Applying for a Mortgage or Loan during a Credit Crunch
September 17, 2020
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When times are tough, getting a loan may become more difficult. Why is that? There are many reasons why lenders become stricter on loan approvals during a recession.
A recession typically leads to hiring freezes, layoffs, and higher unemployment. With the increased chance of job loss or furlough comes a heightened risk that borrowers will delay loan payments, default on a loan, or declare bankruptcy.
You may recall the government bailouts for banks and other financial institutions during the Great Recession. (For the record, RSI Bank has never had a bailout in its 167+ years in operation.) Banks work within certain guidelines established by Federal and State regulators to manage risks, including credit risk associated with making mortgages and loans to consumers and businesses. Managing these risks helps ensure a bank will remain a safe and sound institution and it helps protect borrowers as well.
During a recession, home values may fall, which in turn reduces the amount of equity in the property. Equity is the difference between the market value of a home and the amount owed on any mortgage and/or home equity loans on the property. You may have heard the term being “underwater” on a mortgage. It means owing more on your loan(s) than the market value of the home.
To mitigate the risk, mortgage lenders may tighten up their underwriting standards during a recession. They may look more conservatively at factors such as credit score, maximum loan to value, debt to income ratio, and financial reserves, among other considerations.
Similar assessments are made for businesses seeking commercial real estate loans, business loans, and lines of credit. Decision-makers consider many factors that paint a picture about the borrower’s financial security and ability to repay the loan.
These conditions sometimes lead to a credit squeeze, also known as a credit crunch. People and businesses may be unable to qualify for loans they would normally use to finance major purchases, such as buying real estate, making renovations, funding business operations, or purchasing new equipment. Credit crunches have consequences that may impact the economy and further contribute to a recession.
How you can prepare
Understanding what lenders look for when reviewing an application for a mortgage or home equity line of credit can help you prepare for when you want to apply for credit during an economic downturn. Here are some key points to keep in mind:
Income history – Lenders generally look for a regular, steady stream of documented income. Self-employed applicants usually must provide more documentation for income verification and it can be more difficult to qualify.
Credit score and credit report - Missed or late payments, defaults on loans, and bankruptcy are red flags.
Debt-to-income (DTI) ratio- Lenders usually look at outstanding debt against monthly income as a consideration of likelihood to repay a loan.
Financial Reserves – Other terms for financial reserves are cash on hand or liquid savings. Put another way, how much money do you have available in case of a financial emergency? (Read our blog post on emergency funds)
Down payment – How much money can you put down on a home? The amount you have set aside for your down payment has a direct impact on your Loan to Value (LTV) ratio, another important consideration when buying a home. Familiarize yourself with common mortgage terms
For more information on some of these concepts, read our post on preparing for home ownership. Speak with a Residential Loan Officer at RSI Bank for specific information on our mortgage and home equity programs. Call 732.388.1800 to be connected to a Residential Loan Officer.
The information provided in this article is meant for educational purposes only and is not advice.
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