Equal Credit Opportunity Act

Loan application process

Loan underwriting

Qualifying the buyer

Loan commitment


To qualify for a mortgage loan, a borrower must meet the lender’s qualifications in terms of income, debt, cash, and net worth. In addition, a borrower must demonstrate sufficient creditworthiness to be an acceptable risk.

Equal Credit Opportunity Act          

The Equal Credit Opportunity Act (ECOA) requires a lender to evaluate a loan applicant on the basis of that applicant’s own income and credit rating, unless the applicant requests the inclusion of another’s income and credit rating in the application. In addition, ECOA has prohibited a number of practices in mortgage loan underwriting. Accordingly, a lender may not:

  • discount or disregard income from part-time work, a spouse, child support, alimony, or separate maintenance. Further, the loan officer may not ask whether any of the applicant’s income is derived from these sources.
  • assume that income for a certain type of person will be reduced because of an employment interruption due to child-bearing or child-raising. The loan officer may not ask about the applicant’s plans or behavior concerning child-bearing or birth control.
  • refuse a loan solely on the basis that the security is located in a certain geographical area.
  • ask applicants any question about their age, sex, religion, race or national origin, except as the law may require.
  • require a spouse to sign any document unless the spouse’s income is to be included in the qualifying income, or unless the spouse agrees to become contractually obligated, or the state requires the signature for some purpose such as clearing clouded title.

If a lender denies a request for a loan, or offers a loan under different terms than those requested by an applicant, the lender must give the applicant written notice providing specific reasons for the action.

Borrower requirements. The lender must rely on eight types of information to determine that the borrower has the ability to repay the loan:

  1. current income or assets (excluding the value of the mortgaged property)
  2. current employment status
  3. credit history
  4. monthly payment for the mortgage
  5. monthly payments being made on other loans on the same property
  6. monthly payments for other mortgage-related expenses
  7. other debts
  8. monthly debt payments compared to monthly income (debt-to-income ratio)

The lender cannot use a temporarily low rate (introductory or “teaser” rate) to determine qualification. For an adjustable rate mortgage (ARM), the highest rate

the borrower might have to pay is generally to be used.

The “ability to repay” requirements are relaxed in certain circumstances where the borrower is attempting to refinance from a riskier loan (such as an interest-only loan) to a less risky one (such as a fixed-rate mortgage loan.

Qualified Mortgage. A Qualified Mortgage is one that meets the “ability-to-repay” requirements, has certain required features and is not allowed to have others. There are exceptions to these rules for certain kinds of small lenders. Issuing a Qualified Mortgage gives the lender certain legal protections in case the borrower fails to repay the loan.

Loan application process                        

The process of initiating a mortgage loan begins when a borrower completes a loan application and submits it to a lender for evaluation by the lender’s underwriters.

Forms. Most lenders use some version of the “Uniform Residential Loan Application” promulgated by Fannie Mae. This form requests the borrower to provide information about the property and the borrower. The standard form includes the loan amount requested, based on an estimate of the purchase, refinance, or other underlying transaction.

Information required by the lender.  The application must include supporting documentation for the information indicated in the following exhibit.

Completion. The application must be complete for the lender to consider it. The form must be signed and dated by the applicant(s) and delivered to the lending institution. The initiation of the application process occurs when the lender receives the completed application package from the applicant. Federal law requires the lender to accept all applications and to give applicants notice concerning the disposition of the application. If the lender denies the loan application because of fraudulent information on the application form, the borrower has no claim to a refund of the application fee.

Loan underwriting     

Loan underwriting is the process of assessing the lender’s risk in giving a loan. Mortgage underwriting includes:

  • evaluating the borrower’s ability to repay the loan
  • appraising the value of the property offered as security
  • determining the terms of the loan

Risk. A lender undertakes a number of risks in lending money. The principal risks are that the borrower will default on repayment of the loan, and that the borrower will damage the value of the property as security. In addition, the lender runs the risk that, in the event of a foreclosure, the sales proceeds from the property will be insufficient to cover the lender’s loss.

Qualification. A lender assesses risks by examining, or qualifying, both borrower and property. In qualifying a borrower, an underwriter weighs the ability of the borrower to repay the loan. This requires an analysis of whether the borrower’s income, cash resources, creditworthiness, net worth, and employment stability meet the lender’s standards.

In qualifying a property, an underwriter assesses the ability of the property value to cover potential losses. In this evaluation, a lender requires that the appraised value of the property be more than adequate to cover the contemplated loan and

costs. To protect further against loss, a lender will usually lend only a portion of the property’s value. The relationship of the loan amount to the property value, expressed as a percentage, is called the loan-to-value ratio, or LTV. If the lender’s loan to value ratio is 80%, the lender will lend only $320,000 on a home appraised at $400,000. The difference between what the lender will lend and what the borrower must pay for the property is the amount the borrower must provide in cash as a down payment.

Even if borrower and property qualify, a lender may, under certain circumstances, seek further protection against risk by requiring the borrower to obtain private mortgage insurance. This is frequently the case with loans requiring a relatively small down payment, leading to a high loan-to-value ratio.

Qualifying the buyer                            

Credit evaluation and credit scoring.  A lender must obtain a written credit report on any applicant who submits a completed loan application. The credit report will contain the applicant’s history regarding:

  • outstanding debts
  • payment behavior (timeliness, collection problems)
  • legal information of public record (lawsuits, judgments,

bankruptcies, divorces, foreclosures, garnishments, repossessions, defaults)

Problems with payment behavior and legal actions are likely to cause a lender to deny the application, unless the applicant can provide an acceptable explanation of mitigating and temporary circumstances that caused the problem.

If a lender denies a loan on the basis of a credit report, the lender must disclose in writing that the applicant is entitled to a statement of reason from any creditor responsible for the negative report.

Since 1995, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association have been encouraging lenders to use credit scoring to evaluate loan applicants. Credit scoring is a computer-based method of assigning a numerical value to an applicant’s credit. The credit score is a statistical prediction of a borrower’s likelihood of defaulting on a loan.

Qualifying ratios.  Lenders want to be assured that the borrower has adequate means to make all necessary periodic payments on the loan in addition to other housing expenses and debts such as credit card payments and car payments. Most lenders use two ratios to estimate an applicant’s ability to fulfill a loan obligation: an income ratio, or housing expense ratio, and a debt ratio, or housing plus debt ratio or total obligations ratio. They also consider the stability of an applicant’s income. Please note that the income and debt ratios in the discussion below do not necessarily reflect the latest ratios used by FHA, VA, or other lenders. Check for updates on the websites of those agencies.

  • income ratio

    The income ratio, or housing expense ratio, establishes borrowing capacity by limiting the percent of gross income a borrower may spend on housing costs. Housing costs include principal, interest, taxes, and homeowner’s insurance, and may include monthly assessments, mortgage insurance, and utilities. The income ratio formula is:

Income Ratio

To identify the maximum monthly housing expense an income ratio allows, modify the formula as follows:

monthly gross income x income ratio = monthly housing expense

Most conventional lenders require that this ratio be no greater than 25-28%. In other words, a borrower’s total housing expenses cannot exceed 28% of gross income. For an FHA-backed loan, the ratio is 31%. VA-guaranteed loans do not use this qualifying ratio.

For example, if a couple has combined monthly gross income of $12,000, and a lender’s maximum income ratio is 28%, the couple’s monthly housing expense cannot exceed $3,360:

$12,000 x 28% = $3,360

  • debt ratio

    The debt ratio considers all of the monthly obligations of the income ratio plus any additional monthly payments the applicant must make for other debts. The lender will look specifically at minimum monthly payments due on revolving credit debts and other consumer loans. The debt ratio formula is:

Debt Ratio

To identify the housing expenses plus debt a debt ratio allows, modify the formula as follows:

monthly gross income x debt ratio =

monthly housing expense + monthly debt obligations

Most conventional lenders require that this debt ratio be no greater than 36%. For an FHA-backed loan, the debt ratio may not exceed 43%.  The VA uses 41% and a variable “residual income” calculation. The FHA and VA include in the debt figure any obligation costing more than $100 per month and any debt with a remaining term exceeding six months.

Using the 36% debt ratio, the couple whose monthly income is $12,000 will be allowed to have monthly housing and debt obligations of $4,320:

$12,000 gross income x 36% = $4,320 expenses and debt

VA-guaranteed loans also require a borrower to meet certain qualifications based on net income after paying federal, state, and social security taxes, housing maintenance and utilities expenses. Such residual income requirements vary by family size, loan amount, and geographical region.

Income stability. A lender looks beyond income and debt ratios to assess an applicant’s income stability. Important factors are:

  • how long the applicant has been employed at the present job
  • how frequently and for what reasons the applicant has changed jobs in the past
  • how likely secondary income such as bonuses and overtime is to continue on a regular basis
  • how educational level, training and skills, age, and type of occupation may affect the continuation of the present income level in the future.

Cash qualificationSince a lender lends only part of the purchase price of a property according to the lender’s loan-to-value ratio, a lender will verify that a borrower has the cash resources to make the required down payment. If some of a borrower’s cash for the down payment comes as a gift from a relative or friend, a lender may require a gift letter from the donor stating the amount of the gift and lack of any requirement to repay the gift. On the other hand, if someone is lending an applicant a portion of the down payment with a provision for repayment, a lender will consider this another debt obligation and adjust the debt ratio accordingly. This can lower the amount a lender is willing to lend.

Net worthAn applicant’s net worth shows a lender the depth of the applicant’s cash reserves, the value and liquidity of assets, and the extent to which assets exceed liabilities. These facts are important to a lender as an indication of the applicant’s ability to sustain debt payment in the event of loss of employment.

Loan commitment      

When a lender’s underwriters have qualified an applicant and the lender has decided to offer the loan, the lender gives the applicant a written notice of the agreement to lend under specific terms. This written promise is the loan commitment. The commitment may take a number of common forms, including a firm commitment, a lock-in commitment, a conditional commitment, and a take-out commitment.

A firm commitment is a straight forward offer to make a specific loan at a specific interest rate for a specific term. This kind of commitment is the one most commonly offered to home buyers.

A “lock-in” commitment is an offer to lend a specific amount for a specific term at a specific interest rate, but the interest rate is subject to an expiration date, for instance, sixty days. This guarantees that the lender will not raise the interest rate during the application and closing periods. The borrower may have to pay points or some other charge for the lock-in.

A conditional commitment offers to make a loan if certain provisions are met. This kind of commitment generally applies to construction loans. A typical condition for funding the loan is completion of a development phase.

A take-out commitment offers to make a loan that will “take out” another lender’s loan, i.e., pay it off and replace it. The take-out loan is most often used to retire a construction loan. The take-out lender agrees to pay off the short-term construction loan by issuing a long-term permanent loan.