What do banks look for when reviewing a mortgage application?

Banks assess various factors to determine the borrower’s creditworthiness and the level of risk associated with lending them money. Lenders considered five main aspects of an application when reviewing a loan:

1. Credit Score & Credit History

A borrower’s credit score is a numerical representation of their creditworthiness. Banks use this score to assess the likelihood that the borrower will repay the loan as agreed. Higher credit scores generally result in more favorable loan terms and a higher likelihood of approval. Prior to applying for a loan you can review your credit report from Annual Credit Report service and sign up for a credit score from a credit bureau or Credit Karma.

AnnualCreditReport.com

This is the only official website authorized by the federal government to provide free credit reports. You can request your reports online at AnnualCreditReport.com, by phone, or by mail. The website is easy to navigate, and you can select which bureau’s report you want or choose to receive all three reports at once. The Fair Credit Reporting Act (FCRA) mandates that the three major credit bureaus must provide you with a free credit report once a year. These credit bureaus are Equifax, Experian, and TransUnion. To obtain your free credit report, you can use the official website:

Credit Scores

There are several websites where you can access your credit score for free. These sites may use different scoring models, and the score you receive may not be the same as the one lenders use. Examples include Credit Karma, Credit Sesame, and WalletHub.

Credit Score Ranges:

Credit scores are numerical representations of an individual’s creditworthiness, and different scoring models may have slightly different ranges. One of the most commonly used credit scoring models is the FICO score. FICO categorizes scores ranging from 300 to 850 into different score ranges.

  • Poor (300 – 579): Individuals with scores in this range may find it challenging to qualify for credit or may be offered credit with higher interest rates. It indicates a higher risk of defaulting on loans.
  • Fair (580 – 669): While individuals in this range may be eligible for credit, they might still face higher interest rates. It suggests a moderate risk to lenders.
  • Good (670 – 739): This range is considered good, and individuals with scores in this category are likely to be offered better interest rates on loans. It indicates a lower risk to lenders.
  • Very Good (740 – 799): Scores in this range are considered very good, and individuals are typically offered favorable terms on credit products. They represent a low risk to lenders.
  • Excellent (800 – 850): An excellent credit score indicates a very low risk of default. Individuals with scores in this range are likely to qualify for the most favorable terms and interest rates on credit products.

Credit History: In addition to the credit score, lenders review the borrower’s credit history for any past delinquencies, bankruptcies, foreclosures, or other negative marks.

2. Income and Employment History

Lenders want to ensure that borrowers have a stable and sufficient income to make mortgage payments. They may review pay stubs, tax returns, and employment history to verify the borrower’s ability to repay the loan.

Employment Stability: Lenders prefer borrowers with a stable employment history. A consistent work history can provide assurance that the borrower has a reliable income source.

3. Debt-to-Income Ratio (DTI)

The debt-to-income ratio is a measure of a borrower’s monthly debt payments relative to their gross monthly income. Lenders use this ratio to assess the borrower’s ability to manage additional debt. A lower DTI is generally viewed more favorably. The 28/36 rule serves as a common benchmark: ideally, the front-end DTI is 28% or lower and the back-end DTI, 36% or lower.

  1. Front-End DTI (or Housing DTI):This includes the proposed monthly mortgage payment (principal, interest, taxes, and insurance) divided by the borrower’s gross monthly income.
  2. Back-End DTI (or Total DTI): This includes all monthly debt obligations, not just the mortgage, divided by the borrower’s gross monthly income. It typically includes items like credit card payments, car loans, student loans, and other debts.
  3. To determine your debt for income ratio you can start by creating a Personal Financial Statement (PFS). A PFS provides an overview of an individual’s financial position at a specific point in time and includes information about an individual’s assets, liabilities, and net worth. 

Assets

These are items of value that an individual owns. One person can own assets, or multiple individuals (such as a married couple) can jointly own them. Additionally, one can own assets outright or purchase them using a loan. One should note assets with outstanding loans and associate them with a loan listed in the liabilities section of the personal financial statement. 

Liabilities

These are an individual’s debts or obligations. Debts should note whether they are associated with an individual, joint signers, or a private business. Examples of liabilities include:

Net Worth

This is calculated by subtracting total liabilities from total assets. Net worth represents the individual’s wealth or the difference between what they own and what they owe.

Download the WorthSheet Personal Financial Statement Template

Worthsheet is a personal financial statement template that is available in Google Sheet or Microsoft Excel. 

4. Down Payment & Cash Reserves

The size of the down payment can impact the loan-to-value ratio (LTV), which is the ratio of the loan amount to the appraised value of the property. A larger down payment often results in a lower LTV, which can be favorable to lenders.

  • Cash Reserves: Some lenders may consider the borrower’s cash reserves, such as savings or other liquid assets, to assess their ability to handle unexpected expenses or financial challenges.

5. Property Appraisal & Loan-to-Value Ratio (LTV)

The lender will typically require a professional appraisal of the property to determine its value. This is crucial in establishing the loan amount and ensuring that it aligns with the property’s worth.

  • Loan-to-Value Ratio (LTV): The LTV ratio is the loan amount relative to the appraised value of the property. A lower LTV is generally more favorable, as it indicates that the borrower has more equity in the property. The ideal LTV ratio can depend on several factors, including the type of mortgage, the borrower’s creditworthiness, and the lender’s specific requirements. LTV ratio targets vary by the type of loan, below are common examples:
    1. Conventional Mortgages:Lenders often prefer setting a maximum Loan-to-Value (LTV) ratio of 80% or lower for conventional mortgages that government agencies do not insure or guarantee. This means the borrower is making a down payment of at least 20%. A lower LTV is generally seen as less risky for the lender.
    2. FHA Loans: The Federal Housing Administration (FHA) may allow for higher LTV ratios in the loans it backs. FHA loans often have a maximum LTV of 96.5%, meaning borrowers can make a down payment as low as 3.5%.
    3. VA Loans: Veterans Affairs (VA) loans are available to eligible military veterans and typically do not require a down payment. As a result, the LTV ratio for VA loans can be 100% or higher.
    4. USDA Loans: The U.S. Department of Agriculture (USDA) offers loans with a focus on rural and suburban areas. These loans may also allow for higher LTV ratios.
    5. Private Mortgage Insurance (PMI): If a borrower makes a down payment of less than 20% on a conventional mortgage, they may have to pay for private mortgage insurance (PMI). This insurance protects the lender in case of default and allows for a higher LTV ratio.

Personal Financial Statement

In addition to requesting the above information, the bank will ask you to complete a personal financial statement. A personal financial statement (PFS) is a summary of a person’s financial health. A PFS provides an overview of an individual’s financial position at a specific point in time and includes information about an individual’s assets, liabilities, and net worth. Additional information related to a personal financial statement can be found HERE.

Download the WorthSheet PFS Template WorthSheet is a personal financial statement template that is available in Google Sheet or Microsoft Excel. 

Finally, before making a decision on a loan or savings plan, run the numbers! The best way to start is by trying out online personal financial calculators such as a simple mortgage calculator, retirement contribution (403b calculator, 401(k) calculator), net worth calculators, and bank rate calculators. You can find an example of a mortgage calculator with an amortization schedule here.

Personal Financial Statement

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