Understanding the Basics

Mortgage Basics-The Four C's of Underwriting
Your Loan Request

Many borrowers find the loan process bewildering and confusing. It doesn't help when those of us who are in the business use verbal shorthand and jargon that separates you from understanding what is going on and what your loan product will do for you.

The creation of your loan, and its approval are variations of four basic moving parts. I learned them as the Four C's: Cash, Credit, Capacity, and Collateral. When lenders design programs and
establish the pricing of the loan (interest rate plus loan fees), they are assessing the layers of risk associated with each of these categories.

Let's take a look at each of them.

Cash: The lender wants to know that you have enough money to provide for your down payment for the purchase of the home, that you can pay for your closing costs, and that have some level of cash reserves after the closing. They also want to know the source of those funds, so if money suddenly appears in your accounts just before closing they will be concerned that the new money is also borrowed. If you are refinancing, they will want to see that your closing costs and reserves are covered.

Credit: Until the advent and acceptance of credit scoring, the lender would review the credit report and make an assessment as to the paying habits, the types of credit the borrower had (mortgage, auto loans, credit cards, student loans, finance companies, charge-offs, collections), and whether they were prudent users or abusers of credit. It was a combination of objective and subjective analysis, and was more art than science.

The credit scoring systems now take all of these factors into account in a "black box" analysis and produce a score. Because each of the three credit repositories use proprietary systems, they don't publish exactly how their scores are produced. http://www.myfico.com/ is one site that will allow you to subscribe and do "what if?" scenarios if you are interested in pursuing a program to improve your credit score.

Capacity: This refers to your ability to pay the monthly payments. The two primary areas of interest are employment stability and that your income is sufficient to support the proposed new mortgage debt, taxes and insurance, homeowner's association fees, and all your consumer credit obligations. As a general rule, lenders are looking for continuous employment in the same job or line of work of at least two years. Also, they like to see that the sum of those monthly obligations listed above fit within about 40% of your gross monthly income if you are salaried or a wage-earner.

If you are self-employed or earn commissions the lenders will do their analysis based on your gross income less business expenses. This calculation gives them an idea of what your personal income is, and it puts you on an equal footing with the salaried person and wage-earner.

Collateral: A real estate loan is secured by a piece of property. The lender ultimately wants to have their loan secured so that if you don't make your payments, they have the ability to recover the unpaid balance of the loan through a foreclosure proceeding. This is why the lenders require an appraisal of the home, so that they can feel comfortable that their loan is well-secured. Lending guidelines change and risk assessments differ when the property is owner-occupied or a rental, if it is a detached home, a condominium, or if it is in a planned-unit development.


When you add in the variables of documenting the loan fully with paystubs, W-2 forms and tax returns, or if you are requesting a loan using the "stated income" option, where the lender makes their decision based on the reasonableness of the income presented without verifying it, or if you are pursuing a 'no-doc' loan, where the lender is making their judgment solely on the appraisal and credit history and scores, you can see that there are a myriad of possibilities and categories for a loan request to fit within.

When you are shopping for a mortgage, and the representative gives you a quote without exploring these variables with you, the information you are receiving is meaningless. Know with whom you are working and that they are taking care to provide you with accurate information so that you are not encouraged to begin the process with false expectations and to be presented with the real terms at a later date.