The Best Loan for House at the Lowest Cost
It’s easier than ever for young people to buy a home,”
writes Bill Rumbler of the Chicago Sun-Times. Lenders and builders are bending over backward to help first-time buyers. They’re lowering interest rates, reducing (or eliminating) down payments, and cutting closing costs. “On top of that,” reports Rumbler, “many lenders, builders, and credit counselors provide homebuyer counseling.”
The San Diego Union-Tribune agrees. “Now’s the time to go from renter to homeowner. The government wants to put people into their own homes and is encouraging lenders to woo first-time buyers.”
With new loan programs, easier qualification, and expanded home-buyer counseling services, you’re nearly certain to find a loan that can move you into home ownership. Educate yourself, plan your finances, and avoid costly mistakes. As you learn from the homebuyer experiences in this article, you will discover how to (1) save money on your mortgage, (2) buy with little or nothing down, and (3) shape up your credit profile.
We never heard of special financing for people like us.
LESSON: If you have the will, you can find a way.
“We always heard that to buy a house you needed 20 percent down and excellent credit,” says Rene Wolpe. “Otherwise we would have bought years ago. Until we heard of the government’s home ownership initiatives, we never knew we could qualify for special financing.”
The Wolpes made the most common and most costly mistake in real estate. They excluded themselves from home ownership because they mistakenly believed they couldn’t qualify for financing. But as Kathy Ortiz of the San Diego Home Loan Counseling Center points out, “There are a lot of loan programs, and there is a program for almost everyone.”
Ortiz goes on to say that most of the people she helps are like the Wolpes. They don’t realize how many different ways there are to finance a home. “A large majority of our clients come in here really hesitant and lack the confidence that they can qualify. But when they leave, they leave with confidence because they have developed an understanding of the homebuying process and they know their options.”
Javier and Maricela Samaniego are living proof of what Kathy Ortiz is referring to. This young couple with a 16-month-old son never believed they could own their own home. They were paying $950 a month for rent and had meager savings. But thanks to Union Bank’s Economic Opportunity Mortgage, they were able to buy. “I thought that without this,” says Maricela, “we would have had to come up with more money, and since we didn’t have much money to work with, it really helped us a lot. … We now have so many plans for the house. It really changed everything for us. The money we were paying in rent is now going somewhere.”
With the help of Realtors, homebuilders, mortgage lenders, government agencies, and home counseling centers, hundreds of thousands of Americans like the Wolpes and the Samaniegos are discovering that traditional rules of mortgage financing no longer block most renters from home ownership. In today’s push to expand home ownership (especially among minorities and low- to moderate-income individuals and families), lenders are reaching out to all creditworthy (not credit perfect) people who want to become homeowners. Although you must check to see what’s available in your area, here’s a brief sampling of the types of home finance programs you might use.
Community Reinvestment Programs
For years civil rights activists and various consumer groups have accused banks and other mortgage lenders of “redlining.” According to critics, bank officers take a red marking pen and draw a circle around minority or low- to middle-income neighborhoods. “These areas are too risky,” say the bankers. “We can’t finance homes there. Property values may go down.”
When bankers cut off mortgages to a neighborhood, they set in motion a self-fulfilling prophecy. If people can’t get money to buy and fix up homes, the neighborhood will decline. Fortunately, lenders now recognize a more positive truth. If they make loans, people will invest in their own homes. Neighborhoods will turn around. Values will increase.
In response to neighborhood activists, federal antidiscrimination laws, the National Home Ownership Strategy, and the profit motive, mortgage lenders are rolling out the red carpet for borrowers who in past years may have been turned away. “We are in a heavy campaign to spread the word to the community that home ownership is not out of reach for low-income families,” says mortgage specialist Fred Thomas III. “This is truly a window of opportunity for folks who previously were shut out of the homebuying system.”
Loan Details Differ
The specific details of these community reinvestment home-finance plans differ among lenders. Some offer low- or no-down-payment plans. Others eliminate or reduce closing costs and fees. Most relax qualifying standards and offer counseling to help individuals and families shape up their finances, improve their credit, and become familiar with the process of buying a home. A large number of lenders combine all these benefits into one program.
Ray Sims of GE Capital Mortgage Services says, “We expect to create business where we haven’t seen it before… . We see this as a potentially large underserved market.”
Even though community reinvestment loan programs are geared toward lower- to middle-income borrowers, the income limits may go up to $40,000, $50,000, or even $90,000 a year. Sometimes no limits apply. American Savings Bank has advertised, “If you pay $1,000 a month or more for rent, you should consider buying a $200,000 home.” Don’t rule yourself out because you think you earn too much money. Most community reinvestment home finance programs reach well into the middle class.
State and Local Governments
“It’s a great program,” says Rebecca Hoffreiter. “Anybody that needs it should go for it.” Rebecca’s talking about a home finance plan sponsored in part by the Pennsylvania Housing Finance Agency. Under this innovative lease-purchase plan, renters can move into home ownership with as little as $1,000 in up-front cash. Then for a period of one to three years, a part of the homebuyers’ monthly payments go into a forced savings account. Once they build up enough money for a five percent down payment, the buyers obtain a mortgage and close on their purchase.
“This is certainly a great program, and we’re really excited about it,” says Craig Cunningham. Craig is director of marketing for K. Hovnanian, one of the new homebuilders who agreed to participate in this lease-purchase program. On the other side of the country, Harry Jensen of Jensen Mortgage says, “We’re putting people in $180,000 homes who could have only qualified for a $120,000 home. At the beginning, the Realtors I know were incredulous.” Harry’s praise is aimed at a shared equity mortgage plan sponsored by the San Diego Housing Commission.
Under this plan, the Housing Commission contributes up to $25,000 in down-payment funds. Homebuyers need only come up with three percent of the home’s purchase price from their own pocket. As an added advantage, the city Housing Commission’s down-payment money doesn’t require any monthly repayments. If the homeowners sell within 15 years, they must then repay the down-payment money along with some profit to the Commission. On the other hand, after 15 years the loan is completely forgiven.
Throughout the United States, both state and local governments are creating dozens of programs that offer special assistance financing. There are low-interest mortgage bond programs, mortgage credit certificates, low-cost home repair or renovation loans, down-payment assistance plans, and even sweat equity and urban homesteading. Some states have created their own version of the VA (U.S. Department of Veterans Affairs) mortgages. Also, if you’re a government employee (teacher, firefighter, police officer, etc.), your town or city may have developed an easy-purchase home finance plan for you.
Fannie and Freddie Get Creative
The largest suppliers of mortgage money in the country are two congressionally chartered corporations called Fannie Mae and Freddie Mac. Since the kickoff of the National Homeownership Strategy several years ago, these lenders have relaxed their underwriting standards and lowered down payments for first-time buyers.
Through loan programs sponsored by Fannie and Freddie, you can borrow as much as 95, 97, and even 100 percent of your home’s purchase price—up to $359,650 (2005). Fannie and Freddie also permit you to buy 2–4 unit properties with a low down payment. Even better, they will agree to approve much higher loan limits:
- 2 units @ $460,400
- 3 units @ $556,500
- 4 units @ $691,600
If you are buying a property that’s located in Alaska, Hawaii, Guam, Puerto Rico, or the U.S. Virgin Islands, Fannie and Freddie increase each of their respective property limits by 50 percent.
I strongly encourage you to weigh the advantages of buying a 2–4 unit property. Not only will your tenants pay most (if not all) of your monthly mortgage payments, but you can gain more dollars each year from appreciation because you will own a higher-priced property. At, say, 4.0 percent appreciation, a $300,000 property gives you a $12,000 yearly gain, whereas a 4.0 percent value increase on a $650,000 property equals $26,000. Over 5 years, that totals more than $70,000. With the larger property, you will also gain more equity through amortization (mortgage payoff).
Fannie Mae permits homebuyers with excellent credit to borrow their down payment from family; obtain a gift, grant, or loan from an employer; or even take a cash advance against a credit card.
Fannie and Freddie are both committed to creating new and easier ways for people to own homes. As long as borrower default rates (foreclosures) remain low, these giant mortgage lenders will “keep their doors open” to almost any homebuyer who can demonstrate financial responsibility. For more on new homebuying programs from Fannie and Freddie, go to their respective websites at www.fanniemae.com and www. homesteps.com.
Where Else to Look
To locate community reinvestment mortgages, first-time buyer loan programs, or other special assistance finance plans, talk to Realtors, loan officers, mortgage brokers, government agencies, and homebuying counselors. Read the business and real estate sections of major newspapers in your city or state. You’re sure to find an easy qualifying, low- (or no-) down-payment home finance plan with your name on it.
We thought the FHA loaned only to low-income people and involved too much red tape.
LESSON: Don’t overlook loans insured by the Federal Housing Administration (FHA).
“We earn $88,000 a year,” says Sam Wright. “We didn’t know we could get an FHA loan, since we stand above the low-income category. Anyway, whenever you get involved with the government, you’ve got too much red tape to wade through.”
Sam has made a common mistake. Many Americans wrongly believe that FHA mortgage loan programs are intended only for low- to middle-income individuals and families. In truth, the FHA places no limits on income. It doesn’t matter whether you earn $12,000 a year or $120,000. As long as you have acceptable (not perfect) credit and earn enough to make your mortgage payments, you can qualify. As for red tape, the FHA does apply rules and regulations. But these shouldn’t present a problem for borrowers who are working with a DE (direct endorsement) lender. These lenders can complete the loan paperwork directly, without submitting it to FHA for prior approval.
Two Drawbacks of FHA Loans
Compared to other home mortgages, FHA loans have two drawbacks. First, if you plan to buy a higher-priced home, FHA loan limits may be too low. For 2005, maximum FHA loan limits range between $172,632 and $312,895. The top limits apply to high-cost areas such as Boston, San Francisco, San Diego, and New York. The lower loan limits apply to the more moderate housing cost areas such as many of those found in north central Florida, Arkansas, Alabama, and West Virginia. (However, no matter where you live, you can find some homes suitable for FHA financing. For example, even high-cost San Diego has neighborhoods where some homes sell for less than $312,895.
Just like Fannie Mae and Freddie Mac, FHA permits larger loans (with small down payments) for 2–4 unit properties:
Low Cost Area
High Cost Area
Again, I encourage you to recognize the financial gains that you can achieve when you own a multiunit property. After a few years, you can buy the single-family house that you might prefer and hold on to your 2–4 unit as an investment. After a few more years, you can trade up this smaller rental to a larger investment property (tax free, I might add).
A second drawback of FHA loans is cost. Compared to many mortgages, FHA insurance and fees can add several thousand dollars to your closing expenses. To offset these higher expenses, though, the FHA does let you roll most of the costs into your loan. You don’t have to pay much at closing. Also, due to a record level of financial reserves, FHA has sliced 40 percent off its fees, making it more competitive with private mortgage insurance.
Benefits of FHA Home Financing
Overall, in deciding whether to use an FHA loan, weigh its somewhat higher costs against these seven benefits:
1. Low down payment: Usually five percent or less.
2. No savings required: Even the relatively small FHA down payment need not come from your own cash savings. Your parents or other close family members may loan (or give) this money to you.
3. Easier qualifying: FHA lenders often will not be as picky as Freddy or Fannie (i.e., conventional) lenders. FHA exists to expand home ownership.
4. Higher qualifying ratios: This means FHA loans expand your buying power (see Mistake #86).
5. Counseling: HUD/FHA offers counseling through hundreds of not-for-profit organizations located throughout the country. These counselors help plan your finances to achieve home ownership. Should you suffer a layoff, health problem, or other financial setback after you’ve bought your home, FHA counselors can reduce your mortgage payments and help you solve your budget problems. FHA discourages “quick trigger” foreclosures.
6. Streamlined refinance. If you finance your home with an FHA loan and mortgage interest rates drop, you can streamline an
FHA refinance to take advantage of the lower rates. Streamlining means you don’t have to jump over any qualifying hurdles again. A streamlined refinance requires no credit check, no income verification, no appraisal, and no points. No conventional lender offers this super deal.
7. Assumability. When you sell your home, your buyers can, with easy qualifying, assume your FHA fixed-rate mortgage at the same rate you’re paying. If interest rates fall, they too will be able to streamline a refinance at the new lower rates.
These last two FHA benefits, streamlining and assumability, provide especially good value. Several years back, when hard times hit some homeowners, they weren’t able to refinance their conventional loans because their income, their home’s value, or both had fallen. They were stuck with old mortgages of 9 to 13 percent even as current market rates then fluctuated between 6.5 and 8 percent. In contrast, through streamlining, FHA borrowers were able to cut their mortgage payments by hundreds of dollars a month—even when they could not have otherwise qualified for refinancing.
As a further benefit, FHA assumability gives you a competitive edge over other sellers when you put your home up for sale. If interest rates are high, you can pass along your lower rate to buyers. If market interest rates have fallen, you or your buyers can streamline a refinance. Your buyers avoid the hassle and cost of taking out a new loan. In addition, it’s usually easier to qualify for an FHA assumption than for a new mortgage.
For many homebuyers, I strongly believe that the benefits of FHA loans outweigh their drawbacks. Although you must decide what’s best in your circumstances, don’t casually ignore FHA. During the past five years the FHA has helped more than 3.5 million Americans become homeowners. This is one government agency that is working hard to move Americans and immigrants into home ownership.
HUD (the U.S. Department of Housing and Urban Development) is the parent of FHA. In those situations when FHA borrowers hit hard times and default on their loans, HUD takes back the property and offers it for sale. The exact deals HUD offers depend on the number of homes it has to sell relative to the number of potential homebuyers.
When HUD sales are slow and foreclosures high, HUD creates buyer incentives. In robust markets, incentives become less generous and HUD prices its homes closer to their market values. Nevertheless, even in hot markets, patience, perseverance, and maybe a little luck can get you a good buy on a HUD home. At present, HUD homes are piling up in states such as Indiana, Ohio, and Georgia. Yet, in California, most HUD homes sell quickly at or above HUD’s asking price. To learn what’s happening in your area, go to hud.gov. Click on HUD homes. You can then follow the links to your state and county. Check regularly because local markets can change quickly.
HUD does not sell directly to buyers. To bid on a HUD home, you must go through a real estate agent who is authorized by HUD. To find these agents, look through the realty firm ads in your local newspaper or consult the yellow pages of your telephone directory. You might also call the HUD office nearest to where you live and request a list of their registered agents.
If you want to stop renting now, a HUD home might prove to be your best opportunity. Put a HUD agent to work for you. There are no guarantees, but passing up this possibility could be a mistake. Nearly anyone (with tolerably good credit) can afford to buy a HUD home.
If you have served in the armed forces (including the National Guard), contact the VA (Department of Veterans Affairs). Your years of service may qualify you for a VA certificate of eligibility. With VA eligibility, you can buy a home priced up to around $359,650—with virtually no cash required for a down payment or closing costs. Some new homebuilders even advertise, “Veterans—$1 Moves You Into Your Own Home.” If you are an eligible veteran with tolerably good credit, don’t overlook this possibility. (See www.va.gov.)
Nonveterans Can Also Benefit from VA
Nonveterans can use VA programs in two ways. First, you can assume a VA mortgage that has been originated by an eligible veteran. Say a veteran bought and financed a $200,000 home two years ago. Now she finds she has been transferred to another area and wants to sell. Her current loan balance equals $203,000 (at the time of purchase, some of the closing costs were added to the mortgage). Today’s market value of the home is $207,000. Pay the veteran $4,000 (or whatever amount you both agree to) and, with a small assumption fee, you can simply take over the veteran’s mortgage. A quick, low-cost, low-down-payment way to buy a home!
Another VA possibility: nonveterans can buy a VA foreclosure (REO). Similar to FHA, VA “takes back” some of the properties it finances when veterans default. It then offers these houses and condominiums on easy terms to anyone (veteran or nonveteran) who meets VA’s (relaxed) qualifying standards.
To locate VA-owned properties, go to va.gov. Click on home loan, which will take you to the home loan guaranty page. Look to the left sidebar and click on property management. From that link click on ocwen.com, which is the bank that manages VA foreclosures. You will then see a map of the United States, which you can follow to locate properties within the states and cities where you might buy. Also, because VA lists all of its homes for sale with local Realtors, you can call an agent who specializes in these types of listings (ocwen.com shows the listing agents for its VA properties along with property descriptions; you can also link to VA foreclosures at hud.gov).
Currently, nonveteran homebuyers can buy VA-owned properties with nothing down (but some closing costs). Investors may place as little as 5.0 percent down, but with 20 percent down they receive streamlined loan processing. In 2005, VA offered 30-year loans at an APR of 5.783 percent.
My recent search of California turned up just two VA properties. But Ohio shows 156 properties; Georgia listed 292; and Texas leads with 462 VA houses for sale. So, keep in mind that the numbers of HUD/VA homes for sale varies greatly by city and local market conditions.
We wanted a fixed-rate mortgage. ARMs were too risky.
LESSON: Before you pass up an ARM (adjustable- rate mortgage), understand and explore your options.
“When we started shopping for a home,” recalls Ari Kyle, “I read that you should avoid an ARM whenever you can get a 30-year fixed-rate mortgage for less than 10 percent. Since at the time, 30-year mortgages were around 8 percent, we didn’t even consider an adjustable rate. With fixed rates that low, why take the risk of an ARM?”
Although Ari asked this question rhetorically, the answer is not as obvious as he thinks. In fact, like Ari, many homebuyers pass up ARMs without considering why an adjustable-rate mortgage might prove their best choice. To help you decide, answer these six questions:
- Is there a strong probability you will sell your home within seven years?
- Do you expect your income to increase during the coming years?
- Would you like to increase your home purchase price range by $10,000 to $40,000 or even more?
- Would you like to cut your closing costs by $1,000 to $3,000?
- Do you expect to keep your home for more than seven years?
- Do you enjoy a financial cushion in your budget and savings accounts?
If you can answer yes to at least three of the above questions, you might profit with an ARM.
Save Money with ARMs
The shorter the length of time you plan to own your home, the more you should consider an ARM. You can nearly always find an adjustable that will cost you less than a 30-year fixed-rate loan if you plan to sell within seven years. Take a look at 5/25 or 7/23 (sometimes described as 30/5 or 30/7) adjustables.
These types of ARMs fix your interest rate and monthly payments for the beginning five or seven years of the loan. Then they periodically adjust to keep your rate in line with the market. Even this limited type of ARM may save you between .5 and 1.5 percent in interest rates as compared to a fixed-rate mortgage. For instance, at a time when 30-year fixed-rates were at 7.25 percent, I saw several 5/25 ARM plans with interest rates as low as 5.75 percent.
On a $100,000 loan, your payments for a 7.25 percent 30-year fixed-rate loan would cost $682 a month. If you selected the 5/25, your payments would drop to $583 a month. Although the rate differences between 30-year fixed-rate loans and various types of ARMs change daily, it pays to at least take a look. When you plan to sell within seven years, the chances are good you can find an ARM that limits your risk at the same time it reduces your monthly payments.
Moreover, if your income is going up, you should be able to handle any increases in your ARM’s monthly payments.
Qualify for a Larger Mortgage
ARMs help you qualify for a larger mortgage. They do this in two ways. First, because ARMs typically start with lower interest rates, for the same amount of monthly payment, you can borrow more. A payment of, say, $1,250 a month will pay off a loan of $187,885 at 7.0 percent over 30 years. With an ARM’s qualifying interest rate of, say, 5.5 percent, you could borrow $220,152. Second, if you can afford it, some ARM lenders will qualify you with more liberal qualifying ratios. For example, with a fixed-rate loan, the lender might limit your payments to $1,250 a month. But with an ARM, the lender might qualify you for a monthly payment of, say, $1,350. Instead of borrowing $202,915 (with a 7.0 percent fixed-rate loan), the 5.5 percent ARM with liberal qualifying would permit you to borrow $237,764.
Lower Points and Fees
To further encourage you to use an ARM, sometimes ARM lenders cut their loan origination fees and closing costs. This benefit, however, may not be the advantage it once was. To meet competitive pressures, many lenders also have been offering low cash-to-close deals on fixed-rate loans. Nevertheless, at least compare adjustable- and fixed-rate mortgages on the basis of cash you need to close.
Longer-Term Cost Savings
An ARM will probably save you money if you plan to sell within seven years. But you also might save money over the longer term. Here’s why.
Say you’re faced with a choice between a 30-year fixed-rate loan at 7.25 percent and a 7/23 that starts at 6.0 percent. You want to borrow $300,000. With the fixed-rate plan, your payments will cost $2,046 a month. With the 7/23, you’ll pay $1,798. For at least the first seven years, you’ll save $248 a month, for a total of $20,832.
Instead of pocketing this monthly savings of $248, though, add it to your monthly mortgage payments. Even though you’re only required to pay $1,798, you go ahead and pay $2,046 ($1,798 + 248 = 2,046). This tactic causes you to pay down your outstanding mortgage balance much faster. By making these extra payments, your mortgage balance after seven years would have fallen to approximately $248,086. On the other hand, your mortgage balance with the fixed-rate plan at 7.25 percent would have dropped to just $274,488. Obviously, if you sell at this point, you’re way ahead of the game with the ARM.
But what if you don’t sell? As long as your new adjustable rate stays below 9.5 percent, your monthly mortgage payments won’t amount to any more than $2,522—about the same as you’ve been paying. At 10.5 percent, your payments would increase only to $2,744 a month. Now, what if interest rates are lower when your loan adjusts after seven years? Not only will you have accumulated an additional $35,159 in home equity, but your monthly payments won’t increase and may actually go down.
These figures are illustrative only. Because the relative costs of ARMs versus fixed-rate loans change frequently, you must work numbers with your mortgage loan advisor that are current at the time you buy your home. Still, this basic fact holds true: The right ARM can put some homebuyers thousands of dollars ahead of where they would have been with a 30-year fixed-rate mortgage.
The Fixed-Rate Solution
Some mortgage loan officers agree with everything I have just stated, but they still argue that for most homebuyers the fixed-rate mortgage (FRM) can give comparable benefits with less risk. Here’s their reasoning:
- Some fixed-rate loans can be obtained without heavy front-end costs and fees. Therefore, the total first-year costs of ARMs versus FRMs may not differ as much as is commonly supposed.
- Should interest rates fall, you can inexpensively refinance your no-cost FRM at the lower interest rates. (Of course, this refinance option presumes that both you and your home continue to meet the current qualifying and loan-to-value [LTV] requirements.)
- Instead of using an ARM to qualify for a larger mortgage, locate a special first-time buyer fixed-rate mortgage that offers easier qualifying, a lower-than-market interest rate, or perhaps both. Or get your seller to buy down the FRM interest rate for the first two or three years of the loan.
- With an FRM you need not worry about payment shock. (Payment shock results when a quick jump in an ARM’s interest rate boosts your mortgage payment by hundreds of dollars a month.)
- Even if you plan to sell within three to seven years, take the security of a fixed-rate mortgage. Why? Because your plans may change. Or, if interest rates dramatically increase (say, from 5.0 percent to 7.5 percent), you may not be able to qualify for a loan on another house. In other words, higher interest rates may put your move-up possibilities on hold until interest rates fall. Then you would be stuck with your high rate ARM.
The Debate Continues
Which is best? An ARM or a fixed-rate mortgage? No one can answer that question. It depends on how FRM points, fees, and interest rates compare to those of ARMs at the time you buy. Plus, the answer depends on your personal financial situation as well as your “sound sleep” quotient. And remember, those zero-cost FRMs generally come with higher interest rates. They’re not zero cost. You just pay the costs over time.
Will an ARM save you money? Can you afford the risks of an ARM? Can you sleep soundly with the knowledge that your mortgage payments could increase? Don’t prejudge the answers to these questions. Get together with a savvy loan rep who will explain a variety of loan products and potential outcomes. Compare dollar amounts. Don’t focus on small percent changes in rates. A two percent change in your mortgage rate can affect your payments by hundreds of dollars a month.
Review the numbers relative to your circumstances. Then choose the best loan for your needs. To locate the best loan at the lowest cost, don’t rely on uninformed beliefs. Contrast savings and risks.
We didn’t negotiate for seller financing.
LESSON: Even when you qualify for financing from a mortgage lender, consider seller financing.
Julio and Tara Scott had only enough cash for a 10 percent down payment. So when they bought their home, their bank charged them a higher interest rate and required them to buy private mortgage insurance (PMI). In addition, because the mortgage insurer applied tight qualifying standards, the Scotts weren’t able to buy as much house as they wanted. In other words, they ended up paying more and getting less.
What the Scotts overlooked was a financing method referred to as an 80–10–10 sale. Here’s how this technique works: You put 10 percent down; you borrow 80 percent of your home’s purchase price from a mortgage lender; and the sellers carry back the other 10 percent as a seller-financed second mortgage.
Save on PMI
Because under this plan the bank has made an 80 percent loan instead of a 90 percent loan, it faces less risk. In exchange for this lower risk, the bank will drop its requirements for PMI, perhaps give you a better interest rate, and possibly relax its qualifying income ratios or other credit standards. You can buy more house for less.
Benefits to Sellers
What’s in it for the sellers? Why would they accept this kind of deal?
First and most important, the sellers get their house sold. For most sellers, that’s their number-one priority. When you write your offer, you make an 80–10–10 plan a condition of the contract. Second, because it’s easier to qualify at the bank for an 80 percent loan, the sellers can feel secure that your purchase will actually close. Many sellers fear they will pull their house off the market for four to eight weeks, then their sale will fall through, and they’ll be back at square one. Anything you do to reduce this fear stands out as a plus in the sellers’ eyes. (A preapproval letter also helps achieve this goal.)
Third, the interest rate you agree to pay the sellers will exceed the amount they could earn on their money in a certificate of deposit or savings account. With CDs paying four to six percent, a return of seven to nine percent to the sellers on a second mortgage can look pretty good. Fourth, an 80–10–10 sale will probably take less time to close than a 90–10 sale with private mortgage insurance.
Of course, an 80–10–10 sale represents just one variation of combined seller–bank financing. If you’re really short of cash, you could try for an 80–15–5 plan, or even an 80–20–0. In fact, any combination is possible. If your credit score is too low, you could decrease the bank’s percentage to 60 to 75 percent—say 70–20–10. Just remember: The lower the bank’s loan-to-value ratio, the greater your chance for loan approval, the less likely you’ll have to buy PMI, and the lower your interest rate.
Eliminate the Bank Altogether
Homebuyers who can’t qualify for bank financing know they must turn to some type of seller financing or an (increasingly rare) nonqualifying mortgage assumption. But even when you can qualify for bank financing, you might still go for a completely seller-financed purchase. Here are four reasons why seller financing works to benefit you:
- You can often get the sellers to accept a lower interest rate than typical mortgage lenders.
- Sellers don’t charge application fees, “garbage” fees, or loan origination fees. You need less cash to close.
- Seller financing involves less paperwork and a quicker closing.
- You can tailor the exact terms, amounts, and payment schedule to the needs of you and the sellers.
More than 40 percent of homeowners in the United States and Canada own their homes free and clear. These homeowners are prime candidates to carry back all or part of your financing. But sometimes you have to do more than ask. You have to make seller financing an essential condition of your purchase offer. Then itemize and explain the benefits. If you make your offer reasonable and responsive to the sellers’ needs (remember win-win), you’ll find that many can be persuaded to accept.
Those were the fastest two years of our lives.
LESSON: Beware of financing that falls due in less time than it takes to wear out a pair of shoes.
“We never worried about it at the time,” says Ruth Mehta. “We were sure interest rates would come down and our home would appreciate. We couldn’t imagine any trouble refinancing. But interest rates didn’t come down. Our home didn’t appreciate. And those were the fastest two years of our lives.”
When Ruth and her boyfriend, Sid, bought their home, they used a 70–20–10 financing plan. They borrowed 70 percent of their home’s price from the bank, the sellers financed 20 percent, and Ruth and Sid put 10 percent down. This technique made it easier for the couple to qualify for bank financing, and it saved them money. Not only did the bank give them a lower interest rate, the sellers even agreed to accept an interest rate less than the bank was charging. But here’s the catch: Ruth and Sid agreed to pay off the sellers’ balloon loan within two years. And they couldn’t do it.
Ruth and Sid had fallen into a common trap. Sometimes sellers who carry back financing will grant their buyers favorable terms for a year or two. After this short term, the seller financing falls due. The buyers then have to either come up with the money themselves or arrange new financing.
Risks of Short-Term Financing
Although in and of itself, there’s nothing wrong with short-term financing, it does present risks that many homebuyers ignore. Ruth says, “We were so eager to stop throwing rent money down a rat hole, we were willing to accept almost any terms the seller wanted. Back then, two years seemed like a long time. With the prospects of home ownership so close, we shut our mind to the risks. As far as we were concerned, there weren’t any. We told each other interest rates had to come down. We told each other our home would probably go up in value by at least 10 percent. Talking between ourselves was like talking in an echo chamber. Neither of us listened critically. We just repeated what the other one said.”
Sid and Ruth’s sleepless nights and anxious days demonstrate the risks of short-term financing. Over a period of one to three years, no one can accurately predict interest rates or home appreciation rates. Although it’s often easy to tell yourself you’ll be able to refinance, often experience has proven otherwise.
Minimize Those Risks
In fact, as many Southern Californians and New Englanders learned in the early 1990s, home prices can fall (in the short term) even when interest rates are heading downwards. Many of these homeowners couldn’t refinance their short-term seller carrybacks. Although a new loan would have meant lower payments, their home values would no longer support the amount of mortgage they needed.
To prevent getting caught in refinance limbo, do the following:
1. Insist on a second mortgage loan term of at least five to seven years. Don’t risk short-term future shock for the immediate joy of home ownership.
- If you do agree to a shorter-term loan, include an escape clause that extends your due date if home values are depressed or if interest rates have risen.
- As another safeguard, develop a plan to create value. Shorter-term finance plans work best when you buy a home at a bargain price. Then redecorate, remodel, or renovate to boost its loan value (or future selling price).
Special Note on Lease-Options
One of the most popular short-term seller finance plans is the lease- option. Most lease-option agreements call for buyers to execute their option to buy within one or two years. Usually, buyers use this time to save money for a down payment, strengthen their credit record, or pay off some of their other bills. For tens of thousands of former renters, the lease-option has been their ticket to home ownership.
If you choose a lease-option, you face the risk that interest rates will go up before you are able to buy. Just as with short-term mortgages, protect your position. Write a clause into your lease-option agreement that gives you more time to close if interest rates head north. Especially follow this advice if you’re paying substantially more for your option and lease payments than you would be paying in straight rent for another similar home. Don’t leave yourself wide open to the danger that you won’t qualify for the financing you need to pay off the sellers as scheduled.
I paid $2,500 down to lease-option a townhouse, then found out that no bank would give me a mortgage.
LESSON: Not all properties or down payments meet lender rules and regulations.
Like many tenants, Eric Coffey was tired of wasting money on rent. But financially, he wasn’t quite ready to buy. Eric wanted time to pay off his car loan, cut down his credit card debt, and build up more savings for a down payment and cash reserves. So he decided to look for a seller who would give him a lease-option.
“After just three weeks of searching,” recalls Eric, “I felt lucky because I found just what I wanted. It was a large end-unit townhouse with two bedrooms, two-and-a-half baths, fireplace, and a lower-level study. At $129,500 it was priced right, and the seller agreed to an 18-month lease-option. Our terms looked like this: I paid $2,500 to move in; my monthly rent payment was $1,500; and out of that $1,500, I received a rent credit of $500 a month toward the purchase price.
“I was quite pleased with this arrangement,” Eric continues. “Everything went well for the first 16 months. Altogether, I had accumulated a total of $18,000 toward my down payment. I had the option payment of $2,500, rent credits of $9,000, and additional savings of $6,500. That was more than enough for a 10 percent down payment and closing costs. I had even paid down my bills like I planned.”
Be Wary of Complexes or Buildings Populated by a High Percentage of Renters
“But my bank still turned down my loan,” says Eric. “The loan representative said too many unit owners in the complex were renting out their townhouses instead of living there themselves. To further complicate matters, the bank would not count my rent credits as part of my down payment. I’d been doing business with this bank for eight years. I had never made a late payment on my car loan or bounced a check. Yet the lender wouldn’t make the mortgage. I began to panic that I was going to lose the townhouse and all the money I’d put into it.
“In the end, we did get things worked out. The bank made a 70 percent loan, the seller carried back 20 percent, and I contributed my 10 percent. But it was really touch-and-go for a while.”
When Eric entered into his lease-option agreement, he ignored the fact that many lenders won’t give mortgages for condo, townhouse, or co-op complexes with high numbers of renters. Once a building or complex drops to less than 60 or 70 percent owner occupancy, lenders believe values in the complex may start to decline. When a property tips toward rentals, upkeep and maintenance often deteriorate.
“Funny Money” Down Payments
Eric also faced a second problem. Some lenders are suspect of “funny money” down payments. They prefer cash down from your bank account. If you want to use your car, a stamp collection, or rent credits as part of your down payment, the lender may feel you and the sellers are manipulating the numbers. In the past, many lease-option sellers have simply overpriced the homes they were selling. In exchange, they give buyers a large rent credit so it appears that they’re building equity—at least on paper. But in fact the rent credit is just whittling down the price to where it should have been to begin with.
Say you agree to pay $330,000 for a condo (or house) that’s actually valued at $300,000. Over two years you build up $11,000 in rent credits that you want to count toward a down payment. From the lender’s viewpoint, those rent credits are funny money. Even after counting them against your purchase price, you’ll still owe more than the home’s worth. So the lender says no deal. You’ve got to come up with a lot more real cash for your down payment.
To solve both these problems, first avoid condo, co-op, or townhouse developments that are close to tipping toward renters. (This is good advice regardless of whether you’re using a lease-option.) Second, make sure your option terms can pass a lender’s sniff test. If your agreement doesn’t smell right, the lender probably won’t go for it. The lender will try to make sure your rent levels, rent credits, and purchase price make sense in terms of the market. A lender doesn’t want to make an 80 or 90 percent loan-tovalue ratio loan that actually turns out to be a 95 or 100 percent loan.
We paid too much for our mortgage.
LESSON: Learn the tricks of the trade.
Until several years back, some real estate agents routinely received kickbacks from mortgage lenders. Although RESPA (the Real Estate Settlement and Procedures Act) supposedly outlawed this practice, it was common in many cities throughout the United States for lenders to pay agents under-the-table referral fees. In fact, unethical agents even demanded lenders pay them kickbacks for bringing in loan customers.
Beth and Ted Cippolla were one couple who fell victim to such a deception. “We trusted him,” says Beth. “He told us we didn’t need to waste time calling a dozen lenders because he had a special arrangement with a mortgage company who would give his buyers the best mortgage terms possible. He had a special arrangement, all right. But the arrangement wasn’t to get us the best deal. It was to get Harold [their agent] a free trip to Hawaii. He cost us an extra $900 in closing costs and one-quarter percent on our mortgage interest rate.”
In an effort to stamp out abuses like those the Cippollas suffered, HUD has cracked down on illegal kickbacks and referral fees. In several well-publicized court cases, HUD has gone after offenders with civil fines and criminal prosecutions. In addition, HUD has strengthened its rules and regulations. “Under current law,” says HUD division director David Williamson, “if agents aren’t providing a bona fide financial service, they aren’t entitled to referral fees, extra compensation, or anything else of value.”
So, become a savvy borrower. Don’t accept your real estate agent’s referrals without first checking the rates, terms, and qualifying standards of other lenders. HUD’s rules can work well only if you think for yourself. Count on your real estate agent to advise and suggest. But, it’s up to you to choose. (To easily compare loan rates and terms, go to www.hsh. com, www.interest.com, www.mortgagequotes.com, or www.iown.com.)
Loan Originators Can Increase Your Costs
In today’s competitive mortgage market, most mortgage originators (loan representatives) work on commission. They want to find you a loan. Otherwise, they don’t get paid.
The bad news is that loan originators earn higher commissions when they place you into higher-cost loan products. If your loan officer says, “The best I can do is a rate of 6.75 percent and two points,” don’t take that as a final quote. Just like a car salesperson (or any other type of salesperson), the loan officer may be testing your reaction.
If you accept, great. If you balk, the loan officer can say, “Oh, wait a minute, I’ve just thought of something else. Maybe I can get the lender to shave a point off those origination fees. They owe me a favor.”
To protect yourself against paying too much, ask to see the loan officer’s rate sheet. The rate sheet shows the wholesale cost of the loans. The bigger the spread between the wholesale rate and the interest rate and fees you pay, the larger the loan officer’s commission. In fact, ask the loan officer straight out, “What’s the amount of your commission on this loan?” If it’s $4,000, you know that more than likely you’ve been placed into a high-cost loan. If the commission is $400, there is far less chance you’re being taken for a ride. (Typical commissions run about 1 to 1.5 percent of the amount you borrow.)
Of course, neither the wholesale-retail spread nor the amount of the loan officer’s commission—taken together or separately—provides the entire picture as to whether you are getting the best possible loan for your needs and financial qualifications. But it is one important piece of the puzzle. Don’t passively accept a loan originator’s quotes. Investigate and negotiate.
Traditionally, mortgage lenders have classified borrowers into the credit categories of A, B, C, and D. (Today, though, most lenders rely on credit scores. Yet, the principles remain the same.) The lower your grade (score), the more you must pay for a mortgage. But just like in school, the grade (score) you receive depends on who’s doing the grading. Even with credit blemishes, one mortgage lender might give you an “A–”, another might downgrade you to a B or even C status—and, correspondingly, persuade you to pay a higher interest rate and fees. (At the same time, of course, the loan rep earns a higher sales commission.)
If you get downgraded because of credit blemishes, don’t meekly accept that verdict. Ask why. Is the loan rep bamboozling you so he or she can make more money? Or do you really deserve the downgrade? Also, learn how long it will take—or what you can do—to reach “A” status. Maybe you should defer buying until you can qualify at lower rates and costs.
To give you an idea of how credit scores affect loan pricing, go to myfico.com. At the time of this writing, the figures were:
720–850 / 6.0%
700–719 / 6.13%
675–699 / 6.66%
620–674 / 7.81%
560–619 / 8.53%
500–559 / 9.29%
Remember, though, these figures represented averages. When you show high cash reserves, low qualifying ratios, higher down payment, or persuasive compensating factors, you can negotiate a rate lower than the averages (at the time you’re mortgage shopping).
Subprime (Predatory) Lenders
Beware of those lenders who prey on people whose credit reports show credit stains such as foreclosures, repossessions, writeoffs, multiple lates, and bankruptcy. Such lenders frequently advertise “Bad credit, no problem.” More often than not, these lenders charge high fees, high interest, and high prepayment penalties. When their borrowers miss a payment or two, they prefer to foreclose quickly rather than attempt a loan workout (as is the case with reputable lenders).
If you thoroughly shop the market of reputable lenders and can’t obtain approval, do not turn to a predatory lender. Instead, try to arrange seller financing or delay buying for a year or so until you shape up your financial fitness. In recent years, a number of high profile predatory lenders have suffered fines running into the tens (or even hundreds) of millions of dollars for their unethical and illegal lending practices. Do not become prey for these predators.
Also, talk with several mortgage companies. If your blemishes consist of nothing more than a few late payments, you can probably find an A-grade mortgage. Even when you’ve suffered more serious setbacks, it’s sometimes possible to provide an excuse that will move you into an A category.
Discriminatory Pricing versus Negotiating Skills
Are two types of mortgage discrimination: (1) stereotypical (“We don’t make loans to ________ .
They’re bad risks.”), and (2) discrimination through “neutral” rules or practices that adversely impact some identifiable groups of borrowers (e.g., African Americans, Hispanics, immigrants, women, singles, and single-parent families).
As company policy, lenders have nearly eliminated stereotypical turndowns. However, studies do indicate that some borrowers pay more for their mortgages than other borrowers—even when their credit records and incomes are fairly similar. As it turns out, the borrowers who pay more are the borrowers most likely to fall into some legally protected category. Does this suggest that lenders are engaged in illegal discriminatory pricing? Not necessarily.
It does suggest, though, that these borrowers fail to negotiate their interest rates and loan fees. When the loan rep says, “Gee, this is the best I can do,” these borrowers are more likely to accept the loan on the terms offered. They don’t realize that they should respond with their own negotiating gambit, “Really, that’s the best you can do? Well, Providence Mortgage quoted us a better deal. Sorry, we’re just wasting our time here.” Or, “We found rates less than that on the Internet. You’re not trying to put one over on us, are you?”
No matter who you are, many loan originators will charge you higher interest and fees—if you let them. If you fear the lending process, fail to negotiate aggressively, or are uneducated about mortgage loan practices, you are prime game—regardless of your race, sex, ethnicity, nationality, or family status.
To protect yourself, assert yourself (politely, of course). For when some loan reps sense a vulnerable and powerless prey, they go for the kill.
30-Year Loans versus 15-Year Loans
Mortgage lenders joke among themselves about the many telephone calls they receive where the caller asks, “What’s your best rate?” Nine times out of 10, the caller really means, “What’s your best rate on a 30-year, fixed-rate mortgage?” Yet, the 30-year, fixed-rate mortgage is nearly always the most expensive loan over the short run—and it’s more expensive than the 15-year, fixed-rate loan over both the short run and the long run. Consider the comparisons on a $200,000 loan shown in Table 8.1. The original monthly payments on a 30-year loan cost less than the payments on a 15-year loan. But that’s where the advantage ends. After five years you will still owe $187,751 for the 30-year loan (compared to a $152,729 balance on the 15-year loan). And after your first 10 years of ownership, you’ll owe $82,432 more on your 30-year loan as compared to the 15-year loan ($170,602 – $88,170 = $82,432). And after 15 years, your 15-year mortgage will be paid off, but you’ll still owe $146,591 on your 30-year loan. In total, the 30-year loan will cost you not only a much slower payoff, but also $158,318 in additional interest expense.
Why do borrowers choose the higher-cost 30-year loan? The answer is the lower monthly payments for the first 15 years. The original lower payment helps borrowers qualify for a larger mortgage. Borrowers also say they don’t want to pay down their loan quickly. They would rather invest their extra money. Or they say, just for safety, we want the 30-year loan’s lower payments, but we plan to go ahead and make larger payments so we can get rid of this debt faster.
Fixed-Rate @ 6.75%
Fixed-Rate @ 6.25%
|Balance @ 5 yrs||
|Balance @ 10 yrs||
|Balance @ 15 yrs||
|Balance @ 20 yrs||
|Balance @ 30 yrs||
|Total Interest Paid||
*Original loan at $200,000
Only you can judge whether any or all of the above reasons may influence your choice of loans. But before you decide, compare the 15-year versus 30-year numbers. Experience proves that for many homebuyers, the 30-year loan proves more costly.
Some borrowers choose the higher-cost 30-year mortgage with the idea of refinancing into a 15-year loan later when rates drop or when their income goes up. If you adopt this strategy, be careful. Some lenders (especially, but not exclusively, in the subprime market) now insert prepayment penalties into their mortgage contracts. If you pay off your loan early (say, within the first three to five years), the lender may stick you with a $2,000 to $4,000 penalty (or more).
Loans with prepayment penalties aren’t necessarily bad because these loans are originated at slightly lower interest rates. For instance, you might be offered a 30-year, fixed-rate loan (no penalty) at 6.5 percent, but with a prepayment penalty, the rate drops to 6.25 percent.
Unfortunately, some loan reps don’t fully explain these choices, nor do they automatically give you the interest rate break that loans with prepayment penalties warrant. Once again, a word to the wise: Ask your loan rep to advise you fully concerning the features and costs of the mortgages that you are evaluating. If your loan includes a prepayment penalty, make sure you get a discounted interest rate.
Points versus Interest Rates
Nearly all lenders trade off points (fees paid at the time the mortgage money is loaned) and interest rates. Say you’re looking at the choices shown in Table 8.2.
The question is, “Which of these choices is the lowest cost?” The answer: It all depends on how long you keep your mortgage. If you keep your loan for more than three years (36 months), the 6.75 percent/ 3 point loan will save you the most money. Although you must pay an additional $3,000 at closing to get this lower rate, this loan will save you $85 a month over the 8.0 percent/0 points loan. In comparison to the 8.0 percent mortgage, you’ll earn your $3,000 in points in just over 35 months ($3,000 ÷ $85 = 35.29). After that, it’s all gain.
Months to Break Even
*These figures represent hypothetical comparisons. In practice, they vary among lenders, loan products, and mortgage market conditions.
The above figures are for purposes of illustration only; the actual trade-offs you see will differ from these. Yet, this type of calculation is a good method (though not precisely accurate) to select the lowest loan based upon your expected circumstances.
A trustworthy and competent loan rep will go over interest rate/points trade-offs with you to figure out which look best for you. A greedy loan rep will steer you into the interest rate/point combination that yields the largest sales commission. Don’t ask your loan rep, “Which one is best?” Instead, ask him or her to work through the numbers with you. Then, after the explanation, you decide.
Closing Costs and Fees
At the time you apply for a loan, your lender will provide a “good faith” estimate of the closing costs and fees that will be charged at settlement. In addition to points (discussed above), closing costs may include charges for an appraisal, credit report, prorated taxes, mortgage application, flood insurance, title insurance, mortgage insurance, homeowners’ insurance, garbage fees, and numerous other expenses that can total in the thousands of dollars.
The question is, how can you reduce the amount of these costs that you have to pay? First, before you apply for a loan, get some idea of the closing costs that buyers typically pay. Then, in your home purchase negotiations, shift some of these costs to the sellers (or at least keep this tactic in mind). Second, in some markets and for some loan products, lenders differ greatly in the costs they levy against buyers. When shopping lenders, compare costs and fees as well as points and interest rates. Third, if the closing costs seem high (or even if they don’t), ask the lender to reduce or eliminate them. It is perfectly reasonable to question and negotiate a lender’s costs and fees.
Watch Out for Bait and Switch
Above, I placed “good faith” in quotation marks. That’s because some lenders will quote you one amount for costs, fees, points, and interest rate. Then, after they get you deep into the loan process, they will “discover” a credit blemish or some other “defect” in your application. “Sorry,” such a lender might say, “you’ll have to pay more because …” At that point, don’t give in without a fight. You may be targeted for the old bait and switch sales tactic. If you do suspect this type of unethical (and perhaps illegal) behavior by the lender, tell them to honor their commitment or you will file a complaint with the state licensing board or the Federal Trade Commission (FTC). Also, you could switch lenders and demand that the offending lender forward your file to the new lender. That way, your new approval process won’t start over from square one.
Bad Faith Lock-Ins
Some unethical lenders also play tricks with lock-ins. At the time you apply for a loan, the lender may (for a fee) lock you in to an interest rate of 6.25 percent for say, 45 days. Then, if market interest rates head up, the lender may “discover” problems in your application that delay settlement beyond the 45 days. “Sorry,” the lender says, “rates have increased, and we have to bump you up to 6.75 percent.”
If you believe that the lender has purposely dragged its feet to push you into a higher rate, don’t accept it. Complain. Demand. Threaten to go to the regulators. More than likely you’ll get the original rate restored.
Some lenders will lock in your maximum mortgage interest rate, yet will also give you a float-down if rates fall between the time you apply and the date your loan closes. “Good news,” your loan representative tells you, “rates have fallen and we can now close your loan at 7.75 percent instead of 8.0 percent. You’re going to save $17.35 a month.”
Yes, that’s good news. But it may not reflect the full market drop in rates. If market rates really sit at 7.5 percent, by fooling you into accepting 7.75 percent, your loan representative will pocket a nice-sized “overage ” commission. Even with float-downs, take care. Make sure you receive the full float-down that you are entitled to.
“Hot” Products/“Hot” Lenders
In highly competitive mortgage markets, mortgage costs such as points, rates, and closing expenses may not vary much among lenders. On occasion, though, some lenders decide to “buy market share” or push a “hot” loan product to rebalance its portfolio of mortgage products. In these cases, if you’re in the right place at the right time, you could score a real bargain loan.
Keep your eyes open to various alternatives. I know borrowers who have picked up super-priced ARMs even though they had mentally committed to a fixed-rate product. In other words, mortgage shopping can be compared to going to a restaurant with your appetite set on sir- loin steak. Then you learn the lobster-prime rib combo is on special at $17.50. In that situation, why pay $19.50 for sirloin?
APRs and ARMs
When you compare the costs of mortgage loans, you will see the term APR (annual percentage rate). To comply with government truth-in- lending laws, mortgage interest-rate advertising must include this figure. The APR always exceeds the stated interest rate because it supposedly accounts for your total cost of borrowing (interest, fees, points, prepaids, and certain other expenses). Presumably, by comparing APRs among various loan products and lenders, you will be able to select the lowest-cost loan.
Unfortunately, life is not so simple. In the first place, APRs that apply to ARMs make no sense. Under the law, they are calculated as if the ARM interest rate will not change during the life of the loan (except for the scheduled boost up from the teaser rate to the initial contract rate).
Yet, the very idea of an adjustable rate mortgage is that the interest rate will change. So, APRs for adjustable-rate mortgages give us mathematically precise, yet irrelevant, figures. True APRs for ARMs cannot be calculated in advance.
In its effort to force lenders to tell the truth about the costs of their mortgage loans, the government misleads borrowers. When comparing ARMs, you cannot rely on the stated APRs. You may find a COFI (Cost of funds index) ARM with an APR of 5.675 percent and a one-year treasury ARM at an APR of 7.25 percent. But since no one knows how these respective ARM indexes will change over time, no one can accurately predict which one represents the lowest-cost loan.
Although it might appear that the APR would apply accurately to fixed-rate mortgages, that is true only in the unlikely event you pay off the loan balance precisely according to schedule over the full life of the loan. If you pay ahead of (or behind) schedule, your actual APR will increase. Similarly, if you sell your house or refinance your mortgage, your actual APR will exceed the APR figure the government requires lenders to calculate.
In mandating APR disclosures, the government addressed a real need: help consumers compare the total costs of mortgage loans. In practice, look beyond the APR. To obtain the best loan at the lowest cost, compare loan products according to your personal financial situation, your tolerance for risk, and the expected period over which you plan to hold your loan.
Summing Up: Loan Costs and Possibilities
To obtain the best loan at the lowest cost, you can’t “dial for dollars” and ask lenders, “What’s your best rate?” Instead, keep an eye out for the ways that unscrupulous (or inexperienced) loan reps can lead you into paying more than you should. Weigh the pros and cons of a variety of loan types. Negotiate assertively. Most important, work with a trustworthy loan rep who demonstrates savvy, knowledge, competence, patience, and concern. A top loan rep operates with the philosophy, “You’ll never come in second by putting the customers first.”
Our lender canceled our loan approval because I went into labor early and had to take temporary leave from work.
LESSON: Don’t change your loan status before you close your mortgage. Your lender may revoke your approval.
Kristi Colburn and her husband, Pat, did all the right things to prepare for buying their home. They saved. They didn’t run up large debts. They kept their credit record spotless. They both had worked steadily since graduating from college seven years earlier. And before they started their home search, they received preapproval (not merely a prequalification) of their loan application. (A prequalification tells you how much house you can probably afford according to the lender’s standards. With a preapproval, the lender okays your loan subject to underwriter verifications.)
“Everything was going great,” says Kristi. “We found a terrific house less than 15 minutes from work. Our offer was accepted and we quickly went into escrow. After years of waiting and months of searching, we were just two weeks from becoming homeowners. Our loan representative told us from now until closing would be smooth sailing. Just paperwork formalities—nothing to be concerned about.
“Instead of smooth sailing, though, during the next two weeks, our sailing ship lost its wind and we hit choppy seas,” recalls Kristi. “Eight months along in my pregnancy, I started to feel severe labor pains. It became too difficult for me to work, so I took disability leave. Ten days later I delivered our daughter Jessy.”
Gain a Daughter, But Don’t Stop Work
“But at the same time we gained a daughter, we lost our loan. The day after I got home from the hospital, the loan representative called and said I needed to go back to my job immediately or the underwriter would withdraw the commitment. The mortgage approval required two incomes, he said. Of course, we knew that and I did intend to return to work—but not for at least two or three months. The loan representative replied that wasn’t good enough. He said I had to go back now.
“In trying to find a satisfactory solution, over the next six weeks we went through sheer agony. Our apartment lease expired and we had to move in with Pat’s parents. My mom agreed to cosign our note. My employer assured the lender my job was waiting for me anytime I was ready to end my maternity leave. We increased our down payment to 20 percent. The lender switched us from the fixed-rate loan we wanted to an ARM.
“Each time we would make one of these concessions or accept a new demand, the loan representative would reschedule our closing date. Then he would call and cancel until we agreed to something else. It was ridiculous.
“But you won’t believe what happened next,” Kristi added. “After meeting all the lender’s additional requirements and suffering through three cancellations and reschedulings, the loan representative informed us the loan underwriter once again had changed her decision. If we wanted the loan, I would still have to go back to work immediately, receive a paycheck, and then show the lender my paystub.
“At that point, we were frustrated and exhausted. There was nothing we could do. We needed a home and weren’t about to start looking for another apartment to rent. I had no choice. I went back to work, got my paystub, and, finally, escrow closed.”
Your first reaction to Kristi’s ordeal might be that the lender discriminated against Kristi because of her pregnancy and the birth of her daughter. But no matter how absurdly the lender handled Kristi and Pat Colburn’s loan processing, it acted within its rights. Whenever a mortgage applicant changes his or her loan status prior to closing, the lender can revoke its loan approval. Since, technically, Kristi’s job income had stopped, the lender wasn’t required to count it. Without the income, the Colburns no longer qualified.
Many Factors Affect Loan Status
In Kristi’s case, her loss of income (even if temporary) triggered the change in the Colburns’ loan status. However, all the factors a lender considers in its loan decision will contribute to your loan status:
- Bills, debts, and expenses
- Length of employment (e.g., don’t change jobs without the lender’s okay)
- Job security
- Credit score
- Credit record
- Source of downpayment
- Cash reserves
- Net worth
- Type of loan, interest rate, amount of your scheduled payments including property taxes, homeowners’ insurance, and mortgage insurance (if any)
After learning that their mortgage had been approved, Phil and Sue Grubbs went out and charged $6,000 of new furniture for their home. When the lender learned of these additional bills through a last-minute credit reverification, the Grubbs lost their mortgage approval. Their additional bills knocked them out of qualifying. Jack Reeves was preapproved for his home loan and then accepted a better job at higher pay. Thinking this was good news, Jack told his loan representative. The loan representative revoked Jack’s preapproved commitment. The lender thought new jobs were too insecure. “Come back after a year,” the loan officer told Jack.
When it comes to approving and closing loans, lenders show a split personality. Sometimes they will lean over backward to bend the rules to get a borrower qualified. On other occasions they act as if they’ve locked their common sense in one of their money vaults. So a word to the wise: After you’ve applied for a loan, don’t do anything that might adversely affect your loan status. If you do, your lender may give you the same kind of hassle (or rejection) that hit the Colburns, the Grubbses, and the Reeveses.
Loan Approval versus Loan Commitment
When a loan representative processes your application data through an automated underwriting system, it may signal “approval.” But that’s not the end of the story. Your loan file will next move to a real live loan underwriter who critically examines the paperwork to make sure every verification and explanation is in order. The automated systems never make the actual loan commitment.
For example, say the system shows you have a 3-bureau average credit score of 730. Thus, it signals approval. But the live loan underwriter notices that your credit record shows a credit card writeoff of $9,346 six years ago. The underwriter may want you to clear that debt before she will commit the lender to the loan. When you talk with the loan representative, probe him to learn whether any aspects of your credit profile will likely raise questions from the underwriter.
Better for you to anticipate problems and plan accordingly than to get a nasty surprise six days before your scheduled closing. Never believe that a loan representative’s “approval” actually commits the lender to making the loan. It doesn’t.
My loan fell through because of poor credit.
But it wasn’t my credit that was bad.
LESSON: Get your credit record and finances in shape before you begin to shop for your home.
Gwen Davis knew she had excellent credit and had never made a late payment in her life. So she didn’t bother reviewing her credit report before she began shopping for a home. As Gwen now realizes, that shortcut proved to be a mistake. It cost her the home she wanted.
“I couldn’t believe it,” says Gwen. “I was in shock. The loan officer told me the credit report showed I was two months behind on my car loan and that my Visa card had been canceled for nonpayment. ‘I don’t even have a car loan,’ I told him. ‘I can show you the title to my car.’ ”
“The loan officer sympathized but said his hands were tied. If the credit report erred, it would be up to me to straighten it out. Until I could show him a clean record, my application would not be considered.
“My next step,” Gwen continued, “was to try to get to the bottom of this. I went to the credit bureau and got a copy of my credit report. Sure enough, the black marks were there for all the world to see. But as I knew, they didn’t belong in my file. What had happened was the credit bureau had mingled my record with the record of Gail Davis my ex-husband’s new wife.” (As an aside: The credit bureau, Experian, formerly did business under the name TRW. In the lending trade, loan officers often said TRW stood for “The Report’s Wrong.”)
Beware: Credit Bureaucracy at Work
“At this point, my education concerning the credit bureaucracy was just beginning. I soon learned that to discover a problem is one thing. To fix it is something else. To get those black marks off my record required endless phone calls, a dozen letters, and threats from my attorney. To make matters worse, Gail didn’t lift a finger to help. She wasn’t eager to see delinquent accounts reappear in her file. All told, it took four months to clear my name. By then, the sellers had already sold their home to other buyers. I really wanted that house, too.”
You can prevent Gwen’s mistake by contacting your local credit bureau or all of the national credit repositories (Experian, TransUnion, and Equifax). Ask them to provide you with a copy of your credit report. (They may charge a fee.) Then examine the report carefully. If you discover bad credit that doesn’t belong to you, tell the credit bureau. Immediately do what’s necessary to get it removed. As Gwen Davis found out, that process can sometimes take months.
Make Your Best First Impression
If you find that your credit record accurately shows late payments or other blemishes, these “derogatories” may stop many lenders from approving you for a loan. At a minimum, make sure all your installment accounts are current. Should your record reveal outstanding past-due debts, write-offs, judgments, or tax liens, many lenders will require you to pay them. Most mortgage lenders will not lend money to someone who has not paid legally enforceable obligations (i.e., valid unpaid debts that remain within the applicable statute of limitations). This practice even extends to disputed claims. The lender won’t take your word. By whatever means you can, clear these from your record. You will have to negotiate, litigate, or otherwise satisfy the claims. (Sometimes lenders do make exceptions for small amounts, unpaid bills or write-offs that go back more than four or five years, or debts for which the statute of limitations has expired.)
To guard against a turndown, review your credit record, get your finances in the best shape you can, and search for a lender and loan product that matches your situation. To gain approval for home financing, weigh your strengths and weaknesses. Then, before you apply, try to identify the lenders whose qualifying criteria best fit your borrower profile. Prepare to make your best first impression.
Our lender turned down our loan application.
LESSON: Prepare, prepare, prepare.
“The lender did not approve our loan application. What can we do?” Each year, the number of mortgage turndowns runs into the hundreds of thousands. Sadly, most of these rejections need not have occurred. In a majority of cases, the people who were turned down hadn’t done their homework.
Many potential homebuyers think they either qualify or don’t qualify for financing, as if this were the result of some type of genetic determinism.
They go to a lender, fill out the application forms, then hope for the best. (Of course, a top loan rep would never permit this foolish practice, but most people who are turned down have not sought the counsel of a skilled loan originator. More than likely, they have dealt with a “paper processor.”)
Before you apply for a mortgage, evaluate four areas of importance: (1) capacity, (2) collateral, (3) credit, and (4) compensating factors.
Nearly every mortgage lender judges whether you bring in enough income to cover your monthly bills, living expenses, and housing costs-tobe (mortgage payments, homeowners’ insurance, property taxes, homeowner association fees). In general, lenders say your total housing costs shouldn’t run any more than 28 percent of your income; your housing costs plus other monthly payments shouldn’t exceed 36 percent of your monthly income. These percentages are called qualifying ratios.
However, those ratios are not etched in stone. That’s why you need a top loan rep. He or she will go over all of your numbers prior to your application. Then he or she will help you arrange your numbers in such a way that loan approval (for the loan program selected) is substantially assured. For example:
- 1. Qualifying ratios. Although 28/36 qualifying ratios are traditional, many automated underwriting programs approve loans with ratios as high as 44/44. FHA and VA frequently approve borrowers with ratios of 33/43—or higher. First-time buyer programs, too, permit high ratios.
- 2. Installment debt. You may make monthly payments on credit-card accounts, car loans, student loans, and maybe alimony or child support. Lenders and loan programs count these debts differently. In addition, you may be able to pay off or consolidate some accounts. These efforts will improve your qualifying ratios.
- 3. Income. Even the amount of income you bring in may not prove as simple to count as you think. What if you’re self-employed, a commissioned sales rep, or expecting a big raise? What about part-time work, overtime, or a second job? What if you receive alimony or child support? Can you bring in the income of a co-borrower? Do you expect to houseshare or bring in rental income from tenants? How should your spouse’s income be figured?
Although it is easy to fill in the numbers on a form to see if you “qualify,” it takes skill, knowledge, and experience to “arrange” your numbers in their best light. Then once you’ve been made to look as good as you can, a top loan representative can search for the mortgage program (or lender) that will best fit your borrower profile.
Many loan programs require cash reserves. Others do not. Nevertheless, in the black box calculations of credit scores and automated underwriting, the greater your cash on hand after closing, the better you look. If it looks like you’re running short, sell a car, hold a garage sale, or otherwise increase the amount of cash in your bank account. Cash reserves dampen the lenders concern that a slight financial disturbance will create a storm of problems for you.
Sometimes, lenders who want to reject an otherwise creditworthy borrower will use a “lowball” appraisal. To guard against this problem, (1) verify the features and selling prices of a large number of comparable sales, and (2) provide the lender’s appraiser with the comp sales data that you (or your real estate agent) have discovered.
Naturally, too, lenders prefer large down payments (i.e., low loan-tovalue ratios) as opposed to low down payments (i.e., high loan-to-value ratios). Should your loan approval look “iffy,” try to raise more cash for your down payment. If you’re planning to increase the home’s value through improvements, tell the lender.
Lenders, too, judge the condition and features of a property. Some lenders may avoid properties that aren’t connected to a sewer, have a flat roof, are wired with aluminum writing, include excessive land, or manifest some other out-of-the-ordinary characteristic (such as, perhaps, a retail store on first level with living quarters above).
In the total scheme of things, lenders reject few loans for reasons of inadequate collateral. Even so, do what you can to convince the lender that your property offers solid value.
Credit Record/Credit Score
Automated underwriting typically places the most emphasis on your credit score, not your total record of payments (or nonpayment). If some old writeoffs or judgments show up in your credit records, you can still achieve reasonably high credit scores. (Remember, for most mortgage loans, lenders will run a tri-merged credit report that shows a credit score that’s based on your credit records from each of the three major credit repositories.)
However, as noted previously, if your credit record displays some stain or blemish, the loan underwriter who personally reviews your total application file might: (1) ask you for more explanatory information, (2) require you to clear the blemish (such as paying off an old debt), or (3) refuse to issue a commitment. In recent years, the press has greatly publicized the issue of credit scores. But, your credit record still counts.
Naturally, too, your credit record influences your credit score (but recency counts far more than events of four or five years back). Obtain copies of your credit reports long before you plan to apply for a mortgage. Get adverse errors corrected. As to old unpaid bills, check your state’s statute of limitations. Beware: if you start making payments on an old bill, it will not only restart the running date for the statue of limitations, but it also will probably pull down your credit score.
Before you take any action, talk frankly with a loan pro (and perhaps a good consumer rights attorney). Sometimes you’re better off just to let an old debt sit there and fade away. (I’m talking legally and financially, not morally.)
Some lenders look for high FICO scores. Others, target borrowers with lower scores. In that case, compensating factors can play a role in the mortgage approval process. What is a compensating factor? It is any evidence that you can provide to support your willingness and ability to make your mortgage payments on time. Here are some examples:
- Low family living expenses
- Energy efficient house
- Low or no costs of commuting
- High net worth (for your age and income)
- Regular pattern of savings
- Low use of credit
- Upward career path
- Rent payments equal to or exceeding your mortgage payments-tobe
- Sterling credit history
- Large cash reserves (or liquid assets)
Also, provide evidence to offset negatives such as write-offs, bankruptcy, foreclosure, or judgments. Lenders forgive isolated instances of trouble—if you convince them that the hardship resulted from some adversity of life such as disability, unemployment, divorce, a spendthrift ex-spouse, real estate market collapse (as happened in Texas, Southern California, and New England), or large, out-of-the-ordinary medical expenses. FHA and VA, especially, have shown forbearance for past instances of explained financial difficulties.
Beware of Stacking Risk Factors
Although many lenders look beyond the traditional qualifying rules, they still proceed cautiously when you stack up too many risk factors (e.g., low down payment, credit blemishes, short time on job, high qualifying ratios, no cash reserves, large family with one breadwinner, high installment debt, large number of open credit accounts, payment shock). If your finances push the limit in more than a few risk areas, get together with a homebuyer counselor or loan rep. Then make positive changes wherever possible. Mortgage lenders want to make loans. But they also want to get their money back according to schedule and without hassle.
Lenders also like consistency. They like a pattern of borrower behavior that shows financial responsibility. They want to see long-term prudent borrowing and repayment. Don’t wait until the last minute to shape up your financial profile. The longer you show a pattern of responsibility, the better you will look to a mortgage lender.
Summing Up: Qualifying Depends on You
Follow the lessons described in this article and work with a trustworthy and skilled loan representative—an upfront mortgage broker. As with most other achievements, a successful loan application requires forethought and planning. Learn the rules. Then learn how to make the rules work for you. Explore many loan possibilities. Provide strong documentation for compensating factors and explanations of “derogs.” You’ll get the loan you need.