Buying a home is a complex undertaking. Borrowers often become overwhelmed as they face the process of qualifying for a mortgage and putting their finances under the microscope.
A bit of basic knowledge about the qualification process can help you clear up the mystery for your clients and set them up for success.
Banks look at five primary measures when evaluating a potential borrower:
1. Loan-to-value ratio
How much is your client looking to borrow versus the purchase price of the home/property? Most banks look for a minimum of 20% of the purchase price as a down payment, or a loan-to-value (LTV) ratio of 80% or less. The more money a borrower is willing to put down, the lower the loan-to-value ratio, and the more attractive the loan is for the bank.
In the case of an interest-only loan, the required ratio will be lower than the typical 80% (more money down). Banks will also look for a lower ratio when the borrower is buying a second home or investment property versus a primary residence.
Tip for your borrower: The more money you are able to allocate for your down payment, the more attractive the loan will be to the bank.
2. Credit score and credit history
A credit report (including credit/FICO score) is a critical component of any mortgage application. Banks typically look for a credit score that is 700 or above.
A credit report details the borrower’s credit history including length, payment history and credit utilization (how much debt a borrower is carrying versus their credit limit). High credit utilization or habitual late payments will give a bank pause when considering a borrower.
The combination of a credit score and credit report provides a good snapshot of the borrower’s level of financial responsibility and what is important to them. For instance, a borrower with a history of late payments would present a higher risk for a bank than a borrower who has never had a late payment.
Tip for your borrower: Request a free credit report from each of the three credit reporting bureaus — Experian, Equifax and Transunion — and review them in detail to ensure they are accurate. If the reports have inaccuracies, credit repair for mistakes can take a month or two.
3. Debt-to-income ratio
Banks also look at a borrower’s debt-to-income (DTI) ratio. This means comparing the homebuyer’s total monthly expenses to their monthly income. This shows the bank how much “cushion” the individual has in their day-to-day finances. Most banks look for this ratio to be 45% or less (i.e., a borrower with a monthly gross salary of $20k should have no more than $9k in expense obligations each month).
Banks will typically use an average of total annual gross income over the last three years.
Tip for your borrower: Clients who are business owners should consider whether they want to distribute themselves more income in the year or claim fewer expenses, both of which will favorably impact their adjusted monthly gross income.
4. Employment history
When it comes to job history, banks look for stable employment — either at one company (longevity of more than two years) or within an industry. If a borrower has hopped from industry to industry or shows a less reliable record of employment, this will give a bank pause, as it is a potential risk for loan repayment. Consistency is key here!
For individuals who are self-employed, the same principles hold true. Someone who has been self-employed for a longer period of time will be a more attractive borrower than someone who recently started their own business, since the tenured business owner is able to show a longer history of income.
Tip for your borrower: Clients should carefully consider pursuing a significant job change or starting a business in the timeframe around when they wish to buy a home. Be ready to address a downward trend in income over time.
The final financial checkbox when evaluating a potential borrower is liquidity. Liquidity is defined as money held in stocks, bonds or any type of bank product (checking, savings, CDs, money market accounts), as well as cash value life insurance. Retirement accounts, hedge fund investments and private equity are considered non-liquid.
When evaluating liquidity, a bank will look at both the potential buyer’s pre-purchase and post-purchase liquidity. Post-loan liquidity is important as it demonstrates how many months of housing payments the borrower has on hand post-closing. A typical desirable level is 6-36 months of post-loan liquidity — the length required will vary depending on the size of the loan, with a longer period required for a larger loan.
Liquidity demonstrates the potential buyer’s ability to weather a job loss or other unforeseen circumstances that could prevent income from being earned for a period of time and hence impair their ability to continue to make mortgage payments.
Tip for your borrower: Review your liquidity position and determine if there is a need to liquidate any non-liquid assets. Consider saving more in the months leading up to the purchase. Business owners may want to consider moving liquid assets held by their business (and not needed for business operations) into their personal accounts.
The bottom line
Buying a home can be stressful, but knowledge is power. You can help your clients feel more comfortable and confident by educating them on the mortgage approval process.
First Republic is here to help; if you want to learn more about the mortgage approval process, we would be happy to host a “lunch and learn” session for you and your team at your convenience. Reach out to us at email@example.com.