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Mortgage Credit Overview
If you have ever had credit problems and tried to apply for a credit card, auto loan or a mortgage, you have probably experienced the disappointment, embarrassment, and frustration of being turned down. Just know this: you are not alone! Over 30 percent of Americans have subprime credit (also known as bad credit). Bad credit can run the gamut from a few 30-day late payments to collections, charge-offs, bankruptcies and foreclosures.
You may be pleasantly surprised to learn that even with serious bad credit problems, it is possible to qualify for a purchase or refinance mortgage. Why? How? Because mortgage lenders look at much more than a potential borrower’s credit profile.
Unlike credit card companies which look primarily at an applicant’s credit score, mortgage lenders consider three main factors: Credit, Capacity, and Collateral (also known as the three Cs).
- The Credit Factor: From a mortgage lender’s perspective, an applicant’s credit score and overall credit profile, indicate his or her “willingness to pay”. By looking at the borrower’s historical payment pattern, they are able to project the likelihood that he or she will make payments on the new mortgage “as and when due.” This is important because if a loan goes into default, the mortgage lender can lose a large amount of money.
- The Capacity Factor: Capacity is the borrower’s ability to repay a mortgage obligation. It is determined by amount and nature of income, stability of that income, and/or liquid assets (reserves). From the mortgage lender’s perspective, a person who receives a salary and has been on the job for five years is more likely to continue making on-time mortgage payments than a self-employed applicant who started a business six months ago and has no track record of success in business. Of course, if the self-employed applicant has substantial liquid assets in the form of savings or investments, the mortgage lender’s comfort level will be increased.
- The Collateral Factor: Collateral is the real estate (house, condo, town home, etc.) that is used to secure repayment of the home loan. All home loans are secured by real estate but some are more secure than others by virtue of the equity (or cushion) in the property. Equity is the difference between the property value and the loan amount; in the mortgage industry, equity is usually expressed as a percentage: if the total mortgage amount on a $100,000 property is $80,000, the home/collateral has 20% equity. All things being equal, a mortgage lender will prefer a loan with 10% equity than one with 5% or 0% equity. Another consideration in collateral is the occupancy of the home. An owner-occupied home has a lower risk to the mortgage lender than an investment property purchased for rental purposes simply because people are more likely to take better care of a personal home.
Even if the applicant's credit history is weak, there are many mortgage lenders that will provide a mortgage to purchase or refinance a home. These lenders will lend purchase money or refinance a mortgage even if they are certain that the borrower will NOT make payments on time; i.e. they expect a few 30-day and 60-day mortgage lates. They do this because they know that the one or both of the other Cs (capacity and collateral) will protect against default and foreclosure losses.
Strength in two of the three Cs can help offset weakness in the third factor. So, while credit profiles and credit scores play an important role, in type of mortgage you can obtain, they are not the only concern and do not always rule out a mortgage approval. Even weakness in all three areas will not prevent an applicant from getting a mortgage because the lender can charge a higher interest rate to offset the risk.
Mortgage Lenders and Credit Scores
The primary credit reporting bureaus (Equifax, Experian, and Trans Union) use credit scoring software to generate credit scores from the payment histories and other data found in an individual’s credit report. Almost all credit scores used by mortgage lenders are generated by software from Fair Isaac and Company (FICO).
Mortgage companies usually request credit reports from all three credit repositories in order to get a good picture of the applicant’s credit profile. Since the three credit reporting bureaus usually contain different data, an individual’s generated FICO scores can differ substantially from credit bureau to credit bureau.
Although most people have three credit scores, occasionally, one or more of credit bureaus may not have enough recent credit data to generate an individual’s credit score.
Mortgage companies usually use the middle of three scores or the lower of two scores (there are a few companies that will accept a single score and even fewer that will accept no score under certain circumstances). Typically, when a mortgage professional refers to an applicant’s credit score, they are referring to the middle of three or lower of two.
FICO scores range from 300 to 850. Although most A-paper mortgages require a 680 minimum score; it is possible to obtain 100% financing with a credit score as low as 580 (even 550 under certain circumstances).
Credit and credit scoring can be very complex. Please call any time for a free consultation.
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