5 Top Reasons for Loan Denial and How to Avoid
The mortgage credit underwriting process is unavoidably complex due to the level of due diligence required in lending large sums of money, and no amount of explanation can fully simplify it. Making things more difficult is that it is a dynamic industry where regulatory mechanisms are continually changing and adding new stipulations and guidelines. However, it is possible to shed some light on the inner workings of the credit decision process. Let us begin with the person responsible for putting on the bank’s stamp of approval, the underwriter.
Underwriters (the credit analyst that ultimately approves or denies your credit request) use a process called “layering” where they assess total risk by summing up individual indicators of creditworthiness. Within this layering process we can identify several key factors that consistently surface as problematic sticking points. Keep in mind that underwriters are human beings that are trying to make a responsible lending decision which will not only be in the best interest of the bank, but also the consumer. Consequently much of the process, though guided by rules and regulations, is subjective and thus open to interpretation.
In the end, we may not like the final decision and adamantly disagree with the underwriter’s interpretation, but as we all now know, even technology which was predicted to rid the industry of human error, “unreliable” subjectivity, and unfair lending practices, is not perfect. The following five factors are provided to help you understand this complex process, help establish realistic expectations and ultimately better prepare you for a more positive experience when it is time to get prequalified.
(1) Making deposits of undocumented funds such as cash on hand or “mattress money” into an account.
Do not deposit any cash you have on hand or from the last garage sale into your primary account unless it is done a good 3 months or more before you apply for a mortgage. Funds that qualify must be “seasoned”. The word “seasoned” refers to funds that have been in an account for at least 60 days. Most loan programs only require 30-60 days worth of bank statements. So as long as the funds were deposited prior to the issuance of the oldest statement in a 60 day period you are ok. There is one caveat however, if you are using the bank statements to prove receipt of income such as alimony, child support or rent being deposited into the account and you are asked to provide 6 to 12 months of statements, the same large deposit rules apply. Any deposit that seems out of the ordinary will need to be satisfactorily explained and documented.
Therefore, if you have a cash intensive business on the side, it may be wise not to co-mingle funds. In other words, maintain a separate account for cash deposits and your every day account where alimony, child support and payroll checks are deposited. That will save you an untold number of headaches later on.
The alternative if you need the funds is to keep documentation of any large deposits. (Bill of sale, title, receipts, etc). However, if you cannot document by an acceptable method, be prepared to delay the application until the deposited funds have met the 60 day minimum seasoning requirement. If that is not possible, be prepared to give detailed explanations on any deposit that seems out of the ordinary in relation to the transaction history but understand, if the underwriter feels the explanation is unacceptable, the loan may come to a rapid halt.
Gifts from family members will have to be documented via form letter that the bank provides called a Gift Letter (A simple letter from mom and dad will not work). The letter is an affidavit that the funds were a gift and not a loan and will not need to be repaid. It is signed by you and the person giving you the gift. You will need to provide a copy of the check, money order or wire transfer for the funds given. The giftor will also need to provide the last 30 day statement to disclose where the funds came from and to show they had the ability to give the gift from seasoned funds and did not have to go out an borrow them.
Gifts or grants from employers will have to be documented with an official employer letter describing the nature of the gift or grant. Funds deposited from a loan are ok as long as the loan can be documented with official loan documents and is secured by an appropriate asset that can be reasonably valued as collateral for the loan. In other words, a $10,000 loan secured by a push-lawnmower will be considered unsecured. Any funds that are not collateralized (secured by an asset of appropriate value) are unacceptable funds for the down payment or other transaction related uses of cash in the mortgage underwriting process (i.e. credit card advances and personal loans are not acceptable).
(2) Managing your credit at the last minute.
The time to manage your credit is not 30 days prior to making an application. If you have been consistently delinquent, owe deficiency balances on repossessions or charged off credit cards, you will have tremendous hurdles trying to obtain a loan. Furthermore, closing or opening new accounts at the last minute is not going to help and may in fact make things worse. Credit has always been of utmost importance and the greatest single factor in the decision making process to approve a mortgage loan, but in the current credit environment, the importance of credit cannot be sufficiently underscored. Today, though the body of credit continues to be scrutinized, the first credit test consists of a very important three digit number, the far reaching impact of the credit score (There are three credit scores, decisions are made on the middle score, not the high nor the low). Scores below 620 and for many loan options below 640, will make it exceedingly difficult to obtain a loan now that the subprime lending market is all but a thing of the past. (Subprime was a loan subsector that catered to consumers with damaged credit that did not meet conventional or government credit guidelines.)
Credit scores started being used commonly as a predictor of risk and a tool for making good lending decisions back in the early 90’s, although they were used to some extent in the 80’s. The heavy use of credit scores coincided with the boom in real estate and the creation of revolutionary credit score dependent underwriting technology by the quasi-government agencies known as the Federal National Mortgage Association (Fannie Mae or FNMA) and the Federal Home Loan Mortgage Corporation (Freddie Mac or FHLMC). These agencies which purchase large blocks of mortgages from commercial banks in order to recycle funds for lending again, securitize the mortgages and sell them in multi-million dollar mortgage backed securities on Wall Street. Back in the early 90’s Fannie Mae developed Desktop Underwriter and Freddie Mac developed Loan Prospector. Both technologies are still used today in practically all residential lending decisions. These technologies were predicted to modernize what was considered an antiquated banking sector, resulting in radical changes to the home buying process. In retrospect, it accomplished both objectives but there were also detrimental non-intended consequences which do not fall within the scope of our discussion but which we see today in the catastrophic breakdown of real estate and mortgage lending.
Now, the credit score models themselves are highly complex statistical models that were created to predict risk. Other than the credit bureaus themselves, no one really knows the interrelationship of factors on the score card, though it is possible to make some educated observations. (The score card being the definitions or algorithms within the statistical model that weigh and process the risk factors in order to compute a credit score). One consistent observation is that opening new accounts at the last minute is futile as lenders normally will require a credit relationship (tradeline) to be opened for at least 12 months. But also the last minute opening of tradelines could be indicative of aggressive pursuit of credit which is a negative risk factor and linked to declining scores. Alternatively, the closing of tradelines can eliminate or substantially reduce the base on which the credit scores are computed and may render your scores as invalid by the lender if the depth of credit appears to be shallow rather than well established. Even paying down debt may not be positive in the overall scheme of things as perhaps the underwriter is not concerned with your capacity to make the payment or the credit, but your reserves depending on the loan program and you have now unnecessarily consumed reserve funds that were a necessary part of the approval.
Foreclosures and bankruptcies (Chapter 7 and 13) in the last 2-5 years will be very difficult to overcome unless you can clearly document a catastrophic, extenuating circumstance and you have been able to redevelop credit for at least two years and have no blemishes on the credit report after the bankruptcy or foreclosure. In building your case, you will want to pinpoint in an explanatory letter the credit problems resulting in the foreclosure or bankruptcy and link to the extenuating circumstance, emphasizing how prior credit was managed well and since then how the credit has remained unblemished. If credit was spotty for years prior to the extenuating circumstance and remained so in the last 12 months, it will be difficult to convince a lender that you know how to effectively manage credit.
Judgments, most liens, charged off credit cards, and deficiency balances on repossessions will almost always have to be satisfied or proved to be in error. Medical collection accounts are the one exception when applying for an FHA loan.
The last 12 months of credit will be the most important factor in determining whether the credit meets Conventional or Government guidelines, but the lender will scrutinize the entire credit and look for patterns of risk throughout the years. In the layering assessment of risk, credit is the most important factor. In fact credit is the only factor for which you cannot truly provide a balancing compensating factor such as additional down payment or a strong co-borrower.
As with most things in life, a balanced and consistent approach is the best advice in developing credit. Develop credit slowly and responsibly. Credit should be a reflection of your accountability, responsibility and financial management skills. Therefore, do not expect to have a stellar credit report and 800 credit scores over night. Patience is truly an important virtue in developing a strong credit history and the kind of credit scores that will open doors in the future.
It is also important to stay on top of your credit profile. You are allowed to order at least one credit report for free (most cases without the credit scores, or for a small fee with credit scores) once a year or any time you have been denied credit. It is important to keep up with your credit because even when you are doing a fine job managing your payments and developing a broad credit file, creditors sometimes make mistakes and report incorrect information on your file. This is especially true for people with very common names like Smith or Jr.’s, where credit information can be incorrectly exchanged. And of course there is the ubiquitous criminal always trying to perpetrate identity theft and access your credit profile. So stay on top of your credit and check at least once a year. If you do not want to be responsible for monitoring, each credit bureau offers different monitoring services for a fee. To find out more, visit each credit bureau at the information below.
For more information on credit scores, see the following links:
(3) A voluntary change in jobs resulting in less income, or from full-time to part-time, or in completely unrelated industries.
Job changes prior to making application or while you are in the middle of the mortgage process can make things more complicated and affect the ultimate credit decision. The key factors that lenders are looking at in employment history is your capacity to repay (vs. willingness to repay which is indicated by your credit profile) and the stability of that capacity based on the frequency of job changes and the trend in earnings potential.
A person that moves from one job to another every six months without any positive growth in income would be considered unstable. A change from being a salaried mechanical engineer to a commissioned real estate agent would also be considered a negative risk factor because nothing in your education or professional background is indicative that you have the talents and skill set to effectively compete in a completely different industry and in a commissioned, production environment.
However, a change that produces higher income in a similar or the same industry is fine. Lateral changes within same industry are ok if there is some logical explanation and are not excessive. Even changes outside the industry are not necessarily a deal breaker. For example, let’s say you were a line worker at a GM manufacturing plant and decided to go work as a forklift operator at Wal-Mart; the actual change from manufacturing to retail does not necessarily cause an issue. The positions are both labor intensive jobs being paid on a hourly basis. The total income earned may be an issue but not the job change itself.
Again, if the job change history is not excessive, makes sense and results in a more positive, income, benefits, expense situation and you are well qualified to compete in the new position, then you should be fine.
Of course, if there is a way to delay the move until you get the mortgage, even if the position is more advantageous, its is recommended that you do so. Think it through and consult with your mortgage professional before making any move.
(4) Failure to document and properly report revenue sources (i.e. rental income and other self-employment income)
This is of course a no-brainer. But every year, countless numbers of well qualified borrowers are denied a mortgage because they cannot document that they are making the type of income which their lifestyle and even bank account support. It use to be that income or even asset documentation was not an issue. Loans such as No Documentation or Stated Income/Asset historically solved the problem of missing, acceptable income and asset documents. However, all these non-standard documentation loan products have been completely and systematically eliminated from the market.
Income and assets must be documented via paystubs, verification of employment, bank statements, tax returns and W2’s (source documents). If your income cannot be substantiated by appropriate source documents, don’t bother putting it on the application, it will not be considered.
(5) Failure to disclose or hide pertinent information.
Borrowers often make the wrong assumption that the bank will limit the credit analysis to information disclosed on the application. Applicant beware, that is not the case, underwriters are not only credit analysts, but highly qualified investigators on the prowl for any indication of fraud. Lenders today have a number of tools and technologies to dig deeper than the information that is disclosed on the application in order to make responsible and prudent credit decisions.
For example if you think that you will get one by on the lender by submitting a professional looking second set of books and tax returns that you keep handy for credit applications, be prepared to explain why it is so different from what you submitted to the IRS. Part of your mortgage disclosures include a one page form known as the IRS 4506 which gives the lender the right to obtain a copy of your most recent returns. It use to be that the 4506 was only used if your loan was part of a quality control audit after the loan closed. Today, more and more lenders use the form at the beginning of the credit process in order to identify fraudulent applications. Think twice before taking the chance to slip by a fraudulent application, it is a federal crime and no house is worth taking that kind of risk.
Another example is “white” money laundering. Huh? Yep you know like “white lies”. You are not involved in any illegal trade, smuggling, nor trying to legitimize your illegal income operations. However, you may have a little cash on hand in the safe deposit box and you know that you cannot just deposit it into your account as explained above so you give it to mom and dad and ask mom and dad to then write you a check for it. Well, that deception is also easily identified by current underwriting guidelines and procedures, and once the little “white lie” is exposed, your integrity is blemished and the validity of your entire loan documentation becomes suspect.
In conclusion, the key to a successful mortgage loan experience is education and transparency. Once you have found an astute mortgage lending professional, be up front and answer all questions accurately. Also ask as many questions as you can, there are no dumb questions. Finally, have the right expectations and understand that a successful experience is not exclusively defined by a loan approval. In the end the loan may be denied, but if that is in your best interest and you started the process educated and with the right and reasonable expectations, then not getting the house will be the right decision for all involved.
- CREDIT REPAIR.GOOD or BAD IDEA?
We have all seen the promises on little yellow signs by the side of the road, in newspapers or on the internet. No matter where you turn, you are bombarded with volumes of propaganda, miracle cures for your…
- Getting Pre-Qualified for a Home Loan
So you have made a New Years resolution to finally become a home owner in 2011. You have saved a little money, done your research on school districts, area attractions, and conveniences. You know what area…
- Developing Credit After a Bankruptcy, Foreclosure or Wide Spread Credit Damage
As many who have gone through the process know, life after bankruptcy and foreclosure is not easy. However, in the current rigid credit environment, there are similar uphill battles in obtaining credit when…