What Do Loan Qualification Standards Accomplish?

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If you don't know the answer to this, don't be embarrassed. Lots of alleged professionals forgot the answers to these questions for several years, if indeed, they ever knew. It seems like quite a few still don't know the answer

Loan qualification standards measure whether or not you can afford a loan. By adhering to them, the lenders both lower the default rates and have some assurance the loans they make will be repaid, while borrowers avoid getting into situations where foreclosure is all but certain. Lest you misunderstand, this is a good thing for both the lenders and the borrowers. It isn't like the lenders want to stand there like the Black Knight shouting "None Shall Pass!" They want to loan money - that's how they make profit. But unless you live in a cave, you may have heard of some problems with defaulted home loans of late. You may have heard they're a major problem for both the lenders and the borrowers. Guess what? They are.

From the lender's standpoint, of course, the important thing is that they prevent loaning money to people who can't afford to repay the loan, but the other isn't a trivial concern. Even if they get every penny back when they foreclose, foreclosures are still bad business, with negative impacts on cash available to lend, regulatory scrutiny, and not least important, business reputation.

Going through foreclosure is no fun from a borrower standpoint either. I don't think I have ever seen or even heard of a situation where somebody ended up better off from having gone through foreclosure than they would have been if the lender had just denied the loan in the first place. So whether you like it or not, the lenders are doing you a favor to decline your loan when you're not qualified.

There are many loan qualification standards, but the two most important ones are debt to income ratio, often abbreviated DTI, and loan to value ratio, often abbreviated LTV. The first of these is much more important than the second, but both are part of every single loan.

Debt to Income ratio is a measurement of how well your monthly income covers your monthly payments. It is measured in the form of a percentage of your gross monthly pay, averaged over about the last two years. The permissible number can change somewhat depending upon credit score in some situations, and with enough in the way of assets in others, but the basic idea is you can afford to be paying out 43 to 45 percent of your monthly income in the form of fixed expenses - housing and consumer debt service. You can cancel cable or broadband internet, you can cancel your movie club or book of the month - but the items debt to income are concerned with are essentially fixed by your situation. You owe $X on student loans, and you're required to repay so many dollars per month. Your mortgage payment is this, your pro-rated property taxes are that, your homeowners insurance and car payments and credit cars are these others. There's no possibility of this money suddenly disappearing - you already owe it, and you are obligated to repay on thus and such a schedule.

Loan to value ratio is not a measure of whether you can afford the loan. It is a measurement of how likely the lender is to get its money back if you do default. With appraisal fraud and similar problems, it's not any kind of a magic bullet - but it is the best they have. When values are rising quickly and holding onto a property for six months generates a 10% profit, it shouldn't surprise anyone that the lenders are willing to take more risks with loan to value ratio than they are in the reverse situation. Many properties have lost value and even if the borrowers had kept up the payments before default, they would still owe more than the property is worth.

Lenders aren't going to refinance on good terms if you're "upside down" or even close to it. But being upside down is not a big problem so long as you have a sustainable loan situation and can afford your payments. You keep making those payments, eventually you are going to have equity again. You try to get another loan after default and foreclosure, and you'll find out in a hurry that lenders are not forgiving. Kind of like the Wild Bunch in a way - mess with one, you mess with them all. Lots of folks are thinking that the smart thing to do is walk away when you're upside down. Even if they do have a non-recourse loan, they're going to find out soon enough that wasn't so smart. Making the payments on a sustainable loan lowers the balance, and values are going to come back - sooner than a lot of people think. Put the two together, and as long as you can hold out until you have equity again, you're better off making those payments.

These standards do, and always have, arisen out of "cut and try". Experience really is the best teacher - unfortunately getting that experience has a habit of being kind of rough. Experience may also be what you get when you didn't get what you wanted - in this case, a satisfactorily paid loan - but the lenders have regulators after them, and those regulators are sensitive to political pressures, and sometimes regulators won't let lenders do something they really do want to do - like loan money with a level of qualifications regulators look askance at - because if the lender makes enough bad loans, even if they survive financially, the regulators may decide they're doing something they shouldn't, and shut the lender down for predatory lending practices. It takes a long time and a lot of evidence to persuade lenders and regulators to relax standards, while a comparatively few bad experiences will have them toughening standards. Over-tightening lending standards has major bad effects upon everyone, including causing foreclosures that would not otherwise have happened, but it's hard to point to any specific victims and there's always idiots with a political axe to grind who will claim the people hurt by over-tightening standards were themselves victims of predatory practice. Right now, both lenders and regulators have been royally burned, and so they don't want to assume any risks they can avoid. This will likely change within a couple years, but for now, that's the way it is. You can learn what you need in order to qualify and get your loan approved, or you can go without. Right now, most lenders are too paranoid to care that having their standards too tight means they lose profit, because they've been burned too much, and the money they have in their accounts is not at risk from having made bad loans. When they make between six and eight percent per year on a successful loan, out of which they have to pay taxes, employee wages, facilities costs and everything else, a one in 100 chance of losing the entire investment to a bad loan is unacceptable, and although the default rates on newer loans is practically zero, they're still working through the bad stuff made during the Era of Make Believe Loans.

Caveat Emptor

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About this Entry

This page contains a single entry by Dan Melson published on April 27, 2013 7:00 AM.

FSBO Horror and Failure to Disclose Property Defects was the previous entry in this blog.

Investing in Second Trust Deeds is the next entry in this blog.

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