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In the early days of home financing, banks would accept deposits from their customers and then use that money to lend out to borrowers who wanted to finance the purchase of a home. Banks were thus limited in how many loans they could make by the amount of money deposited with that bank. To eliminate that limitation and serve more borrowers, lending institutions learned to combine a lot of individual mortgages into "pools" and sell those pools to large investors such as pension funds, insurance companies, and investment firms who liked the idea of investing in debt secured by U.S. real estate but did not want to be in the banking business.

The federal government wanted to promote home ownership in America, and thus created the following financial cousins: The Government National Mortgage Association (GNMA) known as "Ginnie Mae", the Federal National Mortgage Association (FNMA) known as "Fannie Mae", and the Federal Home Loan Mortgage Corporation (FHLMC) known as "Freddie Mac".

Very simply, these agencies sell their bonds to Wall Street investors and in turn use the proceeds to invest in pools of mortgages originated by traditional lending institutions. In this way, there is always enough money for home loans.

Underwriting Guidelines

Three financial cousins represent such a huge part of the home loan market, they collectively set the benchmark guidelines for the home lending industry.

By guidelines, we mean rules regarding borrower income, the quality of credit history demonstrated by the borrower, and the types of real estate property that can be used to secure the loan. These rules are based on a history of the millions of loans in which the three agencies have purchased over the years. Specifically, the agencies study what borrower income, credit, and property characteristics statistically contributed to a higher probability of default.

When we talk about "qualifying for a loan" in the paragraphs below, we refer to the rules set by Ginnie Mae, Fannie Mae, Freddie Mac and other investors who may invest in the loan.

Income and Debt Ratios

One of the very first items a lender may consider is the borrower's ability to afford the payments on the proposed loan. The ability to afford the payments on the loan, other housing expenses, and personal debt is defined in percentages of the borrower's monthly income, or ratios. The following is a description of how these ratios are defined and calculated.

Gross Monthly Income: Normal annual income including overtime that is regular or guaranteed. The before taxes income may be from more than one source. Salary is generally the principal source, but other income may qualify if it is significant and stable.

P+I: Monthly principle and interest payment.

PITI: Four potential components of a monthly mortgage payment. Principal refers to the part of the monthly payment that reduces the remaining balance of the mortgage. Interest is the fee charged for borrowing money. Taxes and insurance refer to the amounts that may be paid into an escrow account each month for property taxes and mortgage and hazard insurance.

Revolving Liability: A credit arrangement, such as a credit card or HELOC, that allows a customer to borrow against a predetermined line of credit when purchasing goods and services. The borrower makes payments on the amount that is actually borrowed plus any interest due.

Two ratios which compare monthly income and debt are:

The Housing Expense Ratio: The percentage of gross monthly income that goes toward paying housing expenses.

Total Expense Ratio: Total obligations as a percentage of gross monthly income. The total expense ratio includes monthly housing expenses plus other monthly debts. Used to help qualify a potential borrower for a home loan.

Ratios are one of the factors a Lender uses to help qualify a potential borrower for a home loan. Other factors are also used which may lower the perceived risk of the loan.

For example, some of these compensating factors are a stable employment history, a down payment over 25%, and a high level of liquid assets remaining to the borrower after the transaction.

The Down Payment and LTV

The down payment is the part of the purchase price that the borrower pays in cash and does not finance with a home loan. Some home loans programs do not require a down payment.

The loan to value (LTV) is a ratio of the total amount borrowed on a mortgage against a property compared to the appraised value of the property. For example, if you have an $80,000 1st mortgage on a home with an appraised value of $100,000, the LTV is 80% ($80,000 / $100,000 = 80%).

The amount of a down payment required varies with the different loan programs. A down payment isn't the hurdle it used to be. Today there are many kinds of loans to choose from that feature down payments of just 5%, 3% or in some cases 0%.

Defaults and foreclosures statistically increase with down payments less than 20%. Lenders normally require PMI (Private Mortgage Insurance) when the LTV is greater than 80%. This insurance insures the lender against losses which would result from a borrower defaulting on the loan.

Down payment funds can be from a variety of sources depending on the loan program guidelines. Some common sources are the borrower's own savings, gifts from relatives, down payment assistance programs, and builder contributions. As a general rule, the smaller the down payment the less flexibility the lender will have on other qualifying criteria such as income and expense ratios.

The Application

Once you and your home loan consultant determine the best loan program for you, the next step is to apply for the loan. This can generally be done in person or over the phone. The loan consultant may ask you for detailed information regarding your income, assets, and current debt obligations as well as information on the property. Generally, most lenders require an appraisal fee and a credit report fee when you apply. Ask your home loan consultant for details.

Processing the Application

After you complete the application you may be asked to provide additional documentation such as evidence of your income and assets documenting the funds you have in a particular bank or account and/or employment verification.

If you have identified a property you wish to purchase, and have reached a contractual agreement with the seller, the lender will also request copies of the purchase agreement, any property inspections ordered and title reports for the subject property. An appraisal may be required.

If all of the borrower and property characteristics fit, then the loan is approved. Sometimes there remains a few missing pieces of information. If additional information is needed, your home loan consultant will explain any conditions that must be met prior to closing. At that point, the loan consultant will communicate the approval, any conditions outstanding, and confirm the terms of the loan.

If there are characteristics of the loan which are outside of the investor's guidelines, the loan
consultant often can recommend an alternative loan program.

The Closing

The closing (or settlement) is the meeting at which you sign the paperwork and pay all expenses to take official ownership of your home. If you're looking for a day to celebrate buying your new home, circle this one on your calendar.

Although the closing process varies from place to place, many activities are standard. You'll be required to sign certain documents and pay closing costs. If you have questions, your home loan consultant can tell you more about this process.

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