Qualification and Underwriting

Underwriting is the process of evaluating a borrower's creditworthiness and the property's value to determine whether to approve a mortgage loan. Understanding underwriting criteria is essential for MLOs to properly qualify borrowers and set realistic expectations.

The Four Cs of Underwriting

Underwriters evaluate four key factors when reviewing a loan application:

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Borrower Analysis

Assets

Assets represent what the borrower owns and can use for the down payment, closing costs, and reserves.

Acceptable Asset Sources:

Asset Verification Requirements:

• All funds must have a documented paper trail
• Large deposits (exceeding 50% of monthly income) require explanation and documentation
• Gift funds must be documented with a gift letter stating no repayment required
• Seasoned funds (in account for 60+ days) are preferred

Liabilities

Liabilities are debts that reduce the borrower's ability to repay the mortgage. Underwriters count recurring monthly obligations.

Debts Counted in DTI:

Debts NOT Typically Counted:

• Utilities (unless in collections)
• Cell phone bills
• Insurance premiums (unless part of PITI)
• Debts paid off before closing (with documentation)

Income

Income is the borrower's ability to generate funds to repay the loan. Different income types require different documentation and calculation methods.

Types of Income:

Income Stability Requirements:

• Most income sources require a 2-year history
• Income must be likely to continue for at least 3 years
• Declining income trends may require explanation
• Gap in employment must be explained with documentation

Credit

Credit evaluation examines the borrower's history of repaying debts.

Credit Score Factors (FICO Model):

Credit Score Requirements:

Credit Issues and Waiting Periods:

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DTI Ratios

Debt-to-Income (DTI) ratios measure what percentage of a borrower's gross monthly income goes toward debt payments.

Front-End Ratio (Housing Ratio)

The front-end ratio compares the proposed housing payment (PITI) to gross monthly income.

Formula:

Front-End DTI = Monthly Housing Payment / Gross Monthly Income x 100

Housing Payment (PITI) Includes:

• Principal
• Interest
• Taxes (property taxes)
• Insurance (homeowner's insurance)
• Plus: HOA dues, PMI/MIP if applicable

Front-End DTI Limits:

Back-End Ratio (Total DTI)

The back-end ratio compares all monthly debt payments to gross monthly income.

Formula:

Back-End DTI = (Housing Payment + All Other Debts) / Gross Monthly Income x 100

Back-End DTI Limits:

DTI Calculation Example

Borrower Information:

• Gross monthly income: $8,000
• Proposed mortgage payment (PITI): $1,800
• Car payment: $450
• Student loan: $200
• Credit card minimum: $150

Step 1: Calculate Front-End DTI

Front-End DTI = \$1,800 / \$8,000 x 100 = 22.5%

Step 2: Calculate Total Monthly Debt

Total Debt = \$1,800 + \$450 + \$200 + \$150 = \$2,600

Step 3: Calculate Back-End DTI

Back-End DTI = \$2,600 / \$8,000 x 100 = 32.5%

Result: This borrower has a 22.5% front-end DTI and 32.5% back-end DTI, which would qualify for most conventional and FHA loans.

Maximum Loan Calculation Example

Given:

• Gross monthly income: $6,000
• Maximum back-end DTI: 43%
• Other monthly debts: $500
• Interest rate: 7%
• 30-year term

Step 1: Calculate Maximum Total Debt Payment

Maximum Total Debt = \$6,000 x 0.43 = \$2,580/month

Step 2: Calculate Maximum Housing Payment

Maximum Housing = \$2,580 - \$500 = \$2,080/month

Step 3: Subtract Estimated Taxes and Insurance

Assume \$400/month for taxes and insurance
Maximum P&I = \$2,080 - \$400 = \$1,680/month

Step 4: Calculate Maximum Loan Amount

Using the mortgage payment formula at 7% for 30 years (factor: 6.65 per $1,000):

Maximum Loan = \$1,680 / 6.65 x \$1,000 = approximately \$252,632

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Ability-to-Repay (ATR) Rule

The Ability-to-Repay (ATR) rule, enacted under Dodd-Frank and Regulation Z, requires lenders to make a reasonable, good-faith determination that a borrower can repay the mortgage.

What ATR Requires

Lenders must:

• Verify borrower information (not just stated income)
• Document the verification process
• Consider all eight required factors
• Retain records for 3 years after closing

The 8 Underwriting Factors

Under ATR, lenders must consider and verify these eight factors:

Fully Indexed Rate for ARMs

For adjustable-rate mortgages (ARMs), lenders must qualify the borrower using the fully indexed rate, not the initial teaser rate.

Fully Indexed Rate = Index + Margin

Example:

• Initial rate: 5.00% (teaser rate for first 5 years)
• Index (SOFR): 3.50%
• Margin: 2.75%
• Fully indexed rate: 3.50% + 2.75% = 6.25%

The borrower must qualify at 6.25%, even if the initial payment is based on 5.00%.

ATR Violations

If a lender fails to comply with ATR:

• Borrower can sue within 3 years of violation
• Borrower can raise as defense to foreclosure (no time limit)
• Damages can include all finance charges and fees paid
• Enhanced damages for certain violations

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Qualified Mortgage (QM) Standards

A Qualified Mortgage (QM) is a loan that meets specific criteria designed to ensure borrowers can repay. QM status provides legal protection for lenders.

QM Safe Harbor

A QM provides a safe harbor or rebuttable presumption of ATR compliance:

Safe harbor applies to QMs that are not higher-priced (APR within 1.5% of APOR for first-lien loans).

QM Requirements

Points and Fees Limits:

Prohibited Features in QM Loans:

• No negative amortization (principal cannot increase)
• No interest-only payments (generally)
• No balloon payments (with limited exceptions for small creditors)
• Loan term cannot exceed 30 years

General QM vs. Temporary QM

General QM (Post-2021 Rule):

• Uses price-based approach (APR vs. APOR)
• No fixed DTI limit (replaced with pricing threshold)
• Must meet all other QM requirements
• Safe harbor if APR within 1.5% of APOR (first lien)

Temporary QM (Expired):

• GSE Patch allowed loans eligible for Fannie/Freddie purchase
• DTI could exceed 43% if GSE-eligible
• Expired in October 2022

QM DTI and APOR Safe Harbor

Under the current General QM rule:

Note: While there's no fixed 43% DTI cap under the current rule, many lenders still use 43% as a guideline, and manual underwriting guidelines often reference this threshold.

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Compensating Factors

When borrowers don't meet standard guidelines, compensating factors may allow approval at higher DTI ratios or with credit issues.

Common Compensating Factors

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Exam Tips for Qualification and Underwriting

For the SAFE MLO Test, remember:

• Four Cs: Capacity, Capital, Collateral, Credit
• Front-end DTI: Housing payment only (PITI) - typically 28% conventional, 31% FHA
• Back-end DTI: All debts - typically 36% conventional, 43% FHA/QM guideline
• ATR requires 8 factors to be considered and verified
• Fully indexed rate (index + margin) must be used for ARM qualification
• QM provides safe harbor for ATR compliance
• QM prohibits: Negative amortization, interest-only, balloon (generally), terms over 30 years
• Points and fees cap: 3% for loans ≥ $100,000
• Credit scores: Conventional 620+, FHA 580+ (3.5% down) or 500-579 (10% down)
• Income verification typically requires 2-year history

Loan Program Qualification Guidelines