6 Mortgage Underwriting Standards

To determine your request for a mortgage, lenders apply a variety of underwriting guidelines

1. Collateral (property characteristics) – check whether that property meets the criteria (number of units, condition, location, etc) of the lender you intend to use

2. Amount and source of down payment and reserves – lenders like to see their borrowers put at least some of their own cash into their properties at the time they buy them and enough reserve to cover 2 to 3 months of mortgage payments

3. Capacity (monthly income) – monthly income from employment and other sources, as well as the expected NOI of the property you’re financing

4. Credit history (creditability) – good credit expands your possibilities

5. Character and competency – education level, career advancement potential, job stability, dependability, etc

6. Compensating factors – persuade a lender to approve your loan, emphasize your positives and play down or explain away negatives

^McLean, Andrew, & Eldred, Gary W. Investing in Real Estate. 5th ed. New Jersey: John Wiley & Sons, Inc, 2006

Owner-Occupancy Financing

The easiest, safest, and lowest-cost way to borrow nearly all of the money you need to buy a home involves owner-occupied mortgage financing. Many high-LTV owner-occupied loan programs are readily available on single-family homes, condos, townhouses, duplexes, etc that offer 95-100 percent financing.

Owner-occupants pay lower interest rates than investors. To qualify, you must tell the lender that you intend to live in the home for at least one year. For investors, the strategy would involve living in the home for one year, then renting it out, and repeating the process. You could also move into a new property and find a good tenant for your current home.

^McLean, Andrew, & Eldred, Gary W. Investing in Real Estate. 5th ed. New Jersey: John Wiley & Sons, Inc, 2006

High Leverage Financing

Most real estate investors borrow money to help them build wealth. Should you invest with little or no cash or credit? Leverage means that you use a small amount of cash to acquire a property.

With leverage you can increase your return on investment and build wealth faster than if you paid 100 percent cash for your properties. But leverage also increases risk. Highly leveraged acquisitions expose you to greater potential loses.

In theory, the more you borrow and the less cash you invest in a property, the more you increase your cash returns. Besides annual income, your rental properties will appreciate in value over a period of years. When you add returns from annual net rental income and appreciation, high leveraged properties may produce phenomenal annual rates of return.

Managing risks

1. Buy bargain-priced properties
2. Buy properties that you can profitably improve
3. Buy properties with below-market rents that you can raise to market levels within a relatively short period (6-12 months)
4. Buy properties with low-interest financing such as mortgage assumptions, adjustable-rate mortgages, buy downs, or seller financing
5. Buy properties in up-and-coming neighborhoods that are soon to be revitalized
6. When all else fails, to reduce the risk of high leverage to a comfortable level, increase your down payment to achieve a lower loan-to-value ratio and lower monthly mortgage payments.
7. Never expect the value of real estate, stocks, or any other type of investment to increase by 10, 15, 20 percent year after year
8. Beware of negative cash flows
9. Don’t overextend yourself
10. Even when the financing looks good, avoid overpaying for a property because you invite financial trouble

^McLean, Andrew, & Eldred, Gary W. Investing in Real Estate. 5th ed. New Jersey: John Wiley & Sons, Inc, 2006

How Amortized Loans Work

Amortization is a method for repaying a loan in equal installments. Part of each payment goes toward interest due for the period and the remainder is used to reduce the principal (the loan balance). As the balance of the loan is gradually reduced, a progressively larger portion of each payment goes toward reducing principal.

If you borrowed $100,000 from a lender with an agreement that at the end of 30 years you would repay the original loan amount plus 7%, then your total repayment would be $107,000. This is not how mortgage loans work, as mortgages utilize a nominal interest rate (the interest rate per year).

The interest rate of 7.00% per year is compounded 12 times a year, resulting in a monthly rate of 0.58% (dividing 7.00% by 12).

To calculate the interest due for a given month, the monthly rate is multiplied by the current loan balance. If you borrowed $100,000 at 7%, at the end of the first month your interest due would be $583.33 ($100,000 x (0.07 / 12)).

Monthly Payment Calculation

LB(0) = Original loan balance (the $100,000.00 you borrowed)
ID(1) = Interest due at the end of the first payment period
I = Effective interest rate per payment period (0.07 / 12)
ID(1) = LB(0) * i

PP(1) = Principal part of the first monthly payment (the part that goes toward the loan balance)
PMT = Monthly payment
PP(1) = PMT - ID(1)

LB(1) = Loan balance after the first payment
LB(1) = LB(0) - PP(1)
LB(1) = LB(0) - (PMT - ID(1))
LB(1) = LB(0) - (PMT - LB(0) * i)
LB(1) = LB(0)*(1 + i) - PMT

LB(2) = Loan balance after the second payment
LB(2) = LB(1)*(1 + i) - PMT
LB(2) = (LB(0)*(1 + i) - PMT)*(1 + i) - PMT
LB(2) = LB(0)*(1 + i)^2 - PMT*((1 + i) + 1)

LB(3) = Loan balance after the third payment
LB(3) = LB(0)*(1 + i)^3 - PMT*((1 + i)^2 + (1 + i) + 1)

LB(n) = Loan balance after n payments
LB(n) = LB(0)*(1 + i)^n - PMT*((1 + i)^(n-1) + ... + (1 + i) + 1)

The sum of the finite series: 1 + a + (a^2) + (a^3) + ... + (a^n) is (1-a^(n+1))/(1-a)

Now, with a simple re-arrangement, our equation for loan balance after n payments becomes

LB(n) = LB(0)*(1 + i)^n - PMT*(1-(1 + i)^n)/(1-(1 + i))
LB(n) = LB(0)*(1 + i)^n - PMT*((1 + i)^n-1)/i

LB(0) = Loan balance after 360 payments which is $0.00
LB(0)*(1 + i)^360 = PMT*((1 + i)^360-1)/i

PMT = i * LB(0)*(1 + i)^360 / ((1 + i)^360-1)
PMT = (0.07/12) * 100000*(1 + 0.07/12)^360 / ((1 + 0.07/12)^360-1) = 665.30

The first 9 months of an amortization schedule for a $100,000, 30 year, 7%, fixed-rate mortgage will look like this: