How Many "C's" are in "Underwriting"?

Over the last one to two years, major changes have occured in both the availability of certain mortgages and the guidelines that banks and lenders require in order to get loans.  While many types of loans have disappeared almost completely (stated income, 100% investor loans, Sub prime loans), others have experienced few overall changes (FHA and VA) although many people are under the false impression that it's impossible to obtain a mortgage without perfect credit and a large downpayment. 

What's essentially happened is a return to normal and established standards which have, in some cases, been overly tightened to compensate for negative market conditions.  Once those conditions return to normal, most people won't notice much difference in the way things are compared to the way they were prior to 2003. 

Stated loans are basically gone.  Created as a way to streamline the application process, they quickly morphed into a way to lie about income to qualify for loans that people couldn't afford.  And what about pay option ARM's?  Those are gone too (although there are still plenty of bait and switch advertisements left on the internet to reel in consumers looking for a deal that's too good to be true).  High LTV loans for investors, especially with stated income, have also gone the way of the do-do bird. 

But still, rarely a week goes by where i don't hear "I just don't understand why I can't get a loan with a 620 credit score.  I thought that's all you had to have??"  

Well it used to be.  But we have to remember and recognize this was the OLD logic (if you can call it logic) that caused the majority of the problems we are having today with the mortgage market. 

Simply stated, the idea that a credit score can be used as the sole indicator of one's ability to repay a mortgage loan was a terribly flawed logic and may go down in history as the worst lapse of financial judgment on planet Earth.  The losses caused by these bad loans have already exceeded 10% of our entire GDP, and will probably continue to rise before stabilizing.   

So where does that leave us?  A return to normalcy and back to the long established standards of underwriting that began decades ago before this short period of creative destruction caused by financial "ingenuity". 

Depending on who you ask, there are either four, five or six "C's" of underwriting.  I'm in the camp that says there are six:

1. CREDIT
2. CAPACITY
3. CAPITAL
4. COLLATERAL
5. COMMON SENSE
6. CONDITIONS (as in MARKET conditions). 

The first five have been around longer than most of us have been alive.  Prior to the days of automated underwriting, subprime loans and securitized mortgages, the five C's were looked at universally by all lenders.  But during this decade (primarily from 2004-2006), lenders decided it would be a smart idea if they ignored the last five factors as long as PART of the first one (CREDIT SCORE) met a certain minimum standard.  I'm not going to get into all the reasons WHY this happened (there are many), but the fact is that it did and things have changed because it was a terrible model for predicting risk of foreclosure.  And that's the primary reason why we're well over a Trillion dollars in bailouts, emergency loans to banks and record drops in the stock market and real estate values.  

Which brings me to the sixth C...Conditions.  This one only makes an encore appearance into the equation when the economy and/or real estate market (or both) are not performing well.  Unfortunately that is the case right now, but that doesn't mean it's impossible to get a loan.... 

So let's take a look at these five "C's" of underwriting and review exactly what each entails and what lenders are looking to establish about a borrower and/or property for each one. 

CREDIT -

WHAT IS THE BORROWER'S CREDIT SCORE, CREDIT HISTORY, CREDIT DEPTH? 

Analyzing credit has much more to do with simply rating a credit score as acceptable or unacceptable.  Many people assume this means a borrower has to have a certain minimum credit score to qualify for a loan.  This is only HALF of the story.  The other half is credit history and depth.  In other words, how a person has paid their bills, how many bills they have and also how long of a history they have paying them in a timely fashion.  Simply having a certain computer generated score doesn't really mean anything without an objective analysis into these factors. 

For example, I had a client call me today who had a 648 credit score.  Not too bad, except for the fact that over the last seven years, he had two reposessions, 16 collections (only two of which had been paid), multiple 30, 60 and 90 day late payments and a judgment.  On top of that, he had no accounts which were currently open and active, so there was no way for anyone to make a determination as to how he paid his bills, other than to use non-traditional credit sources for verification.  Unfortunately this was not an option with this person. 

The major factors that are considered include:

• Credit score.  What is the credit score.  Is the score a true reflection of their ability to repay their debts?
• Credit depth.  Do they have at least a minimum of three accounts that have been open and active for the last 12 months?  If they don't, can they show acceptable documentation of alternative credit, such as utilities, rent payments, insurance and other bills?  Almost every loan type requires at least three credit references that have been open and active for the last 12 months.  Sub prime loans eventually got to the point where credit history and depth did not matter: only credit score. 
• Credit history.  Have they paid their bills on time?  If not, is there a reason why they didn't that was caused by extenuating circumstances beyond their control that are no longer present?  And have they reestablished a good payment history of at least 12 months since then?   

CAPACITY - 

DOES THE BORROWER HAVE THE CAPACITY TO REPAY THE LOAN? 

Capacity analyzes several factors regarding a borrower's employment, income and debt-to-income ratio, as well as the overall likelihood that their income will be consistent enough to pay the loan on time.

• Does the borrower's employment history reflect stability, strength of income?  Remember, they are applying for a 30 year loan.  It only makes sense that we determine if they have a good work history for the last two years.  Is there a reason to believe they may be an issue with continued future earnings?  A prime example of this would be a self-employed individual who has earned substantially less in the most recent year versus the year before.  Another example would be a borrower who leaves a well paying job for a lower paying job, especially if that job is not related to their field, and they have not yet worked there long enough to constitute a reasonable definition of stability.  Those situations may cause problems if they can't be addressed in a manner that makes sense and instills confidence that they will be able to pay their mortgage on time.
• Does the borrower make enough money to qualify for the loan?  What is the debt-to-income ratio?  Is it over 45-50%?  If so, this loan may be tough to approve, despite the stength of the other four factors...
• Can they prove their income?  (i.e. stated income and almost all no doc loans are a thing of the past). 
•  

CAPITAL

DOES THE BORROWER HAVE SUFFICIENT DOWN PAYMENT, EQUITY AND/OR CASH RESERVES?

There are two main categories that fall into this factor:  Equity and Reserves.  In the case of a purchase, the equity is the down payment.  In the case of a refinance, the equity is the amount owed on the final loan amount versus the appraised value.  In both cases, reserves refer to how much money a borrower will have in documented assets, such as checking and savings accounts, money market funds, IRA's, 401K's and other equity assets AFTER closing.  This is most often expressed as a number of months of PITI they have in reserves.  Not all loans require a down payment, nor do they require a specific amount of reserves.  However, borrowers who will have less than two months of the total PITI in reserves after closing must typcially exhibit strong factors related to the other five "C's" or they will have a very tough time getting approved. 

Some of the details that must be taken into consideration include:

• How much money does the borrower have in all of their accounts?  Can the borrower prove this money has been seasoned in their account for the last two months?  If not, did it come from an acceptable source, and is there documentation to support this?
• If the borrower is getting a gift or down payment assistance, is the source acceptable?  Do the loan guidelines allow for a gift?
• How much equity (cash down payment for a purchase, or hard equity in the case of a refinance) does the borrower have?
• Will the borrower have some money left over after closing, or will they use all of their money for down payment?  Statistically, people are much more likely to default if they have less than two months of PITI in reserves.

COLLATERAL

DOES THE HOME BEING PURCHASED OR REFINANCED PROVIDE SOLID, MARKETABLE COLLATERAL TO THE LENDER?  IS IT CURRENTLY IN A MARKETABLE AND LIVEABLE CONDITION?

This is definitely one area that can quickly overrule the other four if there's an issue.  Regardless of a borrower's credit, their capacity to repay the debt or even their capital, the collateral can make or break a deal.

• What is the market value (appraised value) of the home, and did the appraiser determine the value in a way that meets the lender's requirements?
• What is the condition of the home?  Is the foundation in good condition or in need of repair?  What about any major safety issues?  Most of these can be repaired before closing and in some cases can even be escrowed for repair after closing.  Escrows must be approved by the lender. 
• Has the home been on the market for an unusually long time compared with other homes in the area?  If so, why?  Was it simply overpriced, or is there something that makes it unmarketable or extremely uncommon and would pose a problem if the lender had to foreclose and sell the property?
• Is there something about the home that makes it undesireable to the masses?  Are there similar homes in the area with similar characteristics that have sold within the last six months?  Did the appraiser have to use comparables that are too far away and/or different to justify the value?
• Is the zoning and usage of the property strictly residential?  Or is it mixed use?  Does it meet the definition of "residential"?
• For condominiums, is the occupancy and other standards up to par with the requirements of FHA and Fannie Mae?  Or is it considered "non-warrantable"? 

Investors that are looking to purchase and rehab properties in very poor condition (poor foundation or roof, no climate control and/or general lack of habitability) must use private money (hard money) loans to purchase homes.  Fannie Mae and Freddie Mac were created to increase the home ownership rate, not to increase the wealth of investors and speculators.  Although Fannie and Freddie do allow investor loans, they require the home to be in fairly decent condition and do not provide funds to repair properties for investors to sell and make a profit.  Serious investors must consider working with a small independent banker or private investor that is willing to take on a higher level of risk (and thus, demand a higher rate of return on their investment) if they want to purchase and "flip" investment properties. 

COMMON SENSE

DOES IT MAKE SENSE THAT THIS PERSON WILL BE ABLE TO PAY THE MORTGAGE ON TIME?  DOES THE LOAN, IN GENERAL, MAKE SENSE?  DOES THE OCCUPANCY DISCLOSURE MAKE SENSE? 

Also, when the first four factors are borderline or questionable, many loan officers and underwriters must revert to common sense in order to make a final decision.  Here are some examples:

• Payment shock.  Is the borrower increasing their payment to a level that doesn't make sense or doesn't reflect their reserves?  For example, a buyer who currently lives with his parents and pays $300 per month in rent and decides he wants to buy a $120K home with an $1,100 per month payment.  Does he have some savings that shows he has the extra money to pay such a huge increase in housing expense (not to mention utilities, etc)?  Did he just get a raise, or has he made the same income for the last two years? 
• Does the borrower have enough residual income?  How much cash will be left over after all debts and the house payment have been made each month?  Debt ratio is only expressed as a percentage and doesn't always show a realistic picture of how much a person truly has left to spend each month on everyday expenses. 
• For people keeping their current home as a rental property - Is the new home an upgrade in size or is it smaller?  Are they moving closer to work?  Is there another logical reason they would want to buy a smaller house?  Or are they disguising this new home as an investment property.  This is one of the most common and also most serious types of loan fraud.   Lenders are performing random occupancy verifications after closing, and lenders can call the full amount of the loan due immediately if it's determined the buyer lied about occupying the property. 

CONDITIONS

WHAT ARE THE MARKET CONDITIONS OF THE AREA?  IS THE MARKET RAPIDLY DECLINING IN VALUE, OR IS IT RELATIVELY STABLE?

This can be relevant in either a macro or a micro sense.  Fannie Mae and Freddie Mac have required larger down payments in entire states, such as Calfornia and Nevada, where the overall market values have experienced rapid declines.  And in other areas where high foreclosure rates are confined to specific cities and even subdivisions, lenders may require a higher down payment if there is evidence to suggest the value of the home (COLLATERAL) may further decline in value.  Fortunately most of this rapid decline in value has escaped Texas, but there are still specific areas (mainly lower end new home subdivisions where builders did not escrow properly for taxes and other areas where subprime loans were very common) where foreclosures are a major problem. 

Having foreclosures in a particular neighborhood does not always mean the value is lower for all homes or that the area is considered a declining market.  Lenders typically analyze the proportion of foreclosures to non-distressed sales and make a common sense determination as to whether or not the foreclosures should affect value.  If the preponderance of home sales are non-distressed, then most lenders will usually consider the non-distressed sales as more representative of true market value.  It ultimately depends on the lender and the appraisal and their respective opinions of the market value as a whole.   It also depends on the condition of the foreclosures that have sold.  If a home is selling for $30K under market but it has $20K in damage, common sense dictates that not all homes in the neighborhood are worth 30K less. 

 Many lenders are also instituting arbitrary guidelines that may be more strict than the actual loan guidelines.  For example, FHA does not require a minimum credit score, but the vast majority of all lenders require between a 580 and a 620 credit score in order to consider an application for approval.  This may eventually change once foreclosures settle down, but for now lenders are cutting off the loans that are causing the most losses, and credit score is the first factor they look to set a minimum.