When the lending business began, I suppose, it was a very simple proposition. You wanted a loan you needed collateral. If the collateral wasn't enough to get you the loan, you added some more collateral. When the lender felt good about the deal you got your loan. Simple, fair and relatively easy. What happened? The loan business expanded into a mortgage industry and that is when the problems began. In every industry there is a right way and a wrong way to do business, which is generally defined, and that is how business is conducted. Like everything else that is vibrant, the definition of right and wrong are changed or amended over time. In some cases the definitions become interchangeable and that can lead to a parcel of problems.
The previous paragraph sums up the mortgage industry from its inception through the present time. Now we are back at the beginning crossing every "t" and dotting every "i", and I feel there is probably a better way. So I invite you, the reader, to join me in developing a new and better mortgage loan formula for success. I will lay out the tools and you can lay out the parameters for their use. I bet you will find out it isn't as easy as it seems it should be.
The four main ingredients that every borrower has are a property with a value; a credit score; earnings and cash reserves. Which one is the most valuable? Which is the least valuable to you? To the lender? Additional information we have is the type of transaction: purchase, refinance or cash out. We have the usage of the property: primary residence, second home or investment. The type of property: single family residence, condo, high rise condo, duplex, tri-plex or four-plex. Should all of the above be treated the same or should there be different rules for different situations?
Let's start with the loan to value of the property. If it is a purchase do you use the purchase price, or the appraised value? What do you do if the appraised value is higher than the purchase price? Lower? The standard current rule is to use the one that is lower which means the borrower doesn't get any value for an under the market purchase and is forced to bring in additional monies if the purchase is deemed to be over the market. Would you keep this rule? On a refinance or cash out transaction would you review the appraisal or ask for a second one? Would you accept the appraisal as is? The current rule is to review every appraisal and if there is concern have a field review done by another appraiser or get a second appraisal. Does this seem to be the best way to operate to insure proper security?
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When it comes to credit scores most reports have three bureaus reporting to them and we use the middle of the three scores. Is that your way of gauging credit or would you look for a different method? We generally use the middle score of the borrower who makes the most money and ignore the spouses, or significant other's score, unless that score is too low and would disqualify the loan (generally a score of 620 for a conforming loan and 660 on a jumbo loan). Before credit scoring, about 10 years ago, we looked at the credit and made a determination from that. Perhaps that is still a better idea?
We are now left with earnings and reserves. Earnings can be from a W-2, 1099, K-1 or from the remainder of the monies in a sole proprietorship or from a sub chapter S corporation. The current rules suggest a two year employment history or business history to qualify. What about recent graduates who get employment contracts, athletic contracts or entertainment contracts? Do they need two years? And how do you look at the earnings from a self employed person, or an employed person with a side business? Do tax returns show the potential of the tax payer or just the history of said tax payer?
Last but certainly not least are reserves: the glue that holds the various pieces of the puzzle together. We like to see six months principal, interest, taxes and insurance but is that enough? Do we count retirement money? How about transfer payments: social security, pensions, alimony, child support, notes receivable, disability income, annuities, etc? What about large sums of money such as stock portfolios, mutual funds, commodity accounts and large money market holdings? Do you count any or all of the above? How much weight do you put on the various holdings, or is a mutual fund equal to a money market account? Which of the transfer payments belong under earnings and which under reserves?
I believe it is important for you to see how difficult it is to make rules for the mortgage industry because not only are there four major tools, but a myriad of other factors to consider. There is a need, of course, to standardize this industry because of the ever expanding size. The mortgage industry which funds loans into the trillion dollar range, must be able to identify and classify each and every loan. We have unfortunately seen what happens when rules aren’t standardized, aren’t followed and don’t protect the borrower or the lender. To avoid a replay of the latest credit crisis everyone must have an understanding of what they are doing when applying for and procuring a mortgage loan. You have had a basic look at some of the decisions that need to be made on every loan, but realize this is just a cursory look of the process. It is far more complex with a lot more variables then were used in this discussion. Information and knowledge are your best defense in any transaction, especially a financial one, that you might consider. You must decide when you are comfortable with the
Information and knowledge you have to move forward. I hope this column brought that point home to you.
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