Much of lending makes sense if you think about your relationship with your teenage children. Suppose your 16-year old wants you to buy a car for him. It will cost $2,000. He will pay you back at the rate of $150 a month, using money generated from his lawn care business. It’s May, and business is good. You are motivated to make the loan because it is a learning experience for him, and because you are REALLY tired of ferrying him and his equipment.
You know that with his own car he’ll be able to take on more customers, and will make more money. You are confident he’ll make enough money to pay you each month, save some for college, and have some spending money. Everybody is happy. Then you say,
“How will you make your payments in November, when no one cuts their grass, everyone is spending their money getting ready for Thanksgiving and Christmas, and money is tight all the way around?”
Your son says, “Don’t worry, I’ll get my customers to pay me to put up their Christmas decorations and then take them down.”
You say, “Good thinking. What about February?”
Your son says, “Something will come up. Don’t worry. It will be okay.”
You say, “Wrong answer!”
That exchange pretty much describes the issue in Part Two.
Besides Debt Service Coverage Ratio (DSCR, described in prior post), lenders want to know how you will make the mortgage payments if the property is vacant for several months. It would be nice if someone just came out and asked you this question, but they often don’t. No, someone in underwriting will review your paperwork, feed the numbers into their computer model, and read the answer that pops out. Even when a real live human being makes the decision to loan you money or not, that real live human being is a bean counter in underwriting.
My husband can count the beans in a 40-acre field, so I’m not trashing the breed. BUT, many of them have no communication skills and no contact with the public. The following conversation almost never takes place:
BC (Bean Counter): According to the Borrower’s financial statement, she has liquid assets consisting of a CD of $5,000. That’s enough money to pay the mortgage payment if the property were vacant for five months. We require six months worth of mortgage payment coverage payments in liquid assets. I’m sorry, we’re turning down this loan.”
LO (Loan Officer): “What if the Borrower agreed to buy another CD for $1,000, giving her $6,000 in liquid assets and the ability to cover the mortgage for six months if the property were vacant?”
BC: “That won’t work, because we need to see that they’ve had those liquid assets for at least six months. That indicates it’s truly a “savings account” for emergencies. If the money has been set aside for just a short period of time, it’s more likely the borrower will have it today, spend it tomorrow, and then we don’t have a vacancy cushion any more.”
LO: “What if the Borrower had a total of $6,000 in CDs AND she gave us a security interest in the CDs? That would make it impossible for her to spend the money without our permission, and we’d be protected. Would that work?”
BC: “Sure! Why didn’t she just offer to do that at the beginning?”
LO: “Because neither one of us knew your rules, that’s why! You just say, ‘Approved’ or ‘Denied’ and you never tell us the reason.”
The point of this comment is: Ask any loan officer about the underwriting requirements for the ability to make mortgage payments even if a rental property is vacant. They all have different rules. One lender might approve your loan and another one might turn you down. Minor differences in your financial statement could make a difference in whether you get approved or not.
Some lenders evaluating a small investor will view total family income when deciding if the potential borrower can make mortgage payments even when a property is un-rented. Do you have “day job” that covers all your normal living expenses plus a certain percentage more for investment cash flow problems? (What percentage? Every lender is different.)
- Knowing this, you might be much more careful when completing the income and expense form on a loan application. Don’t estimate numbers, get REAL numbers. Minor changes in your monthly expenses could make the difference between loan approval or a turn-down.
Sometimes, if your DSCR is large enough, that’s sufficient.
Sometimes, you need liquid assets, and the lender might want to hold some or all of your liquid assets as additional collateral. If they do have such a requirement, ask if the security interest can be released after a certain period of time. For example, “If I make every mortgage payment on time for 24 months, will you release my additional collateral?” “Yes, we can agree to that.” “Thank you. Please include that in the ‘Additional Provisions’ section of my promissory note and the security agreement.”
How much of a “cushion” will you need? As usual, every lender is different, and the answer could change depending on the type and size of loan. You must ask questions when interviewing potential lenders. If the loan officer does not know, ask them to inquire of the people in underwriting.
Remember, obtaining a loan is a two-way conversation. Obtain as much information as possible ahead of time, and engage in possibility thinking if your loan is turned down. A “no” from underwriting doesn’t mean you are a bad person. It means you don’t meet one or more of the underwriting requirements. Ask what those requirements are, and see if you can meet them with a little extra work.