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Loan Underwriting Approval: Collateral, Character, and Capacity

by | May 17, 2012

Qualifying ratios are only the beginning of the loan approval process. The three Cs of loan approval in lending are:

  1. Collateral,
  2. Character (credit), and
  3. Capacity.

Collateral – The lender will look to the collateral to hedge its loss if the creditor defaults on their loan. To help analyze the collateral, the lender will order an appraisal to verify the collateral value and then determine a loan-to-value ratio (LTV). For a new home purchase, the LTV ratio is calculated by dividing the requested loan amount by the lesser of the purchase price or appraised value. LTVs are also used when refinancing a mortgage or borrowing against equity. Different mortgage loan programs have different LTV requirements.

A $600,000 home with a $480,000 mortgage has a 80% LTV. Rationale: $480,000/$600,000=.80 or 80%

The equation for the LTV is: Current loan balance ÷ Current appraised value = LTV.

Character – Character refers to creditworthiness. Lenders use a combined credit report from the three standard national credit reporting agencies – Equifax, Experian, and Trans-Union. The information and scoring in the combined report provide the foundation for approval, which type of loan will be best for the borrower, the interest rate to be charged, or grounds for loan denial. The credit history of the borrower is the most crucial consideration in granting a mortgage.

Credit scoring considers a variety of components. While the element of how much a borrower owes and their payment history is one objective element, several subjective factors determine the credit score. These elements can include account balances that are 75% or more of the credit limit, which indicates high financial leverage and creates a higher risk to the lender. A large number of open accounts with zero balances is also a consideration since these can lower the credit score because they provide the potential for future excess debt, thereby affecting the borrower’s ability to service the loan debt. Most lenders who sell their loans into the secondary market use the following parameters when evaluating credit scores:

  • Scores above 720: Borrowers will receive better terms and interest rates on their loans.
  • Scores between 680 and 720: credit risk is good and can help compensate for other borrower profile risks.
  • Scores between 620 and 680: comprehensive review to look for potential risks.
  • Scores below 620: cautious review required; borrowers may find themselves locked out of the best loans and terms available.

Credit reporting agencies are required to investigate and correct borrower-reported errors in a credit report. They must allow borrowers to include statements of explanation for derogatory information in their report.

The Fair Credit Reporting Act (FCRA) requires credit reporting agencies to give borrowers denied credit a free copy of their credit report. Borrowers who have not been declined can also receive a copy for a nominal charge.

Capacity – Capacity refers to the borrower’s ability to repay the loan (to service the debt), emphasizing two ratios. The first is the borrower’s monthly proposed housing costs to total gross income. Total housing costs will also include PITI and homeowners association dues. Most conventional lenders look for a ratio that does not exceed 28%. FHA allows up to 31%.

The second ratio is the borrower’s total debt payments (inclusive of the proposed loan) to the borrower’s gross monthly income. Most conventional lenders do not allow this to exceed about 36%. FHA will allow up to 43%, and VA allows up to 41%. If a borrower qualifies comfortably on one of the ratios, a lender may allow a little leeway on the other.

The lender also considers the employment history of the borrower. Employment history evaluates such factors as the reliability and stability of the borrower’s income, length of time on the job, type of occupation, overtime pay and bonuses, and the probability of continued employment.

Another factor considered by the lender is the net worth of the borrower. To determine net worth, the lender will subtract borrower liabilities from borrow assets (Assets-Lisbilities=New Worth). Fannie Mae regards “an accumulation of net worth as a strong indication of creditworthiness.” By establishing net worth, the underwriter evaluates the borrower’s ability to cover the down payment and any additional costs for the purchase and is verifying adequate cash reserves.

Total Assets of $1,500,000 – Total Liabilities of $500,000 = $1,000,000 net worth. Rationale: Assets-Lisbilities=New Worth.

The equation for Net Worth is Assets-Lisbilities=New Worth.

After evaluating the collateral and the borrower, the underwriter summarizes their evaluation and sends it to a loan committee. The loan committee makes the final decision on whether to approve the borrower for the loan. If the committee approves the loan, they will issue a loan commitment letter to the borrower. A commitment letter is a written agreement by the lender to make the loan, subject to any specific terms and conditions listed in the letter.

Note: Qualifying ratios and credit score parameters change based on economic conditions. Always check with your qualified mortgage professional for the most current information for today’s market conditions.


OnlineEd blog postings are the opinion of the author and not intended as legal or other professional advice. Be sure to consult an appropriate party when professional advice is needed.

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