Chapter 9

Borrower Qualification

I. Introduction Page 182 Qualification of a borrower means an analysis to determine whether or not a person is both capable and willing to repay a loan. Until recently, human judgment has made the decisions, but in the mid-1900s, computers with new software began giving substantial assistance to decisions. Even though no two borrowers offer the same qualifying information, there are some basic patterns and mathematical calculations that can be expedited by a computer. Federal agencies encourage its use as faster, lower cost and it minimizes possible human bias. See Borrower Qualification Workshop Problems in Section 3 of this Instructor's Manual. Two categories of loans for analysis purposes: (1) home loans made to individuals with repayment expected from the borrower's personal income, and (2) commercial loans to acquire business property with repayment generally expected from the property's income. Home Loans. Comprise over two thirds of all mortgage loans. Can be classed into four major categories: (1) HUD/FHA, (2) VA, (3) conventional/conforming, and (4) other conventional. "Conventional/conforming" loans identify a category that meets Fannie Mae/Freddie Mac requirements. "Other conventional" has few uniform characteristics other than required documents. Category also includes a variation under the umbrella term of affordable housing loans targeting low and moderate income people. Loan analysis begins with the loan application. A standard application form has been designed to comply with ECOA limits on questions that can be asked of loan applicants. II. Equal Credit Opportunity Act Page 183 ECOA was passed in 1974.. Purpose is to prohibit certain kinds of discrimination in the granting of credit. Questions may not be asked on such income as alimony, child support, or separate maintenance if this income is not to be used for loan repayment. Marital status may be questioned in community property states, otherwise question is limited to married, unmarried, or separated. III. The Loan Application Page 184 As a result of ECOA, the Fed designed 5 model application forms. One applies to residential mortgage loans. Since November, 1986, a revised form (FNMA 1003/FHLMC 65) has been the standard application form required for use by all lenders (see illustration of form in Appendix). Information required in the application form: 1. 2. 3. 4. 5. 6. 7. Identification of borrower Employment and income Monthly housing expenses Cost of house, financing Assets and liabilities Credit references Applicant's certification

A. Commercial loans Page 184 Do not follow a standard form. They require more info, primarily financial statements. Further examination of commercial loans follows that of residential loan qualification. IV. Financial Evaluation Of The Borrower Page 184 Borrower evaluation still requires a "judgment call" by an experienced underwriter, based on (1) ability to pay, and (2) willingness to pay. In 1994, Freddie Mac introduced a prototype of its "automated underwriting system" comprising a computer software program capable of analyzing a loan applicant. The computer gives nearly instant response: granting approval or requesting additional data. Fannie Mae announced a similar system of its own in 1995. Analysis by a human is termed manual underwriting by a computer, it is called automated underwriting. Computer analysis has made number-oriented "credit scoring" more important. (See Chapter 14 for more detail). Three "Cs" of good underwriting: (1) Capability, (2) Credit, and (3) Collateral. Examination of applicant extends beyond the mathematics of income qualification. It must consider two other basic questions: (1) ability to pay, and (2) willingness to pay. A. Ability To Pay Page 185 Basic source of loan repayment is the family's income requiring review of employment record, present income and future potential. 1. Types of Income Page 185 Distinction is made between production related income such as commissions, bonuses, which must show a solid record of achievement and assured income comprising salary and wages, which is more easily verified. Examples of different types of income include salary, commissions, hourly wages, overtime wages, bonus, second job, unreported income, co-borrower's income, income from children, pension and trust income, child support and alimony, self-employed income, interest and dividends, part-time employment. 2. Stability of Income Page 187 Along with the amount of income and the type of income, an underwriter examines whether or not it can be expected to continue. Determinants are: (1) length of time on job, and (2) type of work. 3. Length of Time on Job Page 187 While standards vary, some length of time on the same job is a measure of stability. The changing nature of job tenure has brought a reduction in the former three-year standard to a more common one-year requirement. 4. Type of Work Page 187

While a person with a long record of steady employment provides a very good answer to the question of income stability, many seeking loans cannot provide such a record. This very much relates back to the stability of income. 5. Liabilities Page 188 Unlike a commercial loan evaluation that examines total liabilities in comparison with total assets, the residential analysis examines liabilities more as monthly payments and measures them against monthly income. Liabilities are limited by guideline percentages measured against applicant's income. 6. Assets Page 188 Very important in commercial loan analysis; not so necessary for home loans. If applicant can show an accumulation of assets it is a good indication of credit management and would make income qualification easier. B. Willingness to Pay Page 189 Sometimes called "credit character", it is most difficult to judge. Best information comes from credit reports showing how other creditors have been paid. Another measure of willingness to pay is an applicant's motivation for owning a home. Decision is a judgment call. C. Credit Reports Page 189 Credit information is assembled by a number of different credit bureaus. Each bureau has its own subscribing members who submit their records of experience with individual or company debtors for exchange with other members. 1. Keepers of Credit Records Page 190 In addition to local credit bureaus, three "national repositories" maintain database files on most individuals. Mortgage lenders normally require reports from at least two as part of loan documentation. The three are: Equifax Experion Trans Union 2. Credit Information Page 190 Credit reports contain applicant identifying information, present employment, previous address and employment, and a credit history. Unfavorable credit info can be deleted if proven inaccurate. Mortgage credit reports include a review of county records for judgments and liens. 3. Responsible Federal Agency Page 191 Federal Trade Commission, Washington, D.C. with regional offices in major cities. In 2003 the Fair and Accurate Credit Transactions Act (FACT) was passed protecting consumers’ privacy rights when reporting credit.

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Included consumers’ right to inspect their credit reports for accuracy. Consumers can contest possible errors and attach explanations regarding derogatory listings. Notification for the use of a credit report for the denial of a mortgage loan.

4. The Privacy Act Page 182 All the information collected from borrowers to be able to qualify them for the various loan programs comes under the Federal Trade Commission’s Privacy Rule, issued in 2003. This ruling established that mortgage brokers are financial institutions because brokering loans is a regulated financial activity. The Privacy Rule requires that mortgage brokers as well as depository institutions provide an initial privacy notice as soon as the customer relationship is established. 5. Credit Reporting Problems Page 192 Even though computerization has simplified the handling of data, errors can occur. Out-of-date data is not always removed. Name changes can cause problems. A creditor cannot require a Social Security number as a condition for extending credit, so that is not always available. 6. Credit Scoring Page 192 The increased use of computer analysis has brought greater use of credit scoring to mortgage lending. Credit scoring is the assignment of a numerical rating to consumers based on their credit history.

V. Qualifying The Applicant Page 193 Qualification for a mortgage loan requires a creditworthy borrower capable of repaying the loan plus an adequate property pledged as collateral. To make comparisons of the different income qualification methods, each is presented with examples as follows: (1) HUD/FHA percentage method, (2) VA residual method, (3) VA income ratio, (4) conventional/conforming procedures, and (5) other conventional as found in affordable housing loans. A. HUD/FHA Borrower Income Qualification Page 193 In 1989, HUD/FHA made a major change in its income qualification method that is now very similar to that long used for conforming/conventional loans. B. Percentage Guideline Method Page 193 Certain monthly liabilities of an applicant are measured against income at two points ( 1 ) housing expense should not exceed 31% of applicant's effective income, and (2) housing expense plus other recurring charges (identified as the "fixed payment") should not exceed 43% of income. 1. Effective Income Page 194

Includes borrower and coborrower's gross income from all sources that can be expected to continue for three years. (Deductions are no longer taken for income taxes). 2. Housing Expense Page 194 Includes the mortgage payment of principal, interest, real estate taxes, and hazard insurance. Also, mortgage insurance premiums and homeowners association fees if applicable. 3. Recurring Obligations Page 194 Any debt that matures in more than ten months or is recurring in nature. 4. Fixed Payment Page 194 Sum of housing expense and recurring charges. 5. Residual Income Page 194 Gross effective income minus fixed payment. 6. Ratios Page 194 If compensating factors are present, guideline ratios may be exceeded. 7. Borrower Rating Page 196 Income qualification alone is not final determinant. An underwriter's judgment of the applicant as to accepted or rejected based on four additional elements: (1) credit characteristics, (2) adequacy of effective income, (3) stability of effective income, and (4) adequacy of available assets. VI. Recent Additional Credit Score Requirements Page 196

A. FHA Institutes Minimum Credit Scores and Loan-to-Value Ratios Page 196 FHA new minimum credit scores and loan-to-value (LTV) ratio requirements for FHAinsured loans, effective September 3, 2010.  Borrowers with a minimum credit score at or above 580 are eligible for maximum financing.  Borrowers with a minimum credit score between 500 and 579 are limited to 90 percent LTV.  Borrowers with a minimum credit score of less than 500 are not eligible for FHA financing. VII. VA Borrower Qualification Page 197 The VA uses two methods to qualify an applicant's income: (1) residual method, and (2) income ratio method. A. Residual Method of Income Qualification Page 197

The VA residual method starts with the applicant's gross income, deducts the mandatory expenses, and ends with whatever the applicant has left, called "residual income." It is the most cumbersome of the methods now used. VA terminology and definitions follow. 1. Gross Income Page 197 Recognized income of both borrower and spouse that should have a reasonable expectation of continuing. 2. Tax Liabilities Page 197 Federal and state income taxes, Social Security taxes, and any other tax liabilities due. 3. Shelter Expenses Page 198 Includes the mortgage payment (PITI) plus any special assessments. Also includes estimated maintenance and utility expenses for the proposed house. 4. Other Monthly Obligations Page 198 Installment obligations with 6 or more monthly payments still due, revolving account payments, alimony or child support, and job related expenses. 5. Residual Income Page 198 After deducting taxes, shelter expenses, and other monthly obligations from gross income, the remainder is called "residual income." 6. Cost of Living Expense Page 198 Unlike any other underwriting procedure, with the residual method, VA uses a calculated figure to determine applicant's cost of living (see table 9-l). Applicant's residual income must be sufficient to meet the VA's required cost of living amount. 7. Excess Residual Income Page 199 The amount that applicant's residual income exceeds the cost of living amount is called "excess residual." If the excess residual is 20% or greater, it may offset failure to meet the income ratio guidelines. 8. VA Income Ratio Method of Qualification Page 199 In 1986, VA added an additional method of qualifying an applicant's income in an effort to weed out marginal applicants. The income ratio method is very similar to the conforming/conventional method as well as HUD/FHA procedures. However, income ratio is still used in conjunction with the VA residual method. 9. Shelter Expenses Page 199 The mortgage payment is the same as for FHA and conforming loans: principal, interest, taxes, and insurance. Neither maintenance nor utility expense is deducted in this method.

10. Other Monthly Payments Page 200 Includes loan repayments, installment obligations, revolving account payments, and other obligations such as child support. Tax obligations are not included. 11. Income Ratio Page 200 The sum of shelter expense plus other monthly obligations is divided by applicant's gross income. The ratio should not exceed 41%. (Same limit as now used by HUD/FHA.) 12. Comparison with Residual Guideline Page 200 As a final check on qualification, should the applicant's income ratio exceed 41%, he or she may still qualify if the excess residual in the prior calculation exceeds 20%. 13. Other Qualification Considerations Page 200 As in all qualification methods, the applicant's income is only one of the measures. For VA, other measures include: 1. 2. 3. 4. 5. 6. 7. 8. Ability to accumulate assets Ability to use credit wisely Relationship between new housing expenses and old expenses Number and ages of dependents Likelihood of income changes Work experience and history Credit record with other debt Amount of any down payment

B. Conforming/Conventional Loan Qualification Page 201 Conforming loan is one that meets Fannie Mae/Freddie Mac standards. While both agencies are privately owned, they fall under oversight requirements of HUD, which results in both Congress and HUD setting some qualification standards. Mortgage payment cannot exceed 28% of gross income and total of mortgage payment plus other monthly payments cannot exceed 36%. 1. Mortgage Payment. Consists of principal, interest, taxes, and insurance plus any special assessments and cannot exceed 28% of gross monthly income. 2. Other Monthly Obligations. Includes installment obligations extending beyond 6 months, revolving charges, and those payments that represent a fixed claim on applicant's income and cannot exceed 36% of gross monthly income. C. Other Conventional Loan Qualification Page 202 Few standards with conventional loans as lenders are free to set their own requirements so long as they do not violate non-discrimination laws. In practice, many follow the lead of conforming loan requirements even though the loans may not be intended for sale.

1. Affordable Housing Loans Page 203 A fairly new category of conventional loan resulting from the Community Reinvestment Act and its FIRRREA amendment, is a variety of programs under the umbrella term of "affordable housing loans." While numerous variations exist, thrust of these loans is to target low- and moderate-income people (low income: 80% or less of area median incomemoderate income: 115% or less of median income.) Purpose is to recognize that many creditworthy people follow different living patterns than has been customary for loan qualification. Many pay a greater percentage of income for housing anyway, justifying an increase of housing ratio from 28% or 29% to 33%. This group generally does not overload other debt justifying a total fixed obligation limit of 38% rather than an FHA or VA 41%. 2. Temporary “Making Homes Affordable” Programs Page 204 Starting in 2006, poor credit and underwriting practices and overly aggressive origination-to-distribute mortgage programs were one of many factors that led to the recent financial crisis. Many programs have been developed to assist homeowners to stay in their homes during the crisis. Only the most widely used programs—HAMP, HARP, HHF, and HAFA—will be discussed in detail below. 3. HAMP Page 205 The Home Affordable Modification Program is intended to help borrowers lower their monthly mortgage payment to 31 percent of their verified monthly gross (pretax) income to make their going-forward mortgage payments more affordable. The eligibility requirements for a borrower are as follows. • The mortgagor must occupy the house as their primary residence. • The mortgage must have been obtained on or before January 1, 2009. • The current mortgage payment must be more than 31 percent of monthly gross (pretax) income. • The mortgagor can owe up to $729,750 on the home. • The mortgagor must show that he or she has a financial hardship. • The mortgagor must have sufficient, income to support the modified payment. • The mortgagor must not have been convicted within the last ten years of a felony. 4. HARP Page 205 The Home Affordable Refinance Program is intended to help borrowers who are current on their mortgages and have been unable to obtain a traditional refinance because the value of their homes has declined. Applicants must meet the following criteria. • Mortgagor must have a mortgage owned or guaranteed by Fannie Mae or Freddie Mac. • Mortgage cannot be a FHA, VA or USDA loan.

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Mortgagor must be current on his or her mortgage payments and have not been more than 30 days late in making a payment over the past year. Mortgagor can owe more than the home is worth, but the mortgage cannot exceed 125 percent of the current market value of the home. As refinanced, the mortgage must improve the long-term affordability or stability of the new mortgage (a fairly subjective process). Mortgagor must have the ability to make the new mortgage payments.

5. HHF Page 206 The Housing Finance Agency Innovation Fund for the Hardest-Hit Housing Markets was a new program established by the U.S. Treasury Department in early 2010 to provide at least $7.6 billion in targeted aid to states hit hard by the economic crisis. The HHF program fund as been allocated to just 18 states plus the District of Columbia. The programs vary greatly by state but commonly include the following benefits. • Mortgage payment assistance for unemployed or underemployed homeowners • Principal reduction to help homeowners get into more affordable mortgages • Funding to eliminate homeowners’ second lien loans • Help for homeowners who are transitioning out of their homes and into more affordable places of residence 6. HAFA Page 206 The Home Affordable Foreclosure Alternatives Program is targeting those borrowers who have a mortgage payment that is unaffordable when the borrower is interested in transitioning to more affordable housing. The typical borrower is eligible for a short sale or deed in lieu of foreclosure through HAFASM. For a mortgagor to be eligible for a HAFASM, he or she must meet all of the following criteria. • Mortgagor must have lived in the home for the last 12 months • Mortgagor must be able to document financial hardship • Mortgagor must not have purchased a new house within the last 12 months • The first mortgage must be less than $729,750 • Mortgagor must not have received the mortgage on or before January 1, 2009

E. Comparison of Qualification Guidelines Page 207 See chart in text for comparison of percentage guidelines. VIII. Commercial Loans Page 207

Commercial loans offer a variety of qualification information and, unlike home loans, are usually one of a kind. Prudent lenders examine all phases of a business operation—and study company financial statements. A loan agreement is commonly required. A. Commercial Loan Application Page 207 Without consumer protection requirements and a variety of business loans to work with, application forms are usually prepared by lenders. Special information is crucial for different kinds of properties—knowing what to ask develops from experience and creates specialization among commercial lenders. An upfront non-refundable application fee is a normal requirement. Financial statements required are a balance sheet, profit and loss statement, and most likely, pro forma statements showing impact of loan on future profitability. Audited statements may be required. (Financial statements are considered further in Chapter 11.) B. Loan Agreement Page 209 It is customary to prepare a loan agreement when a corporation is involved so as to protect the lender's position with the company should a change of management or ownership occur while the loan is outstanding. IX. Private Mortgage Insurance (PMI) Page 209 PMI is an imprecise name for default insurance, but it is the term most commonly used. Need for PMI expanded in the 1980s as source for mortgage money moved from local lenders to national financial markets. A. History of Private Mortgage Insurance Page 209 Early efforts to sell PMI in the 1950s were not very successful as there was no real need. Turnaround came in 1971 when regulators allowed savings associations to write loans up to 95% LTVR (previous limit was 90%) providing loans over 90% carried insurance against default. By 1972, private insurance reached a greater volume than FHA. In the boom that followed, many companies sacrificed loan quality in favor of greater premium volume and the industry suffered a shakeout. B. Private Mortgage Insurance Companies Page 210 Only about 15 companies specialize in this kind of insurance. Current leaders are Mortgage Guaranty Insurance Corp. and General Electric Capital Mortgage Insurance Co., each with about 25% of the total market. C. Qualifying Information Required Page 210 All insurers work through a system of company approved agents who are usually loan originators.

Since PMI insures the lender against loss, it faces the same default risk as the holder of a mortgage note. Thus, qualification for insurance requires an underwriting evaluation similar to that for making a loan. D. Amount of Coverage Offered Page 210 Private mortgage insurance carriers issue a variety of policies for residential loans that range from a low of 12 percent of the loan amount insured to a high of 35 percent. 1. Terms of PMI Insurance Page 210 Comparing insurance coverage: FHA and VA underwrite for the life of a loan; FHA insures 100% of a loan, VA guarantees a portion of a loan. PMI offers a variety of coverages but all are limited to a portion of the loan ranging from 12% to 35%. Further, PMI is sold for a shorter term of years than the life of a loan. 2. Type of Property Covered Page 211 PMI is available for a greater variety of property loans than are the government programs. E. Premiums Charged Page 211 Because PMI covers less than the full amount of a loan for shorter terms, it can offer lower premiums than government programs. Premiums are usually set by state insurance commissions. Recent change is to charge on a monthly basis with no upfront premium. F. Cancellation of PMI Coverage Page 211 In the past, it has been normal for borrowers to pay PMI premiums for life of the loan. This policy was changed by federal legislation effective 7129199. The law exempts FHA and VA loans. Lenders are required to notify consumers of their right to cancel PMI when equity in their houses reach 20% (lender may require an appraisal to prove this). Further, the law requires lenders to automatically cancel PMI when the loan reaches 78% of original value of house. 1. Who Determines Need for PMI? Page 212 Lenders, not borrowers, determine need. General rule is loans over 80% LTVR must carry insurance. The federal regulator rule for regulated lenders is PMI must be carried if loan is over 90%. 2. PMI Obligations in the Event of Foreclosure Page 212 Insurers have generally followed a policy in the event of loan default of paying off the lender and taking title to the foreclosed property. It has been a good marketing tool. However, escalating foreclosures caused some modifications by many companies limiting payments to the insured amount. 3. Indemnification Clause Page 212 Not too well understood by borrower/consumers is the fact that PMI coverage protects the lender, not the borrower against loss. Some PMI contracts contain

indemnity provisions that obligate the borrower to reimburse the insurance company in the event of a loss.