The 4 C’s are the four factors underwriters look at to determine whether or not you qualify for a loan.
Understand How A Mortgage Application Gets Reviewed and Qualified
So you’ve finally decided to take the plunge and buy a new house. Ever wondered what goes on behind the scenes and what the questions, qualifications and factors are that make the difference between an approval and denial?
Given that our mission is to supply the community with tools and education and to enable everyone to be an informed, educated, and empowered consumer, here we will give an overview of how an underwriter analyzes an application (AKA the person who decides on the outcome of your application).
“The 4 C’s of Underwriting”- Credit, Capacity, Collateral and Capital. Guidelines and risk tolerances change, but the core criteria do not.
Credit… the dreaded word! The truth is, the number behind your credit score doesn’t need to be such a mystery.
Credit refers to the prediction of a borrower’s repayment based on the analysis of their past credit repayment. To determine an applicant’s credit score, lenders will use the middle of the three credit scores reported by the three credit bureaus (Transunion, Equifax, & Experian).
By reviewing one’s financial factors, such as payment history, total debt compared to total available debt, the types of debt (revolving credit vs. installment debt outstanding), a credit score is given each borrower which reflects the probability of well managed and repaid debt. A higher score tells a lender that there is a lower risk, which results in a better rate and term for the borrower. The lender will look to run credit early on, to see what challenges may (or may not) present themselves.
In addition to reviewing an applicant’s credit, lenders want to analyze their ability to repay the mortgage over time. Capacity is the analysis of comparing a borrower’s income to their debt. The primary tool they use for this analysis is a debt-to-income ratio. Simply put, the debt-to-income ratio is the sum of all monthly payment obligations an applicant has (including the potential upcoming housing payment) divided by their gross monthly income.
However, keep in mind every application is different. Consult a Mortgage Advisor to determine how the underwriter will calculate your numbers.
Collateral refers to the security of your loan in case of any issue that may arise that prevents repayments.
This is usually done through the appraisal of your home. An appraisal considers many factors – sales of comparable homes, location of the home, size of the home, condition of the home, cost to rebuild the home, and even rental income options. Obviously, the lender does not want to foreclose (they aren’t in the real estate business!) but they do need to have something to secure the loan, in case the payments stops (also known as default).
Capital is a review of your finances after you close. There are two separate parts here – cash in the deal and cash in reserves.
Cash in reserves: Important considerations for a lender are: Does an applicant have a financial cushion to fall back on if their income is unexpectedly interrupted for a period of time? Has the applicant shown a pattern and habit of saving money over time? Do they have capital accounts with liquid assets that a borrower could access if need be?
Cash in the deal: Simply put, the more of your own money involved, the stronger the loan application. At the same time, the more money you have after closing, the less likely you are to default. Two prospective borrowers that each have the same income and credit scores have different risk levels if one has $100,000 after closing and the other has $100. Makes sense, doesn’t it?
Each of the 4 C’s are important, but it’s really the combination of them that is key. Strong income ratios and a large down payment can balance out some credit issues. Similarly, strong credit histories help higher ratios and good credit and income can overcome lesser down payments. Talk openly and freely with your Mortgage Advisor. They are on your side, advocating for you and looking to structure your loan as favorably as possible!