The
Mortgage Application and Approval Process
The
first stage of the mortgage lending process involves
filling out the application, verifying the information
on this application, and confirming the value
of the property. The process of determining the
risk of an application, and whether to approve
it, is called underwriting.
The
underwriter considers three primary components
of each application. The task of underwriting
is to determine the borrowers ability to repay
the funds under the agreed upon terms, their willingness
to repay, and the adequacy of the real property
as security for the mortgage loan.
1. The current financial position of the applicant.
Net
Worth
The
applicants net worth is determined to decide their
overall financial well being. Of particular concern
is the verification of available net worth for
the purpose of down payment. The accumulation
of assets beyond liabilities can be used as a
general test of the applicants personal finances
and income management in prior years.
Gross Income
One
of the most important components of the loan underwriting
process is determining the borrower's gross income.
The income of all borrowers and co-borrowers is
included in the calculation. The income can be
derived from several sources, but it must be supported
by historical documentation and have a high likelihood
of continuation in the future. The underwriter
is concerned with the quantity of income earned
in order to determine the maximum mortgage allowable,
and also the durability of these earnings to insure
that the borrower will be able to make their mortgage
payments for the full term of the mortgage.
The
following outlines the types of income that may
qualify as well as the verifications required
to confirm them:
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Salary: Income derived from any kind of
salary, whether monthly, weekly or hourly is acceptable.
Two or three years employment history is usually
required.
Commission
and bonus: Commissions and bonuses may be
qualifying income if it is an ongoing and persistent
component of overall earnings. To verify this
the underwriter will average the last two or three
years of income shown on your income tax returns
and the year-to-date earnings from the written
verification of employment or pay stubs. The task
if to determine if this income is likely to continue
in the future, and at what levels given the employment
type.
Self-employment
income: Generally, the underwriter will average
the income earned through self-employment for
the last three years from the applicant's income
tax returns and the year-to-date earnings from
a profit and loss statement of the business. Self
employment can take many different forms so the
underwriter will require as much supporting evidence
as possible to determine and verify qualifying
income. In determining the current amount of qualifying
income generated by self employment the underwriter
will take into consideration the trends in your
business or industry in an effort to forecast
future prospects.
Other
Income: Income earned from rental properties,
interest, dividends, pensions, and social security
can be used, as long as it can be verified and
will persist long into the future. Some incomes
are discounted, or do not qualify at all, for
the purposes of mortgage loan application. One
time gifts or windfalls are not income nor is
occasional overtime or a single bonus from your
employer if it is not likely to be received again.
In general, unemployment benefits or other insurance's
with a finite disbursement period are not considered.
Funds
to Close:
When the proposed loan is being used to finance
the purchase of a home, the lender will determine
the source of funds for the down payment as well
as closing costs. The mortgage lender is verifying
that closing costs and down payment amounts are
not also going to be borrowed and have been accumulated
over time from the borrowers own resources.
The
following are acceptable sources of funds for
closing:
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Funds
on deposit: Money that has been on deposit
for at least 60 days in checking or savings accounts
at any depository institution or investment company
is acceptable, so long as it can be verified on
bank statements for the past two months.
Stocks,
Bonds, Mutual Funds, etc.: Cash equivalent
investments are acceptable forms of funds. They
can be validated through statements from investment
companies for the last two months.
Sale
of existing property: Many times the source
of funds for the down payment on a home comes
from the equity in a property that will be sold.
The sales price of the property being sold is
indicated on the loan application and any existing
loan is verified on the credit report or through
a verification of previous mortgage. The contracts
of purchase and sale must be submitted to the
mortgage lender in order to verify that the proceeds
of disposition are sufficient and closing dates
are in order.
Gifts
from family members: Gifts from family members
for the down payment and/or closing costs are
acceptable so long as there is no requirement
for repayment. CMHC will require the execution
of a gift letter as proof that the gift is bona
fide.
CMHC
requires the borrower to demonstrate their ability
to cover closing costs in the amount of 1.5% of
the value of the property. Closing costs can be
equal to as high as 3% of the value of the property
being purchased and can vary widely depending
on the property being purchased, services required,
taxes and insurance's applicable, whether the
home is new or old, closing dates affecting interest
adjustments, and the balances of any prepaid expenses.
Closing
cost are typically one time fees that must be
paid as a result of the purchase transaction.
Other immediate costs are also incurred as a result
of a home purchase. These include moving costs,
costs to ready the home for your family, insurance
coverage, lock smith and security costs, renovation
costs, household affects such as drapes, appliances,
and furnishings, and the installation of telephone
- cable and internet access etc.
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2.
How Much Home Can You Afford
Once
the lender has determined the applicants qualifying
gross income and expenses they will calculate
whether the applicant can afford the mortgage
loan based on their ability to carry the shelter
costs. Lenders use a ratios approach to determine
this ability by setting maximum expenditure amounts.
Shelter
costs include:
- The
Mortgage Payment
- Property
Taxes
- Condominium
Maintenance Fees
- Heating
Costs
While
these are not the entire costs of home ownership,
they are the most quantifiable ongoing expenses
that will have to be paid.
Gross
Debt Service Ratios (GDSR)
The GDSR is the ratio between gross income and shelter
costs. The lender will set an upper limit on this
ratio. As a general rule mortgage lenders will not
allow you to spend more than 30% to 32% of your
gross income on shelter costs. If the sum of the
mortgage payment, property taxes, condo fees and
heating costs exceeds the lenders stipulated Gross
Debt Service Ratio, the mortgage will likely be
declined, or a revised loan amount offered.
Assume
the applicants monthly gross income is $5,000 and
they are applying for a mortgage of $200,000 at
an annual rate of 8% to be repaid over 25 years.
The monthly mortgage payments would be $1,526. The
lenders maximum GDSR is 32%.
The
lender will add up the shelter costs related to
the purchase of the subject property. In this case
it is a single family dwelling with property taxes
of $100 per month and $50 per month heating costs.
The
Shelter Payments amount to 33.5% of the applicants
gross income, higher than the maximum allowed by
the lender. As such the lender will reduce the financing
available to the applicant in line with the 32%
GDSR maximum.
With
Gross Income of $5,000 per month and a maximum GDSR
of 32% the lender will only permit the applicant
to have a maximum shelter payment of $1,600 (32%
of $5,000)
By
subtracting the property taxes of $100 and the Heating
Costs of $50 we are left with the maximum gross
income available for mortgage repayment. In this
case $1,450. This is the applicants maximum mortgage
payment.
The
$200,000 mortgage the applicant has requested results
in a mortgage payment of $1,526 at current interest
rates of 8 %, exceeding the applicants maximum mortgage
payment and pushing their GDSR above the limit.
The
lender will calculate the maximum loan amount using
the applicants maximum mortgage payment of $1,450.
This results in a maximum mortgage of $189,986,
given the current interest rate.
The
applicant will have to provide a larger down payment
in order to proceed with the purchase of the subject
property. Given that their maximum mortgage is $10,014
less than they had anticipated they will have to
provide these funds from savings or they will be
forced to look for a more affordable home.
Total
Debt Service Ratios (TDSR)
The TDSR is the ratio between the sum of both shelter
and non shelter financial obligations combined,
and gross income.
The lender is concerned with the applicants ability
to carry costs other than simply the shelter payments.
The maximum the applicant will be allowed to spend
on both shelter and non shelter financial
obligations combined is usually set at 40% to 42%.
Total Debt Service Ratios above 42% result in payments
that are likely to be unmanageable for the borrower
in the long term.
Disregarding
the applicants other financial obligations could
mean approval of a loan to a borrower that has substantial
non shelter financial obligations and may increase
the risk of mortgage payment default.
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Non Shelter Financial Obligations include:
- Car
Payments
- Credit
& Charge Card Payments
- Personal
Loans
- Lines
of Credit
- Finance
Company Loans
- Long
Term Leases (more than 1 year)
- Tax
loans
- Long
term RRSP catch up loans (more than 1 year)
Let's
assume that the applicant agrees to a reduction
of the mortgage amount to $189,986 in order to bring
their GDSR within the allowable 32% limits. The
next step is to determine if the borrowers other
financial obligations are within the allowable Total
Debt Service Ratio limits. Again the shelter costs
are summed and any additional costs are also added.
If these combined costs do not exceed the 42% maximum
the borrower will be past the first step.
If the applicants GDSR is at the 32% maximum they
will must not have more than 8% of their gross income
committed to non shelter financial obligations,
42% in total.
How Personal Debts Can Affect Housing Affordability
If the applicants existing non shelter financial
obligations are, say 18% of their gross income,
the income available for shelter financing is squeezed
and reduced to 24% of their gross income. 24% of
the applicants $5,000 gross income results in a
maximum shelter payment of $1,200. If we subtract
the heating cost of $50 and the property tax costs
of $100, the resulting maximum mortgage payment
is now $1,050.
$1,050
will finance a mortgage in the amount of $137,576
at 8% per annum. This is substantially lower than
the $189,986 the applicant would qualify for based
solely on the GDSR. The applicants non shelter financial
obligations are having a negative impact on housing
affordability by reducing their available financing
and consequently the applicants purchasing power.
In
the graph below the applicant has credit card payments
of 7% of gross income and car payments of 6% of
gross income. The combined non shelter financial
obligations of the applicant equals 18%.
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After Taxes Ratios
The debt service ratio above may appear to leave
a good deal of income for all other expenitures.
However these ratios are based on gross income
and not after tax income. A look at the applicants
remaining income after taxes reveals a different
picture.
The
graph below displays a the maximum GDSR of 32%.
After taxes these shelter costs constitute 49% of
their disposable income.
The remaining 35% of after tax income does not leave
the borrower with much room. In the case of our
applicant with a gross income of $5,000 the remaining
after tax income they will have is only $1,150 per
month. These remaining funds must pay for all other
expenses such as food, clothing, medical and dental,
vehicle maintenance and operating costs, entertainment,
personal property, and savings.
Gross
Debt Service Ratios and Total Debt Service Ratios
are the maximums set by mortgage lenders.
Purchasers
may consider opting for longer mortgage terms in
order to avoid the risk of rate increases. In addition,
many purchasers are wisely advised to pay down their
mortgage, particularly if a renewal at lower interest
rates has resulted in a lower mortgage payment.
Set
Your Own Debt Service Maximums
While these maximums set risk guidelines for mortgage
lenders, the applicant should also calculate their
own maximum GDSR and TDSR. In many cases the lenders
maximums are too high for an applicant who wishes
to have a little more spending money in their pocket
each month. Applicants know their lifestyle priorities
and spending habits far better than the mortgage
lender. The maximum shelter costs a borrower can
handle should be carefully determined by the family
regardless of what the lenders maximums are.
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3. Creditworthiness
Credit
Analysis:
Another very important part of the underwriting
process is determining the creditworthiness of the
borrower. Loan underwriters review the borrower's
credit report to find evidence of debt repayment
behavior. Some of the important areas that are reviewed
are:
Past and existing mortgage debt: The past
repayment history on mortgage debt can be a good
indication of a borrowers attitude toward mortgage
obligations. A good payment history on mortgage
debt is very important in the credit analysis.Generally,
payments received 30 days past the due date are
reflected in the credit report as late. Lenders
vary in strictness, and some may not allow any late
mortgage payments, while others will allow 1 or
2 in the last two years if there is a good explanation.
Installment
and revolving credit: Other items on the credit
report can also indicate a borrower's attitude toward
their financial obligations. Credit reports indicate
the outstanding balance, payment amount, and terms
of payment on the borrower's revolving and installment
debts. Underwriters review these credit obligations
to determine the borrower's patterns of credit use
and repayment behavior. Revolving credit refers
to department store credit and bank credit cards.
Installment credit refers to longer term credit
with structured payment plans, such as car loans.
Generally, underwriters are not concerned over isolated
and minor slow payments indicated on the credit
report. They look for an overall profile of the
applicants attitude towards their financial obligations.
Collections,
repossession, foreclosures and bankruptcies: Credit
reports also indicate public records such as collections,
repossessions, foreclosures, and bankruptcies. Though
these items may indicate past credit problems, they
sometimes have valid explanations. Underwriters
may require a letter of explanation on items noted
in the public records. Many times consumers have
re-established credit and have an excellent payment
history on their current obligations. It is important
to forewarn the lender if there is an item on your
credit report that requires explanation. Provide
that explanation in detail so that the underwriter
is comfortable with it.
Some
lenders will approve applicants that have previously
been bankrupt provided they have since re-established
a good credit history and the cause of the bankruptcy
was reasonably not the fault of poor credit management
on the part of the bankrupt.
CMHC will, on a case by case basis, approve applicants
that have been bankrupt provided two years has passed
since they were discharged.
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4.
The Property
The home is the collateral for the mortgage loan.
The lender must determine that the property offers
adequate value as security in relation to the mortgage
loan amount. In addition they must determine whether
it is likely that there will be any capital or maintenance
costs that would put a drain on the applicants financial
resources and could affect their ability to manage
their mortgage payment obligations in the future.
In order to make this decision the underwriter hires
a professional real estate appraiser. The appraiser
will submit a report detailing their estimate of
the value of the residence based on the recent sale
of comparable properties in the area.
The
underwriter will be particularly interested in the
overall value of the property to ensure that it
sufficiently covers the mortgage loan within the
required loan to value ratio limits, usually 75%.
The age and condition of the property determines
its' remaining economic life. No mortgage amortization
should exceed the economic life of the property.
Properties in poor repair will likely cost more
in maintenance or renovation in years to come. These
costs are factored into the analysis.
Loan to Value Ratios (LVR)
The loan to value ratio is calculated by dividing
the mortgage (s) by the property value or purchase
price. This ratio sets another upper limit on the
amount of financing a lender will provide to a qualified
purchaser.
Mortgage
lenders typically lend based on the borrowers ability
to afford the costs associated with the property
and financing. The amount of mortgage an applicant
receives is determined by the borrowers debt service
ratios and the value of the property. If the subject
property has a lending value of $200,000 the maximum
mortgage loan the lender will provide is usually
75% of this value, regardless of whether the applicant
qualifies, from an income perspective, for a mortgage
of $200,00. The lender will only approve a mortgage
of $150,000 on this property unless the added risk
of the high ratio loan is insured away by mortgage
default insurance.
Mortgage
lenders want to ensure that the applicant will have
a sufficient stake in the property. In addition
their equity contribution must be adequate enough
to cover all costs and balances owed in the event
that the lender has to take possession or sell the
property. These costs can include legal proceedings,
accrued interest, property repairs, insurance's,
marketing expenses and Realtors fees as well as
added administration costs. The equity also acts
a safety buffer in the event that property values
decline in a slower market.
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Conventional
Mortgage
Mortgages with a loan to value ratio of 75% or less
are termed Conventional Mortgages. 75% is the maximum
a lender can advance. If the applicant requires
more financing they will have to purchase mortgage
insurance
High
Ratio Mortgage
High Ratio Mortgages have a LVR above 75%. The risk
of these loans is substantially increased due to
the lower amount of owner equity. Mortgage lenders
will only allow an applicant to have a high ratio
purchase mortgage if the applicant insures the mortgage
through one of Canada's mortgage insurers, GE Capital
Mortgage Insurance Services Canada or Canada Mortgage
and Housing Corporation. By insuring the mortgage
the applicant will be able to receive financing
up to 95% of the value of the property. This substantially
reduces the down payment requirement and allows
more families to buy a home earlier.
Underwriting
Conclusion:
After
the underwriter has reviewed the entire loan package,
there can be four outcomes:
Approval:
If the loan is "picture perfect" and the
underwriter has no questions, the loan will be approved
with no conditions.
Approved with conditions ( the most common
response):
(a) If the underwriter needs additional documentation
before a final credit decision can be made, a conditional
approval will be given. In essence, the loan documents
will not be prepared until the condition has been
satisfactorily met. An example of a condition could
be a pay stub to validate the borrower's income.
(b)
If the loan can be approved, but a condition must
be met prior to closing, a "prior-to-funding"
conditional approval will be given. In this case,
the loan documents will be prepared and sent to
the lawyer, but the lender will not fund the loan
until the condition has been met. An example of
a "prior to closing" conditional approval
could be proof of sale of existing home where the
equity will be used as the down payment.
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Suspended:
In this case there is insufficient documentation
of verification to decide whether or not to approve
or decline the applicant. The mortgage lender will
request the information and will set the file aside
until these items are delivered.
Denial:
Underwriters
will be unable to approve a loan if the loan file
has substantial deficiencies and does not meet the
minimum standards of the lender or the lender's
secondary market investors. Some lenders require
that a second underwriter review the loan package
before a final denial is communicated to the borrower.
Underwriting criteria can be different among lenders
and a borrower may be able to find other acceptable
financing alternatives in the market place.
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