Process of a Loan

There are two key factors a bank focuses on to determine the likelihood and terms in your getting dough from them:

One: Can you afford to pay the loan back? Like what do you do for a living? How much do you make? Is it likely you’lll still be employed after the next economic downturn? Stuff like that.

And then two: If you don’t pay back the loan you promised to pay back. Then which of your assets can they take from you so that they get their money (and interest) back? OK, example time:

You’re buying a house. First one. You’ve scrimped. you’ve saved. And now you think you can afford this half million dollar home in Palo Alto. You have 50 grand in savings ready to put down on the house and you have a nice job as a personal trainer to the stars of Silicon Valley. So yeah, you’ll never be out of work.

You make about 70k a year, but it’s all as an individual contractor so you have great periods of time where you make bank. And then months where you make a whole lot of...nothing. After taxes, your 70k is about 50k, which is all you’ve got to your name. You thought you’d put 10 percent down, but didn’t realize that you’d have to pay real estate taxes in advance and other closing costs, so you really needed 60k, but the bank wants your business - mainly because their biggest customers are your clients.

Prevailing interest rates on mortgages are 6% but you’re not exactly a Bill Gates credit risk, so yours will be higher. They quote you 8% if you put 20% down. But you don’t have 20% to put down. You have less. Which means more risk to the bank in lending you the money, so they’ll charge you more for renting it from them. So the price is 10% interest to rent the money, because you have to pay for insurance that covers you if you don’t pay. And yes that sounds harsh and cruel, but uh...welcome to the real world.

So you’re thinking that you have a loan of 460k. That extra 10 grand covers closing costs and taxes. On 10% interest, you’ll pay 46 grand a yea, just in interest. Essentially, all of that interest is deductible, so instead of your 70k being 50k after taxes, as far as the IRS is concerned you no longer make 70k, you make 70k minus 46k, or 24k a year. And your taxes on that are like 2 grand. You almost qualify for food stamps.

And that’s good. You might need them because 2 grand will just barely pay for the food you’ll need to...live. So the bank juuuust barely passes you to qualify for this loan after checking to be sure that you’ve never had a missed payment on a credit card, any other loan, or had any other issues like a DUI or some criminal thing that would give any lender cause to pause.

So the above is all about your ability to pay. What comes next is all about the risk to the bank. You’ve bought a home in a very active market - the bank presumes that they can always sell it but the home has doubled in value in the last 3 years and the bank knows that this is not normal. So there’s a lot of risk that the home drops in value 30...40, maybe even 50 per cent in the short run.

So there is a scenario where the home you just bought for 500 grand ends up selling for 300 grand, less 20 grand in commissions and costs, and nets only 280 g’s. The bank loaned 460 grand and, in this scenario, you’d of course lose your 50 grand down payment but the bank would then lose 180 big ones as well.

And banks don’t like to lose money…At least...the ones that do don’t stay in business for very long...