For most consumers, there are four main types of credit they will apply for: credit cards, personal loans, auto loans, and mortgages. Credit cards, which are unsecured loans with high interest rates and generally the smallest loan type, are the easiest to get approved for. Mortgages, which are secured loans with low interest rates and generally the largest by loan amount, are the hardest. For a lender to approve a mortgage, they will consider six key criteria: credit, income, assets, employment, valuation, and title.
Credit scores are calculated based on the information contained in a consumer’s credit report – such as amount of credit extended, age of credit, and credit utilization – and range from 300 to 850. To qualify for an FHA mortgage, a consumer needs a credit score of 580 or above, although most lenders require higher credit scores. Whatever the minimum credit score a lender requires, the higher the credit score a consumer has at the time they apply for a mortgage, the lower their interest rate is likely to be, all other things being equal.
In response to the COVID-19 pandemic, many lenders upped their minimum score requirements. But some lenders accepted the minimum FHA score to help under-served demographics, as highlighted by Frank Fuentes, National Vice President of Multicultural Community Lending at New American Funding in our recent Ask the Expert webinar, Customizing Lending to the Hispanic Community:
“Most lenders were increasing their FHA requirements from 620 to 660 or 680. We lowered them to 580. And that decision was made straight from the top from Patty Arvielo, who’s the president and co-founder of New American Funding. She goes, ‘I believe passionately in this demographic. I’m Latina. We’re going to continue following the FHA rule book and continue to do FHA loans down to a 580.’”
People’s incomes can range from no income if unemployed all the way up to millions of dollars per year. Given that property prices range so broadly, there is no hard and fast rule as to the minimum income a consumer needs to obtain a mortgage on a property. But there is a rule of thumb, also known as the 28/36 rule, which says that a consumer will only be approved for a mortgage loan with a monthly payment equal to 28 percent or less of their gross monthly income, and total debt payments that equal 36 percent or less of their gross monthly income.
In terms of total loan amount, the rule of thumb is 4.5 times a consumer’s gross annual income. In other words, a household with an annual income before taxes of $100,000 should be able to get a mortgage on a house worth up to $450,000. Just like a consumer’s credit score helps a lender assess their creditworthiness and likelihood of keeping up with their monthly payments, the consumer’s income tells a lender whether they will be able to afford their monthly payments given competing bills and expenses they have to cover each month.
The third way a lender will assess a consumer’s likelihood and ability to repay their mortgage – and conversely, the risk that they will default on the loan – is the assets the consumer has in their overall financial portfolio. Should the consumer fall on hard times and face a period of unemployment, they can utilize other assets to cover their monthly mortgage expense. There are multiple asset types that lenders can take into account:
- Cash or cash equivalents
- Physical assets
- Non-physical assets
- Liquid assets
- Fixed assets
- Equity assets
- Fixed-income assets
The more liquid asset types are considered more valuable in the overall assessment as they could be turned into cash to cover a mortgage payment faster and more easily should a homeowners income take a hit.
Prior to the housing crisis of 2007/8, it was possible to get a NINJA mortgage loan on a residential property. NINJA stands for No Income, No Job, No Assets, and the availability of these loans was based on the house acting as security for the loan. This worked fine in a rising house market where the property was worth more than the loan soon after the initial purchase. But when house prices crashed 20 percent or more within a matter of months, lenders that extended NINJA loans faced major losses.
Consumers can earn income in a variety of ways – wages, tips, bonuses, rental income, business income, dividends, and so on. W2 income, or full time employment, is the best sign of the income consistency needed to cover monthly mortgage payments. Consumers also have to show that their income is established, and a lender will usually want to see two years of a given income type to consider it as part of a mortgage application.
Because a mortgage is a secured loan and the house or apartment is what will be seized in the case of a foreclosure to cover the debt, the valuation of the underlying asset is vital in a mortgage application. FHA loans require a low minimum downpayment of 3.5 percent, so there’s not a lot of leeway for the valuation.
Before approving a mortgage, a lender will consider the LTV (loan-to-value) ratio, with anything more than 80 percent considered a risky loan to make. For consumers putting down between 3.5 and 20 percent of the purchase price, they will have to pay PMI (Primary Mortgage Insurance), which covers the lender in the case of a borrower that defaults to the point of foreclosure.
Just like the valuation of the mortgaged property needs to be sufficient to cover the lender in the case of a foreclosure, a lender will want to know that the title is passed on to the consumer clear of any liens or other claims. Title is a legal document that proves ownership of the property. Similar to PMI, title insurance protects the lender from any issues that may arise with the title in the case that they have to foreclose. Although the lender is the beneficiary of the title insurance, it is the consumer that pays for the policy.
Traditionally, title and escrow agents will go through a long-winded process to cure any defects in the title, and the lender relies on this process being complete before approving a mortgage loan. Doma takes a different approach to title insurance, using machine intelligence and various data sources to assess the likelihood of any lien or encumbrance. This allows Doma to insure approximately 80 percent of property titles in under a minute, as compared to the traditional process that can take hours or days. As a result, lenders can process loans faster, increasing pull-through rates and ensuring more applications result in a loan closing.