Every lender looks at a variety of factors when considering your loan application. While each lender has different underwriting requirements, every lender considers three factors. In the mortgage industry, they are known as the ‘three C’s.’
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The ‘three C’s’ are credit, capacity, and collateral. We look at each factor below to give you a good understanding of what lenders expect.
What is Credit?
As you probably know, lenders pull your credit for most mortgage programs. This report lets the lender know your level of financial responsibility. They usually pull what’s called a ‘tri-merged’ credit report. This is a combined report from all three bureaus – Equifax, Experian, and Trans Union.
Lenders look at both your credit score and your credit history on these reports to make a determination. They use this information to determine your credit-worthiness for the loan program. But, they also use it to determine your interest rate and the total closing costs for the loan.
Your credit score is a result of a complicated algorithm. While you may not understand the calculations, you can have a thorough understanding of the basic requirements you should meet to increase your credit score:
- Timely payments – Try to avoid making any payments 30 days or more past the due date
- Credit utilization – Try to keep your outstanding balance less than 30% of the available credit
- Type of credit – A healthy balance between revolving and installment credit may help your score
- Age of accounts – Try keeping old accounts open, even if they have a zero balance as the older an account, the more it helps your credit score
Keeping these basic factors in line will help you maximize your credit score. Be careful, though, you can go overboard and make these positive factors turn negative. For example, having too many credit cards with a zero balance may be seen as a liability. It shows future lenders that you have the ability to take on a lot more debt without applying for new credit.
In general, in addition to the credit score, lenders look for:
- Late payments either mortgage or non-mortgage related
- Foreclosures
- Bankruptcies
- Collections
- New inquiries
The lender takes all of this information in, looking at the big picture. They won’t turn you down because you have one 30-day late payment on a revolving account, for instance. If you have multiple late payments, and are over-extended on several accounts, though, it could be grounds for denial.
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Luckily, many programs are available today that cater to people with different types of credit histories. This includes conventional, FHA, USDA, and VA programs.
What is Capacity?
Your capacity to repay the loan is the combination of your gross monthly income and current debts. Lenders typically look at your debt ratios for this ‘C.’ These ratios are the housing ratio and total debt ratio. This shows the lender your ‘capacity’ to repay the proposed loan.
Your housing ratio is the front-end ratio. It compares the total housing payment, including the principal, interest, taxes, and insurance against your gross monthly income. Ideally, you want a 28% housing ratio, as that is the conventional loan guidelines. Other loan programs do allow for higher ratios, though, such as the FHA loan, which allows a 31% front-end ratio.
Your total debt ratio is the proposed housing payment plus your existing liabilities compared to your gross monthly income. In a perfect world, a 36% total debt ratio is ideal. At least, that is what conventional loan guidelines require. FHA and USDA programs allow for as much as a 41% total debt ratio, though.
In addition to your debt ratios, lenders will consider your employment stability and type of income. If you are self-employed, lenders will have to take that into consideration. They may ask for more compensating factors or require a 2-year history of proof of income to make sure your income is consistent. As far as job stability, if you changed jobs several times over the last 2 years, it could throw up a red flag. Lenders will need to know why you changed jobs so often as well as determine if there were any gaps in employment.
Finally, lenders look at your assets to determine your capacity to repay the loan. Do you have reserves on hand? This is money beyond the down payment and closing costs you’ll pay. It’s the money you’ll leave untouched in your checking, savings, or liquid investment account that you can use to pay your mortgage if necessary.
What is Collateral?
Collateral is the house you buy or refinance with the loan. Collateral is one of the most important factors in the process as it’s what lenders use to recoup their money if you default. The value of the home, as well as the amount of the down payment, play important roles for this factor.
Your lender cannot lend you more than the value of the home. In most cases, though, lenders will only lend a portion of the home’s value. For example, FHA loans allow you to borrow up to 97.5% of the home’s value. VA and USDA loans do provide 100% financing, though, if you meet the eligibility requirements for these programs.
Collateral is where your down payment plays a role. The more you put down on the home, the less risk the lender takes. Conventional loans do allow down payments as low as 5% as long as you have good credit and stable income. If you go this route, you will pay Private Mortgage Insurance while you owe more than 80% of the home’s value. If you put 20% down on the home, you can eliminate the need to pay the PMI.
Underwriting is Like a Big Puzzle
Putting these three factors together is like putting together a big puzzle. When your loan goes through underwriting, you don’t have to worry if you have one less than perfect qualifying factor. If you have other factors that make up for it, you may still have a good chance of securing a loan approval.
Lenders look for the good and the bad in a file. The hope is that the good outweighs the bad, like a lower credit score can be offset with a low debt ratio. It’s all about the risk you pose to the lender. The more positive factors you provide, the greater your chance of an approval.