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.
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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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