by Brian Risler

How does the bank see your mortgage loan application when you’re buying a home? If you’ve ever been through the process, you know it can be an anxious, stressful time. 

As it turns out, though, the bank’s view of your credit application is a lot like the jeweler’s evaluation of a precious gem. To the bank, your loan is an asset, and like the jeweler, the bank wants to determine the long-term value of that asset. 

The jeweler carefully considers the four C’s of the stone: Cut, Color, Clarity and Carat. Together, these indicate overall brilliance and lasting value. The bank has its own version of the four C’s: Credit, 
Capacity, Capital, and Collateral. 

Let’s take a closer look at each item and see how each impacts the overall perception of the loan.

Credit: In simplest terms, credit involves consuming a product or service before you’ve paid for it. Each time you borrow money (or apply to borrow money) to purchase something you’re not yet ready to pay for, it gets reported on your credit history. If you repay the money as originally agreed, your credit history improves. When the money is not repaid on time, it warns other creditors that you may have trouble meeting future obligations, because you’ve had trouble in the past. 

The most recent credit data counts the most, so if you’ve made all your payments on time in the past twelve months, you’re probably in good shape. If not, you have some fences to mend. As a general guideline, credit scores used for mortgage financing range from 350 to 850. Higher is better. Most traditional lenders prefer to see credit scores of 600 or higher. If your scores are below 600, it doesn’t mean you can’t get a loan, but it’s more likely you’ll pay a higher rate of interest on a so-called “sub-prime” loan, and your down payment requirement might be higher. If you’re in the market for a sub-prime loan, the risk of being duped by a predatory lender also increases significantly.

What if you have no credit history? Say you’ve never borrowed a dime in your life. Some banks offer a solution. They’ll ask for evidence of alternative credit, such as canceled checks for rent or utility bills you pay in your own name. If you’ve been timely with your landlord, cell phone, cable company, and electric utility, you’re all set; otherwise, you’ll need to establish some other history of meeting commitments as agreed.

Capacity: How much stable income is available to repay the loan after meeting your other obligations? Other obligations include minimum payments on installment loans such as student loans, auto loans, and the like. These also include store charges and major credit cards. Don’t forget to factor in child support, if it is also part of your budget. 

What counts as “stable” income? Wages, salaries, and tips that appear on your Form W-2 from paid employment are easiest and most common to document. As a general rule, most forms of income should have a two-year history and be reasonably expected to continue. That doesn’t mean you need to keep the same job for two years. It just means that you’re currently employed in a job or industry in which you have at least two years’ experience.

Self-employed income requires a two-year history, as shown on your federal income tax returns. How much of your income does the bank count? It’s the net income after deducting business expenses. After all, these are the only funds available for personal use. Depreciation is a non-cash expense, so it can be added back into net income. 

What about part-time income? Two years is the general rule, although there are exceptions. Disability earnings? Unemployment income? If you receive disability payments for a condition that your doctor expects to continue for the next three years or longer, it counts. If you’re employed in a business that involves seasonal layoffs during which you receive unemployment benefits, these count as well. If you’re collecting unemployment between jobs or receiving short-term disability payments, though the income is considered unstable.

Unstable earnings have given rise to No Income Verification loans. So many people have a track record of making good on their obligations without the benefit of stable income that banks have begun to offer loans primarily on the basis of a strong credit history, but because one element of loan quality is missing altogether (capacity), borrowers who take advantage of these loans should expect to pay a premium.

Capital: Capital comes in two forms. The down payment is the most familiar. If you don’t have enough for a down payment, the loan is considered riskier than if you do. Typical down payments for first-time buyers are 3% to 5%, but can be larger. Until your loan amount is paid down to 80% of the purchase price or less, you might need to pay private mortgage insurance premiums (known as PMI or MI) to protect the bank against the risk of default. If your equity (ownership percentage) in the property is less than 20% and your property is foreclosed, mortgage insurance pays the deficit between the resale value of the home and the balance owed on the loan. 

The other form of capital involves principal payments on the loan. Traditional mortgage payments include interest on the amount you’ve borrowed as well as a portion that is applied toward the principal balance. Some borrowers may defer principal payments and pay only the interest portion of the loan. Termed “interest-only” obligations, these loans are considered riskier assets by the bank and generally are available only to customers with superior credit. 

Collateral: What kind of property is pledged for the loan? Unless it’s real property, there is no mortgage. That means that mobile homes without a foundation or permanent lot are off limits, as are yurts, tents, timeshares, and the like. Condominiums, single-family homes, duplexes, triplexes, and quads are the typical properties that are acceptable for collateral. Planned-unit developments (PUDs, often known as gated communities) typically involve single-family homes bound by agreement to a common homeowners association. PUDs are similar to condo, and equally well-suited as collateral for the loan.

Not all collateral is created equal, though. A single-family, owner-occupied home is considered the least risky. Risk rises with multifamily homes, as it is understood that the borrower is at least partially relying upon rental income to make the monthly mortgage payment. If the rental market dries up, the mortgage may become increasingly uncertain.  Rental properties that are not occupied by the owner are even dicier, because an investor who doesn’t live in a property can choose to walk away from the obligation without wreaking household havoc. 

What does your application look like to a bank? Is it a diamond, ruby, emerald, or is it more like paste? 

Generally, the collateral is the nonnegotiable element of the equation. If you don’t have collateral, there is no mortgage loan. Assuming you do have solid collateral, though, most borrowers need to show commanding mastery of credit and capacity, credit and capital, or capacity and capital. The best borrowers demonstrate all three.