There are two main considerations lenders are looking for when qualifying a borrower for a mortgage loan. The first is the ability to repay and the second is the willingness to repay. The ability to pay considers employment stability, income to debt ratios and down payment. Willingness to pay considers a borrower’s past payment history – revealed by his/her personal credit rating. And while some of the components may be more vital than other, particularly depending on the type of loan being desired, they are all interdependent on each other.

Ability to Repay:

Employment

The ability to repay starts with establishing the income that will be used to repay the loan. This is probably the most important piece of the overall qualification – if you don’t have adequate income to repay a loan, you will likely not qualify. You will have to list a full 2 years of employment history on your loan application. Your employment and income will need to be established and verified to determine the likelihood of continuance. Employment history is important as it provides a track record for your earning ability and shows stability of earnings.

Lenders look at your income in ways other than the total amount. It is important to determine not only the employment history and the stability, but also how the income is earned. For example, income from bonuses, commissions and overtime can vary from year to year. If these sources make up a large percentage of your income, or are needed to qualify for the loan, your lender will want to know how reliable they are. If you are an hourly wage earner with overtime, not only will the history of the overtime need to be examined but your employer will have to verify the likelihood of continuance of the overtime. Likewise, bonuses and commissions have to be averaged and the likelihood of continuance must be determined.

Income that is earned via a salary or hourly wage will typically be verified with pay stubs and most recent W-2’s, and most likely an employment verification (written or phone) from employer. Non-guaranteed income from your employer, like bonuses and overtime, also have to be confirmed with employer to have a likelihood of continuance via an employment verification form. Self employed income, commission income, interest/dividend income, rental income, and really any income that is not guaranteed by an employer, will need to be verified with 2 most recent year’s tax returns. Income will be averaged when 2 years of returns are used and concerns will arise if income is declining year over year.

Keep in mind that these are just general guidelines and each circumstance is different and can create unique nuances. Every loan will be underwritten based on the guidelines the lender is following. So while the descriptions here, particularly as they relate to income, are generally accurate, they are not all encompassing.

Debt Ratios

Because one of the main considerations in determining ability to repay is making sure that there is enough income to pay monthly expenses, your lender will also consider the relationship between your income and debt obligations. Generally, your fixed housing expenses (monthly mortgage payment, insurance, property taxes, and any association type dues) should not be more than about 30% of your gross monthly income. That simply means that you divide your total housing payment by your gross monthly income and the percentage should not exceed 30%. Your total payment ratio (all monthly debt obligations including new housing payment) should generally be under 40%. Simply add your monthly housing payment to all other monthly debt payments (installment loans, credit cards, child support/alimony are examples, but does not include regular monthly expenses like gas, groceries, utilities and such) and divide by your gross monthly income – that figure needs to be less than 40%. Although this is not an absolute rule, and will vary dependent on all the other factors, like credit score and down payment amount, it is a good rule of thumb.

Also remember that monthly income is determined by taking the annual income amount and dividing by 12. For those who are self employed, the annual income is the amount on which taxes are paid – the bottom line amount after expenses are taken out of gross earnings. Don’t mistake gross earning for taxable earnings. This is a common mistake for self-employed borrowers.

Down Payment

The difference between the sales price of the home being purchased and the amount being borrowed is the down payment. This is the amount that you as the buyer are investing in the home. The more you have invested of your own money, the more you have to lose by letting the loan go in default. That is why the down payment is so important to a lender. The less you have invested in the home, the easier it is to walk away if payments get tough to make.

Traditionally, 20 percent of the value of the home is the standard down payment. However, there are many types of mortgages that require less than that. But if you are putting less down than 20%, your lender will scrutinize your loan more from an underwriting standpoint for the reason mentioned above. If you borrow more than 80% of the home’s value, your lender will also require private mortgage insurance (PMI). That helps protect the lender against default. Depending on the type of loan and percentage of down payment, the cost of the mortgage insurance on a monthly basis can vary. But the payment can be pretty significant. As an example, on an FHA loan with minimum down payment (3.5%) on a $250,000 sales price, the monthly mortgage insurance payment will be over $230 per month. If you are able to put at least 5% down, then you might consider a conventional loan which will have a smaller mortgage insurance payment assuming you have good credit.

There are other options that will allow you to put down less than 20% and not pay mortgage insurance. If you can only afford, for example, 10 percent down, but have good credit, you can still get a loan, and even avoid paying PMI. Ask your lender about an 80/10/10 loan — an 80 percent first mortgage, followed by a 10 percent second mortgage, and 10 percent down. This gives the lender the ability to keep your first mortgage at a level that avoids the cost of mortgage insurance. The second mortgage may not be at as favorable of a rate and term as the first. But typically the blended payment allows a cheaper overall payment.

The source of your down payment is also important. You will be required to provide asset statements to document that the funds are available and coming from an acceptable source. Lenders will typically only allow you to borrow the funds for a down payment if the loan is secured against an asset you own. And any funds recently deposited will require documentation proving where the funds came from and that the source is legitimate (not borrowed on an unsecured loan, for example). A gift is allowed in most cases, but requires documentation validating the gift. And on certain loans, like conventional loans, a certain amount may be required from the actual borrower if there is less than 20% being put down. An FHA loan will allow the entire amount of the up-front money be a gift as long as it is documented and from an acceptable source. And if the down payment is coming from the proceeds of the sale of a current residence, that would not have to be documented by asset statements but would have to be supported by the settlement statement showing the current home being sold and the amount netted.

Willingness to Repay:

Credit

Your lender will run a credit report on you as part of your application process. Your credit report will result in your overall credit receiving a rating or a score. Typically a mortgage lender will order a credit report that has three scores – one from each respective credit bureau (the most common are Equifax, Trans Union and Experian). The lender likely will use some type of average or select the middle score as the score representing your credit. According to your credit score, the lenders can analyze what risk you pose on them. As per the financial theory, increased credit risk implies that a risk premium has to be added to the price at which the money is borrowed. Credit scoring has become very important in determining one’s ability to qualify – and typically, particularly with most conventional type loans, the better the score, the better the rate.

What makes up the credit score and why is it so important? A credit score is a statistical technique to determine the probability of an individual to pay back the money he or she has borrowed within a specific period of time. When you borrow money or take on credit, your lender sends the detailed information to the credit bureau or credit score rating system to create a credit report for analyzing how well you handle your debts. The credit bureau that issues these free credit score ratings have various evaluation systems, and which depend upon many factors. The main factors employed to evaluate an individual's credit report score rating are the person's credit payment history, current debts, time length of credit history, credit type mix, and frequency of applications for new credit. Scores can range from 350-850. An excellent credit score is typically considered to be anything above 740. A score of less than 620 will make qualifying for a loan very difficult.

Tips to Improve Your Credit Score:

• Make your payments on time and for the right amount.
• Avoid over-extending your credit, and stay away from unsolicited credit cards as they won't benefit in any way to your credit score.
• Don't ignore your overdue bills, and if you face any problem regarding repaying your debt, contact your creditor for repayment arrangements.
• Be sure of what type of credit you have, as credit from some financing companies can affect your score in a negative way.
• Try keeping your outstanding debt as low as possible – particularly on revolving debt (credit cards). Extending your credit close to your limit constantly is considered to be bad and poor.
• Restrict your number of credit applications as a credit report having many hits is viewed poorly. In other words, the more times you let people pull your credit, the worse your score is likely to be. But not all hits are considered to be negative, like monitoring of accounts, prescreens, etc., are viewed positively.