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Will Mortgage Underwriting Get Tougher?

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After years of tightened lending requirements following the housing crisis of 2006-9, there are signs that it may be easier once again for borrowers with less-than-stellar credit and relatively high levels of debt to be approved for a home mortgage.

Lenient underwriting helped get us into the crisis — riskier borrowers were approved for mortgages, many of which were bundled into pools that were then sold to investors. Demand for those mortgage-backed securities helped drive up home prices. When the bond funding of subprime mortgages collapsed, this resulted in lower prices and many of those who couldn’t afford their mortgages were unable to sell their homes and pay off the debt. Foreclosures and repossessions increased.

In other words, lenders have good reason to be cautious, but many would-be homeowners were shut out of the market as a result. Today’s loosening requirements may be a path to homeownership after years of renting, but many of these applicants may be wondering if it really is easier and how long it can last. We’ll explain how the underwriting process works and what can you do to avoid repeating some of the mistakes of the past.

What is underwriting?

Underwriting is the most fundamental element of the mortgage process. Before you can take out a loan and purchase a new home, an underwriter must assess your financial history and your risk profile to determine your creditworthiness. The underwriting process impacts not only whether you’re approved for a loan, but how much you may borrow and what interest rate offers you’ll receive.

When conducting these assessments, underwriters will look at several factors, including the house you want to buy and its appraisal, along with the full spectrum of your financial circumstances. According to Roger Ma, a certified financial planner in New York City, underwriters consider borrowers’ credit scores, salaries, asset and liability profiles, and overall net worth when making a lending decision.

Of course, outstanding balances on student loans and auto financing can come into play as well, though these aren’t necessarily dealbreakers. However, if there’s anything concerning in your credit history, the underwriter may ask you for a letter of explanation in which you can walk them through the issue and make your case for creditworthiness.

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How is mortgage underwriting regulated?

Mortgage lending in the U.S. is regulated by the federal government. Following the subprime mortgage crisis that precipitated the 2008 financial crisis, the government passed the Dodd-Frank Wall Street Reform and Consumer Protection Act that imposed new standards on lending practices and on underwriting requirements for lenders.

Specifically, the act tightened restrictions on lenders so that they could only give mortgages to creditworthy borrowers who appeared to have low risks of default. It also restricted the use of features such as interest-only and balloon payments to further decrease the chances of another crisis. The Consumer Financial Protection Bureau (CFPB) was also established in the wake of the collapse and now serves as a regulatory body for the mortgage industry as well.

The Department of Housing and Urban Development (HUD) determines mortgage underwriting standards on loans backed by the Federal Housing Administration (FHA). HUD sets thresholds for qualifying factors, such as debt-to-income (DTI) ratios, credit scores, and required down payment amounts.

What is considered creditworthy may depend on the type of mortgage you’re seeking.

Conventional loans

Government-sponsored enterprises (GSEs), including Fannie Mae and Freddie Mac, made mortgage financing more accessible to a wider pool of borrowers when they relaxed DTI standards. DTI measures the amount of your income that goes toward debt each month and, from a lender’s perspective, the lower the number the better. While 43 percent is the rule of thumb for many lenders, Fannie Mae and Freddie Mac will back loans with a DTI ratio up to 50 percent.

It’s important to remember that Fannie Mae and Freddie Mac are not direct lenders — mortgage companies may have stricter rules. One mortgage insurance company, for instance, stated that borrowers with a DTI above 45 percent would need a credit score of at least 700 to qualify for a mortgage.

Loan-to-value ratio. Lenders may also take a hard look at a borrower’s loan-to-value ratio (LTV), meaning the size of the loan compared with the value of the house you want to buy. The lower the amount a borrower puts down on a house, the higher their loan will be and therefore the less favorable the LTV. This increases the lender’s risk, because if the homeowner defaults on the loan, the lender is less likely to recover the principal.

“I’m sure some of the mortgage companies are taking a hard look at that, especially on a high-LTV loan, because it’s certainly more risky,” said Brian Walther, a mortgage loan officer with First Tech Federal Credit Union.

Jumbo loans

“Non-conforming” or jumbo loans, on the other hand, might require borrowers to show that you have a certain amount of cash reserves in place. That number could include six to 18 months’ worth of expenses, including the mortgage payment and associated fees, along with insurance, tax payments and homeowners’ association fees, where applicable. While most conventional loans, like those backed by Fannie Mae, don’t carry reserve requirements, Walther said, jumbo loans might.

Jumbo loans surpass Fannie Mae and Freddie Mac’s conforming limit of $453,100 — only private lenders offer these products, and they can set their own rates and requirements.

But even if you’re not in the market for a jumbo loan, cash reserves can aid in the underwriting process:

“Some lenders will make exceptions if you’ve got a lot of reserves and your credit score isn’t right where it needs to be,” Walter said. They may see a large cash reserve as a compensating factor that helps you get approval despite other potential red flags.

Government-backed loans

Mortgages insured by the federal government — including Federal Housing Administration loans, Department of Veterans Affairs loans and U.S. Department of Agriculture loans — often have lower credit score requirements than other types of loans.

FHA loans, for example, may consider applicants with credit scores as low as 500 — far lower than a conventional loan’s 620 minimum — though such borrowers will be required to put down a larger deposit.

The future of the mortgage underwriting process

There are signs that those with lower credit scores are gaining greater access to home mortgages of all types. A FICO study showed that new mortgage account openings for those with scores lower than 750 climbed from 41 percent in 2009 to 53 percent last year. Even those with scores between 550 and 650 showed gains. The Mortgage Credit Availability Index, reported by the Mortgage Bankers Association, rose by 1.7 percent in July, and availability rose in both the conforming and jumbo mortgage markets.

But even so, Walther said many lenders will pass on unqualified candidates: “They’re not going to let you get a loan you can’t afford. Those days are gone.”

Diego Zuluaga, a policy analyst with the Cato Institute, said lenders are heeding the lessons of the recent past.

“It seems to me that the expectation that if anything went wrong, that they would be held responsible for it, as happened in 2009 and 2010, also drives some of their behavior,” he said.

In a booming economy with low unemployment rates, Zuluaga said, federal policies may loosen. But in a tighter period, the government can implement stricter lending standards, which also impacts private companies’ abilities — particularly when they’re working with government-backed loans.

In his view, the growth of online lenders in the fintech sector could drive increased lending opportunities because their compliance standards are different from those of traditional lenders and they can use more comprehensive risk assessment platforms that accommodate a broader range of borrowers.

3 tips for a smooth underwriting process

Tip #1 Start saving. If you’re planning to apply for a mortgage, you should save as much money as possible, Walther said. However, he advised against using all of the cash you’ve set aside for the initial purchase.

“You don’t want to use everything you’ve got to buy a house,” he said. “You’re going to need some money left over.”

Ma echoed this concept. “Even though the bank allows you to borrow up to a 43 percent debt-to-income ratio, financial planners usually like to see your housing payment no more than 28 percent of your gross income,” he said. “I think that just goes to show that just because you can borrow a significant amount of money doesn’t mean that that’s the house you should be buying.”

Tip #2 Monitor your credit. Walther also emphasized the importance of monitoring your credit and keeping your debt-to-income ratio low. “I see a lot of people who’ve got money, but their credit’s got issues so you’ve got to keep an eye on your FICO,” he said. Generally speaking, you want to use 40 percent or less of each credit line.

Avoid opening too many accounts before applying for a mortgage as well. Hard inquiries can lower your score, so be discerning about whether you’re going to apply for a new credit card or other type of loan in the months leading up to your mortgage application.

Tip #3 Understand why you’re buying. “Most people are told that housing is primarily an investment, and this was very prevalent before the crash,” said Zuluaga. “People were told, ‘Even if you can’t afford the monthly mortgage payment, you can get yourself one of those balloon mortgages … or you can even have negative amortization, but as long as the property appreciates, you’re going to be able to pay it back and make a profit in due course.”

The housing crisis taught many people that home values can also fall, and at times rapidly and severely. “Housing is primarily a place to live,” Zuluaga said. “It’s a consumption good, not an investment.”

Thinking about it in this way might reframe the way you approach the mortgage process and how much you want to borrow.

The bottom line

Practices such as monitoring your credit score and keeping debt in check are smart strategies regardless of the current underwriting environment. Guidelines can change if the economy shifts, and private lenders may demand increased security if they accommodate the loosened requirements. Knowing the factors that impact underwriting decisions, as well as your goals in purchasing a property, will likely increase your chances of approval and getting fair rates even if mortgage requirements change.


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