BY BONNIE NEEL, CANOPY MORTGAGE LLC
Bonnie Neel is a licensed Residential Mortgage Loan Officer in California, Colorado, Georgia, Nevada, New Mexico, and Texas. NMLS# 1613742.
I tell all my first-time homebuyers that a mortgage is essentially made up of four categories. If you play video games, it’s helpful to think of these categories as your player stats: How you “score” within each one of these categories influences everything from your down payment to your interest rate to your monthly payment.
These four categories are called “The Four Cs”: credit, cash, capacity to repay, and collateral. Knowing where you stand in each category (and knowing how to boost one stat or compensate for a potential weakness in another) can make the process of applying for a mortgage loan and buying your first home feel either like an enjoyable Adulting 101 experience or like undergoing dental work without anesthesia.
Credit
Let’s start with credit: TransUnion, Experian, and Equifax are private companies that have proprietary algorithms with disproportionate power over your lives. These companies sell numeric codes that control whether you can get a job, an apartment, a right-swipe on Tinder, or a mortgage loan.
The minimum credit score for a Federal Housing Administration (FHA) or Veterans’ Affairs (VA) mortgage is 580, but extra cash penalties are applied for risk posed by this low credit score.
The next threshold is 620, the minimum score for most conventional loans and most down-payment assistance programs. But, again, some cash penalties can be applied for a score this low.
Generally, 640 and above qualifies for mortgages without a cash penalty; credit scores 740 and above are considered excellent credit scores.
Most Americans have scores between 600 and 699.
Mortgage lenders evaluate your credit scores, the debts listed on your credit report, and the minimum payments on those debts, as well as your payment history. Student loan repayments, even if in deferment or forbearance, are considered active debt and a percentage of their outstanding balance is tallied as part of your overall debt-to-income (DTI) ratio. Mortgage lenders calculate your DTI as the sum of your minimum monthly debt payments plus your proposed monthly mortgage payment. Generally, mortgage lenders want your DTI ratio to be 50 percent or less of your gross monthly income.
Cash
Cash is our second category and covers the down payment and closing costs. The minimum down payment for FHA loans is 3.5 percent, and 5 percent for conventional loans. As a rule of thumb, expect closing costs to run from 1 to 3 percent of the sale price. Thus, if you are looking to buy a $500,000 home, you’ll need to have (at minimum) $40,000, or 8 percent of $500,000, for a down payment and closing costs.
I tend to estimate high on all closing costs and fees because I don’t like surprises, but cash is the one category where homebuyers can negotiate. The only funds that must come out of your pocket (or a verified gift donor like a parent or down-payment assistance program) is the down payment amount. Your real estate agent can negotiate with the seller (or lender) to pay some or all of your closing costs, but 8 percent of your anticipated sale price is a good ballpark estimate for total cash needed to close.
Capacity to Repay
Capacity to repay is where lenders document and verify your employment and income. Essentially, we want to know where you’ve lived, where you’ve worked, and what you’ve made for the last two years and verify that you will make the same amount or more for the next three years.
If you are currently employed as a salaried or hourly employee with steady hours (even with an offer letter and your first paycheck yet to come), this process is fairly simple: We request proof of your gross annual income, divide it by 12, and use your gross monthly income for our DTI calculations. Bonus, overtime, and commission income must have been received for two years to be included.
If you are self-employed, either Schedule C, S-Corp, C-Corp, or a more exotic tax entity, the process is more restrictive and complicated. Our calculations require two years of net taxable income (with some expenses added back in). If you are self-employed and considering buying a home, I highly recommend working with an accountant and a mortgage lender sooner rather than later. Let us buy the drinks and bring all your tax returns for the past two years.
Collateral
Finally, collateral rounds out the “wild card” category in the mortgage process. Collateral is the property that secures the loan itself. Single-family homes are the norm. An experienced real estate agent is worth their weight in gold and can deter you from offering on a house with foundation issues that won’t pass appraisal and thus won’t qualify for financing.
Condos pose an ongoing exciting risk (thanks, Florida) because, unlike a single-family home, you are not purchasing a single structure attached to a single piece of land, but a small piece of a structure that is part of a bigger whole. Thus, the value of that piece is intrinsically tied to how the bigger whole is managed and maintained. Condos must undergo a questionnaire process to determine their “warrantability,” and this questionnaire evaluates the condo regime’s overall financial wellbeing, occupation mix, land use, management, and litigation viability for financing. A condominium’s warrantability status can be the difference between a five-percent down payment and market interest rate loan or a 20-percent down payment and subprime interest rate loan.
The collateral category is known as the “wild card” category in mortgages because it is the one category that cannot be known before the homebuyer begins shopping. My goal is to make sure that my first-time homebuyers have all the surprises of their prospective loans removed by the time they begin their home searches. Once they are entertaining their options, dreaming of paint colors and furniture designs, the only thing they should be worried about is whether the property is good enough for them, not whether the loan will get approved if their offer is accepted.
Buying your first home is both a wise and brave step. Regardless of the Federal Reserve’s interest rates or doom-and-gloom housing headlines, homeownership remains the best and most proven path toward wealth-building in America. The key is to be educated and strategic, with experienced and trustworthy partners in your journey.