The Basis of Sound Underwriting

As the largest purchaser of mortgages in the secondary market, FNMA sets the standards for the industry. We are now going to review what is needed for a mortgage to be underwritten to FNMA standards. Having a working understanding of FNMA requirements will provide you with a foundation to understand the guidelines of all secondary market purchasers.

Everything about our industry is constantly evolving. Underwriting guidelines are no exception. What was considered standard practice yesterday could easily change by tomorrow and it is vitally important that you stay on top of these changes. As much as we try to keep this course current, there are times that you will be working with revised guidelines that we haven’t yet incorporated into this course. Information supplied to you from your underwriter should supercede what we’re providing as underwriting will have the most up to date guidelines.

The applicant must be a “natural person”. It can’t be a legal entity such as a corporation, general partnership, limited partnership or real estate syndication. This doesn’t mean that a corporation can’t finance property; it simply means that it doesn’t meet FNMA guidelines and would need to be sold to a different investor. In most instances this would be a commercial mortgage and underwritten as such.

The borrower should be at the age in which the mortgage note can legally be enforced in the jurisdiction in which the property is located. There is no maximum borrower age limit. The borrower needs to be a U.S. citizen or an alien who is a lawful permanent resident of the United States. Permanent resident aliens must either have a valid “green card” or an unexpired foreign passport stamped “Processed for Temporary Evidence of Lawful Admission for Permanent Residence.”

Underwriting is addressing the “4 Cs” of the applicant.

·    Capacity – Does the borrower have the income flow necessary to meet the financial obligation of owning a home and the necessary liquid assets to make the purchase?

·    Credit – Does the applicant show a willingness to live up to his obligations to pay back money that he borrows?

·    Character – Does the applicant demonstrate stability in work history and fiscal responsibility?

·    Collateral – Does the subject property have a market value that is substantial enough to ensure the lender that they can recover their investment in the event the borrower defaults?

Determining the market value of the subject property is done via an appraisal. The appraiser will inspect the property, the neighborhood and research closed sales history of the community.  They will then write a summary report that will support his conclusion of value.

Appraisals (Collateral)

An appraiser will address 3 different approaches to support his conclusion of market value; the cost approach, the income approach and the sales comparison approach. The details of the transaction will dictate which approach will carry the most weight. For example, a purchase of an investment property would have the income approach carrying the most weight whereas a property that is being purchased by a buyer looking to use it as his primary residence would have the sales comparison approach as the main focus.

The Cost Approach – An approach to determine a property’s market value based on the current cost of constructing a home from materials as similar as possible to those used for the property being appraised.

The Income Approach – An approach to determine a property’s market value based on the assumption that the market value of a property is related to the income one can expect to earn from that property.

The Sales Comparison Approach – The approach appraisers most commonly use to determine the market value of single-family residential properties, based on the assumption that a home buyer will not pay more for a property than it would cost to buy a comparable property in the same neighborhood or in a similar neighborhood.

All 3 approaches are used in the report and then the appraiser will note in his comments to which approach he gave the most weight. The appraiser begins his report with the specifics of the subject property and its neighborhood. Here he will identify the legal description of the property, the type of property, property taxes and a detailed description of the neighborhood. It’s here where it is noted if the subject property is a typical property type for the neighborhood and the overall trend of market values. Are we looking at a one-family home located in a predominately commercial area or a home in a predominately residential neighborhood? Are market values trending up, down or staying flat? Is the area changing, that is, is it an area that has historically been commercial and is redeveloping into a residential neighborhood? What is the range of prices in the community and where in the range does the subject fall? These are the types of issues that are addressed in the beginning of the report.

After completing this section of the report, he will now begin the cost approach. An appraiser should give this approach the most weight if he has reason to assume that a homebuyer would consider building a new residence of the same type, and for the same use, as the subject property. Data used for the cost approach should be based on the cost of building a home constructed from material as similar as possible to the property being appraised.

Next, the appraiser will present the data used and the conclusion drawn through the sales comparison approach. This approach is the most commonly used to determine the market value of single-family residential properties. This approach is based on the assumption that a homebuyer will not pay more for a property than it would cost to buy a similar property in the same or similar neighborhood. The data is assembled in a spreadsheet or grid format to make it easy to follow.

He begins by listing all the attributes of the subject property: Lot size, living space, number of rooms, bedrooms, baths, garage etc. Every important detail is listed. He will then list a least 3 different properties that are physically located as close to the subject as possible and with similar amenities. He will then make dollar value adjustments for each amenity to make the comparable sale become, on paper at least, the subject property.

For example, if the subject property has 2 bedrooms and the comparable sale has 3 it is reasonable to assume that the comparable is worth more than the subject property. A dollar value is assigned that is subtracted for the comparable’s sale price to adjust it to the subject’s feature. The subject property has a garage and the comparable sale doesn’t. A dollar value is now added to the comparables sales prices to reflect its potential value if it had a garage. These adjustments are done feature by feature and then they are all added up for each of the comparables chosen. From these adjusted sales prices a conclusion is drawn as to the market value of the subject property.

A good appraisal report will have small adjustments across each feature. Each line adjustment shouldn’t exceed 10% and the net adjustment shouldn’t exceed 15%.  After all, the comparable sales were chosen in the first place because they were similar to the subject property. Any large adjustments should be addressed in the appraiser’s notes on the report. Maybe the subject property has some unique features that make the adjustments difficult. Maybe there haven’t been many recent sales in the neighborhood limiting the number of sales to work with. There can be any number of reasons for an appraiser to be forced to use less than perfect comparables. Seeing a large adjustment is a red flag, but not necessarily a reason to claim that the appraisal is inaccurate.

The appraiser will then do the income approach. Now instead of comparing the different physical attributes of the subject property to the comparable sales, he is comparing the cash flow of other similar investment properties to the subject.

The appraiser will now come to his opinion as to the market value of the subject property. His estimated value is his expert opinion, not a scientific calculation. It is important that you never lose sight of this fact. Two appraisers can come to 2 different market values on a property and both be right.

Credit & Character

Determining the applicant’s creditworthiness is straightforward if there is enough data reported to the credit agencies to generate a credit score. If the data is accurate, then the score is valid. From there it is simply a matter of matching the products available to the qualifying score. If there are any inaccuracies on the report then we need to work with the applicant in getting the errors corrected and then request an updated report reflecting the revisions.

The work gets more involved when there isn’t sufficient information available to generate a credit score. We then need to develop a non-traditional credit report. Just because an individual has limited data in their credit file, doesn’t make them a bad credit risk. It just means that they are not a user of credit. The applicant does have monthly expenses and has a payment history with those bills. All we need to do is to prove it. The applicant probably pays rent. We’ll need copies of 12 months cancelled rent checks. If they pay their own utilities we’ll need 12 months cancelled checks or a printout from the utility companies. Cable bills, telephone, cell phone and car insurance payments are other possible avenues with which to work. Time consuming, yes but it has to be done.

Assets (Capacity)

Verifying the liquid assets of an applicant means collecting bank and brokerage statements. A 2 month history of assets is needed. Remember that they need to provide all pages of each month’s statements. Any large deposits or withdrawals will need to be explained and documented.

If the sale of a home is being used, then a copy of the HUD-1 from the sale will need to be produced. The HUD-1 is the last document that is signed at the closing. It summarizes all the money that has changed hands at the closing and is signed by the seller, buyer and the lender. This will prove what the net proceeds of sale was and that any outstanding mortgages were also paid off at that time.

If there is gift money involved, then a gift letter will need to be signed by the donor. The donor will need to show he has the ability to give the money and the transfer of the gift into the applicant’s account will need to be documented.

Income (Capacity & Character)

The final piece of the puzzle is to confirm that the applicant has sufficient income to support the new housing expense. There are numerous ways that an individual receives income and the necessary documentation will vary depending on the source of the income. We are going to go through all the major sources of income and the required documentation needed.

Salaried Income – This is the most common form of income. If the applicant is paid through computerized pay stubs, he will need to provide 1 month of pay stubs. Things we look for when review pay stubs:

·    Overtime – Overtime needs to be proven to be regular. A  2-year history needs to be documented and then averaged.

·    Bonus – Bonuses are usually paid in the beginning of the year for the previous year. For example, a bonus earned in 2006 was probably paid in January 2007. This will skew the year to date income figure on the pay stub and needs to be adjusted for. Bonuses, just as with overtime, need to regular and averaged for the previous 2 years.

·    Commissions – If they are not segregated on the pay stub we will need to adjust the year to date figure to separate base pay from commission income. Just as with overtime and bonus income we will need to prove it is regular and average it for the last 2 years.

·    Deductions – Besides the normal withholding taxes there may be contributions to a 401K, not an issue, but all payments on a 401K or pension loan are debt that must be addressed in the ratio. There may be coding for a deduction that will require an explanation of exactly what it is. Many companies have a coding system that is unique to them. 

It is not uncommon for people to deduct employee business expenses, especially when dealing with individuals with commission income. These expenses are shown on their Federal Tax return (The 1040) form 2106. The total expense listed needs to be subtracted from the income used for qualifying. Why? The applicant is paying for job related expenses in order to receive his income. He needs to pay that expense first before he has any income. It is possible that the employee has an expense account with his employer that covers all, or a part of these expenses. The money paid to the applicant for expenses may or may not appear on the pay stub. We will need to find that out and document it.

Nontaxable Income – Income sources such as interest on tax-exempt bonds, child support, disability, retirement, social security and workers’ compensation can be used to qualify for a mortgage. We need however, to document that the income flow will continue for the next 3 years. We are also able to “gross up” this income, meaning, you can use the equivalent taxable income amount in the income used for qualifying.

Military Income – Military personnel may be entitled to various types of income in addition to their base pay. Examples include flight or hazard pay, rations, allowances for clothing and quarters, or proficiency pay. We will need to document its history and establish that it’s ongoing.

Part-time Income – Part-time or second-job income will be considered if it can be documented that it has been earned for the last 2 years and is likely to continue. Seasonal part-time income may qualify as uninterrupted income. For example, if a borrower has worked for the same recreational facility for the past 3 summers and expects to be rehired for the next season, it may consider as uninterrupted income.

Retirement Income – To verify this income an award letter from the organization providing the income needs to be provided. This will show the amount of income and when it started. We  also need to show receipt of the money. If it’s paid by check, there will be stubs available. If it’s direct deposit, then the bank statement posting the deposit will serve as proof.

Social Security Income – This requires the same proof as retirement income, an award letter and proof of receipt. Any tax-free component can be grossed up.

Maintenance or Child Support – In order for maintenance (also called alimony) or child support to be considered, it must be documented that it will continue for at least 3 years. A copy of the divorce decree or the separation agreement will be the required proof. We will also need to prove that the payments are actually being made through cancelled checks or court documents.

Foster Care Income – Foster care income that an applicant receives from a state or county sponsored organization in return for providing temporary care to one or more children may be counted as stable income for underwriting purposes. The applicant will need to prove that he has been providing this care under a recognized program for at least 2 years and that this income is likely to continue.

Income from Notes Receivable – A copy of the note and prove that the payments are actually being made will need to be provided. The remaining term of the note must be for at least 3 years.

Income from Interest & Dividends – Proof must be provided that the income has been received for the last 2 years and is likely to continue. The tax returns for the last 2 years will confirm the history. The income used from these sources will need to be reduced to reflect money used to close on the purchase.

Mortgage Differential Payments – Sometimes as part of a relocation benefits package, an employer will subsidize a borrower’s mortgage payments by paying all or part of the difference between the borrower’s present mortgage payment and proposed payments for the borrower’s new home. This typically occurs when a borrower is being relocated to an area with higher housing costs. This compensation is considered as part of the applicant’s gross monthly income, not as a credit to his new mortgage payment. The employer will need to confirm this arrangement in writing and the payments will need to run for at least 3 years.

Income from Trusts – To use this income we need a copy of the trust to confirm the amount of money being distributed each year and that the distribution is to continue for at least 3 more years.

Veterans’ Administration Benefits – A copy of the award letter showing the amount of money being received, that it will continue for at least 3 years and is not for educational purposes is needed. Educational benefits must be used only to pay for education.

Rental Income – Rental income from other properties is documented through the Schedule E of the tax return. Current leases can be used to show any increase in rent payments from the time the taxes were filed. Remember, the deduction for depreciation is added back in when calculating the net rental income for qualifying purposes. Depreciation is a paper loss, not an actual operating expense so it should be added back in. If there isn’t enough history of ownership of the property to determine the operating expenses then 25% of the rental income can be used to approximate the expenses. Boarder income cannot be used as additional income.

Automobile and Expense Account Allowances – Expense reimbursements that are in excess of what is listed on form 2106 can be used as additional income. A 2 year average is used. If however expenses exceed what is being reimbursed, then that amount needs to be deducted from the income figure used.

Unemployment Benefits – In dealing with seasonal employees, it is common for them to receive unemployment benefits during their off season. If the tax returns support this over the last 2 years then the unemployment benefits can be used in the gross monthly income calculation.

The Self-Employed Borrower

An applicant is considered self-employed if:

·    He files a Schedule C with his federal tax return, or

·    Owns 25% or more of the stock in a corporation, or

·    Own s 25% or more of the stock in an S-corporation, or

·    Is a 25% or greater owner in a partnership

An individual working as a consultant, freelancer or independent contractor is considered a sole proprietor. Companies that he works with typically don’t withhold income taxes and social security and issue him a 1099 instead of a W-2. An independent contractor may be paid on some projects on a W-2 but in most cases it will be on a 1099. His income is documented on the Schedule C of his federal tax return. This form of business entity has advantages and disadvantages. Its advantage is in its simplicity. Business income and the business expenses are listed on the Schedule C and the profits are then taxed based on the individual’s personal income tax rate. The main disadvantage is that there is no separation from the individual to the business. The individual has unlimited personal liability for business debts and losses. The business does not have its own tax id number; the individual’s social security number is the only identification for the business. To calculate the income here the last 2 years of the borrower’s federal tax returns and a year-to-date profit and loss statement is required.

From the simplest form of business we move to the most complicated, the corporation. The corporation (more specifically a C-corporation) has its own identity. It has its own tax id number. The owners’ (the stockholders) liability is limited to the investment they have made in the corporation. The corporation files its own tax return, an 1120, and pays its own taxes. The advantages here are limited liability to the stockholders and there is no limit to the number of stockholders a corporation can have. The disadvantage here is the issue of double taxation. The owners can take their income from the corporation in the form of salary or dividends. The salary is a corporation business expense and the owner simply treats this income the same way as any other salary he receives. The remaining profits of the corporation are taxed at the corporate tax rate. If the corporation pays out a dividend to its stockholders, that income is again taxed at the individual’s level as dividend income. Thus the term double taxation. In order to calculate the income here, we will not only need 2 years personal tax returns, and a year-to-date profit and loss on the corporation will also need 2 years of the 1120s.

An S-Corporation is a simplified version of the C-corporation. An S-corporation has all the liability protections of the C-corporation but without the double taxation problem. All profits of the corporations are taxed at the owner’s income tax rate. The corporation issues a K-1, which reflects the profit that each owner earned and that becomes an attachment to each owner’s personal tax return. The disadvantage here is that the S-corporation is limited to no more than 75 shareholders. This limits the ability of the corporation to raise additional capital by bringing in more shareholders. The same supporting documents here as with the C-corporation needs to be provided. The only difference here is that the S-corporation files an 1120S instead of the 1120 and a copy of the K-1 is also needed.

A partnership has its own id number and files a 1065 to show its business activity. It pays no taxes; all income is passed through to the partners, who then show it on their personal returns and pay taxes at their individual rate. Partnerships can be made up of General Partners and Limited Partners. The General Partners make the business decisions for the partnership. They are all personally liable for the partnership’s debts and losses. Limited Partners do not have any say in how the partnership conducts business. Their liability is limited to the cash they have invested in the partnership. The supporting documentation here is exactly the same as with the S-corporation except the 1065s instead of the 1120Ss are provided.

The newest form of business entity is the Limited Liability Company (LLC). In 1998, LLCs were authorized by the IRS for pass-through-status, meaning it authorizes them to pass on their profits directly to the owners just as in an S-corporation. Each state has different laws governing LLC. The advantages of this form of business it that it functions exactly like an S-corporation but without the 75-stockholder limitation. The disadvantage is that since an LLC is not a corporation, it does not issue stock. This makes partial transfers of ownership more complicated.

When working with self-employed applicants you need to be aware of the following issues:

·    The default rate on self-employed borrowers run 25% higher than salaried employees. This requires more stringent underwriting.

·    The underwriter will need to focus on earning trends and sources of income instead of simply the total amount of income.

·    Underwriting will be looking for stable, predictable and recurring income.

·    An accountant, based on numbers provided by the business itself, prepared the supporting documents that the underwriter is working with. There is no third party verification as in the case of a salaried borrower.

·    The accountant’s job is to present the business in such a way that minimizes its taxable liability. The underwriter is looking at the same paperwork in an attempt to find the real cash flow that will secure the mortgage payments.