This Is Your Father’s Mortgage

To try to help sort out how the mortgage crisis came to be where it is today, it may help to look back at where the industry has been.  Since the earliest days of mortgages, well over 100 years ago, borrowers wanting to purchase a home put down a sizeable down payment, usually 20%, or more, and proved their credit, income and assets to qualify.  The lender, usually a bank, after providing the loan, held it in-house in what is called a portfolio, bearing all the risk of repayment by the borrower.

Along these lines, one factor contributing to the crisis is the emergence of the Mortgage Backed Security (MBS), in the 1980s.  An MBS is a security that is made up of mortgages that have been bundled together.  These securities, like others, are traded by investors.  This is an important point, in that the traditional lender/borrower relationship had now changed, with the investor influencing the lending decision.

As time passed, and these securities were used more by investors, they, the investors – looking to increase their rates of return – began relaxing their acceptable criteria. They directed lenders, from whom they would buy the loans, to lend money to borrowers that were either putting down less than 20%, or less creditworthy than in prior years, or both. Many of these mortgages were what was called sub-prime.

Moving forward to the current market, as these sub-prime borrowers are turning out to have high default rates, investors, who are watching their mortgage portfolios implode, are returning to the purchase of more traditional mortgages.  This will in turn limit options of borrowers today, holding them to more strict standards, as they were a generation ago.

Your Mortgage’s Hidden Story

There are three stages in the life of a mortgage: origination, funding and servicing. The origination phase is where the borrower and loan professional sit down and determine the best course of action for the borrower.

Once this process is complete, and the borrower goes to the closing, the money is given to the borrower and/or seller, in what is called loan funding.  Once the loan is funded, it needs to be serviced.  This means collection of payments, escrows, and the disbursement of those escrows to the tax collector, insurance company, etc.  This servicing can be done by either the lender itself, or contracted out to what it called a servicing company.

Regardless of who services the loan, the loan itself is either kept by the original lender, in what is called a portfolio, or sold to investors.  Borrowers give lenders this right to sell their loans, through a loan servicing agreement.  The original lender agrees that the terms of the loan will remain the same, regardless of who owns it, and loans may be sold multiple times.

When they are sold, mortgages of similar types and borrower grade, based on creditworthiness, are bundled together into what are called Mortgage Backed Securities, or MBSs.  These securities are bought by and sold to investors around the world, similarly to other types of securities.

As with any other type of security, and as you might expect, they also carry risks to the investors that own them.  Riskier and less creditworthy borrowers, many of whom are starting to default on loans that have been bundled, with like loans into these securities, are causing the securities themselves to lose value.

Investment Properties: What You Need to Know

Before looking at properties, determine first what the current market rents are for the property type you have in mind in your area.

An experienced real estate agent or property appraiser should be able to tell you this.

You can then determine what your net income on the property would be each month (also remember the tax benefits, if any) after factoring in regular and unforeseen maintenance expenses.

Determine also your long-term strategy for owning the property.

Will you be willing or able to break even, or potentially take a loss on the property each month, anticipating a high sales price in the future?  Will you be able to hold the property during times of declining property values, as we are experiencing now?

Getting a Mortgage

Mortgage lenders will typically charge a higher interest rate (one or more percent) on an investment property than they would on a property that a borrower will live in.

This is partly due to the fact that both renters and the rental market itself can be unpredictable.

In calculating their risk, things that lenders look at when considering to lend on a rental property are:

  • How much money will the borrower be putting down?  Typically lenders want between 10% and 25% (for first time investors) to show the borrower has a vested interest in the property and wants to make it work.
  • Landlord experience: How long has the borrower been managing rental properties, if at all?
  • Income and assets: Will the borrower have enough money in the bank to cover the mortgage, taxes, and other expenses if the property is vacant for an extended period?  Typically lenders want six months in reserves.

Earn Money from Your Home

A reverse mortgage is simply a mortgage where a lender will lend a borrower money against the equity in the home in which he or she lives.  Repayment to the lender, unlike in a traditional mortgage, will occur after the borrowers have either passed away, sell the property, or permanently move out of it due to health reasons.

What Qualifies You for One?

The minimum eligible age to receive a reverse mortgage is 62.  The older a borrower is, the more money he/she will be able to borrow against the property (minus the cost of the reverse mortgage itself) regardless of the amount of equity in it.

Borrowers will have access to most, but not all, of the equity in the property.

Credit checks are not normally required by lenders–although they do get a copy of the title to the property to determine if there are any liens against it–which could affect the amount of available equity.

Often the reverse mortgage will be used to pay off an existing mortgage, or mortgages, thereby making the reverse mortgage the only lien on the property.

There are typically three ways in which borrowers receive the funds from a reverse mortgage. They are:

  • A line of credit.  This is the most common way.  Similar to a home equity loan, the borrowers would only draw, and accrue interest on, the money that they use.
  • In a lump sum, paid when the reverse mortgage is taken out.
  • In a fixed payment stream.

Why Lenders Consider Debt-to-Income Ratios

Perhaps you are thinking of purchasing a home or refinancing your current mortgage.

Your debt-to-income (DTI) ratio is considered one of the most important qualification requirements when getting approved for a loan.  Simply put, it is a calculation of your monthly debt obligations compared to your adjusted gross income.

When lenders consider your application, along with reviewing your credit they also consider your debt-to-income ratio, which can be used to determine your ability to pay as well as how much they will lend.

Lenders scale this ratio and will restrict the type of programs you qualify for. The higher the ratio, the more limited you are.

There are two debt-to-income ratios that you should be aware of.

The front-end ratio, also known as the housing ratio: This is the ratio for home-related monthly payments to monthly income. These include mortgage principal and interest payments, hazard insurance, property tax, homeowners’ association fees, and private mortgage insurance when applicable.  Conforming mortgage lenders require that front-end ratios not exceed 28%, while FHA mortgage lenders will qualify borrowers at 31%.

Back-end ratio, also known as the total-obligation ratio, is the more important of the two. It looks at total monthly debt obligations that include anything found on the credit report, such as credit card payments, auto payments, student loans, etc. Conforming mortgage loans have a  back-end ratio of 36% or less, while the limit on an FHA mortgage is 43%.

A new loan is always included in the DTI calculations. If the amount you are applying for raises your DTI above the limit, you will have to pay down some of your other debts in order to secure the new one. You can do this by reducing your down payment and using the money to pay off or pay down the other debts.

What You Need to Know about PMI

Private mortgage insurance (PMI) is a reality that is hard to escape, especially for first-time home buyers.  PMI does not give the borrower additional homeowners’ insurance coverage but rather protects a lender against loss if the borrower defaults on a loan, and enables borrowers with less cash to have greater access to homeownership.

The cost is based on the type of mortgage product you secure, the amount  you borrow for your house and the amount of your down payment,  and is added to your monthly payments. On average the cost runs about 5% annually of your total mortgage amount.

Removing PMI

Private mortgage insurance should never be permanent. Prior to agreeing to and signing the mortgage loan, ask for a written disclosure from your lender stating when the PMI payments can be removed from the monthly mortgage payments.

Once you have paid at least 20% of your loan, it is up to you to contact your lender and ask to have the PMI payments terminated.  It is a good idea to make this request by phone and in writing.  They most likely will agree to do this if you have made your mortgage payments in a timely manner.

To avoid PMI, consider asking your mortgage broker if they will waive private mortgage insurance requirements if you accept a higher interest rate on the mortgage loan.  If they do, you may see on average an increase of .75% to 1%, depending on the down payment.

Tips to Help You Get the Best Mortgage

Finding your dream home is easy, but obtaining a competitive home loan is not. Thankfully, with sufficient planning, you can obtain the best mortgage possible – providing you with significant financial savings in the long run.

Check for Credit Score Errors

The most important element of obtaining a competitive loan is your credit score.  Even if you have stellar credit, obtain a copy of your credit report from the three reporting agencies to check for any reporting errors.  Considering that 40% of credit reports have errors, it is important to resolve these problems before you apply for your mortgage.
Raise Your Credit Score

Generally, it takes six months to one year to improve your credit.  The earlier you begin, the better your score will be.  However, if you plan on applying for a loan within the next two months, you can still improve your credit.  Reduce your debt-utilization ratio by paying down your credit cards and staying well below your maximum credit limits.

Show Your Savings

During the mortgage application process, the lenders will scrutinize your financial health.  Do not keep your savings in a checking account.  Instead, open a savings account or CD to demonstrate your ability to save money.  Remember, the more you have for your down payment, the better your mortgage rate will be.

Become Pre-Qualified

Becoming pre-qualified for your home loan locks in interest rates, protecting you from fluctuations.  In addition, being pre-qualified demonstrates that you are a financially serious buyer, which aids greatly during your closing negotiations.

Planning ahead increases your probability of obtaining the best mortgage possible for your dream home.

Tax Tips: Should You Rent or Buy Your Home?

If you are contemplating renting or buying, keep in mind that Uncle Sam rewards you handsomely in tax benefits for being a homeowner.

Mortgage interest: Your mortgage interest on your home is 100% tax deductible.

Private Mortgage Insurance (PMI): If your lender requires you to have private mortgage insurance, the PMI premiums are also deductible for mortgages obtained between 2007 and 2010.

Property taxes: All the property taxes you pay are fully deductible from your annual income.

Home office: If an area of your home is utilized specifically for a business, then you can deduct a portion of your expenses, such as depreciation, repair, and insurance costs.

Capital gains: Unlike other investment instruments, selling your primary residence at a profit shields you from capital gains tax.  For gains up to $500,000 on your primary residence of the last two years, you are excluded from capital gains tax.

Home improvements: If you obtain a loan to finance home improvements, you can fully deduct the interest on that loan.  Keep in mind that this deduction only applies for improvements that are a “capital improvement,” not just repairs.

The benefits of buying a home significantly outweigh renting, not the least of which is building equity in your name.

How Your Credit Score is Calculated

Credit scores are becoming increasingly important, with many employers even factoring this into their hiring decisions.  A credit score is based on a credit report, which is a detailed account of one’s credit history, borrowings, repayments, and credit inquiries.  It indicates the financial responsibility of an individual, including on-time monthly payments, types of credit accrued, and complete credit history.

The three prominent credit bureaus which maintain credit records are TransUnion, Equifax and Experian. Any non-payment is immediately reported to these bureaus and reflected in one’s credit report. A credit score is calculated by a special type of software from Fair Issac Corporation Company, from which the FICO score name stems.

There are several different components, with individual weightings, that comprise your credit score:

Payment History – This accounts for 35% of a credit score and indicates timely payment of monthly bills or otherwise.

Extent of Indebtedness – How much an individual owes constitutes as high as 30% of the total credit score.  Thus, it is important to keep your borrowings low, preferably below 40% of maximum credit limits.

Length of Credit History – How long a person has maintained credit carries a weighting of 15%. The longer the credit history, the better this reflects on your score.

Types of Credit – The composition and different types of credit that a person has comprise 10% of the credit score.

New Credit – The size of new credit and inquiries has a weighting of the remaining 10% on the credit score.

A credit score varies between 350 and 850. While a score of 850 indicates excellent credit, 350 very poorly on the individual’s financial responsibility.  To improve a score, should reduce credit card debt, pay bills in time, and be careful in the types of credit you utilize.

Fixed or Variable Rate?

Purchasing a house may be a daunting task for anyone, especially for first time buyers. One of the complexities involved is to decide between a fixed or variable rate mortgage.  Depending upon the market and your financial expectations, each option provides different benefits and drawbacks.

A fixed rate mortgage has many positive features, such as guaranteed rate of interest, monthly payment certainty, low down payment, few calculations, and easy understandability. Fixed mortgages are controlled mortgages and easy to administer. Because of all these factors, these are popular with first time home purchasers.

On the other hand, fixed mortgages come with high rates of interest and may not be suitable during times of falling interest rates.
Variable mortgages are generally cheaper and result in savings when rates fall.

Studies have shown that there have been more savings with variable rate mortgages, and they are favored by a large number of buyers.

However, variable mortgages require a higher down payment and are unstable. These are difficult to manage, as the monthly payments may fluctuate.  They can also be complex, as there are many types, such as standard, discounted, cash back, and tracker mortgages.

Choosing between the two depends on individual situations and interest rate deals.

An informed decision can be made in consultation with financial professionals.