Preparing for Homeownership - Step Four
UNDERSTANDING THE HOME BUYING PROCESS
Once you have determined that you are ready to buy a home, it is important to educate yourself on how the home buying process works. This section will take you through the home buying process so that you can understand how best to prepare yourself for homeownership.
DETERMINING HOW MUCH YOU CAN AFFORD TO PAY
How much of a house payment can you afford? Mortgage lenders will qualify you for the maximum loan amount, according to your income, debt, and prevailing interest rate. However, this may not be the actual amount you want to borrow. Remember that you can always borrow less. Take your projected PITI (principal, interest, taxes, and insurance) and all your other debt payments and calculate what you have left, based on your net income. Do you have extra money left? Or will you be “house poor?”
A mortgage loan officer takes many variables into account when they pre-qualify a prospective homebuyer. Credit score, current salary, employment history, and current debt are major factors in the approval process. However, the homebuyer must be keenly aware that it is he who is paying the mortgage note. Lenders often qualify a homebuyer for a loan amount that exceeds the comfort level of the borrower. It is the homeowner’s responsibility to tell both the lender and the real estate agent that they wish to spend less than that amount.
As mentioned in a previous section, you must also understand the difference between what you desire in a home and what you can afford. Once you establish what you can afford, you must familiarize yourself with the particular areas within your local real estate market that are likely to offer houses in your price range.
UNDERSTANDING HOME BUYING RATIOS
Lenders use two common ratios to determine the maximum home mortgage loan amount they will allow you.
The first ratio lenders use compares your total monthly housing costs with your total monthly gross income. Your expected monthly housing costs, including mortgage principal, interest, taxes and insurance (PITI) should not exceed 28% of your income. (Although, some home loan programs allow up to 33%.)
The second ratio lenders use is your debt-to-income ratio (DTI). Your total monthly debt, including your expected PITI, credit card, and other loan payments, should not exceed 41% of your gross monthly income. The actual percentages vary by lender and home mortgage loan program, but keep in mind that your goal is to arrange a mortgage that best suits your needs without creating a financial burden.
Your home buying ratios, in combination with your credit score, which is also known also known as a FICO® score, are two of the most important factors lenders consider when you apply for a home mortgage loan. (See the section “Examining Your Credit” for further explanation of FICO scores.) Keep in the mind that taxes and insurance vary from county to county.
EXAMINING YOUR CREDIT
It is preferable for a homebuyer to have at least four good credit references when qualifying for a loan.
Traditional credit references include:
• Car loans
• Credit cards
• Student loans
• Personal loans
Non-traditional credit references can include:
• Rent payments
• Utility payments
• Phone payments
• Storage payments
• Title loans
• Car insurance payments
If a homebuyer has poor credit, it is more difficult to qualify for a mortgage. A borrower with good credit means that s/he has:
• No unpaid judgments or liens
• No foreclosures within 10 years
• No bankruptcies within the last two years
• No unpaid collections
• No slow pays or late pays within twelve months prior to applying for a mortgage
• No delinquent child support obligations
CREDIT SCORES
Credit scores are one of the most important factors in determining if a consumer qualifies for a favorable interest rate on a mortgage loan. The higher your credit score, the more favorable your insurance rate will be.
Along with checking your credit report, lenders can also access your credit score, which is based, in part, on the information in the report. That score is calculated by a mathematical equation, which evaluates a variety of factors in your credit report. By comparing this information to the patterns in hundreds of thousands of past credit reports, the score identifies your level of future credit risk.
The term FICO refers to a credit scoring system developed by Fair Isaac & Company. The FICO® score was developed in the 1950’s as a tool lenders can use in determining the creditworthiness of the prospective borrower. It calculates the statistical likelihood that a borrower will or will not pay a debt. FICO® scores range from 300 to 850. The higher the score, the more attractive the interest rate the homebuyer will receive. In order for a FICO® score to be calculated on your credit report, the report must contain at least one account that has been open for at least six months. In addition, the report must contain at least one account that has been updated in the past six months. This ensures that there is enough information — and enough recent information — in your report on which to base a score.
ABOUT FICO® SCORES
Three major credit reporting agencies, Equifax, Experian, and TransUnion, provide FICO® scores to lenders.
FICO®scores are believed to provide the best guide to future risk based solely on credit report data. The higher the FICO® score, the lower the risk of default. At the same time, no score can predict whether a specific individual will be a “good” or “bad” customer. And while many lenders use FICO® scores to help them make lending decisions, each lender has its own strategy, including the level of risk it finds acceptable for a given credit product. There is no single “cutoff score” used by all lenders and there are many additional factors that lenders use to determine your actual creditworthiness and interest rate. At least you now have a general idea of how lenders determine how much credit to offer and what interest rate to charge a particular borrower.
OTHER NAMES FOR FICO® SCORES
FICO®scores have different names at each of the three credit reporting agencies. All of these scores, however, are developed using the same methods by Fair Isaac & Co., and have been rigorously tested to ensure they provide the most accurate picture of credit risk possible using credit report data. The chart below gives the proprietary name each bureau uses in referring to a credit score.
|
Credit Reporting Agency
|
FICOScore Name
|
|
Equifax
|
BEACON®
|
|
Experian
|
Experian/FairIsaac Risk Model
|
|
TransUnion
|
EMPIRICA®
|
In general, when people talk about “your score,” they are talking about your current FICO® score. However, there is no one score used to make decisions about you. This is true for the following reasons:
• Credit bureau scores are not the only scores used.
Many lenders use their own scores, which often will include the FICO® score as well as other information about you.
• FICO® scores are not the only credit bureau scores.
Although FICO scores are the most commonly used, there are other credit bureau scores. These credit bureau scores may evaluate your credit report differently than FICO® scores. In some cases, a higher score may mean more risk, not less risk, as with FICO® scores.
• Credit reporting agencies may score differently.
The FICO® score from each credit reporting agency considers only the data in your credit report at that particular agency. If your current scores from the three credit reporting agencies are different, it is most likely because these agencies each have slightly different information on you.
• Your FICO® score changes over time.
As your data changes at the credit reporting agency, so will any new score based on your credit report. So your FICO score from a month ago is probably not the same score a lender would get from the credit reporting agency today.
IMPROVING YOUR CREDIT SCORE
Raising your credit score is a bit like losing weight: it takes time, and there is no quick fix. In fact, quick fix efforts can often backfire. The best advice is to manage credit responsibly over a period of time.
Following are tips that will help you maintain good credit history:
• Pay your bills on time.
Delinquent payments and collections will have a negative impact on your score.
• If you have missed payments, get current and stay current.
The longer and more consistently you pay your bills on time, the higher your score will be.
• Be aware that paying off a collection account will not remove it from your credit report.
• Be aware that paying off a collection account will not remove it from your credit report.
Your history will stay on your report for seven years. However, most lenders require that collection accounts be paid in order to proceed with your mortgage approval process.
• If you are having trouble making ends meet, contact your creditors or see a legitimate non-profit credit counselor.
This will not improve your score immediately, but if you can begin to manage your credit and pay on time, your score will get better over time.
If you have accounts on which you carry a balance, the following tips will assist you:
• Keep balances low on credit cards and other revolving credit accounts.
High outstanding debt can affect your score.
• Pay off debt rather than move it around.
The most effective way to improve your score in this area is by paying down your revolving credit. In fact, owing the same amount but having fewer open accounts may lower your score.
• Don’t close unused credit cards as a short-term strategy to raise your score.
• Don’t open new credit card accounts that you don’t need just to increase your available credit.
This approach could backfire and actually lower your score.
• If you have been managing credit for only a short time, don’t open several new accounts too quickly.
New accounts will lower your average account age. This will adversely affect your score,
particularly if your file contains limited credit information. Additionally, rapid account buildup can look risky, especially if you are a new credit user.
If you are trying to establish or re-establish credit history, the following tips will help you:
• Do your rate shopping for a given loan within a limited period of time.
FICO®scores distinguish between a search for a single loan and a search for many new credit lines in part by the length of time over which inquiries occur.
• Re-establish your credit history if you have had problems.
Opening new accounts responsibly and paying them off on time will raise your score in the long term.
• Request a copy of your own credit report.
You are entitled to a free copy of your credit report each year from all three credit reporting agencies. If there are inaccuracies or errors in your credit report, you can request that the credit reporting agencies review your credit report and make corrections. Your free credit report does not include your credit score. You can obtain a copy of your credit score separately, but you will have to pay a small fee.
• Apply for and open new credit accounts only as needed.
Don’t open accounts just to have a better credit mix. It probably won’t raise your score.
• Manage credit cards responsibly.
In general, credit cards and installment loans (and making timely payments) will raise your score. Someone with no credit cards tends to be higher risk than someone who has managed
credit cards responsibly.
• Be aware that closing an account doesn’t make it go away.
A closed account will still show up on your credit report, and it may be included in your score.
Although each credit reporting agency formats and reports this information differently, all credit reports contain basically the same categories of information. Your social security number, date of birth, and employment information are used to identify you. These factors are not used in scoring.
Updates to this information come from information you supply to lenders.
UNDERSTANDING TRADE LINES
Trade lines are your credit accounts, past and present. Lenders report on each account you have established with them. They report the type of account (bank card, auto loan, mortgage, etc.), the date you opened the account, your credit limit or loan amount, the account balance, and your payment history.
MAKING INQUIRIES
When you apply for a loan, you authorize your lender to ask for a copy of your credit report. This is how inquiries appear on your credit report. The inquiries section contains a list of everyone who has accessed your credit report within the last two years. The report you see lists both “voluntary” inquiries, spurred by your own requests for credit, and “involuntary” inquires, such as when lenders order your report so as to make you a pre-approved credit offer in the mail.
UNDERSTANDING PUBLIC RECORD AND COLLECTION ITEMS
Credit reporting agencies also collect public record information from state and county courts and information on overdue debt from collection agencies. Public record information includes bankruptcies, foreclosures, suits, wage attachments, liens, and judgments.
CHECKING YOUR CREDIT REPORT
You should make sure the information in your credit report is correct. Not only is your credit score based on this information, but lenders also review this information in making credit decisions. Review your credit report from each credit reporting agency at least once a year and before making a large purchase, like a house or car. If you have been turned down for employment or credit during the last 60 days, you are entitled to one free credit report. To request a copy, contact the credit reporting agencies directly:
|
Credit Reporting Agency |
Agency Phone Number |
Agency E-Mail |
|
Equifax |
(800) 685-1111 |
www.equifax.com |
|
Experian (formerly TRW): |
(888) 397-3742 |
www.experian.com |
|
TransUnion |
(800) 888-4213 |
If you find an error, the credit reporting agency must investigate and respond to you within 30 days. If you are in the process of applying for a loan, immediately notify your lender of any incorrect information in your report. Your lender will need to reorder your credit report and score once any changes have been made to your credit file. Small errors may have little or no effect on your score. If there are significant errors, however, the lender may disregard the score.
UNDERSTANDING MORTGAGE LOANS
There are a number of loan products available to low- and moderate-income buyers. The majority of loans that these homebuyers use come from the following sources:
• FHA (insured by Federal Housing Administration, a department of HUD)
• VA (guaranteed by Veterans Administration)
• Rural Development
• Conventional
FHA LOANS
FHA loans are originated by an FHA-approved mortgage lender and are guaranteed by the Federal Housing Administration, a division of HUD. Borrowers often have easier access to FHA mortgage loans because historically FHA credit requirements have been more flexible. Borrowers never have direct contact with HUD or FHA, as neither HUD nor FHA loan money. Instead, an FHA loan means that in the event that you were to default on your mortgage loan, FHA would pay off the lender and take possession of the house.
FHA loans typically:
• Have more flexible credit requirements.
• Require mortgage insurance, which involves an up-front premium charge as well as ongoing monthly premium payments. The exact charges are based on a percentage of your loan amount. The up-front premium may be financed in the loan, and the monthly premium is usually included in your total payment (PITI). The monthly mortgage insurance payment will automatically be cancelled when the outstanding principal balance reaches 78% of the original purchase price, provided that the monthly mortgage insurance payments have been made for a minimum of five years and the loan has not been delinquent in the past 12
months. The Federal Housing Administration also insures other types of specific loans, such as loans to Native Americans on trust land or the 203(k) rehabilitation loan for any owner- occupied residence.
VA LOANS
VA loans are loans guaranteed by the Veterans Administration for qualified veterans. To determine if you are qualified for a VA loan, contact your local VA office for an eligibility certificate. VA loans do not require the borrower to make a down payment. Not unlike FHA and HUD, the Veterans Administration does not loan money. Instead, they guarantee the loan. The guarantee means the lender is protected against loss if the borrower fails to repay the loan.
VA loans typically:
• Require no down payment.
• Require a funding fee that can range from 1.25% to 3% of the loan amount, depending on whether the borrower is a first-time or subsequent user of benefits.
• Require no mortgage insurance premium. When you are shopping for a VA loan, it is extremely important to choose a lender that knows how to originate VA loans.
RURAL DEVELOPMENT LOANS
Rural Development (formerly Farmers Home Administration) is another government entity. In contrast to FHA and VA, however, Rural Development does loan money directly to borrowers, in addition to guaranteeing loans made by eligible mortgage lenders. Their loans are available in communities with a population of 20,000 or fewer people. Rural Development has a variety of different loan types including rehabilitation loans, leverage loans, and guaranteed loans.
Rural Development loans typically:
• Target low- to very low-income families.
• Subsidize interest rates to in order to qualify these families for mortgages.
CONVENTIONAL LOANS
Conventional loans are loans that are not guaranteed or insured by a government entity. Private investors that provide capital for these loans take the risk. Mortgage loans that are not targeted toward first-time homebuyers are often conventional.
Conventional loans typically:
• Qualify borrowers for a home loan using lower front-end and debt-to-income ratios.
• Require the borrower to pay a monthly private mortgage insurance premium for loans with less than 20% down. This premium may be gradually reduced as the principal balance of the loan is paid down, and once the principal balance is 80% or less, the premium may be cancelled.
• Have more stringent credit requirements.
• Require more money down—usually a minimum of 5%.
MFA LOANS
In 1975, the New Mexico state legislature created the New Mexico Mortgage Finance Authority (MFA) to provide capital for affordable housing. MFA has a number of loan programs that are designed specifically for first-time homebuyers. Each prospective homeowner must meet certain income eligibility criteria, must not have owned a home within the three years prior to applying, and the property cannot exceed certain sales price limits.
MFA does not lend money directly to first-time homebuyers, nor does it take applications from them or qualify them for loans. MFA has many lenders throughout the state that are approved to use MFA programs to help first-time homebuyers. A list of eligible lenders can be found on MFA’s website: www.housingnm.org.
MFA programs include:
• Mortgage$aver Program - Below-market, thirty-year fixed rate mortgage loan for low- to moderate income first-time homebuyers.
• Mortgage$aver Plus - Thirty-year fixed rate mortgage loan with a slightly higher interest rate than the Mortgage$aver loan, and a 3.5% grant that can be used for down payment and closing costs.
• Mortgage$aver Zero - Thirty-year fixed rate mortgage that doesn’t charge an origination fee.
• Mortgage Booster – A second mortgage loan of up to $8,000 that may be used for down payment and closing cost assistance. Mortgage Booster loans have an interest rate of 6% and a fixed-rate, thirty-year term. Mortgage Booster loans may be used in conjunction with Mortgage$aver and Mortgage$aver Zero
• Payment$aver - Lower-income families in most areas of the state may be eligible for an 8% subsidy for down payment, closing costs, principal reduction and/or interest rate buy-down. Used in conjunction with Mortgage$aver and Mortgage$aver Zero, Payment$aver does not need not to be paid back unless the property is sold or refinanced. After the first five years of living in the home, Payment$aver loans are forgiven at a rate of 20% per year; they are completely forgiven in ten years.
• Helping Hand - Provides down payment and closing cost assistance to low-income families in which one person has a disability. The Helping Hand loan can be used in conjunction with a Mortgage Saver and Mortgage$aver Zero loan. A maximum amount of $8,000 is available with the Helping Hand program.
• Building Trust - Provides below-market, thirty-year fixed rate loan to Native American families or individuals from federally recognized tribes who have a home-site lease. MFA makes Mortgage$aver loan products available and waives first-time homebuyer requirements.
APPLYING FOR A LOAN
INCOME
Your income will determine the amount of money you can borrow. Some mortgage lenders will allow you to exceed their standard debt-to-income ratio requirements if you can prove that your current housing cost is more than your projected mortgage payment. In other words, it is riskier for the lender if the borrower’s new mortgage payment will be substantially higher than the amount of monthly rent the borrower is used to paying.
Another factor that affects the amount you can borrow is interest rate. The lower the interest rate, the higher the amount you can borrow. The higher the interest rate, the lower the amount you can borrow. See sample chart below:
|
INTEREST RATE |
MORTGAGE |
PRINCIPAL & INTEREST PAYMENT |
|
5.00% |
$120,000.00 |
($644.19) |
|
5.25% |
$120,000.00 |
($662.64) |
|
5.50% |
$120,000.00 |
($681.35) |
|
5.75% |
$120,000.00 |
($700.29) |
|
6.00% |
$120,000.00 |
($719.46) |
|
6.25% |
$120,000.00 |
($738.86) |
|
6.50% |
$120,000.00 |
($758.48) |
|
6.75% |
$120,000.00 |
($778.32) |
|
7.00% |
$120,000.00 |
($798.36) |
|
7.25% |
$120,000.00 |
($818.61) |
|
7.50% |
$120,000.00 |
($839.06) |
|
7.75% |
$120,000.00 |
($859.69) |
|
8.00% |
$120,000.00 |
($880.52) |
Note: Your housing expense or “front-end” ratio includes property taxes, hazard insurance and mortgage insurance payments (PITI). The principal and interest payment calculations in the above table do not include property taxes and hazard insurance, nor do they include monthly mortgage insurance premiums, which are not generally impacted by interest rates.
EMPLOYMENT & INCOME REQUIREMENTS
You need a minimum two years of employment in the same line of work to count that income when qualifying for a loan. If you receive assistance such as social security, it must have a documented two-year history and projected two-year future (not unlike a job).
The above information is only a basic guideline for mortgage qualification. Every lender will consider “compensating factors” that may offset certain aspects of your situation that may be weaker than what is typically preferred. Compensating factors can include:
• Amount of time at current place of employment and projected duration of employment with current employer
• Part-time job that cannot be used as qualifying income
• Child support income
• Large down payment
QUESTIONS TO ASK YOUR MORTGAGE LENDER
Buying a home for the first time can be overwhelming. Real estate agents, builders, and mortgage lenders may use terms with which you may not be familiar, and you will be asked to provide a significant amount of personal financial information in order for a mortgage lender to determine which loan is right for you. Knowing the right questions to ask your mortgage lender will ease the stress, and it may also save you time and money.
• What is the interest rate and annual percentage rate (APR) on this mortgage?
To know exactly what you will be paying in interest over the life of the loan, you need to know these rates. These are two of the important figures to obtain.
• Will I have to pay origination fees (‘points”) to get the loan at this rate?
A “point” is equal to 1% of the original loan amount. For example, a one point charge on a
$100,000 loan equals $1,000. Lenders can charge discount points that act to lower, or “buy down” your interest rate and origination points that serve as compensation to the lender for making you a loan, or “originating” your loan. Find out how many points you will be expected to pay for the loan, which kind of points they will be, and whether they’ll be included in your loan amount or if you’ll be expected to pay cash up front.
• What closing costs will be charged on this loan, and how will I know the total amount of closing costs I will pay?
Mortgages come with legitimate fees for various services that lenders and other parties
involved in the transaction provide. Early on in the process, you will need to find out what you will be charged. The federal laws governing real estate loan transactions require that you are given certain cost estimates in writing at the time of loan application (“Good Faith Estimate”). If your lender doesn’t volunteer the information, be sure to ask. If your lender is reluctant to provide information or clear answers to your questions, you may be better off shopping for a different lender.
• When can I “lock in” the interest rate, and what will it cost me to do so?
Because mortgage interest rates can fluctuate daily, you may want to ask your lender about
“locking” a quoted rate for your mortgage. Quite often, the time period between when you first apply for a mortgage and the time you actually close can be several weeks. You may not
want to risk letting the rate “float” until the closing date, because it could increase. Be sure to ask the lender if there is any fee for locking in the rate. An advantage to locking in your
interest rate is that you’ll know exactly what interest rate you’ll receive at closing. The main disadvantage to locking in a rate is that if market rates decrease, then you will be “locked” at
a higher rate than you might have been had you allowed the rate to “float”. Ask your lender to clearly explain your options to you.
• What is the minimum down payment required for this loan?
Depending on the amount of your down payment and its relation to the price of your home, you might be charged different interest rates or quoted different loan terms. Loans made at high
loan-to-value, or “LTV” ratios (meaning the borrower has made a small down payment) can cost more than loans with larger down payments. Nevertheless, borrowers with good credit
who are willing and able to pay private mortgage insurance (PMI) can get conventional loans with down payments that are much lower than 20 percent.
• What are the qualifying guidelines for this particular loan?
The qualifying guidelines can relate to your income, employment, assets, liabilities, and credit history. Some first-time homebuyer programs and government-sponsored loans have easier qualifying guidelines.
• What documents do I have to provide?
You will need to provide proof of income and assets to get a mortgage loan. Find out what
documents will be required in your particular situation by asking your lender. It’s a good idea to gather and organize your personal financial documents prior to beginning the loan
application process. By doing so, you may prevent delays in the process later on.
• How long will it take to process my application?
This varies from lender to lender. It often depends on how much business your particular lender
is doing and how busy the mortgage loan industry is overall. During periods of peak activity, underwriting departments may back up, appraisals may take longer to obtain, and other
bottlenecks may develop. Get a realistic estimate, and use that to figure out if it makes sense to
pursue a rate lock and how long it should be.
• What might delay the approval of my loan?
If you provide the lender with complete, accurate information, everything should go smoothly. However, there could be a delay if the lender discovers credit problems or if other unforeseen
circumstances develop. This is why it is critical to get your credit in order.
UNDERSTANDING PRIVATE MORTGAGE INSURANCE (PMI)
Private Mortgage Insurance (PMI) protects the lender from the expense of foreclosing on the property if you default. If you buy a house with a conventional mortgage, and you make a down payment of less than 20%, in most cases you will be required to pay for PMI.
The insurance benefits the lender, but the borrower pays for it. The premiums for PMI are added into the borrower’s total monthly mortgage payment. The cost of PMI varies, depending upon the size of the mortgage and the percentage of the down payment.
RECOGNIZING PREDATORY LENDING PRACTICES
Predatory lenders take advantage of consumers with credit problems and those who fail to safeguard their own financial transactions. These lenders charge extremely high fees and interest rates. A loan from a predatory lender will cost you much more throughout the life of the loan and—in extreme cases—could lead to foreclosure on your home. Predatory lenders take advantage of those borrowers who are not able to secure lending from traditional financial institutions.
In recent years, many observers claim that the incidence of abusive or predatory lending practices has increased. The State of New Mexico has passed legislation to combat predatory lending, but there are still quite a few predatory lenders operating in the state.
Remember that you are responsible for protecting your own financial well-being. Do not transact any business with a lender who pressures you sign documents you haven’t read or don’t thoroughly understand.
AGGRESSIVE AND DECEPTIVE MARKETING
Predatory lenders often employ very aggressive, and sometimes deceptive, marketing campaigns. Their goal is to reach those individuals who, for any number of reasons, would be more likely to agree to apply for a loan. Once they have identified a potential customer, they try to reach them by mailing, phoning, and even visiting them in their homes to encourage them to take out a loan.
One of the most common methods used by predatory lenders is to mail “live” checks to prospective borrowers. These checks are usually for several thousand dollars, and by cashing or depositing them, the borrower is entering into a loan agreement with the lender.
This initial loan is sometimes just an entry point into the financial life of the homeowner. The loan has an artificially high interest rate and monthly payment, so that the predatory lender can offer an opportunity to refinance it, along with other debts, with another loan. The predatory lender’s ultimate goal is to get the homeowner to refinance their first mortgage with them.
