Never
again obtaining a home mortgage loan consistently surfaces as
the primary fear of people considering bankruptcy. Luckily, those
searching for a home mortgage loan will find that within one
day after their bankruptcy discharge home loan financing will
indeed be available to them. Within the mortgage business lending
to borrowers with very, very bad credit including bankruptcy
and foreclosure can go by several names including the sub-prime
market, b,c,d credit lending or simply bad credit home loans.
The wonderful side of this industry for debtors is the fact that
it exists. On the other hand individuals with bad credit must
understand that what will be expected from them and that what
will be available for them in the sub-prime mortgage market bares
little resemblance to the type of home mortgage loan available
to a borrower with perfect credit. Before
attempting to obtain a home mortgage loan, borrowers should
first understand exactly where they stand from a credit
point of view. Lenders categorize borrowers using two systems.
The first mirrors standard grades used in school. Borrowers'
credit will be evaluated and given a grade, where A is
the best, B will be credit showing a bit of tarnish, C
represents fairly bad credit, D means very bad credit,
occasionally I've even seen some F's. I have included a
chart estimating where someone's credit will fit into this
system. Remember that humans evaluate most of these credit
reports, with the result that some credit evaluators will
assign different grades to the same borrowers and that
some lenders may assign more or less importance to certain
types of negative items on a credit report.
The next type of scoring model
more closely resembles an SAT score, with 800 being near perfect and 400 approaching
as bad as it gets. These scores carry names such as FICO, Beacon or Empirica;
each of these names corresponds to one of the particular major credit reporting
agencies. The exact mathematical formulas used to calculate these scores remain
proprietary information of the credit bureaus, computers use the formulas to
establish a credit score. It is safe to say, however, that the same negative
items which would affect a letter grading system also negatively affects the
numeric scoring systems. You may use the Equifax link on the mortgage
tools page to get a copy of your credit report online including your FICO
score. For more information I have written an article on credit
repair and credit rebuilding.
The next important
concept in calculating loan eligibility would be the ratio between
the amount being borrowed and value of the property being placed
as collateral. The common name of this ratio is "loan-to-value" or
LTV. Easy examples include: A borrower qualifying for an 80% LTV
loan buying a $100,000 house could obtain a loan for $80,000; refinancing
a $200,000 house at 70% LTV would mean a $140,000 mortgage. Borrowers
should note that the value used for this calculation on new purchases
would almost always have to be the lower of the purchase price
or the appraised value. With a refinance, provided that the home
owner has been in the property for a long enough period of time
(usually six months to a year) appraised value only may be used
in the loan to value calculation. This distinction can be a problem
in certain cases such as when a borrower has brought a home truly
worth $100,000 at auction for $60,000.00. The home may actually
appraise for $100,000 but the purchase price of only $60,000.00
must be used resulting in a greatly diminished availability of
funds for the purchase. Money needed exceeding the mortgage usually
comes from a cash down payment. When the loan available due to
the LTV limitations for the borrower yields too little to buy the
home in question owner financing, family help or a down
payment grant can sometimes bridge the gap. In many D credit
cases the lender requires at least 5% must be put down even though
the sale may not necessitate it. In budgeting a transaction do
not forget to include closing fees. When LTV issues prevent a refinance
some debt workout options may
help. Provided the borrower qualifies for the loan based on their
credit score and loan to value requirements the next hurdle will
be a review of the debt to income ratio.
Calculate the debt
to income ratio by adding together all of the borrower's debt payments,
including not only the loan being applied for but also any auto
loans, consumer debt, credit cards etc, etc; divide this number
by the net cash available each month available to the borrower
for living expenses as well as debt. Most lenders would prefer
this ratio to be approximately 40% or less; in fact, to obtain
certain low interest loans a low DTI would be a requirement. In
the sub-prime market lenders will also allow more flexibility to
the debt to income ratio allowing the percentage to climb as high
as 55 to 60%. As with the other parameters, flexibility abounds
in sub-prime lending. On the other hand, the borrower pays for
these flexibilities in the form of a higher interest rate.
With all of the above data gathered
you should be able to determine approximately where you fall in the credit rating
system used by most mortgage lenders. While points and rates can vary greatly
the broad chart attached below indicates what you might expect to find for rates,
points and loan to values. You may use the mortgage calculator on the mortgage
tools page to estimate projected mortgage loan payments.
Lenders charge more points and
higher interest rates to those with bad credit. Loans to borrowers with poor
credit carry far more risk and lenders deserve compensation for this risk. Borrowers
with good credit should not let themselves enter into a loan agreement where
they pay points and rates based on a bad credit loan. One national company recently
filed bankruptcy to protect themselves from litigation on fraudulent loan practices.
One of the common fraudulent
loan practices involved charging good credit borrowers bad credit rates and points.
If you have worked hard for good credit you deserve the benefits. It may take
some extra work depending on your geographic area but don't allow yourself to
pay more interest and fees than you have to.
While bad credit
most often means higher interest rates and origination fees for
anyone needing a loan, there are limits to amounts generally deemed
proper in the mortgage industry. A point on
a loan means a fee corresponding to one percent of the amount of
the loan. As indicated in the charts, people with great credit
may sometimes pay no points while those with poor credit may pay
up to four points or five points. Unwary customers may find loan
brokers attempting to charge them as much as ten points. Occasionally
charging this many points is justified. For example a loan of only
$15,000.00 for ten points still presents a relatively small fee
in terms of the total dollars charged. I have seen other "hard
money" loans where private financiers take risks well beyond even
the standard sub-prime market where perhaps the extra fees make
sense. In general, however, higher points should be a red flag
that someone is trying to take advantage of you. It is not uncommon
for such transactions to be explained by a claim that the mortgage
broker can provide a loan where no one else can. Most cases do
not merit these claims. Finding a loan broker or lender to do a
difficult loan may take some extra work on the part of the borrower,
but with enough diligent effort sources can be found that will
not only make the loan but will treat the borrower fairly. What
many borrowers fail to notice regarding points could cost them
many thousands of dollars. Points may bear many names like "origination
fees", "discount fees", "broker fees" or "yield spread premium".
Regardless of what they are called there are two basic forms of
points. The first type I will refer to here as "Upfront Points".
The borrower pays these points to either the broker or the lender
as compensation for creating the loan transaction. In general points
represent a loan brokers only source of income. They work hard
to make a loan come together and deserve to be paid.
On the other hand some unscrupulous
brokers may charge points far in excess of the industry standards to a customer
who does not realize what to expect. The chart below should provide a general
guide for consumer expectations. In addition to these points borrowers may have
the option of paying additional points to "buy down" the rate. As long as the
borrower understands the mathematics there is nothing wrong with buying down
a rate using points. Just remember that the numbers dictate that most often a
minimum of 3 to 5 years will be needed to break even on buying down a rate. Unless
you have a fairly high level of confidence that you will be remaining in the
house and you will not be refinancing for a very, very long time buying down
the rate may not make sense. For the majority of people homes and mortgages are
often sold or refinanced over periods of time 5 years and less making buying
down a rate imprudent.
The second type of point I'll
refer to as a "Back End Points". The lender generally pays these points to the
mortgage broker. In some cases these fees simply represent additional incentive
from the lender to the broker to make a particular loan. In other cases it represents
a payment from the lender to the broker as a reward for obtaining a loan with
a higher interest rate. For example a borrower may potentially be able to obtain
a loan at a 10% interest rate yet the broker will only offer an 11% interest
rate in order to receive two extra back end points from the lender. In cases
where a lender is merely trying to promote a certain product and offering brokers
a small reward through back end points, for example one point or less, there
may be no harm to the consumer. I have seen cases where back end points may be
useful, particularly in an effort to save a house from foreclosure and where
available funds are so limited that closing fees make the difference between
keeping a house or losing a house. By charging no up front points and allowing
the broker to be paid through back end points it is possible for the broker to
make his fair compensation on a loan and for the borrower to complete a transaction
with thousands of dollars less out of pocket at time of closing. The borrower
in such cases should make sure they are aware of exactly what is transpiring
and attempt as soon as feasible to refinance into a lower interest loan.
Problems with back end points
predominately take two forms. First, as with front end points, unscrupulous brokers
may attempt to charge far in excess of market practices. These problems are compounded
by the second issue: some states do not require disclosure of back end points,
leaving the consumer no way to even realize what is happening to them unless
they have a very, very clear understanding of market interest rates which allow
them to discover a discrepancy resulting from back end points. Where mandated
reporting exists or has been undertaken by a responsible loan broker look for
back end points on the HUD1 closing statement form near the top of page 2. Since
the broker got paid directly by the lender the figures will not be in the columns
with the numbers. Look for it as a part of a description on the left. It may
be called a "yield spread premium" or simply list the fee as an amount paid from
the lender to the broker paid outside closing (POC).
A problem I see
just as often as lender abuse involves Borrowers demanding unrealistic
points and interest rates from brokers and lenders. Bad credit
loans take a great deal more work than good credit loans and the
risks taken by the lenders are significantly higher. Borrowers
with bad credit should not expect to pay the rates and points charged
to someone with good credit.
Excessive rate shopping, for
example sending a mortgage application to 15 or 20 loan brokers, will often result
in the brokers not paying attention and rightfully being annoyed by such attempts.
Contacting many sources in order to eliminate those who do not have the ability
to make your loan is one thing. Pitting more than a handful of legitimate brokers
against each other generally will not yield any significant difference in what
you may achieve. Remember most mortgage brokers are working on a commission basis
and if they feel you are wasting their time they will tend to ignore you and
more on to the next customer. Particularly in the bad credit loan market where
each loan can be quite time and labor intensive.
While the D credit
market provides a vehicle to offer financing to almost everyone
it does not follow that everyone should take advantage of it. Just
because you may be able to get a mortgage does not mean that committing
to a mortgage and purchasing a house would be a prudent financial
decision. Postponing a house purchase may allow the potential borrower
time to change some of the important variables. Most obviously
the accumulation of down payment money. Not only does a larger
down payment result in smaller payments and better affordability
(because of the reduced loan balance) but a larger down payment
also results in a lower loan to value ratio translating to a smaller
interest rate and again lower payments. In addition to using time
to accumulate the down payment the time passing in and of itself
will help to heal any damaged credit. Even better, aggressively
use the time to rebuild your damaged credit. The best answer for
when to buy a house with bad credit will be different for every
individual. Those who buy sooner always have the option of refinancing
to obtain a lower rate a year or two later. Personal cash flow
issues may necessitate no option available other than waiting.
Be careful when examining cash flow not to leave yourself without
some cushion, especially if the cash management issues caused your
earlier credit problems. Taking on mortgage payments beyond your
means may lead to yet another down-fall and in the credit industry
a second collapse will be looked upon much more harshly. Many creditors
are forgiving if a basically creditworthy person had an isolated
problem. Those with more than one bout of bad credit may be looked
at as a habitual problem borrower or even someone who fraudulently
seeks credit without intent to repay the debt.
Credit Grade
FICO Score
Credit Items
LTV
DTI
Interest Rate
Points
Max LTV
A
620-800
none or minor
80%
40-45%
-1.75 / .5
0 / 2
125%
B
550-650
1 or 2 30-60 day lates
80%
45-50%
-1 / 2
1 / 2.5
100%
C
500-620
many lates 1 up to 120 days
80%
50-55%
0 / 3
1.5 / 3
95%
D
400-580
many lates over 120 days, bankruptcy, foreclosure etc.
65%
55-60%
2.5 / 6
2.5 / 5
n/a
Notes to Chart:
1. All items represent rough estimates. Only
a lender can quote or offer you a specific mortgage.
2. FICO is a trademark of Equifax
3. A, B or C borrowers needing higher DTI can opt
for a lower credit score product.
4. The LTV column shows the standard LTV for a regular purchase
or refiance. Electing a lower LTV can sometimes mean a lower interest rate. The
Max LTV column shows maximum LTVs available for special high LTV loan products,
such loans carry much higher interest rates.
5. Rates in the chart relate to the prime
rate. While most residential rates generally relate to other indexes, I use
it here only because more people have familiarity with prime rate. For example
-1.5 / 2 in the chart would mean a range of prime minus 1 to prime plus 2. With
prime at 9.5% this would mean an esimated range of 8.5% to 11.5%.
