Home Mortgages and the 4 C’s of Lending

All you need to do to make sure you have a better success rate in getting your home loan application approved at the terms you want is education and preparation regarding the process the lenders go through to approve your request.  When evaluating your request for a mortgage loan, a mortgage lender will assess the application you have filled out with the supporting documents you have submitted.  This process is referred to as underwriting the home loan.  During this stage, the mortgage lender investigates the integrity of the data and evaluates the risks in order to qualify the applicant. 

The home loan application is a summary of your assets, credit and income position at this particular point in time.  It does not measure your character nor does it measure potential future changes such as potential employment changes or debts that maybe incurred or satisfied. 

In order to evaluate your present position the mortgage lender will review your financial position, take inventory of your assets, income and credit profile.  This procedure is accomplished by verifying your employment, verifying the funds you have on deposit with financial institutions, verifying the equity in the home by appraising the property, reviewing your debts outstanding and analyzing your credit history.  This process has become highly automated with computer modeling and approvals but the underlying process is basically the same.

These criteria that are evaluated were once referred to as being the four C’s of lending or collateral, capacity, credit, and character.

Collateral – Collateral is a measure of the value, condition and marketability of the property.  The mortgage lender will order an appraisal to determine the market value of your home.  From here the loan to value or equity position in the property is determined.  Loan to value is the ratio of loan amount to the appraised value.  If the borrower is agreeing to down payment of $10,000.00 on a $200,000.00 home, the loan to value will 95%.  This formula works on the refinance as well.  If a borrower wishes to refinance an amount of $100,000.00 on a $200,000.00 home, the loan to value will be 50%.  Loan to value (LTV) and the appraisal are the biggest factors in measuring collateral.  Lower loan to values leave more equity in the property and is inherently less risky for the mortgage lender since it not only cushions the mortgage lenders risk but leaves more at stake for the borrower.

Capacity – Capacity is short for capacity to pay.  In regards to mortgage qualifications the capacity to pay is measured by housing and debt ratios.  The mortgage lender will ascertain the borrower’s gross monthly income first.  The new housing payment on the mortgage requested is calculated as well as a summary of all contractual debt payments.  Capacity is then measure by dividing the monthly mortgage payment by the gross monthly income to obtain the housing ratio and then dividing all contractual debt payments by the gross monthly income to get the total debt ratio.  For example, if the total obligations of the borrower were $1,400 ($1,000 for housing expenses and $400 for other credit obligations), the housing ratio would be 25% ($1,000/$4,000 = 25%) and the debt ratio would be 35% ($1,400/$4,000 = 35%).  Lower housing and debts imply greater capacity to pay a home loan back and hence lower risk.

Credit – Credit is evaluated by reviewing the credit report and the credit score.  With the use of credit scoring, credit evaluation has become one of the simplest attributes of a loan request to measure.  The credit is broken into three primary categories.  Mortgage lenders will use credit scores, known as FICO scores, to determine the overall credit risk of the home loan borrower.  From here a review of the public records such as, tax liens, bankruptcy filings, and judgments will be assessed.  Finally, the individual accounts or trade lines in the credit report will be reviewed for delinquency, credit amounts, depth and length of time on accounts.  Generally speaking, the higher the credit score the better the credit risk.

Character – Character is a qualitative measure of a borrower’s stability, integrity and honesty.  Measuring character was mostly a measure of a borrower’s commitment to their credit and the new debt they intend to take on.  Character may be classified as a measure of responsibilities with the loan commitment.  Since mortgage lending and underwriting is almost entirely based on quantitative analysis, character is predominantly ignored.  Since it is difficult to evaluate the risk and to even measure a borrowers character, in residential mortgage lending this gauge is rarely used.

Qualification for most mortgage loans and the mortgage rate a lender will charge depends on these three main factors.  Understanding the basic guidelines and having knowledge of what a mortgage lender looks for in analyzing your loan request will make your mortgage application and homeownership experience and far smoother and less nerve racking experience.