This is the follow up post after part 2. If you have not ready part 2, probably best to jump back so you are caught up.

After you submit the documents and application to the Loan Officer, what do they actually look at to determine your approval? This may seem like more information than you need if you just want to start the pre-approval process, but you would be wise to make sure you are getting the strongest pre-approval you can, so you need to know what is important for you to focus on with your finances.

I want you to be like the celebrity of home buyers. When lender’s see your information come across their desk, they call you “Sir” or “Mam”, offer to get you something to eat or drink and offer you more money than you need. They also offer to pick up your dry cleaning in order to gain your business.

Though that is not actually going to happen (the dry cleaning at least), we can help you out by helping you understand how to make your finances strong enough that lenders give you the best programs, rates, costs, and attention, possible.

So, time to jump into a deeper understanding of what lenders are going to look at when they give you and your financial picture the once over. HEADS UP ON THIS ONE, THIS IS A LONGER BLOG POST DUE TO THE EXTRA DETAIL WE GO INTO ON THIS ONE. YOU ARE NOT READING A NOVEL OR ANYTHING, BUT PLAN FOR A BIT OF A LONGER READ.

A good example of understanding what a typical mortgage loan officer is going to review in regards to approving you for a mortgage, we want to understand “The Four C’s of Lending”.

Do you want to guess what one of the C’s are? I’ll give you 5 seconds:

… 1 Mississippi …

… 2

… 3

… 4

… 4 1/2 . . . 4 3/4, …

If you guessed “Credit” as one, you are a genius. Congratulations on your brain power victory.

Ok, so maybe that was not hard to guess. Credit is the easiest of the four C’s to anticipate. What are the Four C’s in total? The Four C’s: are Credit, Capacity, Capital and Collateral. Let’s check them out.

1.  Credit:

As your genius brain told you, credit history and your credit scores are a large component of getting approved for a mortgage, getting good programs, good interest rates, and so on. If you, again, want to focus on information on how to get your credit scores up to super sexy ranges, please read through the blog series:

So for basic knowledge, what is good credit? When looking at general credit information, credit ranges are often broken out into segments that we will call great credit, good credit, decent credit, passable credit, and not going to work credit. These are Midwest Money Mentor terms, not actual credit agency or lender terms. Their terminology sounds much more sophisticated and elegant. I’m just going to give it to you as it is.

Great credit scores are often going to be in ranges between 740 and up to the maximum scores available (usually 830 to 850 depending on bureau scoring). Good credit will be in that 700 to 739 range, as an approximate. Decent credit will usually be in that 660 to 699 range, passable credit in the 620 to 659 range, and often not going to work credit is below 620. Now, I will say that there are programs that will go below 620 credit scores and still give approval, but it is increasingly difficult to get approval in those ranges (with below 580 credit ranges being a straight “No, try again”), plus your interest rates are likely going to be teetering on atrocious below that 620 range. So, good goal to have? Never get below 620 credit and preferably always stay above 740.

Each mortgage program will have different criteria for credit scores and credit history. FHA loans and VA loans, for example, do allow some borrowers to be approved for a mortgage with credit scores as low as 580, under special circumstances. But, as we mentioned above, it is very difficult to get approved in these ranges and your rates will not be super attractive. Scores, with these two programs, above the 620 range are usually more likely to gain approval (not to mention better rate pricing). No matter what, getting your scores above the 740 range is recommended to save yourself as much interest cost as possible, regardless of program. But, if you need to move forward quickly, that 620 range and above is likely to secure you a possibility of being approved.

What can you do to improve your credit? We discuss this in the blog mentioned above “Making Your Credit Scores Magnificent”. But for the Cliff-Notes version, we will take some notes from another writing of mine in a Homebuyer Education Company curriculum called REDUE:

The credit bureaus look at what are called your credit mix, your credit history, your length of credit, your revolving utilization, and your recent credit inquiries. The best ways to increase your scores are:

• Have no future late payments and no future accounts go to collection, judgment, foreclosure, etc.. This positively affects your credit history by showing you can manage your payments. If you have any accounts in judgment or collection currently, work to get them paid off or back to paid up.
• Pay all your credit card balance down to below 30% of their credit limits. If your credit card has a credit limit of $1000, then pay your credit card balance to below $300 (300/1000=.30 or 30%) and keep the balance below that range moving forward. This proves you can properly manage your revolving debt (credit cards, and others) by not taking out too much revolving debt in comparison to the amount of limit you have available. This revolving utilization percentage makes up about 30% of your FICO credit score. Funny enough, if you do not have an open credit card, you are actually missing a large portion of your credit activity and that can lower your score. This may sound counter-intuitive, but you should actually have one active credit card at all times but keep the balance very low to improve your scores.
• Have very few credit pulls (inquiries) done for new credit accounts. Do not let lenders pull your credit often. If you have quite a few credit pulls in a short period of time, this may show you may not be using credit appropriately and your scores will decrease because of it. A big culprit here is when people get their credit pulled by car dealerships. Car dealerships often will pull credit through 5 to 10 banks at once when they work to approve someone for a vehicle. They do this to try to get the person the best deal, but all those credit pulls at once can drop your credit scores quite a lot (30 to 50 points at times). A better recommendation would be to go to your bank and have them approve you. Then your scores would only be pulled once for your approval. Keep the number of credit pulls low to your best ability.
• Create the longest credit history you can. The longer you show a history of having credit, the better your scores can be. 15% of your FICO score is based on the age of your credit accounts (active and inactive). So keep gaining more credit history by leaving accounts open and active and your scores will likely improve.

2. Capacity – If you guessed that the word capacity was another one of the 4 C’s of lending, I’ll hand it to you that you may be a genius. Capacity is pretty simple in its meaning, which is can you pay back your mortgage? Do you have the financial capacity to do so?

How is this determined? There are a few important pieces.

• Likelihood of Your Income Continuing: What is your employment history and how consistent is it? If you have changed jobs multiple times in the last few years, taken long time frames off of work (months), or had long gaps between jobs (3 or 6 months), the government agencies (that insure the loans) are unlikely to trust your income too much. Who is to say you do not change jobs again, or quit your job and take a long time period off of working again? Doing so (quitting or leaving a job, not working for a while) could make it so you are less likely to be able to afford your mortgage payments. So, how can you make sure you look strong in this area? Work! Just go and work like a normal American and do it consistently. Do not have job gaps, do not change jobs constantly (unless there is a clear and evident improvement to your income with each change), just work consistently so your income shows as reliable. Also, if there is a likelihood that your income will end in the next 3 years, you need to review this with your loan officer. One of the major criteria for using income to qualify is that it is likely to continue for at least 3 years. If you know you are leaving the military, or retiring from a job, or your child support income is ending soon because your kid is turning 18, review this with your loan officer to make sure everything is good to go.
• The Percentage of your Gross Income that is Used Up by Your Debt Payments: This is called a “Debt-to-Income Ratio” (DTI for short). I’m sure you can visualize and understand that if a very large percentage of your income is going towards required payments on student loans, credit cards, car loans, mortgages, etc. so that you do not have much income left to cover your other needs in life, you are at larger risk of not being able to make all your payments. Any life hiccup can pop up and make it so you have trouble making those payments (including your mortgage payment) and that would cause a high likelihood of a foreclosure or other not very good situation. So, the programs will have requirements on how high they are going to cap your debt payments as a percentage of your income, in order to qualify for a home loan (which is more debt, after all). In general, a good rule of thumb (for qualifying, not for actual financial advice) is that your total debt payments monthly should not be above 50% of your monthly gross income. So, if you make $5000 a month before taxes, and your mortgage, car loan, credit card payments, and student loan payments equal $2600 a month combined (2600/5000 = .52), your debt to income ratio is 52% and is likely too high. You need to pay off debt, or make more money, but preferably both as far as financial advice is concerned (financial advice would obviously be to keep your debt-to-income ratio much lower, like 35%, so you have a large amount of your income that you can put towards debt payoff, savings, investing, etc.). VA Loans and FHA loans will usually allow higher debt-to-income ratios than that 50% range, but your credit, assets, and other factors will determine what range you can go to in the programs you fit. You can calculate your own debt-to-income ratio very easily before you go to a lender for approval. If you are above that 50% range, do not be overly surprised if you need to do a little extra work before you can be approved.
• Percentage of your Gross Income that is Used Up by your Housing Payment: This is called “Housing Ratio” for short. For some programs, this ratio is not as important, but in general financial conversations it definitely is, even if the program does not look at it heavily. Remember, qualifying is great, but you being financially strong is even better. The calculation is similar to DTI, except you do not add in your other debt payments. So, if your gross income before taxes is $5000 a month and your mortgage payment will be $2200, your housing ratio is 44% (2200/5000 = .44). As with debt-to-income ratio, you want this percentage to be as low as possible so you do not show you will be over leveraged too much by your house payment. The programs that do watch this a little more closely usually will be fine if your housing ratio is below 45% (for qualifying). Though if you wanted to look at Rural Development as a mortgage program, for example, they likely would cap your housing ratio at 33% or lower. Someone who wants to keep themselves in a strong, financial position should also look at being below 33% of your income going towards a mortgage, with some financial educators even going as low as recommending less than 25%. For many Americans, 25% is not realistic with current interest rates and home prices, but needless to say, the lower the better so you have money that can go towards protecting yourself/your family and investing for your future.

3. Capital – We are not talking a capitol, but capital for expenditure. Or, less elegantly, how many dollar, dollar bills you got, yo! I forgot to tell you I can be gansta at times.

Liquid money, in bank accounts, investment accounts, money markets, CDs, etc. is important to your approval for many reasons. This should be pretty easy to grasp. The more money you have available to you the less likely you have trouble paying your bills. It also makes it much easier to cover your costs associated with buying a home, such as inspections, realtor fees, lender fees, and down payment.

There are programs that do not require down payment or that have down payment assistance loans or grants available, so you may not need to cover the down payment (possibly). But, in this conversation as far as qualifying goes and just general financial advice, the more money you have saved the better position you are in.

When we are talking about mortgage approval, the three big pieces that you will potentially have to prove you can cover is the down payment, the closing costs, and any reserves. Let’s jump into each of these quickly so you know what to expect to show for capital.

• Down payment – Just like paying a deductible when you have an insurance claim, a down payment is the amount of money you are covering out of your pocket to purchase the home. The more money you put down on the purchase of the home, the less risk the loan is to the government programs and to the lender.

Now, we seem to run into people every year that believe that in order to buy a home, you have to put down a large sum of money up front (often thought to be 20% down). On the flip side, we have others on the opposite spectrum that believe that just because they are first-time homebuyers, they should not have to put down any money. Each program will have different criteria but the general answer is neither of those beliefs are usually true. If you are a first-time homebuyer, you may be able to qualify for a down payment assistance program or a no-down payment program. But that will depend on your credit, your income, your assets, and more. Similarly, you may have to put down quite a bit of money in order to qualify, but that will depend on your debt-to-income ratios, your credit, and all the other pieces we listed.

 In general, here are some example programs and what they require for down payment (or not). What you can qualify for specifically will have to be researched by your loan officer, with your help.

Conventional Loans– These are programs backed by Fannie Mae and Freddie Mac. They have down payment requirements but just like the other programs, the requirements are traditionally very small. If someone is a first-time homebuyer, they can put down 3% of the purchase Price (as long as they are buying their primary residence). If they are not a first-time buyer or choose a different version of the programs then the down payment is equal to 5% of the purchase price. So, if you buy a $400,000 home, down payment may be $12,000 or $20,000. This does not include if you can get down payment assistance to help you cover the down payment.

FHA Loans – These loans are backed by HUD (Housing and Urban Development). They are much more lenient programs when it comes to credit scores and debt-to-income ratios and require a down payment of 3.5% of the purchase price. Therefore, if you buy a $400,000 home, the down payment would be $14,000.

VA Loans – I’m guessing you can figure out that these loans are insured by the Veterans Administration. Unless a veteran has used up large portions of their VA entitlement, the VA program is one of the few programs that allows 0% down payment. These programs also are very lenient on credit scores they allow, debt-to-income ratios, and often can have better interest rates than other programs. Serving our country does have some perks.

Rural Development Loans – These loans are insured by the United States Department of Agriculture and are also one of the programs that allows someone to put 0% down. Rural Development residential housing loans (called its Guaranteed program) are very helpful in that it is $0 down, but as mentioned before, many of its other criteria are very strict and can make qualifying for the program more difficult. One simple aspect that can cause issues with many areas of the county is that you have to buy a home in rural area. So, those living in cities often won’t have this program available to the same extent.

Down payment assistance options – On top of the programs listed above there are a variety of programs through state, local, and nonprofit agencies that can also be eligible for FHA, Conventional, VA, and possibly even Rural Development loans. These programs can supply grants or down payment assistance loans to people to help them cover some or all of the the down payment and closing costs required to purchase a home. As expected, in order to qualify for these programs, you traditionally cannot have very high income, be able to put large amounts of money down, etc. These programs are designed to help lower and low-middle socio-economic classes with acquiring a home. The monies they have available are finite, so they need to make sure those who need the funds receive the help.

But, in this scenario, if you do not qualify for VA loans, are not buying a home in a rural area, and make good money, you still would likely only have to do 3% to 5% down.

• Closing costs – Next in line of planning for out of pocket costs is the conversation around closing costs. When you purchase a home, depending on area, lender, etc. you may have a variety of costs associated with the transaction. Here are a number of the standard costs you will see on the “Loan Estimate” that you should be asking your lender for so you can compare costs between a couple lenders (and make sure you are getting a good deal):
  • Lender Fees (titled under Origination Charges on the Loan Estimate)- These costs will be shown by titles such as origination fee, admin fee, processing fee, tax service fee, underwriting fee, and application fee. They will all be listed near the top of the fees sections and specifically in section A of the loan estimate. An example range of low fees in these categories would add up to $1500 or less, combined.
  • Points or Loan Discount Points (titled under Origination Charges on the Loan Estimate) – “Points” always confuse people because it is so rare that conversations of “Points” arise in our daily lives, outside of buying a home or refinancing. Points are just percentage fees you pay to lower your interest rates. If you pay 1 “Point” or 1 “Loan Discount Point” you are paying 1% of you loan amount in extra fees to help lower your rate. If you pay 2 “Points” then you are paying 2% in extra fees. If your loan amount was $300,000, 1% would be $3,000 and 2% would be $6,000 (that means $3000 or $6000 in extra money to bring to closing). The extra confusion lies in how much paying these extra fees ($3000 or $6000 in this example) actually lowers your rate. In reality, on average, paying 1% (1 point – $3000 in that example) in extra fees may lower your interest rate by around .25% to .5% or so. Make sure you are not being shown paying 2 points or more in costs by a lender who is just trying to make their rates look lower by charging you a bunch of extra money.
  • Appraisal Fees (under “Services You Cannot Shop For” on the loan estimate)- Traditionally there will only really be one or two fees that come with the appraisal. The original appraisal fee, and sometimes a subsequent final appraisal fee under unique situations. Average appraisal costs around the country probably range from $450 to $850.
  • Closing Agent Fees (under “Services you Can Shop For” on the loan estimate) – one way or another you need to close on your purchase in the end, and you will either be closing with a title company or an a closing attorney (depending on where you are buying the home). Both closing agents will be charging their own fees, which can be closing service fees, title fees, endorsement fees, settlement fees, and more. These costs will range pretty wide depending on location you are buying.
  • Escrow Set up – though this portion is not technically closing related fees, the majority of the time mortgage programs are going to require an escrow account is set up with the mortgage so that your property taxes, homeowner’s insurance, mortgage insurance, and other possible pieces are paid through your mortgage company and escrow account. This make payments easier on you (the homeowner) because you only need to make one monthly payment for everything. And it is safer for the lender and mortgage insurer because they know everything is getting paid on time. At the time of closing, your escrow account needs to get set up correctly with the right amount of money to start. This means you may bring more money to closing to fund the account, but then don’t have to worry about things getting paid moving forward.
• Reserves – A final piece that may or may not come into play for your approval are what are called reserves. Reserves are just extra money that you need to show in liquid accounts beyond what you need to cover your down payment and closing costs. The different programs like to see that you have mortgage payment amounts already saved in your investment accounts, bank accounts, etc. so they know you are in a good position to make your payments. For instance, if you are required to have 2 months reserves for your approval, that means you need to show 2 months of the new mortgage payment beyond what you need to show for down payment and closing costs. If your mortgage payment will be $2500, then in that example you would need to show an extra $5000 somewhere in your various accounts. Most of the time, if you are buying the home as your primary residence, you do not need to show reserves unless you have very low credit scores or some other factor that makes the lender and programs nervous. If you are buying an investment property or a vacation home, it is more common that you need to show extra reserves to get approved for those properties.

4. Collateral – Finally, the last of the 4 C’s. As I mentioned near the top, this post is much longer than most. But, we wanted to give you detailed information to prepare yourself for any future home buying experience. When you hear collateral, most people think of personal loans or business loans where they need to provide their car or other assets as collateral to get the loan. If they do not pay the loan back, the bank gets to keep the car or whatever was pledged. Unlike those scenarios, when you are buying a home, you already have built in collateral, which is the home you are buying. If you stop making mortgage payments, the bank can step in and take back the house in a foreclosure. So, with this conversation, what collateral is referring to is the quality of the home you are buying. Any property type that has much higher foreclosure histories, or any property that has damage or needs repairs that could lead to much higher cost for the buyer is a larger risk for the lender and program. If that property damage causes the buyer to have to put tens of thousands of dollars into the property to repair it, that might make it difficult for that homeowner to then pay their mortgage payments. So, when the appraiser goes out to value the property, they will also notate any repair needs or unique property aspects that could cause the lender more risk. They then will require the repairs be fixed before you can close on the property. Or if the property is too unique or the damage is too much, the property may not qualify. All this to say that the lender and program will be picky on the property you try to purchase. If it is a pile of junk, the lender and program may deny the loan because they do not want to risk lending on the property.

Whoooooeeeee. This was a lot. Hopefully your brain doesn’t hurt too much. If it does, go get a pina colada or something and take a break. Our next blog information will still be there for later. I am proud of you for reading all the way, if anyone did. ha.