Applying For a Mortgage – How Lenders Evaluate a Loan Application

For several reasons, most home buyers are apprehensive of the mortgage application process. Fear of the unknown is the primary concern followed by fear of rejection and anxiety related to divulging personal financial data. Applying for a mortgage becomes much more relaxed when the applicant has a thorough knowledge of how their qualifications are evaluated.

Every application is evaluated by an underwriter and the approval or rejection decision is based on four primary criteria. They are the borrower’s credit profile; income and debt ratios, liquid and semi liquid assets, and an appraisal of the contracted property. Each of these factors must meet certain standards for the application to be approved. These standards are consistent between lenders because mortgage originators universally subscribe to FNMA/FHLMC guidelines.

Credit Profile

Credit analysis is based on a tri-merged credit report consolidating the records of Experian, Trans Union, and Equifax into one report. Each of these repositories will provide a credit score. For underwriting evaluation the high and the low scores are eliminated although the credit data and history is not. The middle credit score is considered the more reliable application score because creditors do not always report to all three bureaus. Credit scores can vary significantly due to unreported positive or negative data. The minimum middle score required by lenders in today’s mortgage world is 640. Higher scores may provide the borrower some qualifying, loan program and interest rate advantages. Lower scores above 600 are not necessarily a show stopper but are certainly problematic.

All debt listed on the tri-merged credit report is considered in the evaluation process. Qualifying ratios are determined by the minimum monthly payment required by each credit account with an outstanding balance. Underwriters are normally only concerned with debts listed on the credit report. If an applicant bought an auto from a relative and is making monthly payments to that person, that debt would not be considered in qualifying because individuals do not normally report to the repositories and is therefore unknown to the underwriter. Obviously it is imperative that borrowers obtain a copy of their credit report and reconcile inaccuracies prior to applying for a mortgage.

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Income and Debt Ratios

There are two mathematical calculations underwriters apply in evaluating the borrower’s ability to consistently make the mortgage payment. The “Income Ratio” is simply the total monthly mortgage payment divided by total gross monthly income. The “Debt Ratio” is the total monthly mortgage payment plus minimum payment on long term debt divided by gross monthly income. FNMA underwriting guidelines suggest a cap of 28% on the income ratio and 36% on the debt ratio. However this can be a little nebulous because there is a great deal of flexibility in the ratios based upon “compensating factors”. High credit scores, exceptional liquid and semi liquid assets, job stability, upward career mobility and other factors that give strength to borrowers ability to repay the loan. In these cases income ratios may be stretched into the high thirties and debt ratios into the high forties.

Home buyers frequently stretch their buying power to close to the limit because they know that a mortgage payment that is a little too high today will not be a problem in the future. Underwriters have flexibility in the debt sector and strategies can be employed to keep ratios in line. Installment loans do not count in the qualifying ratios if there are ten or fewer installments remaining. An auto loan with eighteen payments remaining may be paid down to ten months therefore eliminating the debt for ratio purposes as long as the borrower can document that the funds are available to do so. Student loans can be consolidated to reduce their monthly payment and credit card balances can be reduced.

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Liquid Assets

For most first time home buyers the primary difficulty is accumulating the capital required for the purchase transaction. An FHA mortgage requires a down payment of 3.5% of the purchase price and the seller is allowed to pay all of the purchasers closing cost up to six percent of the purchase price. Since the closing costs are normally two to three percent of the sales price in most jurisdictions, the remainder of the six percent seller contribution can be used to buy down the interest rate substantially. This strategy will certainly limit the buyers negotiating power with the seller but a home can be purchased with less than 5% into the transaction.

Mortgage applicants are required to document the source of their funds to complete the purchase transaction plus reserves of several months of mortgage payments with some programs. In addition to bank deposits, sixty percent of 401K and IRA balances are considered liquid because these funds can be borrowed without interest or penalty. Otherwise, borrowed funds to complete the purchase are not allowed. Gifts from relatives must be documented but are acceptable. Deferred income payments or bonuses are also acceptable but must be received prior to closing. The primary concern of the underwriter is that all the required funds are not borrowed and thoroughly documented.


Lenders are investing in the applicant and the property as well. They will require that an approved appraiser inspect the subject property and submit a report. The borrower is required to pay for the appraisal and the credit report up front. All other fees associated with the loan are normally collected at settlement. The appraiser will evaluate recent comparable sales, property condition, neighborhood and community influences and determine a market value for the property. The lender will grant the mortgage based on the sales price or appraised value whichever is less. This is a great protection for the buyer as well as the lender.

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For those who are comfortable that they can afford the payments, have their credit scores and debts in control and can reconcile the cash requirements, the mortgage approval is a matter of documentation and there is not much to be afraid of.