$30 Sears
$75 Master Card
----------------
$625 per month

Remember, their total debts (mortgage plus other debts) must be less than or equal to 40% of their gross monthly income.

$4,500 X .40 = $1,800

$1,800 is the maximum debt the borrower can have, debts and mortgage payments combined. Can the borrower keep all their debts and have the maximum mortgage payment allowed? NO!

In this case, the borrower, since they have high debts, must adjust the maximum mortgage payment downward, because:

$625 debts
$1350 mortgage
--------------
$1,975 - which is more than the $1,800 (40% of gross income) we calculated above.

The maximum mortgage payment is therefore:

$1,800 - $625 (monthly debt) = $1,175

See our calculators to avoid doing these calculations by hand.

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