Why do some mortgage applications get approved while others are denied?
Loan rejections are more common than you may think. In fact, the Mortgage Bankers Association reports that lenders reject about 50% of all applications they receive for mortgage refinances and 30% of all purchase loan apps are denied.
So why are one-half and nearly one-third of all mortgage loan applications being turned down? According to data from the Home Mortgage Disclosure Act, the number one reason for mortgage application denial – for both purchases and refinances – is insufficient applicant credit score or credit history. Other common reasons for loan denials include too much debt, too little income, and not enough money in the bank as reserves.
Getting turned down for a mortgage isn’t just an inconvenience, it actually could cost you a lot of money, time (and therefore, more money), and even possibly you’re your chances to get approved in the future.
The good news is that while applying for a mortgage loan may seem like a complex and mysterious process, there are some fundamental factors that every underwriter and lender looks for before approving a borrower’s application.
So whether you’re shopping for the best rate on a refinance or applying for a mortgage on your first home purchase, it’s important to understand these 5 building blocks of any of mortgage loan approval:
1. Your Credit Score
Like we mentioned, a borrower having a low credit score (or other negative items reporting on their credit like foreclosures, bankruptcies, and judgments, etc,) is the number one reason for loans getting denied. Therefore, your credit score (commonly called FICO score after the preeminent credit reporting agency, Fair Isaacs) is a major factor when applying for a mortgage. Lenders carefully scrutinize a borrower’s credit report not just for the number, but as a valuable way to gauge the risk of the borrower defaulting or not paying back the loan.
As a general rule, the higher the credit score, the more lending options the borrower has available to them and the better their interest rate will be, so it’s a good idea to check your credit at least six months BEFORE you plan on applying for a mortgage loan, and paying off debt or doing some fixing to raise your score if necessary.
2. How much income you make
Underwriters at any bank or lending institution want to know, plain and simple, if you’ll be able to comfortably repay the loan. In fact, the #1 mandate for their job is to determine if you’ll keep paying on time and in full every month! Of course, the clearest indicator of your ability to keep making those mortgage payments is your monthly income.
However, it’s not just about what you make, but what you owe, too, a calculation called Debt-to-Income Ratio. That ratio factors in not only what you make (and your gross – not your net) but also how much is going out every month, including the proposed new mortgage payment (with principal, interest, taxes, and insurance included,) as well as credit card and installment loan payments, student loans, alimony or child support, etc. If the ensuing ratio lies below their threshold for that loan program, they consider you a safe bet to repay the loan.
3. Your employment and job history
A big payday this month may be great, but lenders want to gauge how stable your income will be. For instance, if you just started the job a couple of months ago, that’s way more volatile than if you’ve worked there for over two years. And if you’re self-employed or at a job that pays commissions instead of a set salary, there is a huge chance you’ll have down months and not be able to pay your mortgage. Lenders value stability, so they love loan candidates who have been at the same job, in the same career, and receiving steady paychecks as a W2’d employee for a good amount of time.
4. Collateral (both your assets and the home’s value)
Lenders also want to ensure that there is adequate collateral if they approve you for a loan. You thought collateral was only for installment loans? In fact, mortgage lenders look for sufficient collateral from a borrower in two forms.
First, they want to make sure that the borrower has sufficient assets before approving the loan. During the loan process, underwriters will look for bank accounts, retirement accounts, stocks, investments, and even other homes that are paid off. All of this is evidence the borrower is solvent and has a nice financial pad or safety net in case of a job loss, divorce, or anything else that might threaten to derail them from paying their mortgage every month.
The second form of collateral is value in the house itself, above and beyond the amount of the loan. Lenders will always request a formal appraisal to make sure the house is worth what it should be in real life – not just on paper.
5. Down payment or equity
Generally, the more the borrower puts down for the home, or the more it’s worth above the loan amount, the lower the risk for the bank. So banks will look at a ratio called Loan to Value as a huge consideration. That references how much money the borrower is putting down if they are purchasing the home, or how much equity is in the property if it’s a refinance or home equity or second mortgage.
In fact, the banks learned a valuable lesson through the real estate bust and recession. They found that the biggest predictor for default on a mortgage isn’t a borrower’s credit score, or what kind of loan or interest rate they get, but how much money they put down or equity they have. (If a borrower doesn’t pay and they have to take the home back and resell it, they’ll actually recoup their money!)
***
Now we know the five building blocks of any mortgage loan approval! Do you have questions about any of these factors or want to see if YOU will qualify for a great low-interest purchase loan or refinance? Contact me!