I was asked recently who has the best mortgage for people with “low credit scores.”

“Low credit score” is a nebulous term, so let’s see if we can narrow it down a bit.

A borrower’s FICO score is a three-digit number derived from data kept in each of the three credit repositories: Experian, Equifax and TransUnion. The FICO models (there are several of them) consider payment history, credit utilization, age of accounts and types of credit, among other factors. “Derogatory” entries include a history of late payments, collection accounts, over-limit credit cards and public record entries such as foreclosures, bankruptcies, liens and judgments.

Conventional loans (those that will ultimately be purchased by Fannie Mae or Freddie Mac) require a minimum score of 620. FHA loans, which are insured by the Department of Housing and Urban Development, will allow scores as low as 580 with a 3.5% down payment.

To have a score as low as 580 or 620, a consumer must have some combination of the following negative factors:

• Recent history of late payments
• Unpaid collection accounts
• Public record items
• High credit card balances

Each of these factors lowers a consumer’s credit score. Some of them, assuming they have been correctly reported, can’t be fixed quickly. Others, however, lend themselves to immediate remedy—and significant score improvement.

A word about “credit repair.” There are companies that promise to improve a consumer’s FICO score—for a fee. They claim that they can remove even those derogatory entries that are correct. They do this by disputing every negative item on the consumer’s credit report. Under the Fair Credit Reporting Act (FCRA), credit bureaus are required to investigate these disputes with the creditors and confirm their accuracy within 30 days. If they are unable to confirm them, they must delete them.

The credit repair company knows that some of the creditors reporting negative information will not respond to the credit bureau’s query within 30 days. In that case, the negative entry will magically disappear from the consumer’s credit report.

The problem with this is that while the derogatory entry may disappear, the creditor may report the same negative information to the credit bureaus at a later time. Furthermore, while the account is “in dispute,” it will be reported as such on the consumer’s credit report. Lenders know how credit repair companies operate, so they require that disputes be resolved. Removing a dispute (but not the negative entry) will cause the consumer’s score to go down.

Apart from trying to remove accurately reported negative items from one’s credit report through a sort of loophole in the law, there are some actions a low-FICO consumer can take to get an immediate—and often dramatic—improvement.

Collection accounts

If a consumer doesn’t make their payments on time (or doesn’t make payments at all), the creditor will assign the account to an internal department or third party to collect the debt. When they report the account as being in collection, the consumer’s credit score takes a beating. Not only is there a history of late payments, but the balance reported may be over the credit limit, with a past-due balance. A single account could cost 50 points on a consumer’s FICO score.

The first step is to contact the creditor or collection company to negotiate a settlement. I know, I know…these people are nasty and rude. They’ve been dunning you mercilessly for payment. They are threatening to sue you.

You have to talk to them. Be aware that bill collectors are really sales people. It’s the dark side of sales, but they earn a commission based on the money they collect. In most cases, they are willing to settle for a lesser amount than what they have reported to the credit bureaus. In many cases, the collection company has purchased the debt for pennies on the dollar, so everything they are able to collect over what they paid is profit to them.

When you speak with a collection agent, tell them you’d like to settle your account. They’ll give you a number, which will include accrued interest and late fees. Tell them you can’t pay that, but you’d like to offer this much for full settlement of the account. The bill collector will tell you they have to “talk to the manager.” They’ll put you on hold for a few minutes. When they come back on the line, they’ll either give you a higher number, or accept he offer you’ve made—but only if you agree to a “check by phone” right then.

Don’t do it.

You should not agree to give them any money without having a settlement from them in writing. The agreement—which can be in the form of an email or fax—should specify that they will accept the proposed amount in full settlement of the account. They should also agree to immediately report the account as settled. This won’t change the history of past-due payments, but the status will change from “collection account” to “paid collection. This will improve your score significantly.

Credit card balances

The FICO model refers to “credit utilization.” This means the balance on credit cards as a percentage of your credit limit. When you exceed about 30% of the credit limit, your score starts to suffer. A maxed-out card can cost you 20 points on your score. If you are over the limit, the impact could be 30 points.

Paying down credit card balances helps you in two ways. First, keeping your balance below 30% will improve your FICO score. Second, do you really want to keep paying 18% or more on those balances? It is a waste of your money.

Public record items

If someone sued you in small claims court and won, the court will enter a judgment against you. Your credit report will how the amount of the judgment, and possibly a lien, depending on the type of action. You’re going to have to settle it one way or another. After you settle, the judgment will still appear on your credit report, but the effect will not be as severe. Most lenders will require that judgments be satisfied before they will approve your loan.

The power of time

A low credit score is never permanent. The older a negative item gets, the less its effect on your credit score. A missed payment to Macy’s last month could cost you 25 points. A year from now, the cost could be just 10 points (assuming no other derogs). After two years, the effect is negligible.

Are there lenders who fund “sub-prime” loans for borrowers with very low credit scores? Yes. But they invariably charge very high rates and require larger down payments. It is a far better strategy in every respect to perform some rudimentary cleaning of your credit picture in ways that will genuinely improve your financial situation. If you have the funds available to deal with these items, you could be 30 days away from a much higher credit score—and far better terms or your financing.

Mortgage lenders use the borrower’s credit score to determine the rate they will get. Fannie Mae and Freddie Mac call this “risk-based pricing.” They publish a chart containing ranges of credit scores and loan-to-value ratios. Where the two axes intersect for a given borrower, the lender will find the adjustments to the interest rate. A borrower with a 620 score will pay about .75% more in rate for a conventional loan than will a buyer with a 740 score. The adjustments for FHA loans are equivalent, except that FHA allows a score as low as 580 for a loan with a 3.5% down payment.

We are always happy to provide advice and guidance for getting the best loan possible–even if your credit report shows some battle scars. You can always call us at 925-383-2846.

 

Being a buyer in today’s hyper-competitive Bay Area market can be discouraging. You can put the odds in your favor, though. Just be aware of the basics and keep your expectations in line with reality.

Let’s start with the “reality” part.

Prices

Prices here are stratospheric. There’s nothing we can do about that fact, but you should keep in mind that when a Realtor lists a home at a certain price, they have already researched earlier sales of similar homes in the area to arrive at an offering price that is likely to draw an offer (or offers). A property listed at, say, $750,000 may seem drastically overpriced to you, but a seller is very unlikely to accept a price far below that figure. In those common instances where multiple people are vying to buy the same prices, sales above asking price are not at all uncommon.

Competition

Inventory all across the Bay Area is in short supply, so properties sell very quickly—often in a matter of days. Because of this fact, buyers have very little opportunity to “mull over” a possible purchase. Taking a few days to decide to make an offer on a home is very likely to mean someone else gets it.

Competing with all-cash offers

If a seller receives two offers netting them precisely the same amount of cash at close, but one has a larger down payment, that will almost always be the one they’ll accept. The reason for this is the misinformed belief that getting a mortgage is insanely difficult, and the buyer with the larger down payment has a better chance of ultimately getting funded. This is simply wrong, but sellers—and their agents—continue to believe it.

Dealing with “rejection”

Accept the likelihood that you may not get the first property you like and offer to buy. It’s disappointing, but it is not a personal rejection. It is just the reality of today’s marketplace. If the seller accepts someone else’s offer, just brush yourself off and go to the next house that meets your needs. If you keep at it, you WILL succeed.

Now that I’ve spelled out the unattractive reality, I’ll suggest some strategies to succeed in your quest for home ownership.

Your financing

No seller will seriously consider any offer unless the buyer provides convincing evidence that they’ll be able to get their loan. You may have heard the term, “prequalification.” You should now eliminate that word from your vocabulary. A “prequal” is meaningless; it is essentially a mortgage loan officer’s opinion about your ability to qualify for a mortgage. They will have pulled your credit report and possibly taken a loan application. Based on that basic information, the loan officer writes a “prequal letter” indicating that you are qualified for a purchase of a certain amount.

Sellers (and their agents) are highly skeptical of these kinds of letters because they have been burned a few times. What you want is a preapproval. This means that your lender will have gotten all the documentation needed to approve your loan. They will have verified your income and assets using pay stubs, W2s, possibly tax returns and bank statements. Their preapproval letter should outline exactly what they have done to preapprove your loan.

If your financial situation is up to interpretation in any way—such as a self-employed borrower, a wage earner who receives bonuses and/or overtime, someone who receives income from rental property—you should ask for a “TBD approval.” This means that the lender’s underwriter has fully reviewed and approved your application even though the property is To Be Determined. This way, the seller will know that your loan has been fully approved, waiting only for the purchase contract, title report and appraisal. This is by far the most convincing and effective type of letter to accompany your offer.

Asset documentation

When you’re making your offer, it’s a good idea to document the source of your cash to buy. You can do this with a recent bank statement showing that you have the wherewithal to close. Redacting (blanking out account numbers) is completely acceptable.

Letter to the seller

Selling a home can be an intensely personal and emotional experience. You may be able to tilt the odds in your favor by writing a personal letter to the seller to include with your offer. You’d talk about how much you appreciate their home and look forward to raising your family there if they accept your offer.

I’ll be the first to admit that this “love letter” approach is cheesy; but there is absolutely no downside to doing this. I advised a couple to do this a few years ago. They went completely over the top with their letter—and prevailed over several other competing offers. It was such a lovely story I wrote about it—and included their excellent (and effective) letter in an earlier post.

I should also mention dealing with the high prices—and payment shock—in our market. The effect of rising prices is exacerbated by the steady (and expected) upward drift of rates since the first of the year. You may be able to soften that payment shock a couple of different ways. Here are some possibilities to consider:

Make a larger down payment

If you have the ability (and willingness) to increase your down payment, you’ll obviously have to pay on a smaller loan—but you may also get a small benefit in rate. Every little bit helps.

Look to first-time buyer programs

Buyers and their agents tend to think “down payment assistance” when they hear about first-time buyer programs. There are more choices in this area than getting help with the down payment. One of the most useful—and least well known—is tax credits available for many first-time buyers. There are some restrictions for these credits, but if you qualify, you’ll be able to claim 20% of the mortgage interest you pay every year as a tax credit. This means that the amount is subtracted from the actual taxes you owe in that year. If you pay $20,000 mortgage interest, your tax credit will be $4,000, so if your total income tax bill comes to $8,000, you’ll now owe $4,000. You get the credit each year for as long as you own the property and live there.

Consider your credit score

Most mortgages are ultimately sold to Fannie Mae, Freddie Mac or (in the case of FHA or VA loans) Ginnie Mae. Fannie and Freddie use “risk-based pricing.” This means that they adjust your interest rate based on a combination of your credit score and the loan-to-value ratio. Although the minimum score required for a conventional loan is 620, the rate for a borrower with that score will be approximately .75% higher than for a borrower with a score of 740 or higher. There are several steps in between, so if your credit score is close to one of the rate thresholds, you may be able to save thousands of dollars by optimizing your score by even a few points if it gets you into a better pricing bracket. These risk-based adjustments are consistent across all lenders.

Mortgage insurance choices

If your down payment is less than 20%—and smaller down payments are definitely the norm—the lender will require mortgage insurance(MI) to limit their risk. Buying a home for, say, $550,000 with a 10% down payment, you’ll pay $169 per month if your credit score is 740 or higher. With a down payment of 5%, the monthly insurance will go to $257 per month.

You can avoid that monthly MI payment by selecting “single premium MI.” As the name implies, you make a single payment in lieu of a monthly payment. For a 90% loan, the one-time premium is less than 2% of the loan amount—and it is added to the base loan amount. It does not come out of your pocket. Even though your loan amount will be a bit higher, your monthly payment will be significantly lower because you won’t pay the monthly insurance premium.

Getting into the Bay Area real estate market can be daunting. You may have some moments of discouragement; but if you take some time to prepare, you’ll be fine.

If you’d like a detailed action plan for your own situation, just give us a call: 925-383-2846.

You CAN do this!

The Fed Open Market Committee (FOMC) voted today to increase the Federal Funds Rate by .25%. This was widely expected, but people still ask us, “Is the Federal Reserve going to lower mortgage rates anytime soon?”

We get the question often enough that now would be a good time to explore how mortgage rates work.

Fannie and Freddie’s Role

Banks ultimately sell the vast majority of the residential mortgages they fund to investors. The best known of these–and the largest–are Fannie Mae and Freddie Mac. We refer to them as Government Sponsored Enterprises, or GSEs. They are private corporations presently in conservatorship in the wake of the 2008 meltdown.

Fannie and Freddie do not make loans. They buy them from lenders like Pinnacle, then pool them into a type of bond called Mortgage Backed Securities (MBS). These bonds are bought and sold by investors.

Bond Prices Fluctuate

The price of the bonds fluctuates according to market activity, in the same way that a company’s stock goes up and down as invstors buy and sell them. When the price of the MBS goes up, rates go down. This is because lenders get a higher price for the loans they sell to Fannie and Freddie, so they can lower their rates to borrowers.

Investors decide to buy or sell bonds largely driven by fears of future inflation. If they believe inflation will pick up more than expected, the bonds become a lot less attractive to them, so they sell. That makes their price go down, and rates go up. Remember that: Fears Of Inflation.

What the Federal Funds Rate Does

The Federal Reserve, our central bank, uses the Federal Funds Rate to stimulate the economy (lower rates) or slow it down to keep inflation from getting out of hand (higher rates). Increasing the Federal Funds rate, as they did today and will likely do three more times this year, was a proactive step in a recovering economy to keep it from growing too fast. In other words, they have tapped the economic brakes on the economy to keep it from spinning out of control (inflation). Consumers will see the effect of this increase in the cost of credit cards and HELOCs, both of which determine their rates by the Prime Rate, which in turn follows the Federal Funds rate.

The Future for Mortgage Rates

Now that the Fed has raised that one rate, what’s going to happen to interest rates?

Looking just at the bond action today, we can say that they will go down a bit–a very tiny bit. Investors have stepped back into the market to buy bonds again, now that they know the Fed’s decision. That has caused to price of the MBS to go up a bit, lowering rates.

I can hear you wondering why raising rates at the Fed level would cause mortgage rates to go down. Why is that? Remember “fears of inflation?” The investors believe the Fed is being vigilant and proactive, paying attention to inflation, the number one enemy of fixed-income investments like Mortgage Backed Securities. So, with the Fed’s announcement today, investors heave a big sigh of relief and go back to buying bonds, pushing their prices back up and rates down slightly.

What to Do Now

Mortgage rates have been artificially low for a number of years because the Federal Reserve entered the market directly, buying zillions of dollars in MBS (actually, they presently hold slightly less than $1.8 trillion in MBS. I’ll call that close to a zillion). As they have stopped that massive buying effort, we have seen rates gradually increase. In all likelihood, they’ll continue to increase a bit all year.

What does this mean for you, as an owner or prospective buyer of real estate?

If you’re hoping for lower rates, you’re likely to be disappointed. If you are hoping to buy or refinance, it is better to do it sooner, rather than later, since rates are likely to be higher int he future than they are today.