What is My Credit History?

The term credit history merely refers to how you have managed your credit and debt over a period of time. It looks at how you have financed purchases, as well as how you made your payments on the amounts financed in terms of the amount paid and whether or not the payments were made on time. It is used by lenders to evaluate how you will handle future loans. They look at your past to predict your future.

A bad credit history has become an increasing problem. There are two basic reasons for this. First, it has become very easy to get credit. You are probably inundated every day with solicitations from credit card companies. College students can now easily get credit cards without any work history. Auto dealers advertise that they will sell a car to people with no credit history or a bad credit history. This allows many people to receive credit who cannot handle it well. The inevitable result is a failure to pay the debt on time or at all.

The second reason is that these loose lending practices have caused many people to believe that paying bills on time is not very important. Much of this comes from advertising. Companies, even some dealing with mortgages, say things like, “Bad credit shows that you are only human.” Since credit is often easy to obtain—even with a poor credit history—paying on time does not seem to be very important.

But when it comes time to try to buy a house, a good credit history is a major factor in qualifying for a mortgage. To some lenders, it is the most important factor, even over your income-to-debt ratio. For example, many retirees are able to get loans that their income does not seem to support. This is because they have excellent credit. The lender believes that they will budget properly and repay the loan on time.

What is Underwriting and How does It Affect my Loan?

When you apply for a mortgage loan, the success of your application depends on underwriting. Underwriting is the process used to decide whether to accept or reject a loan application. It is also used to qualify a borrower for a loan program. Qualifying for a loan is not an all-or nothing scenario. A borrower may be rejected for the least expensive loan, but approved for a higher-risk, more expensive loan.

There has been a major change in the underwriting process in the past decade. Today, fewer and fewer people do the actual underwriting— instead, it is done by computers. This is called automated underwriting. As the name implies, a machine (rather than a person) does the work, and approves or rejects the application. Somewhat surprisingly, this has been a major benefit to many borrowers. It turns out that it is much tougher to get approved by a person than by a machine. The computer has been programmed in most instances to be much more forgiving for problems with credit, income, and debt than were the human underwriters. And, the computer does not worry about losing its job if it approves too many bad loans.

Regardless of whether a person or computer is actually doing the underwriting, there are three major factors that are considered in the underwriting process:

1. credit history;

2. income-to-debt comparison; and,

3. property value-to-loan comparison (down payment).

Why do so many people have bad credit histories?

A good way to understand why so many people have a bad credit history is to examine the use of credit cards. There are two ways to use a credit card. One is as a convenience. Those who use credit cards solely for convenience tend to not want to carry a lot of cash and find writing checks to be a nuisance. They pay for their purchases with their credit card and each month pay their credit card bill in full.

If this describes you, you have made the credit card a useful tool. You may even get extra benefits, such as cash back or airline miles. However, in the credit card industry, you are called a deadbeat. Using a credit card to your benefit is not what the credit card company had in mind when it issued the card. Some credit card companies will charge you a fee for not making installment payments (paying interest). Even though the credit card company charges a fee to the seller of your purchases, the big money is made on interest paid by the credit card holder. Furthermore, while you have made your credit cards a valuable tool, you are not developing a credit history, as the loan companies mainly look at how you handle making regular payments on a balance so they can determine how you will handle making a thirty-year mortgage payment.

The second way to use a credit card is to pay less than the total monthly bill, thereby costing you an interest payment. You are borrowing money every time you use your credit card, and what that costs you depends on how you use the card. While paying this interest is certainly costing you money, it is giving you a credit history you can later use to borrow greater sums of money, such as what you will need to buy a house. All of this depends on your ability to properly manage your credit cards and your payments.

What is a loan-to-value ratio?

One of the standard procedures before making a loan is to determine the value of the property. This is done by an appraisal, which determines a value for the property for loan purposes. The lender may have its own appraisers (in-house appraisers), or it may use an independent (outside) appraiser.

There are several different types of appraisals, some of which are highly complicated and require the appraiser to complete special education and licensing procedures. Appraising a home, especially a tract house or condominium, is relatively easy. The most common appraisal method used is to compare similar properties that have recently sold. A computer database with this information is available to the appraiser, who physically inspects the subject property to assess its condition. The property is then valued based on the sale prices of similar properties in the area, called comparables or comps. If the comps are not exactly the same model as the subject property, a price adjustment is made for square footage, lot size, and any amenities, such as a swimming pool or room addition.

For certain types of loans in which there is an extremely low loanto- value ratio, the lender may even use a desktop appraisal. With this method, the values of comparable properties are checked on a computer and there is no physical examination of the property beyond a drive by by the appraiser.

The amount of money you ask the bank to lend you compared to the value of the property is the loan-to-value ratio. The lower the ratio, the lower the risk for the lender. For you, the lower the ratio, the lower your credit score can be.

What is a promissory note?

When you sign all the documents that go along with giving a mortgage, you will sign what is called a promissory note (also referred to simply as a note). This is the document that sets out the terms of the loan, and as the name implies, is your promise to repay the money. The mortgage is the document that puts up your real estate to secure repayment. In other words, the promissory note describes how much you are borrowing and the terms of the loan, while the mortgage is what gives the bank the right to take your home if you do not live up to what you agree to do in the promissory note. It is common for the mortgage to restate all the terms of the note, making the documents sometimes look very similar. However, they have very distinct purposes.

The reason the note is so important is because it is a negotiable instrument. Negotiable instruments are what make the system work. A buyer of a negotiable instrument, as long as the procedure is done properly, becomes a holder in due course. The point behind a holder in due course is that once the loan has been sold, you may be stuck with it—even if you did not fully understand the terms or there were irregularities because of a dishonest original lender.

Negotiable instruments are treated differently from other contractual promises. They must be in a certain form (they are sometimes called form or formal contracts.) When in the proper form, they create rights for those to whom they are transferred (those who buy them) that other contracts do not.

How are mortgages structured?

There are two general ways that mortgages are structured. The structure affects how the foreclosure procedures are performed should you not make your mortgage payments. In title theory states, the lender owns the property and deeds it back to the borrower when the loan is repaid. In lien theory states, the borrower owns the property and the lender has a lien on it. Title theory states are more commonly found in the eastern part of the country, with more lien theory states in the western United States.

In either a title theory state or lien theory state, the general effect is the same. The lender’s rights in the property are only for the purpose of securing the loan. If the borrower abides by the terms of the note and mortgage, the lender has no right to interfere with the borrower’s use and enjoyment of the property.

The differences in the theories may become important when the borrower fails to abide by the terms of the mortgage loan. The foreclosure process varies from state to state, with some state laws being more favorable to the borrower and some to the lender. Since state laws control the real property located within that state, every person must follow the laws of his or her particular state.

What is a mortgage?

In simple terms, a mortgage is putting up real property (real estate) to secure a loan. This means that if you fail to meet the terms of the mortgage—for example, by failing to make your agreed-upon monthly payments—the lender can sell your house through a process called foreclosure to get back the money you borrowed to buy it.

You should familiarize yourself with certain technical terms used in the mortgage industry.

A mortgage is a two-party document—the mortgagor (borrower) gives the mortgage, and the mortgagee (lender) lends the money. Most people incorrectly say that they are going to “buy a mortgage.” The expression has become so common that everyone knows that someone who says it is trying to borrow—not lend—money.

Another term that you should know—which is often used incorrectly— is pledge. To pledge something is to deliver physical possession of it, like if you are getting a loan from a pawnshop. When you do not give up possession, you hypothecate the property—you do not pledge it. Since pledge is a simpler word than hypothecate, it is commonly used—even though not technically correct.

Can I use a gift to pay for my down payment?

Check with your lender to see if all or part of the down payment can be covered by a gift from a third person. If you have a relative who is willing to help you with the down payment, get a gift letter from that relative (along with the gift) stating that you do not have to pay back the money. How much of your own money you will need depends on the type of loan you are seeking and the lender’s policy (which usually contains a minimum credit score requirement).

If you are using a gift as part of your down payment, ask the lender for the form gift letter it wants you to use. There is no standard form used by all lenders.

A gift letter must contain the following items.

• The names of the donor (giver of the gift) and the donee (receiver of the gift).

• Whether the gift has been given or only promised. The lender

may require that it be given before accepting the letter.

• The purpose of the gift (to help purchase the home). The property address is also given in this section.

• A statement that no repayment is required or expected, either in cash or future services. (Although by definition a gift does not have to be repaid, lenders want it emphasized.)

• The relationship of the donor to the donee, such as parent or sibling. The donor may also be a nonprofit organization that helps low-income buyers or those having specific jobs.

• The date and signature of the donor and an acceptance and signature of the donee. Notarizing the signatures is usually not required. If it is, your lender will most likely have a form for you to use.

The lender may also require that the donor disclose the source of the funds, such as the sale of stock, a savings account, etc. There may also be a statement that no party to the sale, such as the seller or real estate agent, is the real source of the gift.

Most lenders want you to have at least 5% of your own money in the deal. You will have to show proof that the money is yours, and not borrowed or a gift. Bank statements showing regular deposits to a savings account or a letter from your employer stating that you were paid a bonus are examples of what you may need to show your lender.

What is Private Mortgage Insurance (PMI)?

Lenders want to make loans at the lowest risk possible. With a 20% down payment, most lenders are comfortable with the risk level of the loan. To cover risks with down payments of less than 20%, private mortgage insurance was developed. Private mortgage insurance (PMI) insures the lender in the event that the foreclosure of a mortgage results in a sale that nets less than the balance owed on the loan. The cost of the insurance is paid by the borrower. For a loan with a down payment of less than 20%, you will have, as part of your monthly mortgage payment, an additional payment for PMI. The insurance does not cover the entire loan amount—only a small percentage. So, if you have only 10% to put down, the lender requires you to buy PMI to cover the other 10%. If the lender takes a loss, the insurer will cover that loss up to 10% of the amount of the loan.

Theoretically, the lender’s risk is the same as if it made an 80% loan. As a practical matter, though, the lender’s risk is greater, since borrowers who put 10% down are more likely to default than borrowers who put 20% down. The more you put down, the better chance you will get the most favorable interest rate for a loan and have to pay less in PMI.

The rates you will pay for PMI vary, based on the percent covered and the borrower’s credit score. Borrowers who put down 5% pay more than those who put down 15%. This makes sense because more insurance is required. It also makes sense that a higher down payment means a lower risk of default.

The lender may have a choice of how much insurance it requires. The lender may buy insurance to cover 30% of the loan, rather than 20%. This will cost more. If you are getting PMI, ask if the lender is getting the minimum insurance. If you have good credit and good income-to-debt ratios, you should question why the extra insurance is necessary. At the time you apply for the loan, you also want to ask about cancellation of the PMI. Once you have paid on the loan to a point that PMI should no longer be required, you should stop paying for it or get a refund if you paid the total up-front. Laws now require a lender to cancel PMI when the loan-to-value ratio reaches 78% of the value of the property at the time when the loan was made if cancellation is not requested by the borrower, and at 80% if the borrower makes a request. Ask about cancellation before taking a loan and always contact your lender when the loan-to-value ratio reaches 80% to have it canceled.

Many people hate having to pay PMI. There are ways to avoid PMI using different types of loans that will be discussed later. One way to increase your down payment and lower or eliminate PMI is through a gift.