Mortgage underwriting is built on three pillars; credit, income and assets. These pillars determine whether you qualify for a particular program. There are also three main categories of loan programs. At the top of the ladder, you find the A-paper programs with the strictest guidelines. In the middle of the ladder, you find the Alt-A programs designed for those who don’t quite qualify for A-paper loans. At the bottom, you get the Subprime loans with the most accommodating guidelines.
As you might expect, rates become more competitive as you climb the ladder of loan programs. A-paper loans, for example, provide the best rates for borrowers who qualify. On the other hand, the lower down the ladder you go, the looser the guidelines become but you pay for that luxury with a higher interest rate. The three pillars of underwriting demonstrate this same progression as better qualification levels are achieved.
Before we begin, it’s important to discuss exactly where we get all of your information regarding your credit, your income and your assets. Your credit is given to us through your credit report. It gives us your credit score and there’s no way for us to change it on that particular day. Of course, you can change your credit score by doing certain things over a period of time. There’s even such a thing as a “rapid rescore” which can update your score with new information within a 72-hour period but your score on the day we run your report is a finite number.
The credit report also gives us all the other credit liabilities that have been reported in your name, including those that have long since been paid off or closed. It tells us your payment history on all those accounts, even the ones you closed or stopped using long ago. The liabilities that still have open balances list the minimum payments required to keep those accounts in good standing. Minimum payments contribute to your debt ratios calculated in the income section of the application. We’ll get to that in a moment.
Your income information and your asset information are given to us directly by you. You provide your pay stubs as well as your W-2s or your tax returns. You also provide your bank statements verifying your liquid assets like bank deposits, investments and certain retirement funds. Well, as the lending industry has become more competitive and guidelines have been widened, many programs no longer require verification of your income or your assets. There are pricing implications for these relaxed documentation requirements so we need to discuss the various options before we talk about underwriting.
There are four major levels of documentation. Again, you can think about this as a ladder. In fact, you can consider the documentation options as a mini ladder within each of the three major loan categories; A-paper, Alt-A and Subprime. Most of these documentation options exist within each of the three loan categories so they essentially break each loan category down with four subcategories.
At the top of the ladder is Full Doc. That refers to a loan where both income and assets are “Fully Documented”. In those situations, the lender knows exactly how much you make and how much you’ve got in the bank. The next level down is called SIVA or Stated Income Verified Assets. That means the borrower simply states their income but the actual number is not verified by the lender. Meanwhile, their assets are verified with bank statements.
Below that is SISA or Stated Income Stated Assets. Here, the borrower states both their income and their assets, and neither are verified. The bottom level is No Doc where nothing is even stated. No income, no assets. That means no debt ratios; no reserves; nothing. The entire loan is done based on the credit score and the Loan-to-Value (LTV) ratio.
The original idea behind Stated Income loan programs was that certain people are self employed or in sales positions that pay mostly commission. With such occupations, the IRS allows tax payers to deduct a variety expenses before calculating taxable income. These deductions often distort the true income these people earn. People have a legal right to minimize their tax liabilities so long as they don’t break the law and many people in these occupations declare income far below what should reasonably be considered income from an underwriting point of view.
Anyway, the objective behind these reduced documentation programs has all but faded away because Stated Income programs are available from almost all lenders and in all three loan categories, although they are scrutinized much more closely in the A-paper category. The reality today is that many Stated Income borrowers overstate their income in order to squeeze into the debt ratio limitations of various loan programs.
House values have gone dramatically in recent years and the average person is really squeezing to make the mortgage payment along with the rest of life’s expenses. Car payments are the norm and credit card balances are at record highs so the debt ratios of the average person today are higher than they were in years past. Although they weren’t originally designed to do so, Stated Income programs have accommodated these new realities by providing a mechanism for borrowers to qualify for loans they probably wouldn’t qualify for otherwise.
The lending community has all but accepted the new motivations for using reduced documentation options. In essence, the borrowers are asking lenders to trust they can make the payments. And since they’re not documenting their income (or perhaps even their assets), these borrowers pay for that trust with a slightly higher interest rate. It’s important to mention, however, that a 2-year history of employment is still verified even though the actual income is not. This represents a problem for those people who have recently changed careers or become self-employed, or are not employed at all.
The only documentation level that does not verify employment is the No Doc option. Here, nothing is verified. In fact, nothing is even stated. The only thing the lender makes their decision on is the credit score and the LTV ratio. For obvious reasons, interest rates are significantly higher for this level of documentation but it does provide an option for those who do not have a verifiable employment history.
Back to the three pillars of underwriting; credit, income and assets. Let’s look at each one individually. Please keep in mind that this discussion requires that we generalize underwriting guidelines across multiple lenders and programs; a dangerous activity to say the least. There are huge variations between different lenders and loan programs. Please do not assume all programs follow the guidelines we’ll identify. The purpose of this discussion is to give you an idea where the various programs are targeted. Who is the ideal borrower for an A-paper program? Who is the ideal borrower for a Subprime loan? And so on. Most of these programs are designed to accommodate people far outside their target audience and this author acknowledges that reality openly.
The lending industry tries to flatter its clientele so an A-paper borrower is commonly said to have a credit score of 680 or higher. Fact is, a credit score of 680 is already in the bottom half of the population. More than half of the credit scores in the nation are above 700 and underwriting generally classifies A-paper at 720 or higher. Some A-paper programs offer price betterments at 750 or even 780 but a score of 720 or higher is a pretty good start when you’re looking for a mortgage loan.
The Alt-A category specializes in credit scores between 620 and 720. Again, they offer alternatives outside those boundaries but their ideal borrower falls within them. The Subprime category specializes in the 500 to 680 range but also offers solutions beyond those limits. It’s worthwhile noting that the lowest credit score you can have to do 100% financing is generally 575 or 580 for a Full Doc program and 620 for a Stated Income program. So if you’re considering 100% financing, make sure your credit score is at least that high before you start looking.
Income is the second pillar of underwriting and it contributes to the underwriting process in the form of debt ratios. One of the most common ratios in underwriting is a borrower’s DTI ratio. DTI stands for Debt-to-Income and it measures the percentage of a person’s gross income that goes towards all credit liabilities, including the proposed housing payment, any car payments, student loan payments and all credit card minimum payments. Where applicable, it would also include things like child support payments, alimony, judgments and liens. If a program allows a DTI ratio of 50% or less, exactly half the gross income (that’s before-tax income) needs to cover all those debts each month.
You can work this out with your own numbers. You know what you make each month. You know what your credit card payments are and you know if you have a car payment or student loans or whatever. And you also know your current housing payment (either your mortgage or your rent). So add up all those expenses and divide by your gross income. Generally speaking, the A-paper programs want to see a DTI of 38% to 42%. Some will go as high as 45% under certain conditions. The Alt-A programs allow DTI ratios between 40% and 45%, and Subprime programs commonly allow DTI ratios as high as 50% or even 55%.
That’s incredibly high if you think about it. Given federal and state taxes, not to mention healthcare costs, most people only take home about 65% of their gross earnings. That means Subprime programs allow almost all that money to go straight to debt payments, leaving the borrower with only 10% of their gross earnings to pay for things like food, gas and utilities. You can see how the Subprime programs are more lenient than A-paper. Their guidelines are more accommodating and allow things A-paper programs wouldn’t touch.
Assets are the third pillar of underwriting and are considered in one of two ways. First, assets present themselves in the form of a down payment so a 20% down payment shows significant assets while 100% financing shows absolutely no assets. The second consideration involves the cash reserves so underwriters look at how much money you’ll have left over after the transaction closes, either in the form of bank deposits, investment accounts or retirement funds.
Underwriters look for these funds to be sitting in your accounts for at least 60 days to qualify. This ensures the borrower didn’t just borrower a bunch of money from family or friends. If such a family loan existed, they would want to include an additional payment in the debt ratios so it’s critical that you keep your assets nice and stable, sitting there quietly for at least 60 days before you apply for the loan.
A-paper underwriters look for two to six months of the total housing payment in reserves after the deal closes. If the borrower is using a Stated Income documentation level, they may require four months of the income stated as well. If the borrower states they make $10K per month, the underwriters will want to see at least $40K in reserves somewhere. They refer to this as “assets commensurate of the income stated” and it’s usually only a requirement in the A-paper category. Alt-A programs look for two months of the housing payment and the Subprime programs sometimes require even less.
There are different levels within each pillar and borrowers need to remember they need all three to qualify for a particular loan program. Credit alone doesn’t satisfy the requirements unless a “stated” program is chosen. An understanding of the different levels along with the various documentation options is the first step to deciphering the underwriting process and that can only benefit you in the end.