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The “3 Cs” Every Lender Examines Before Approving Your Mortgage

Mark Fitzpatrick
5 min read
The “3 Cs” Every Lender Examines Before Approving Your Mortgage

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If you’re looking to purchase a new home or refinance an existing one, it’s important to understand the basics of qualifying for a mortgage so you can get the best deal possible. It’s not as easy to get a mortgage these days as it used to be, so it’s important to understand the basics of qualifying and take some simple steps ahead of time to “groom” your financial profile. The idea is to position yourself ahead of time to get the best deal you can.

Mortgage lenders look at a variety of factors when making a lending decision, but most can be classified into three general categories, credit, capacity, and collateral — or the “3 Cs.”

Credit: Do you faithfully repay your debts?

Your credit scores are an important factor in mortgage qualifying because they indicate how well you manage debt. Mortgage lenders require a credit report from the three major credit bureaus (Equifax, Experian, and TransUnion) to document your payment histories for mortgages, auto loans, personal loans, credit cards, and any derogatory information such as collections, foreclosures, judgments, charge offs, bankruptcies, liens, etc. Credit scores are considered highly predictive of the risk of lending to you, so lenders give them a lot of weight. The higher your credit scores, the better!

Credit scores range from 300 to 850, with most people falling in the mid 600s and above. Scores below 620 are considered bad, and scores above 720 are considered good. Ideally, you want to have all three of your credit scores in the mid 700s or better to get the best mortgage deals.


Related: What’s Better for Investors — a 15-Year or 30-Year Mortgage?

The following are some of the factors that weigh heavily on your credit scores:

  • Debt payment history: Late payments, particularly on mortgages, can have a big negative impact on your credit scores. Be sure to make all your payments on time.
  • Credit utilization: If you carry credit card balances that are more than 30% to 50% of your credit limit, it can have a big negative impact on your scores even if you’re making your payments on time. Over-utilizing your credit can make you look “maxed out” and is considered a risk factor, which is why your credit scores are downgraded accordingly.
  • Collections or charge offs: Past debts reporting as collections or charge offs can damage your credit scores significantly. If you have some of these in your credit file, be sure to get them resolved as soon as possible. If the debt is with a collection agency, you may be able to negotiate a reduced payoff, but be sure to get the agreement in writing.
  • Bankruptcies and foreclosures: If you’ve had a bankruptcy or foreclosure in the recent past, pretty much the only cure for your credit scores will be time. Fannie Mae and FHA also have waiting periods of two to four years before you will be able to qualify for new mortgage financing.

Capacity: Do you have the financial ability to repay the loan?

Capacity has to do with your financial ability to repay the home loan. W2 income (you work for somebody) is considered the most stable income because it doesn’t typically vary much from month to month. Self-employed income is considered riskier from a lending standpoint because it can vary widely from month to month and the self-employed borrower is responsible for generating the business that creates the income.

If you’re a wage earner, the lender will typically want you to document your income with W2s, pay stubs, and tax returns. If you’re self-employed, you typically won’t have W2s, so you’ll be required to document your income with tax returns.

An important component of capacity is your debt-to-income ratio, or DTI. Your DTI is important because it shows what portion of your income is dedicated to debt payoff. The higher your DTI, the tighter your finances are and the riskier it is for the lender to give you a loan.

Depending on the loan program, a mortgage underwriter typically won’t want to see a DTI higher than 45% to 50%. In other words, no more than 45% to 50% of your qualifying income should be going to debt service for mortgages, auto loans, credit cards, installment loans, etc.


Related: Applying for a Mortgage Loan? Do These 3 Things Ahead of Time.

Collateral: What is the security for the loan?

Because the property you’re financing will serve as collateral for the mortgage, the lender will be concerned with the value, type, quality, and condition of the property.

The value of your property is one of the most important factors because it allows the lender measure risk with a ratio called loan-to-value, or LTV. LTV is essentially the percentage of the value of the property that you are borrowing. For instance, if your property is worth $100,000 and you are borrowing $80,000, the loan-to-value is 80%.

Lower LTV loans are less risky than higher LTV loans because the lender isn’t as likely to incur a loss in the event the borrower stops making payments. It’s because of this that lower LTV loans typically have better pricing and lower interest rates.

Most of the time, you’ll be required to get a full appraisal to verify the value and condition of your property, but there are some refinance scenarios where a limited appraisal or no appraisal at all is needed.

3 Steps to Take Before Applying for a Mortgage

1. Check your credit.

If you plan to purchase or refinance in the near future, it’s important to first check your credit to make sure there aren’t any issues that need to be cleared up ahead of time. Again, credit scores are an important factor when you finance a home, so you want to make sure they are as high as possible so you can get the best financing deal possible.

2. Pay off outstanding debt.

If you have a lot of debt, I highly recommend paying off as much as you can before you apply for a home loan. Doing so will lower your debt-to-income ratio, make qualifying easier, possibly raising your credit score, and maybe resulting in better financing terms. Having a lower debt-to-income ratio could also position you to take advantage of shorter-term loan programs that offer lower interest rates and faster payoffs — which can put a lot of money back into your pocket over the life of the loan.

3. Take care of any needed repairs.

If you’re refinancing, it’s important that your home appraise for as high as possible. If your home has some minor cosmetic issues or repairs that need to be done, take care of them before the appraiser comes out. Having your home in good condition could help you get a higher appraised value, which could result in better financing terms.

Preparing for Your Next Mortgage is Well Worth the Effort

Unless you know you have a pristine financial profile, low debt, and high credit scores, I highly recommend doing some legwork ahead of time to make sure you put your best foot forward for your next mortgage loan. It’s common in the mortgage industry for borrowers to get surprised with unexpected hangups, such as derogatory credit items or unexpectedly low credit scores. Understanding how lenders think and preparing your financial profile before you start applying for loans can help you get a much better deal and make the loan process go much more smoothly.

What other tips would you add to this list?

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.