PreApproval Underwriting Guidelines

There are 4 main factors that are used today by underwriters to determine a mortgage approval. These factors help a mortgage underwriter understand the borrower’s qualification. These factors determine if a borrower can receive a preapproval, prequalification, and meet necessary underwriting guidelines.

The first factor known to the American population is called the ‘credit’ criteria. Credit scores can help determine the risk level for interest rates, and private mortgage insurance (PMI). Credit scores over 720+ will help to receive the best interest rates, and credit scores of 620+ will help to avoid high PMI payments. FHA mortgage loans have no score requirement, but look towards the ‘credit worthiness’. Credit worthiness consists of how long the credit tradelines have been open, the quantity of credit tradelines, bankruptcies, foreclosures, judgments, and mortgage lates. A lot of borrowers are obtaining 700+ credit scores after filing for bankruptcy within two years! Every mortgage lender looks for 3-5 credit tradelines that have been opened for at least 24months. Superb credit consists of 5-7 tradelines that have been open for at least 4+years. Credit criteria is one of the first steps taken for preapprovals. Underwriting guidelines suggest strong credit history to make a high risk decision.

The second factor looked for is called ‘capacity’. Capacity is how much a borrower makes in income compared to his monthly debt obligations. It also consists of employment history whether it is stable or will be continuous. Self employment income requires two years of business tax returns with all schedules. Any commissions, bonuses, and overtime will need to have been received for two years, and would need to be averaged by two years. If these guidelines aren’t met, then it will not be included towards a borrower’s income. Income earnings can be verified by last paystubs covering 30 days, last two years of w-2’s, and last two years of full tax returns. Alimony, child support, social security, and disability would need to have been received for the last 3months, and have a continuance period of 3yrs. This step is commonly used to prequalify a borrower. Income is calculated against the debt, and no credit is pulled to prequalify a borrower.

The third factor used in a mortgage approval is called ‘capital’. Capital is how much ‘liquid assets’ a borrower may have to cover the down payment, closing costs, and monthly reserves. Liquid assets consists of checking, savings, 401k, IRA’s, stocks, bonds, mutual funds, and certificates of deposits. The amount used for 401k’s is 70% of the ‘vested balance’ minus any loans against it. Down payments can help lower the interest rate by lowering the loan-to-value (LTV). FHA purchase mortgage loans required a down payment of 3%, and conforming loans are from 5, 10, and 20% down. MyCommunity mortgage & HomePossible mortgages are zero down programs, but will require a 620 credit score to avoid high PMI payments. This is the 2nd step used to prequalify an individual for a mortgage. Automated underwriting guidelines tend to ease up when large assets are present.

The last factor used in a mortgage approval process is called ‘collateral’. The Collateral factor looks at the subject property of the mortgage loan. The mortgage rates can receive price hits due to the subject property being a high rise condo, co-op, Non-warrantable condo, second home, investment property, timeshare, rural area, log cabin, and if there aren’t any comparable homes in the area. Most appraisals require at least three comparable homes to find the value of a subject property. This step isn’t required for preapprovals or to prequalify a borrower. Underwriting guidelines are very strict when the market values are declining. New VA home Purchases has the strictest type of appraisal, and can be overwhelming if the home is over 10yrs of age.

Origination fee & Discount points

Before obtaining good mortgage rates a borrower must understand what actually is included in a ‘mortgage interest rate’. There are many factors that affect all mortgage rates in every mortgage transaction. Discount points, origination fees, Yield Spread Premium, and 3rd party fees are a few factors that can change your interest rate. This information will help a first time home buyer determine the different between an origination fee, and a discount point.

Discount points is prepaid interest that is used to lower a mortgage rate. They are tax deductible, and can help lower your monthly payments. One discount point is equivalent to 1% of your mortgage loan amount.
For example:
Purchase Price $200,000
Down Payment $40,000
Loan amount $160,000
Discount points 1% or $1,600 of your mortgage loan amount.

Discount points MAY lower your mortgage rate by 0.5% for every point paid.
Every lender is different, and may only lower your mortgage rate by 0.25-0.375%.
If your current mortgage rate was 6.5%, and you paid one discount point, then your rate can go as low as 6.125-6.25%. By lowering your rate, you will also be lowering your monthly mortgage payment. The one time closing cost will be 1,600, and will be recovered between 3-4yrs. The way to calculate this is to subtract the higher mortgage payment from the new payment, and divide it by the 1,600.

Origination fees work the same way as discount points do. One point is equivalent to 1% of the loan amount. Origination fees do not lower your mortgage interest rate. Origination fees are paid by the borrower to the bank, lender, and/or mortgage broker. This is a common charge on a HUD-1 settlement statement. This charge is associated with ‘originating’ your mortgage loan.

The cash rebate paid to a lender for selling an interest rate higher than the wholesale par rate is called Yield Spread Premium (YSP). If a borrower isn’t willing to pay origination fees or discount points, then the mortgage interest rate is raised to recover the loss of revenue. Also, if the borrower is unable to pay closing costs, the lender can raise the rate to balance the revenue made. An origination fee can be charged with the closing cost, and the rate can be raised to create more revenue. This is called ‘charging in the front, and charging in the back’.

The 3rd party fees such as title fees, title insurance, attorney/escrow, appraisal, etc. can all affect an APR of a mortgage interest rate. Many lenders do not include all fees, and this is why APR’s can be different with the same numbers on a Good Faith Estimate. If one lender is charging more fees/points, that can lead to a higher APR.

Current mortgage rates are displayed at Freddie Mac’s homepage. They update their web page weekly with rates from actual closings. They also display the average fee/points paid on a 30yr fixed mortgage, and a 15yr fixed mortgage. Do not be fooled by various ‘advertising’ websites that doesn’t verify the ads promoted by their lenders. Many lenders undercut their rates to draw borrowers, but many of these borrowers do not qualify through their terms.

The average revenue made in a mortgage transaction is approximately 2.5% in total origination fees, discount points, and YSP. Some lenders may charge more, but it is still negotiable. Mortgage lenders & Banks aren’t required to disclose YSP. You will normally see the interest rate with origination fees and/or discount points. Mortgage brokers are required to show YSP, and is disclosed on a Good Faith Estimate, and HUD-1 statement. Due to higher overhead costs, a mortgage lender and bank can charge a lot more fees than mortgage brokers.

Fixed Rate Mortgages

A fixed rate mortgage is a mortgage loan where the interest rate on the note remains the same through the term of the loan. Fixed rate mortgages are the most classic form of loan for home and product purchasing in the United States. The most common terms are 15 year fixed, and 30 year fixed mortgages, but shorter terms are available, and 40 year fixed, and 50 year fixed mortgages are now available (common in areas with high priced housing, where even a 30 year fixed term leaves the mortgage amount out of reach of the average family).

Outside the United States, fixed rate mortgages are less popular, and in some countries, true fixed rate mortgages are not available except for shorter-term loans. For example, in Canada the longest term for which a mortgage rate can be fixed is typically no more than ten years, while mortgage maturities are commonly 25 years.

Fixed rate mortgages are usually more expensive than adjustable rate mortgages. Due to the inherent interest rate risk, long-term fixed rate loans will tend to be at a higher interest rate than short-term loans. The difference in interest rates between short and long-term loans is known as the yield curve which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent.

The fact that a fixed rate mortgage has a higher starting interest rate does not indicate that this is a worse form of borrowing compared to the adjustable rate mortgages. If interest rates rise, the ARM cost will be higher while the FRM will remain the same. In effect, the lender has agreed to take the interest rate risk on a fixed rate loan. Some studies have shown that the majority of borrowers with adjustable rate mortgages save money in the long term, but that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate, and the likelihood that the rate will increase or decrease during the life of the loan. FHA mortgages, VA loans, Super Jumbo loans, and other home loan programs usually are offered as a fixed rate mortgage.

Adjustable Rate Mortgages ARM

An adjustable rate mortgage (ARM), variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, negative amortization mortgage, and balloon payment mortgage. Adjustable rate mortgages transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.


Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages. ARMs generally permit borrowers to lower their payments if they are willing to assume the risk of interest rate changes. In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset-liability mismatch: in this case, it would be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors.

For the borrower, adjustable rate mortgages may be less expensive, but at the price of higher risk borne by the borrower. In most situations, when looking at a single period (e.g. a year) short-term borrowing appears less expensive than long-term borrowing, due to the slope of the yield curve. Yet, this difference is likely founded on the expectations of increases in the short term interest rate, hence the risk over many periods. Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage.

Initial Adjustment Rate Cap: The majority of loans have a higher cap for initial adjustments that’s indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2-3% above the Start Rate on a loan with an initial fixed rate term of 3 years or lower and 5-6% above the Start Rate on a loan with an initial fixed rate term of 5 years or greater. FHA loans adjust once per year, and is capped at 1%.

Rate Adjustment Cap: This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of 3 years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of 5 years or greater.

Lifetime Cap: Most First Mortgage loans have a 5% or 6% Life Cap above the Start Rate (this ultimately varies by the lender and credit grade).

Adjustable rate mortgages are typically, but not always, less expensive than fixed rate mortgages. Due to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates (which are the basis for variable-rate loans and mortgages). The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent. Super Jumbo loans generally offer much lower interest rates on ARMs.

The fact that an adjustable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, the rate will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on average, the majority of borrowers with adjustable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs.