Understanding Underwriting

Mortgage lenders evaluate your credit-worthiness by examining four general areas of your financial life.  In years past you had to meet criteria in one or more of these areas, but not necessarily all, to qualify for a loan.  Changes were made in mortgage underwriting guidelines in response to the Mortgage Meltdown of 2007-2008.  Now you must meet the requirements for each and every category, no matter how well qualified you are in any one, two or three. Serving as the underwriting foundation for the entire mortgage industry are the guidelines issued by Fannie Mae and Freddie Mac, whether the loan is “Conforming” (intended for eventual sale to these two agencies) or “Non-Conforming” (i.e. Jumbo or Portfolio loans).  Lenders may have additional “overlays” on top of agency requirements, or may deviate from Fannie/Freddie regulations for specific programs.  But in general, these are the basic rules that lenders will use in reviewing your loan application:

Guidelines first require that you have established enough credit history so that your credit and payment patterns can be evaluated and your credit scores are meaningful.  For most borrowers, quantity of credit history is not an issue.  Qualifying in this category comes down to derogatory credit history and credit scores. In general, lenders do not want to see any mortgage late payments in the last year and have specific “seasoning” requirements for significant credit events like foreclosures (typically 7 years) and Chapter 7 Bankruptcies (4 years). The primary credit criteria for most borrowers is their qualifying credit score.  There are three credit bureaus, each with their own version of the famous FICO score.  (Note:  the scores issued directly to consumers by credit score websites are “FICO-facsimiles”. The true FICO scores used in underwriting your loan request can only be obtained through a lender.)  The middle score for each borrower is their “qualifying score”, and if there are multiple borrowers, the lowest borrower qualifying score becomes the qualifying score for the application. There are minimum credit score requirements for different lender and loan program types.  Currently, government-insured loans (FHA) require a 580 score or above.  Conforming loans require a minimum 620 qualifying credit score.  Many jumbo lenders require a minimum of 720.  However down payment requirements and interest rate pricing is extremely credit score “sensitive”.   All improve at standard score thresholds (680, 700, 720 and 740). See “The Three Rules of Credit”

As a result of the Dodd Frank Act of 2010, the federal government has become directly involved in mortgage underwriting.  Not only do federal regulations require that mortgage lenders evaluate and document in detail a proposed borrower’s “ability to pay”, they also now dictate the criteria used for this evaluation. In general, these regulations require that the sum of your monthly “housing expenses” (mortgage payment, property taxes, association dues and insurance) plus your monthly “debt service” (minimum required payments for auto financing, student loans, personal loans and credit card debt) shall be no more than 43% of your gross monthly income (before taxes) if you are an employee, or of your average net taxable profit over the last two years if you are self-employed.  However, there are exceptions (i.e. up to 49% for Agency and 52% for FHA). Calculating income based on underwriting guidelines can be a complicated process, particularly if you are self-employed and/or an investor.

Lenders want to see that you have been employed, in the same line of business for at least two years. Education related to your current employment can be used to satisfy this requirement.  Gaps in employment history must be explained. If you are self-employed, you will need to show that you have been operating your business long enough to report two years of business related income on your tax returns. (There are exceptions that allow for the use of only the most recent year’s tax returns for underwriting, but in this case you must have been operating your business for a minimum of 5 years.) Borrowers who have changed their employment status from employee to a self-employed/ “contract” consultant, even though they are doing the same work, can find themselves in a two-year mortgage qualifying “purgatory” with conventional loan programs.

For purchase loans this category pertains to the cash required to close (down payment and closing costs) and your post-closing reserves (savings left over after the completion of your purchase).  For a refinance loan, the equity or value of the property above the propose loan amount is considered the same as a down payment on a purchase. The requirements in this category vary a great deal depending on property and ownership type, loan amount and program.  You may qualify for as little as 3.5% down with no reserves for government or agency financing for the purchase of a primary residence, or be required to have 20%-30% in equity or down payment and several months or payment reserves in savings for jumbo loans, loans on investment properties or cash-out refinances.