Real Estate and Financial Insight

The economic forces shaping the direction and valuation of the real estate market are constantly changing.  The following economic insight to Santa Barbara home loans, home financing and mortgages offer topical advice for your investment goals.  Use this timely information in positioning yourself as an enlightened investor in the real estate market.

Credit Scores and How they Affect Your Loan

Everyone knows that to get the lower mortgage interest rates it's better to have a higher credit score.  The "A-paper" rates apply for those whose credit score is 700 or over ... in some cases 680 and over.  The lower end of better borrowing rates is a credit score of 660 or higher ... at Countrywide it's 620.  

What about those borrowers whose credit score is 619 ... or 609 ... or below?  Is there a lending opportunity for these people? What type of loans and rates might they be getting?

Yes there is an opportunity for these borrowers ... and sometimes the rates and terms are not bad given the credit score.

When a borrower has a very low credit score you have to look at why - too much debt compared to available credit (but always paid on time)? An isolated period of late payments?  A lot of new debt (with no payment seasoning)?  A recent IRS lien?  There are numerous reasons but the point is a low credit score does not always mean a bad payment history.

So we analyze the loan request even farther and look for compensating factors. Are the mortgage payments always paid on time?  Are installment debts paid on time?  Is there job stability?  Cash reserves? Loan vs value of the property? All of this would be taken into consideration when an underwriter is trying to approve a loan request.

More importantly a low credit score does not automatically send you to sub prime financing ... or at least it shouldn't.  (Not to pick on any particular lender but Ameriquest Mortgage is paying a big fine for doing just that ('cause there is more profit in these loans) ... this was on the news about 2 weeks ago).  The entire loan gets reviewed and recommended for approval/declination by an underwriter and risk mgt underwriters.  If there is an investor that will purchase that loan then the loan can be made on "A-paper" financing (with possibly a slightly higher interest rate or fee) ... if not then the loan will get referred to our "sub prime" department.

An example of a loan I had last week with a 609 credit score - mortgage payments always paid on time, owned current home more than 4 years, same job for 14 years (although both borrowers would be changing jobs 'cause they were moving to a different area the jobs were in the same line of work and transferable), debt ratio within guidelines, minimal reserves, 80% LTV, ... source of down payment was the sale of their current residence.  We got them a 6.625% 30-year fixed rate loan @ 0pts ... pricing that day for a 620 or higher credit score was 6.50% @ 0pts ... that's a great rate and no sub prime financing!

Another example - customer had a credit score of 618, reduced documentation, cash reserves within guidelines, self employed many years, debt ratio over 45%, 80% LTV, down payment from sale of current residence.  Credit issues were recent paid collection accounts and one small outstanding collection account ... EVERYTHING else was paid on time (so why the low score???).  We approved that with a .5 pt add on to the A-paper financing.

If you have borrowers who say they have low credit scores have them talk to a reputable lender ... see what can be done for them.  Sometimes something as simple as waiting 30-days can improve a credit score dramatically (the difference of 1 month can take a late payment from 23 months to over 2 years since that payment - which then it's late history may not hit the credit score as much as a recent late payment).  I have a customer who's credit score improved almost 40 points in 60-days - nothing really changed other than the credit dings got older!  Sometimes paying down a (example) credit card debt (where the debt is almost to the limit of the card) will improve a credit score - because the debt vs. available credit has been reduced.

Of course, there is sub prime financing for those that can't make it into the A-paper department.  Sub prime loans typically are 2-3% higher than A-paper ... usually have to pay around 2+ points ... 30 and 40-year amortization ... some interest only loans are available, hybrid ARM's and fixed rates.  Some of these loans have 2-3 year prepayment penalties (I'd pay the points to avoid this if possible ... negotiate a higher sales price and have the seller pay some of the closing costs if funds are limited).  If a Borrower can make the purchase, make the payments and (hopefully) improve their credit for the next 24 months they can always refinance into better terms once that credit score improves.

Hopefully this will give you some insight of what can be done for some of those more difficult credit situations.  Each one is unique and depends on a variety of variables ... but it's worth a try to help your customer make that home purchase!

The Interest Only Loan

The news media has the uncanny talent of being able to precipitate out the negative part of a story and turn it into headlines news.

Interest Only Loans have been a recent point of contention and the first paragraph in the news reads something like this: Interest Only Loans ... falling housing prices ... borrower owing more than value of home ... 2 year Interest Only loans about to amortize - interest rate may be as much as 2.00% higher than ... payment skyrockets ... "Option ARM" with interest only payment option ... minimum payment may be negatively amortizing growing the balance of the loan. In about 3 sentences you've been mesmerized by lending terms that sound like they apply to the Interest Only Loans. 

Actually, there are 3 very different loan programs with semantics running them together to sound like one.

The Interest Only Loan - these loan programs are referred to as Hybrid ARM's since they have a fixed time period (3, 5, 7 or 10 years) then become a 1 year (rate & payment amortize one time per year) ARM for remaining term equaling a total of 30-years.  The Interest Only payment requirement is during that fixed time period - the loan payment requirement becomes fully amortized when the loan becomes a 1 year ARM.

The BENEFITS of these loans

1) Payment requirement is interest only - borrower can qualify for more loan OR lower their monthly payment requirement to afford more house

2) The initial interest rate is usually less than a 30-year fixed rate loan

3) If there is a principal reduction during the Interest Only time period the payment will automatically adjust down

4) You can always pay more to voluntarily reduce the principal during the initial fixed rate time period (thus control your cash flow)

The DOWNSIDE of the Interest Only

1) If your goal was to pay down/off the principal balance and you didn't make additional principal reduction payments then you've wasted that amount of time not meeting a financial goal 

2) If you live in an area where property values don't appreciate (like they do in California) then your $ 250,000 loan on a $ 300,000 house today will be just that in (example) 5 years

3) If property values decline then your loan-to-value will increase ... but then if you were paying principal & interest you're equity position would still be deteriorating as well - just taking more of your capital per month with it.  

Sub-Prime Financing - These are the loans that will require a fully amortized payment when they make their first adjustment 2-3 years after origination.  A Sub-Prime Borrower is one with a credit score under 620 (some lenders go sub prime at 660) ... they already know they are difficult to lend to and accept a higher rate & payment from the very beginning.  These loans qualify at the fully amortized rate at the time the loan originates - not at the interest only payment (unless the initial interest only period is a minimum of 3 years)  ... the borrower has already met tough qualifying requirements before even signing on the loan documents.  The headline news on this loan is absolutely correct (the interest rate adjustment and payment going fully amortized) - the implication is that the borrower could be unsuspecting of what the payment requirements could be on that first adjustment (which is not true).

The BENEFITS of Sub-Prime Financing -

1) It gives an opportunity for borrowing to a customer who has not so good credit ... not so good credit does not necessarily mean they don't have the income to support the debt.

2) It gives a borrower an opportunity to improve their credit history by making mortgage payments on time ... once their credit scores improves they may be able to qualify for much better financing terms and will refinance (usually about 2 years of good payment history can improve a credit score enough to get out of Sub Prime Financing)

3) If a borrower paid interest only on this loan for 2 years (and knows that the fully amortized payments would be difficult to make (due to income change from time of qualifying for the loan)) they can always sell ... thus having an opportunity to participate in a home investment.  A house purchased 2 years ago at $ 550,000 using 7% appreciation per year is worth $ 630,000ish now.

The DOWNSIDE of Sub-Prime Financing -

1) Its expense ... rates and fees are more than the advertised A-paper rates ... and usually have a prepayment penalty for 2 years (or more). 

2) If you live in an area where properties don't appreciate - and your income has changed such that you can't support an increased payment at the end of the interest only time period then your options to refinance or sell become a little more difficult (note - this assumes 80% financing at time of purchase ... some of these loans require 25% down which would easily allow for a better loan after 2 years of on time payments and same property value as when the Sub-Prime Loan originated).

Option ARM'S (monthly Adjustable Rate Mortgages) - this is a loan that offers 3-4 payment options every month.  To simplify this the News picks up the negative amortization and warns of the loan size increasing ... which is all very true but the assumption is the borrower will only make the minimum payment and cause this to happen. Without going into a lot of detail (because that's the best way to understand these loans) the best way to summarize these loans is that the borrower has payment options each month ... depending on their cash flow will depend on which payment works for them ... the minimum payment (similar to that of a minimum payment on a credit card), an interest only option, a fully amortized 30 (or 40) year option and an aggressive fully amortized 15-year option.  Lenders qualify on the fully amortized payment (not the minimum 1.00% start rate!) - so it's not the Lender's trying to squeeze borrowers into loans (another implication).

There are a variety of lending opportunities available to help people become home owners ... all of them offer something that helps a borrower with cash flow - whether it be the need to have a minimum payment due to seasonal income to the need to know what the rate is and the discipline of a required principal & interest payment.  Every borrower has a different need ... and these needs can change. 

1) Do you have the money to spend on points vs the lower monthly payments?

2) Is the seller paying any of the buyer's closing costs as part of the purchase contract?

3) Is an employer paying to move an employee and paying a portion of their closing costs?

4) How long does the borrower plan on holding the loan (and paying at the schedule of payments that the loan originates at)?

5) Does paying down the interest rate make the payments that much more affordable for   qualification purposes?

I'm sure there are more reasons but let's look some examples to see how paying points can change the payment structure.  One thing is for certain - if a borrower paid on a mortgage for the entire term of that loan at the payment schedule required every month paying points could save you money ... you just have to pay for it in advance and bet that you'll keep that loan.

On a $ 500,000 purchase loan on today's 30-year fixed rate - here's the rate, the points charged, the cost of the points, the monthly payment, the savings per month vs. a 0 point loan and the number of months that savings (in the form of a lower payment) would take to pay back the cost of the points:

6.375%	0 points	0 point cost	$3119/mth pymt	0 savings	0 months
6.25%	0.25 pt	$1250 cost	$3079/mth pymt	$40/mnt savings	31 months
6.125%	0.50 pt	$2500 cost	$3038/mnt pymt	$81/mnt savings	31 months
6.00%	1.125 pt	$5625 cost	$2998/mnt pymt	$121/mnt savings	47 months
5.875%	1.875 pt	$9375 cost	$2958/mtn pymt	$161/mnt savings	58 months

In this example if I kept the loan 30-years and made all of the scheduled payments I would save $13,160 if I paid .25 pt over the life of the loan, $26,649 if I paid .50 pt, $37,873 if I paid 1.125 pts. and $48,622 if I paid 1.875 pts (this is savings AFTER the cost of the points have been paid back in the form of a lower monthly payment). 

Paying points can save you money in the long run - but that's a lot of extra up front money at closing that could be used for something else?  And how many people do you know that have kept their loan for 30-years?

Here's another example -$500,000 purchase loan ... this is an Interest Only loan ... fixed for 7-years ... then it becomes a 1-year ARM.  The value is in the 1st 7-years (lower rate and lower payments ... after the 7th year the interest rate is unknown ('cause it will adjust to Index + Margin) not to exceed the life time cap (which is 5.00% above start rate)):

6.25%	0 points	0 point cost	$2604/mnt pymt	0 savings	0 months
6.125%	.125 pt	$625 cost	$2552/mnt pymt	$52/mnt svgs	12 months
6.00%	.375 pt	$1875 cost	$2500/mnt pymt	$104/mnt svgs	18 months
5.875%	.75 pt	$3750 cost	$2448/mnt pymt	$156/mnt svgs	24 months
5.75%	1.125 pt	$5625 cost	$2396/mnt pymt	$208/mnt svgs	27 months
5.50%	2.0 pt	$10,000 cost	$2292/mnt pymt	$312/mnt svgs	32 months

The purpose of an Interest Only loan - for the most part - is that it's going to be held short term.  Either the borrower's income picture is going to improve and they will be paying more towards principal reduction ... or the principal balance is going to be reduced in a lump sum ... or the loan is going to be paid off completely before the end of the fixed time period (please note on these interest only loans that any reduction in the principal balance will automatically reduce the monthly payment requirements).

In this example paying an .125 point does result in a savings of $3744 over 7 years without a huge loan origination fee ... by paying 2 points the savings would be $11,856 over 7 years but if I had an extra $10,000 I might put it towards the down payment which would then save me $52/mth at 6.25% on $490K loan.  The answer as to whether to pay points on an Interest Only type loan (or any ARM for that matter) may not be as clear as with a Fixed Rate mortgage.

These are situations I work out every day for my customers - then let them decide whether paying points is worth it for them.  When I quote an interest rate to a customer it's always at 0 points so that the customer has a base line to work from.  Asking questions that they may not have thought of (or have thought of but didn't consider options that could save them money) may change the loan choice completely.  This result is a well informed customer who made an educated decision that best suited his/her/their financial situation ... and hopefully saved them money.

Betsy Riedy, Sr. Loan Consultant / Countrywide Home Loans
Santa Barbara, CA  (805)884-7107 direct