The Three Factors of Credit Worthiness
Between the Internet, well-meaning family and friends, and know-it-all articles in the print media, it's hard to know where the facts end and the nonsense begins. Facts are everywhere, but so are urban legends, hidden agendas, and opinions posing as truth. Fact or fallacy - it can be devilishly hard to tell the difference.
It's all about risk.
Lenders are anxious to lend. It's what they do and it's how they make a profit. But they are every bit as anxious to insure that they will get their money back. Therefore, all mortgage lending is predicated on assessing the possibility that a loan will be repaid.
Since there is no crystal ball, lenders use three main factors in assessing risk.
1) Past Performance
Lenders love history - a borrower's history. They believe that nothing says more about what will happen that what has happened before. Therefore, lenders look closely at how a potential borrower has managed his past obligations. Someone who has a history of making payments late or not at all is assumed to be someone who is likely to continue that pattern.
This is where your credit report comes in. A credit report is a detailed history of how you've treated your credit and responsibilities in the past. Lenders look at your credit report almost exclusively, with the one exception being rental history when buying a house (rental history doesn't show up on your credit report).
Now, information you won't get from your mortgage broker! Credit scores typically range between 350 and 850. From a practical standpoint, scores range between 500 and 700. Anything less than 500 is horrible and anything more than 700 is fantastic. 620 or less is generally considered "sub-prime", meaning you won't get the rate that are the lowest out there and you'll probably have to take a prepayment penalty.
Sometimes if your score is higher than 620 you may still be sub-prime, if you have very little equity in the property or issues with your income. This will be covered in more detail further below, but don't let your loan officer tell you your scores are horrible when they're not!
2) Financial Commitment
The larger the investment, the more likely someone is to protect it. Therefore lenders like to see borrowers make a financial commitment to their home. Lenders consider a 20 percent downpayment to be a much more comforting level of commitment than 5 percent down, and weigh it accordingly.
This is where the term loan-to-value (or LTV) comes in. Loan-to-value is a ratio that compares the size of the loan in relation to the value of the property. For example, if you own $80,000 on a home valued at $100,000, this would be an 80% LTV.
Generally speaking, the lower the LTV, the less risky the loan and the more likely the lender will approve the loan and give you a great rate.
3) Ability to Repay
Motivation to repay is quite different than the ability to repay. Even the most responsible borrower borrower can find himself in difficulty if his income is simply not sufficient to make promised payments. Lenders typically use a ratio called the debt-to-income ratio, or DTI. This is a ratio of the total debts in relation to the gross income. In other words, if your mortgage, credit card, and car payemnts all add up to $3,000 per month and your gross monthly income (before taxes) is $6,000 per month, your DTI would be 50%.
Generally speaking, the lower the DTI the less risky the loan and the more likely the lender will approve the loan and give you a great rate. 50% is generally the max, though 45% or less is ideal.
By putting all three of these criteria together, a lender can get a very good idea of whether they'd like to extend credit to you and if so, what rate and scenario you would qualify for. Generally speaking, by putting more money down (a lower LTV), spending less than you make (a lower DTI), and having a great credit score, you will qualify for better loans and lower interest rates.
Carey Pott has been a licensed mortgage broker for over four years and built a successful mortgage company, January Financial. For more information, go to http://www.januaryfinancial.com
Carey has also partnered with a real estate attorney, Rand Rodman, to create a fantastic ebook called the Home Buying Codex. For more information on this exciting new ebook, check out Home Buying Codex.
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