Qualifying for a mortgage is typically an in-depth process that involves several factors to be considered. If you’re in the market to buy a home and are looking to take out a mortgage to finance this big purchase, you might want to know what’s involved in the home loan approval process.
When evaluating loan applications to identify whether an applicant would be qualified for a mortgage, lenders typically look at four key factors – often referred to as the “4 C’s” – which include credit, capital, collateral, and capacity.
Perhaps the first thing that lenders do when assessing your ability to pay a mortgage is pull your credit report. This will tell them what your actual credit score is, which is the most important of all the 4 “C’s”. For this reason, it’s imperative that you take steps to ensure that your credit score is in good standing. If it’s not as high as it could be, now’s the time to take steps to improve it.
Several factors influence your credit score, including the following:
- Payment history
- Previous loans
- Open and closed accounts
- Recent credit applications
- Collection accounts
Of these, your payment history carries the most weight as far as how your credit score is calculated. In fact, 35% of your credit score is based on payment history over the past 24 months. So, if you have a history of missing payments – even just one – your credit score can be negatively affected.
That said, all of these items listed in your credit report will give your lender a better idea of what type of borrower you’d be based on your previous credit behaviors.
Obviously, you need a certain amount of money in order to qualify for a loan. When a lender assesses your financial profile, they look at your overall capital, and that starts with your income. The more money you bring in every paycheck, the higher your capital level will be and the better the odds of mortgage approval.
Your capital also includes any money in savings and checking accounts, as well as capital that’s tied up in investments, real estate, 401(K) accounts, and IRA accounts that can be sold off to liquidate some equity. Having more capital that can be easily accessed can offer a financial cushion to fall back on should there be a sudden interruption in income.
Collateral is an important factor that lenders consider before offering loans to borrowers, as it provides a way for lenders to recoup their funds if borrowers ever default on their loans. In the case of a mortgage, collateral is the home itself. If the borrower fails to make their payments, the lender can repossess the property, sell it, and recoup their losses through the proceeds of the sale.
As such, lenders consider the current market value of the home that’s being used as collateral for a home loan. An appraisal will usually be ordered by the lender in order to determine the exact value of the home before extending a mortgage. After all, lenders will want to make sure that they’re not loaning out more money than what the home is actually worth.
Lenders will also use the collateral for the loan to determine a borrower’s loan-to-value ratio (LTV), which is a critical piece of information needed to assess the risk level of a particular borrower. The LTV is the ratio of the loan amount compared to the value of the collateral (in the case of a mortgage, the home).
In the eyes of a lender, a higher LTV is associated with a higher-risk borrower. If you’re borrowing an amount that’s close to the value of the home, you’ll be considered high risk to the lender. For instance, if you borrow $400,000 to buy a property worth $425,000, your LTV would be 94%. Ideally, lenders like to see LTV’s under the 80% mark in order to improve the odds of mortgage approval and to secure a lower interest rate.
Not only does your capital play a role in your LTV, so does the value of your collateral.
The job of the lender is to assess whether or not a borrower actually has the capacity to pay back the mortgage. To do that, lenders will look at your debt-to-income ratio (DTI), which is the percentage of your total monthly debt payments (including credit cards, car payments, student loan payments, and your future mortgage payments) relative to your total monthly income. The purpose of this ratio is to give lenders an idea of whether or not you’d be able to comfortably handle more debt in the form of a mortgage.
If your debt load is already high, the odds of you being able to comfortably cover your monthly mortgage payments are lower. Ideally, lenders like to see DTI’s no higher than 43% before approving a borrower for a conventional mortgage.
For instance, if you currently have $500 in monthly debt obligations and will need to pay $2,000 per month for your mortgage, your total debt would be $2,500. If your gross monthly income is $7,000, then your DTI would be 36%. Most lenders would work with this DTI since it’s under the 43% threshold. DTI’s provide lenders with a good indication of a borrower’s capacity to pay the mortgage over time.
The Bottom Line
The more you know about the factors that are considered during the mortgage application process, the better able you’ll be to position yourself to maximize the chances of approval. The “4 C’s” play critical roles in how lenders will perceive you as a potential borrower.
Understanding how your credit, capital, collateral, and capacity affect your ability to secure a mortgage will help you figure out how your lender came to the conclusion about either approving or rejecting your mortgage application. In the case of the latter, understanding your 4 C’s might help you identify areas that require improvement in order to increase the odds of mortgage approval in the future.