While there is not a single formula to follow, lenders have specific guidelines for granting loans. It is a complicated evaluation of the property/collateral used as security for the loan as well as the borrower’s ability and willingness to repay the loan.
Borrower’s Ability to Repay
The lender must determine how much income an applicant is able to devote to the loan payment. Possible sources of income include base salary, overtime, part-time and second job income, bonuses and commission, retirement, dividend/interest income, rental/investment income, alimony or child support and welfare. Once a lender determines an applicant’s gross monthly income, qualifying ratios are calculated. These ratio’s are used to determine how much income is available to repay the loan each month.
If the loan requested is for the purchase of real estate, a housing ratio is used to analyze a prospective borrower’s ability to pay for the home. Expenses in the ratio include the mortgage payment, real estate taxes, property insurance, homeowners or condominium association dues and mortgage insurance.
A debt-to-income ratio is calculated based on information specified in the application and credit reports. This ratio is used to predict an applicant’s ability to adequately meet monthly housing and living expenses in addition to the requested loan amount. Total obligations include the monthly housing expenses plus any debts or loans with remaining terms more than 6 or 10 months.
Any residual income as well as an applicant’s liquid assets are also used when determining the borrower’s ability to repay a loan. Residual income is the gross income less taxes, social security, defined deductions and shelter expense. It is basically the money left to the applicant after all monthly expenses are paid. Liquid assets represent the funds the applicant has available for unexpected expenses. Both residual income and the amount of liquid assets are used to determine the applicant’s ability to pay in the event there is a sudden loss of income.
The accumulation of substantial liquid assets is a strong indicator of financial responsibility. This provides a positive factor in analyzing both the ability and willingness to repay the loan. It is quite possible that a prospective borrower can qualify for a monthly mortgage payment, but lacks the cash to close; or the applicant may be able to pay for closing, but will be wiped out financially to do so. Without any cash reserves, the applicant may not be able to make monthly payments or pay for unexpected household expenses such as appliance repair.
Borrower’s Willingness to Repay
Analysis of delinquencies and foreclosures shows that the credit history of a borrower is one of the primary predictors of loan performance. Good credit history correlates with a high likelihood of future repayment. For this reason, credit reports are used to determine an applicant’s credit history. A lender will review an applicant’s credit history to determine the applicant’s motivation to pay a lender, recent credit inquiries and history of slow payments, bankruptcy and/or foreclosures.
There should be solid evidence reflecting the applicant’s motivation; that they are sincere about a promise to make a payment. Past performance is a good indicator. Analysis of the applicant’s history with respect to credit tells the lender how the applicant handles debt. This is one of the most complex areas in lending, because it deals with many personal aspects of the applicant’s history.
Slow Payments is the term for late payments by the applicant. For example, suppose a credit report shows 2×30 for a car loan. This means that, in the past 12 months, the applicant was more than 30 days late twice. The lender looks for a pattern that may affect risk. One slow payment is not a true indicator; however a pattern of slow payments may indicate an unwillingness to pay.
The number of inquiries on a credit report can also provide information about an applicant. Inquiries are documented on a credit report whenever a creditor requests information. An excessive number of recent inquiries may be an indicator of possible fraud or simply a reflection of multiple attempts at being approved for a loan. In both of these cases, further research may be required to determine the borrower’s creditworthiness.
If an applicant has been involved in either voluntary or involuntary bankruptcy proceedings, the bankruptcy must typically be discharged for a specified period of time at the time of application. Lenders have different requirements for the length of time between bankruptcy discharge and application, but in the intervening time, good credit should have been reestablished. Bankruptcy does not necessarily stop an applicant from obtaining a loan; however, it is important for the applicant to establish why it occurred and whether or not it was avoidable. Like bankruptcy, mortgage foreclosure can be a strong negative factor in the applicant’s credit history. Establishment of unblemished credit since the foreclosure may offset its presence.
When a lender has completed a thorough evaluation of the borrower’s income, assets and credit history, he or she should have a good idea of the applicant’s ability to manage his or her financial affairs.