Bloom's Blog

Mortgage Rates and Apple Pie... a-la-mode is often necessary.

Three important slices

Residential property borrowing strength can be thought of like a juicy fresh apple pie, some better than others. Qualifying is determined by both the size of the pie and how palatable it is. It’s divided into three important slices including:

• Your credit (FICO score – higher is better)
• The loan amount to value of property (LTV – lower is better)
• Your income and assets relative to debt (higher is better)

Some individuals have a great big tasty pie with even slices. These borrowers can pretty much borrow without hassle and little cost, sitting back satisfied and happy. Others have only a bite-sized, single slice, resulting in high lender risk and borrowing difficulty.  They are left wanting more. The majority of people fall somewhere in between. They have ample pie size and fairly even slice size, but require some vanilla ice cream to make it just a bit tastier.

What to watch out for

When you hear mortgage rates quoted, they are generally for borrowers with a marketable pie: excellent credit, high equity and fully documented income to support all their debt. Most mortgages are sold on the secondary market so the pie needs to be as tasty as possible. When credit is only fair, equity is low or income not able to be substantiated, then rates move up based on the increased risk in each area. This less than perfect pie is covered with a hunk of ice cream [higher rate] so it’s more attractive to investors on the secondary market.

Beware of a common “gotcha” when shopping for a loan and terms. The lender assumption is a “perfect pie,” or borrower profile. At the point when your loan is finally in underwriting, often the bad news comes… different terms because some aspect of your profile wasn’t quite good enough and some ice cream is necessary to make it more appetizing. A good broker will be honest up front and quote a rate based on your true profile (at the risk of losing a client to a “better” initial quoted rate).

Compensating slices

The good news is a big slice in one area can help compensate for smaller one of the remaining two. For example, a borrower can still refinance even with a FICO score of 500 if their equity stake is 35% or better. The lender’s risk of a borrower’s poor credit is mitigated by the collateral in the home. If you are in between jobs with NO income, but have a FICO score of over 720, a loan is still possible because you may qualify for a “no documentation” loan. The credit score demonstrates responsible borrowing habits over time and a likelihood of continued behavior in the future.

Generally speaking, the best rates are quoted for a “conforming loan”: one less than $417,000 with an LTV of 80% or less, a FICO of at least 680 and debt to income ratio of less than 40%. If a deviation exists in a negative direction, it results in a higher note rate. A “Jumbo” loan (greater than $417,000) is typically ¼ percentage point or more higher than a conforming loan rate. Starting with the perfect borrower profile, the lender applies ice cream in sufficient quantities to cover up the blemishes, ending up with a rate that tastes good to their investors.

Lender Rate Sheets

Rates are not arbitrary. Every lender sets its underwriting criteria based on its investor expectations of return and risk. Rate sheets are like an al-la-carte menu. As a broker, we start at the base amount established each day by each lender and then add or deduct basis points from the note rate based on the borrower’s FICO, LTV and documentation type. The resulting rate quoted is always a good faith estimate but subject to final underwriting subjectivity.

Since loan rates are based on a complete borrower profile, getting a quote before actually filling out a loan application and pulling credit is meaningless. Know that “quick quotes” are designed to capture your interest and likely to change unless you are one of the relatively few borrowers that fit conforming criteria with an award winning pie. The rate you will pay is only fixed when a “loan lock” commitment is made AND underwriting conditions for funding have been met. Before that, your rate is subject to change and NEVER guaranteed. If your pie isn’t served a-la-mode, be aware as most need at least a little ice cream to satisfy.

Any questions about qualifying with today’s rates, or about rate modifiers, can be directed to my attention. Please don’t hesitate to contact me.

Is remodeling worth the investment?

Rarely will you ever get a dollar for dollar return on remodeling or home improvements. However, some projects are worth more than others so thinking both in terms of lifestyle and investment are important. In general terms, the smallest or least attractive house in the neighborhood can always justify more than the largest. Every neighborhood is different so talking to a real estate professional or contractor can help create both maximum return and functionality.

If home values just finished a major growth spurt, enjoying more living space or nicer amenities may only be possible by staying put. The cost to move up to a nicer house may, very well be beyond your means. I frequently hear, “I could never afford to buy my house today.”

So, where do you put those remodeling dollars to work? Well, the people at Remodeling Online received 2188 email responses from members of the National Association of Realtors to prepare their 2006 Cost vs. Value Report. Following are excerpts from this report for the Pacific region. The costs are an average for projects reported. The final column (Value %) is the increase in home value as a percentage of improvement cost.

So, by the looks of it we like to our kitchens, bathrooms and energy efficient windows. If you had a budget of say, $50,000 and split it between the bathroom, kitchen and windows you’d come close to a 100% increase in value of dollars spent. For those of you thinking about buying an investment property or spec house, think in these terms. Oh, ….and the swimming pool? Numbers vary widely but 50% is probably a pretty good increase of home value to cost with a nicely installed, in-ground, well maintained pool.

Financing home improvements is possible in a wide variety of ways, the most common of which is a Home Equity Line of Credit (HELOC). If your project is a partial tear down or significant addition, you may be a good candidate for construction lending. The benefit with this is a loan to value ratio based on the completed value after improvements are made (where a HELOC only considers value before improvements). This means potentially more money to work with. Your circumstances are unique, so ping me if you would like to discuss options.

Sub-prime, Who's to Blame?

Sub-prime talk seems to have made its way to water coolers everywhere. Wall Street reports sub-prime lenders declaring bankruptcy almost weekly and it’s followed by talking heads suggesting federal legislation to fix the problems. Question is, …what really is the problem?

Sub-prime Explained

First, if you aren’t familiar to the topic, sub-prime refers to a broad classification of loans to individuals with less than “prime” borrowing characteristics (credit score, income to debt ratio, loan to value and payment history). These lenders have pushed the underwriting limits with stated income, marginal FICO scores, high loan to values (LTV) and derivative loan products.

The Option ARM Trap

The most note worthy of these derivatives is the “Option ARM” or an adjustable rate mortgage with the option of paying the full amortized payment, an interest only payment or a “minimum payment” which is often a teaser rate of 1 -2% for a limited initial term of the loan. Making this payment isn’t without cost, however, as the difference between the payment you make and the payment you actually should make is added on to the principal balance of the loan (known as negative amortization). Your loan grows rather than reduces.

While neg-am isn’t always bad, what most people in these loans don’t realize is if the minimum payment is made every month, the loan will “recast” when the principal balance hits typically 110% of the original principal amount borrowed. This usually occurs just before the third year and can cause the payment to double, with no option to pay less than the full amortized payment at the full interest rate (index plus margin). If the index is LIBOR, for example, you could go from paying 2% to 9% when recasting occurs.

Here’s the trap. Because the initial payment is so low, a borrower can qualify for more loan than they can really afford to pay based on income. There is an incredible false sense of cash-flow well being. The temptation of a bigger house or nicer neighborhood is sometimes all too alluring. When that real payment kicks in most people either have to: 1) refinance with the same type of loan again (expensive), 2) sell (disheartening), or 3) in some cases default and be foreclosed on (expensive and disheartening).

Who’s To Blame?

It’s entirely possible to end up owing more than the house is worth if the initial LTV is high and the market softens (like recent history has shown). But, back to my initial question… where is the problem and who’s to blame? There has to be a place to point the finger of blame. Right?

I think there is plenty of blame to go around. Many lenders were creating underwriting guidelines so that anyone with a pulse, many of whom didn’t have legitimate or sustainable means to make a mortgage payment, could get a loan. Plenty of brokers were doing only half their job. Sure they got people into new homes with big smiles, but they didn’t explain the consequences of making only minimum payments and the bind they would be in by doing so.

Finally, many people were simply interested in the immediate gratification and justified a bad decision with the hopes of better income or a profitable sale a few years down the road. After all, we just finished a stretch where home value appreciation saw prices double in as little as 5 years. It was bound to last forever.

What Should I Do?

If you have an Option ARM that is set to recast, refinancing with another one may be your only option to buy some time in the hopes that your income or house value rises substantially within three years. This will either allow you to make the “real” payment or sell without a loss and get into a housing situation that is more affordable.

My advice is to be aware when recasting is going to occur and plan ahead. Too many people get caught off guard, get behind in payments and risk foreclosure. At a minimum, you can destroy your credit score in months and spend years rebuilding it. Talk to a mortgage professional, preferably me, and get advice if you can’t figure out when this event will occur. You aren’t alone. This has been a popular loan product for the wrong reasons.