Credit and Your Consumer Rights
A good credit rating is very important. Businesses inspect your credit history when they evaluate your applications for credit, insurance, employment and leases. Based on your credit payment history, businesses may choose to grant or deny credit, provided you receive fair and equal treatment. Sometimes, things happen that can cause credit problems: a temporary loss of income, an illness, even a computer error. Solving credit problems may take time and patience, but it doesn't have to be an ordeal.
The Federal Trade Commission (FTC) enforces credit laws that protect your right to obtain, use, and maintain credit. These laws do not guarantee that everyone will receive credit. Instead, the credit laws protect your rights by requiring businesses to give all consumers a fair and equal opportunity to receive credit and to resolve disputes over credit errors. This document explains your rights under these laws and offers practical tips to help you solve credit problems.
Your Credit Report
Your credit payment history is recorded in a file or report. These files or reports are maintained and sold by consumer reporting agencies (CRAs). One type of CRA is commonly known as a credit bureau. You have a credit record on file at a credit bureau if you have ever applied for a credit or charge account, a personal loan, insurance, or a job. Your credit record contains information about your income, debts, and credit payment history. It also indicates whether you have been sued, arrested, or have filed for bankruptcy.
The Fair Credit Reporting Act (FCRA) is designed to help ensure that CRAs furnish correct and complete information to businesses to use when evaluating your application.
Your rights under the Fair Credit Reporting Act:
- You have the right to receive a copy of your credit report. The copy of your report must contain all of the information in your file at the time of your request.
- You have the right to know the name of anyone who received your credit report in the last year for most purposes or in the last two years for employment purposes.
- Any company that denies your application must supply the name and address of the CRA they contacted, provided the denial was based on information given by the CRA.
- You have the right to a free copy of your credit report when your application is denied because of information supplied by the CRA. Your request must be made within 60 days of receiving your denial notice.
- If you contest the completeness or accuracy of information in your report, you should file a dispute with the CRA and with the company that furnished the information to the CRA. Both the CRA and the furnisher of information are legally obligated to investigate your dispute.
You have a right to add a summary explanation to your credit report if your dispute is not resolved to your satisfaction.
Your Credit Application
When creditors evaluate a credit application, they cannot lawfully engage in discriminatory practices.
The Equal Credit Opportunity Act (ECOA) prohibits credit discrimination on the basis of sex, race, marital status, religion, national origin, age, or receipt of public assistance. Creditors may ask for this information (except religion) in certain situations, but may not use it to discriminate when deciding whether to grant you credit.
The ECOA protects consumers who deal with companies that regularly extend credit, including banks, small loan and finance companies, retail and department stores, credit card companies, and credit unions. Everyone who participates in the decision to grant credit, including real estate brokers who arrange financing, must follow this law. Businesses applying for credit also are protected by this law.
Your rights under the Equal Credit Opportunity Act:
- You cannot be denied credit based on your race, sex, marital status, religion, age, national origin, or receipt of public assistance.
- You have the right to have reliable public assistance considered in the same manner as other income.
- If you are denied credit, you have a legal right to know why.
Your Credit Billing and Electronic Fund Transfer Statements
It is important to check credit billing and electronic fund transfer account statements regularly. These documents may contain mistakes that could damage your credit status or reflect improper charges or transfers. If you find an error or discrepancy, notify the company and contest the error immediately. The Fair Credit Billing Act (FCBA) and Electronic Fund Transfer Act (EFTA) establish procedures for resolving mistakes on credit billing and electronic fund transfer account statements, including:
- charges or electronic fund transfers that you, or anyone you have authorized to use your account have not made;
- charges or electronic fund transfers that are incorrectly identified or show the wrong amount or date;
- computation or similar errors;
- failure to reflect payments, credits, or electronic fund transfers properly;
- not mailing or delivering credit billing statements to your current address, as long as that address was received by the creditor in writing at least twenty days before the billing period ended;
- charges or electronic fund transfers for which you request an explanation or documentation, due to a possible error.
The FCBA generally applies only to "open end" credit accounts, credit cards, revolving charge accounts (such as department store accounts), and overdraft checking accounts. It does not apply to loans or credit sales that are paid according to a fixed schedule until the entire amount is paid back, such as an automobile loan. The EFTA applies to electronic fund transfers, such as those involving automatic teller machines (ATMs), point-of-sale debit transactions, and other electronic banking transactions.
Your Debts and Debt Collectors
You are responsible for your debts. If you fall behind in paying your creditors or an error is made on your account, you may be contacted by a "debt collector." A debt collector is any person, other than the creditor, who regularly collects debts owed to others. This includes lawyers who collect debts on a regular basis. You have the right to be treated fairly by debt collectors.
The Fair Debt Collection Practices Act (FDCPA) applies to personal, family, and household debts. This includes money owed for the purchase of a car, for medical care, or for charge accounts. The FDCPA prohibits debt collectors from engaging in unfair, deceptive, or abusive practices while collecting these debts.
Your rights under the Fair Debt Collection Practices Act:
- Debt collectors may contact you only between 8 a.m. and 9 p.m.
- Debt collectors may not contact you at work if they know your employer disapproves.
- Debt collectors may not harass, oppress, or abuse you.
- Debt collectors may not lie when collecting debts, such as falsely implying that you have committed a crime.
- Debt collectors must identify themselves to you on the phone.
- Debt collectors must stop contacting you if you ask them to in writing.
Solving Your Credit Problems
Your credit report influences your purchasing power, as well as your chances to get a job, rent or buy an apartment or a house, and buy insurance. A history of timely credit payments helps you get additional credit. Accurate negative information can stay on your report for seven years. A bankruptcy can stay on your report for 10 years. If you are having problems paying your bills, contact your creditors at once. Try to work out a modified payment plan with them that reduces your payments to a more manageable level. Don't wait until your account has been turned over to a debt collector.
Here are some additional tips for solving credit problems:
- If you want to contest a credit report, bill or credit denial, contact the appropriate company in writing and send it "return receipt requested."
- When you contest a billing error, include your name, account number, the dollar amount in question, and the reason you believe the bill is wrong.
- If in doubt, request written verification of a debt.
- Keep all your original documents, especially receipts, sales slips, and billing statements. You will need them if you dispute a credit bill or report. Send copies only. It may take more than one letter to correct problems.
- Be skeptical of businesses that offer instant solutions to credit problems.
- Be persistent. Resolving credit problems can take time and effort.
- There is nothing a credit repair company can do for you for a fee, that you cannot do for yourself for little or no cost.
If you can't resolve your credit problems yourself or if you need help, you may want to contact a credit counseling service. Nonprofit organizations in every state counsel consumers in debt. Counselors try to arrange repayment plans that are acceptable to you and your creditors. They also can help you set up a realistic budget. These services usually are offered at little or no cost.
Universities, military bases, credit unions, and housing authorities also may offer low- or no-cost credit counseling programs. Check the white pages of your telephone directory for a service near you.
For More Information
You can file a complaint with the FTC by contacting the Consumer Response Center by phone: toll-free 1-877-FTC-HELP (382-4357); TDD: 202-326-2502; by mail: Consumer Response Center, Federal Trade Commission, 600 Pennsylvania Ave, NW, Washington, DC 20580; or through the Internet, using the online complaint form. Although the Commission cannot resolve individual problems for consumers, it can act against a company if it sees a pattern of possible law violations.
This document was written in January 1998 by the FTC.
Credit and Divorce
| Mary and Bill recently divorced. Their divorce decree stated that Bill would pay the balances on their three joint credit card accounts. Months later, after Bill neglected to pay off these accounts, all three creditors contacted Mary for payment. She referred them to the divorce decree, insisting that she was not responsible for the accounts. The creditors correctly stated that they were not parties to the decree and that Mary was still legally responsible for paying off the couple's joint accounts. Mary later found out that the late payments appeared on her credit report. |
If you've recently been through a divorce or are contemplating one, you may want to look closely at issues involving credit. Understanding the different kinds of credit accounts opened during a marriage may help illuminate the potential benefits and pitfalls of each.
There are two types of credit accounts: individual and joint. You can permit authorized persons to use the account with either. When you apply for credit, whether a charge card or a mortgage loan, you'll be asked to select one type.
Individual or Joint Account
Individual Account
Your income, assets, and credit history are considered by the creditor. Whether you are married or single, you alone are responsible for paying off the debt. The account will appear on your credit report, and may appear on the credit report of any "authorized" user. However, if you live in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin), you and your spouse may be responsible for debts incurred during the marriage, and the individual debts of one spouse may appear on the credit report of the other.
Advantages/Disadvantages: If you're not employed outside the home, work part-time, or have a low-paying job, it may be difficult to demonstrate a strong financial picture without your spouse's income. If you open an account in your name and are responsible, no one can negatively affect your credit record.
Joint Account
Your and your spouse's income, financial assets and credit history are considerations for a joint account. No matter who handles the household bills, you and your spouse are responsible for seeing that debts are paid. A creditor who reports the credit history of a joint account to credit bureaus must report it in both names (if the account was opened after June 1, 1977).
Advantages/Disadvantages: An application combining the financial resources of two people may present a stronger case to a creditor who is granting a loan or credit card. When two people apply together for the credit, each is responsible for the debt. This is true even if a divorce decree assigns separate debt obligations to each spouse. Former spouses who run up bills and don't pay them can hurt their ex-partner's credit history on jointly held accounts.
Account "Users"
If you open an individual account, you may authorize another person to use it. If you name your spouse as the authorized user, a creditor who reports the credit history to a credit bureau must report it in your spouse's name as well as yours (if the account was opened after June 1, 1977). A creditor may report the credit history in the name of any other authorized user.
Advantages/Disadvantages: User accounts often are opened for convenience. They benefit people who might not qualify for credit on their own, such as students or homemakers. While these people may use the account, you, not they, are contractually liable for paying the debt.
If You Divorce
If you're considering divorce or separation, pay special attention to the status of your credit accounts. If you maintain joint accounts during this time, it's important to make regular payments so your credit record won't suffer. As long as there's an outstanding balance on a joint account, you and your spouse are responsible for it.
If you divorce, you may want to close joint accounts or accounts in which your former spouse was an authorized user. You may ask the creditor to convert these accounts to individual accounts.
By law, a creditor cannot close a joint account because of a change in marital status, but can do so at the request of either spouse. A creditor, however, does not have to change joint accounts to individual accounts. The creditor can require you to reapply for credit on an individual basis. On that basis, the creditor may extend or deny you credit. In the case of a mortgage or home equity loan, a lender is likely to require refinancing to remove a spouse from the obligation.
For More Information
You can file a complaint with the FTC by contacting the Consumer Response Center by phone: toll-free 1-877-FTC-HELP (382-4357); TDD: 202-326-2502; by mail: Consumer Response Center, Federal Trade Commission, 600 Pennsylvania Ave, NW, Washington, DC 20580; or through the Internet, using the online complaint form. Although the Commission cannot resolve individual problems for consumers, it can act against a company if it sees a pattern of possible law violations.
This document was written in January 1998 by the FTC.
Fair Credit Reporting Act
If you've ever applied for a charge account, personal loan, insurance, or job, there's a file about you. This file contains information about where you work, live, how you pay your bills, and whether you've been sued, arrested, or filed for bankruptcy.
Companies that gather and sell this information are called Consumer Reporting Agencies (CRAs). The most common type of CRA is the credit bureau. The information CRAs sell about you to creditors, employers, insurers, and other businesses is called a consumer report.
The Fair Credit Reporting Act (FCRA), enforced by the Federal Trade Commission, is designed to promote accuracy and ensure the privacy of the information used in consumer reports. Recent amendments to the Act expand your rights and place additional requirements on CRAs. Businesses that supply information about you to CRAs and those that use consumer reports also have new responsibilities under the law.
Here are some answers to questions consumers commonly ask about consumer reports and CRAs. You may have additional rights under state laws. Contact your state Attorney General or local consumer protection agency for more information.
Q. How do I find the CRA that has my report?
A. Contact the CRAs listed in the Yellow Pages under "credit" or "credit rating and reporting." Because more than one CRA may have a file on you, call each until you locate all the agencies maintaining your file. The three major national credit bureaus are:
- Equifax, P.O. Box 740241, Atlanta, GA 30374-0241; (800) 685-1111.
- Experian (formerly TRW), P.O. Box 949, Allen, TX 75013; (888) EXPERIAN (397-3742).
- Trans Union, 760 West Sproul Road, P.O. Box 390, Springfield, PA 19064-0390; (800) 916-8800.
In addition, anyone who takes action against you in response to a report supplied by a CRA--such as denying your application for credit, insurance, or employment--must give you the name, address, and telephone number of the CRA that provided the report.
Q. Do I have a right to know what's in my report?
A. Yes, if you ask for it. The CRA must tell you everything in your report, including medical information, and in most cases, the sources of the information. The CRA also must give you a list of everyone who has requested your report within the past year--two years for employment related requests.
Q. Is there a charge for my report?
A. Sometimes. There's no charge if a company takes adverse action against you, such as denying your application for credit, insurance or employment, and you request your report within sixty days of receiving the notice of the action. The notice will give you the name, address, and phone number of the CRA. In addition, you're entitled to one free report a year if (1) you're unemployed and plan to look for a job within sixty days, (2) you're on welfare, or (3) your report is inaccurate because of fraud. Otherwise, a CRA may charge you up to $8 for a copy of your report.
Q. What can I do about inaccurate or incomplete information?
A. Under the new law, both the CRA and the information provider have responsibilities for correcting inaccurate or incomplete information in your report. To protect your rights under this law, contact both the CRA and the information provider.
First, tell the CRA in writing what information you believe is inaccurate. CRAs must reinvestigate the items in question--usually within 30 days--unless they consider your dispute frivolous. They also must forward all relevant data you provide about the dispute to the information provider. After the information provider receives notice of a dispute from the CRA, it must investigate, review all relevant information provided by the CRA, and report the results to the CRA. If the information provider finds the disputed information to be inaccurate, it must notify all nationwide CRAs so that they can correct this information in your file.
When the reinvestigation is complete, the CRA must give you the written results and a free copy of your report if the dispute results in a change. If an item is changed or removed, the CRA cannot put the disputed information back in your file unless the information provider verifies its accuracy and completeness, and the CRA gives you a written notice that includes the name, address, and phone number of the provider.
Second, tell the creditor or other information provider in writing that you dispute an item. Many providers specify an address for disputes. If the provider then reports the item to any CRA, it must include a notice of your dispute. In addition, if you are correct--that is, if the information is inaccurate--the information provider may not use it again.
Q. What can I do if the CRA or information provider won't correct the information I dispute?
A. A reinvestigation may not resolve your dispute with the CRA. In that case, ask the CRA to include your statement of the dispute in your file and in future reports. If you request, the CRA also will provide your statement to anyone who received a copy of the old report in the recent past. There usually is a fee for this service.
If you tell the information provider that you dispute an item, a notice of your dispute must be included anytime the information provider reports the item to a CRA.
Q. Can my employer get my report?
A. Only if you say it's okay. A CRA may not supply information about you to your employer, or to a prospective employer, without your consent.
Q. Can creditors, employers, or insurers get a report that contains medical information about me?
A. Not without your approval.
Q. What should I know about "investigative consumer reports?"
A. "Investigative consumer reports" are detailed reports that involve interviews with your neighbors or acquaintances about your lifestyle, character and reputation. They may be used in connection with insurance and employment applications. You'll be notified in writing when a company orders such a report. The notice will explain your right to request certain information about the report from the company to which you applied. If your application is rejected, you may get additional information from the CRA. However, the CRA does not have to reveal the sources of the information.
Q. How long can a CRA report negative information?
A. Seven years. There are certain exceptions:
- Information about criminal convictions may be reported without any time limitation.
- Bankruptcy information may be reported for 10 years.
- Information reported in response to an application for a job with a salary of more than $75,000 has no time limit.
- Information reported because of an application for more than $150,000 worth of credit or life insurance has no time limit.
- Information about a lawsuit or an unpaid judgment against you can be reported for seven years or until the statute of limitations runs out, whichever is longer.
Q. Can anyone get a copy of my report?
A. No. Only people with a legitimate business need, as recognized by the FCRA. For example, a company is allowed to get your report if you apply for credit, insurance, employment, or to rent an apartment.
Q. How can I stop a CRA from including me on lists for unsolicited credit and insurance offers?
A. Creditors and insurers may use CRA file information as a basis for sending you unsolicited offers. These offers must include a toll-free number for you to call if you want to remove your name and address from lists for two years; completing a form that the CRA provides for this purpose will keep your name off the lists permanently.
Q. Do I have the right to sue for damages?
A. You may sue a CRA, or a user or provider of CRA data, in state or federal court for most violations of the FCRA. If you win, the defendant will have to pay damages and reimburse you for attorney fees to the extent ordered by the court.
Q. Are there other laws I should know about?
A. Yes. If your credit application was denied, the Equal Credit Opportunity Act requires creditors to specify why, provided you ask. For example, the creditor must tell you whether you were denied because you have "no credit file" with a CRA, or because the CRA says you have "delinquent obligations." The ECOA also requires creditors to consider additional information you might supply about your credit history. You may want to find out why the creditor denied your application before you contact the CRA.
Q. Where should I report violations of the law?
A. Although the FTC can't act as your lawyer in private disputes, information about your experiences and concerns is vital to the enforcement of the Fair Credit Reporting Act. Send your questions or complaints to: Consumer Response Center – FCRA, Federal Trade Commission, Washington, D.C. 20580.
For More Information
You can file a complaint with the FTC by contacting the Consumer Response Center by phone: toll-free 1-877-FTC-HELP (382-4357); TDD: 202-326-2502; by mail: Consumer Response Center, Federal Trade Commission, 600 Pennsylvania Ave, NW, Washington, DC 20580; or through the Internet, using the online complaint form. Although the Commission cannot resolve individual problems for consumers, it can act against a company if it sees a pattern of possible law violations.
This document was written in March 1999 by the FTC.
What is a FICO score?
A FICO score is a generic term for a credit bureau score and specifically refers to the score derived from the FICO statistical model. A credit bureau score measures the relative degree of risk a potential borrower represents to the lender or investor. Each of the three credit bureaus have their own method, or statistical model, for calculating scores. The bureaus rely exclusively on their own data for calculating scores. The credit bureaus and their respective models are:
- Equifax (formally CBI) / Beacon model
- Trans Union / Emperica model
- Experian (formally TRW) / FICO model
Fair, Isaac & Co. (FICO) began its pioneering work with credit scoring in the late 1950s. Since then, scoring has become widely accepted by lenders as a reliable means of credit evaluation. A credit score attempts to condense a borrowers credit history into a single number. Fair, Isaac & Co. and the credit bureaus do not reveal how these scores are computed. The Federal Trade Commission has ruled this to be acceptable.
FICO scores vary from approximately 375 to 900 points. Higher scores are better.To get the best interest rates, you will generally need to score 680 or higher. If your score is at least 680, you are considered to have 'A' credit. If your score is below 620, you will generally pay a higher rate on your mortgage, and your credit is considered "sub prime." Depending on your score and credit, you may be considered to be a 'B', 'C', or 'D' credit borrower. If your score is between 620 and 680, based upon factors such as income, assets, etc., the lender may decide into which credit category you fall. Presented below is a general guide which can give you an idea of your credit ranking (A+ through E) based upon your credit score:
| |
Credit
Score |
Debt
Ratio |
Max
LTV |
Mortgage |
Revolve |
Install |
| 30 |
60 |
90 |
30 |
60 |
90 |
30 |
60 |
90 |
| A+ |
680 |
36 |
95 |
0 |
0 |
0 |
2 |
0 |
0 |
1 |
0 |
0 |
| A- |
660 |
45 |
95 |
1 |
0 |
0 |
3 |
1 |
0 |
2 |
0 |
0 |
| B |
620 |
50 |
85 |
2 |
1 |
0 |
4 |
2 |
1 |
3 |
1 |
0 |
| C |
580 |
55 |
75 |
4 |
2 |
1 |
6 |
5 |
2 |
5 |
4 |
1 |
| D |
550 |
60 |
70 |
5 |
3 |
2 |
8 |
8 |
4 |
7 |
6 |
2 |
| E |
520 |
65 |
60 |
6 |
4 |
3 |
10 |
10 |
6 |
10 |
8 |
3 |
FICO scores are calculated by using scoring models and mathematical tables that assign points for different pieces of information which best predict future credit performance. Developing these models involves studying how millions of people have used credit. Some of the predictive factors used in the models are found in the reason codes.
Reason codes are included in credit reports and help explain why a credit report scored as it did, the weight given to factors making up the score, and where a consumer should direct their efforts toward increasing their score. The reason codes and their respective weights are:
- Late Payments, Collections, Bankruptcies--35%
- Outstanding Debt--30%
- Length of Credit History--15%
- Types of Credit--10%
- Inquiries (Applications for New Credit)--10%
Frequently Asked Questions (FAQs)
How can I increase my score? While it is difficult to increase your score over the short run, here are some tips to increase your score over of time.
- Pay your bills on time. Late payments and collections can have a serious impact on your score. Note that late payments, collections and bankruptcies are the most heavily weighted of the reason codes.
- Reduce your credit-card balances. If you consistently have high balances on your credit cards, your credit score will be negatively affected. Note that this applies to the second most heavily weighted reason code.
- If you have limited credit, obtain additional credit. Not having sufficient credit can negatively affect your score.
- Do not apply for credit frequently. Having a large number of inquiries on your credit report can worsen your score.
If several companies check my credit, will that hurt my score? That depends. The scoring system has changed to be more lenient in this regard. A few inquiries over a short period of time won't hurt your score. Mortgage lenders realize that when a borrower is shopping for a rate, their credit may be investigated by more than one lender.
What if there is an error on my credit report? If you see an error on your report, report it to the credit bureau. The three major bureaus in the U.S., Equifax (1-800-685-1111), Trans Union (1-800-916-8800) and Experian (1-888-397-3742). All have procedures for promptly correcting errors. Your mortgage company may also be able to help you correct credit report errors.
How do I correct errors on my report?
Few aspects of both consumer and real estate financing have come under as much written and verbal gunfire as has the credit reporting industry. The skyrocketing volume of credit transactions has put a tremendous strain on credit reporting agencies which deal with millions of requests for information daily.
As a result, a recent report to the U.S. Congress stated that as many as 40% of individual credit histories contain errors of some kind. A single missed keystroke by a data entry clerk, for example, can assign a delinquent account to the wrong file. Corrective information submitted by an individual can be misrouted or entered erroneously.
Our economy could not function without credit reporting. We need it to make purchases both large and small, to enable retailers to accept our checks, to obtain loans for homes, cars or college education. It is necessary for corporations to manage their cash flow for the overall benefit of the economy, and for us as individuals to manage our own finances.
For all these reasons, we must be vigilant about the accuracy of our credit reports. We need to know what goes into them, how to read them, how they are used and how to challenge errors when they occur.
While credit might have once been a private matter between oneself and one's banker, this is no longer the case. Every purchase we make on credit creates a record somewhere and these records flow into the huge databases from which our credit histories are constructed. Those histories, in turn, are used by nearly all credit grantors to determine how reliable we are in the use of credit, and to decide whether or not to extend it to us.
One way to fix an error is to contact the creditor reporting it. If you can get the creditor to agree that what was reported is an error, have them give you that information in writing, plus agree to report the updated information to the bureaus.
The Fair Credit Reporting Act gives you the right to dispute both the accuracy and completeness of your credit history. Any of the three credit reporting agencies must respond to your dispute. They must reinvestigate and record the results of their investigation "within a reasonable period of time." While this period remains undefined, practice indicates it means thirty days. If you don't get results within thirty days, have your attorney send the bureau a letter, together with copies of your correspondence.
If the reporting agency cannot verify a disputed entry, it must delete it. If the information is incomplete, they must complete it. For example, if you were temporarily delinquent on an account, and then brought it current and the agency's report does not reflect that, they must correct your record. Also, should your file show someone else's account (this sometimes happens with "junior-senior" relationships or with common names) the agency must delete it.
At your request (be sure you do request it) the agency involved must send a notice of correction to anyone who has received your credit report within the last six months.
In the event that some unforeseen misfortune resulted in a cluster of late payments in your record, you may send a short statement about the circumstances to each of the agencies. You may wish to report illness, unexpected unemployment, the death of a spouse, military call-up, or unexpected medical expenses. Be brief and to the point. No whining. This statement will be added to your file and will be disclosed whenever your credit file is accessed.
Cosigning a Loan
What would you do if a friend or relative asked you to cosign a loan? Before you answer, make sure you understand what cosigning involves. Under federal law, creditors are required to give you a notice that explains your obligations. The cosigner's notice states:
- You are being asked to guarantee this debt. Think carefully before you do. If the borrower does not pay the debt, you will have to. Be sure you can afford to pay if you have to, and that you want to accept this responsibility.
- You may have to pay up to the full amount of the debt if the borrower does not pay. You may also have to pay late fees or collection costs, which increase this amount.
- The creditor can collect this debt from you without first trying to collect from the borrower.* The creditor can use the same collection methods against you that can be used against the borrower, such as suing you, garnishing your wages, etc. If this debt is ever in default, that fact may become a part of your credit record.
- This notice is not the contract that makes you liable for the debt.
* Laws in your state may forbid a creditor from collecting from a cosigner without first trying to collect from the primary debtor.
Cosigners Often Pay
Studies of certain types of lenders show that for cosigned loans that go into default, as many as three out of four cosigners are asked to repay the loan. When you're asked to cosign, you're being asked to take a risk that a professional lender won't take. If the borrower met the criteria, the lender wouldn't require a cosigner.
In most states, if you cosign and your friend or relative misses a payment, the lender can immediately collect from you without first pursuing the borrower. In addition, the amount you owe may be increased by late charges or by attorneys fees if the lender decides to sue to collect. If the lender wins the case, your wages and property may be taken.
If You Do Cosign
Despite the risks, there may be times when you want to cosign. Your child may need a first loan, or a close friend may need help. Before you cosign, consider this information:
- Be sure you can afford to pay the loan. If you're asked to pay and can't, you could be sued or your credit rating could be damaged.
- Even if you're not asked to repay the debt, your liability for the loan may keep you from getting other credit because creditors will consider the cosigned loan as one of your obligations.
- Before you pledge property to secure the loan, such as your car or furniture, make sure you understand the consequences. If the borrower defaults, you could lose these items.
- Ask the lender to calculate the amount of money you might owe. The lender isn't required to do this, but may if asked. You also may be able to negotiate the specific terms of your obligation. For example, you may want to limit your liability to the principal on the loan, and not include late charges, court costs, or attorneys' fees. In this case, ask the lender to include a statement in the contract similar to: "The cosigner will be responsible only for the principal balance on this loan at the time of default."
- Ask the lender to agree, in writing, to notify you if the borrower misses a payment. That will give you time to deal with the problem or make back payments without having to repay the entire amount immediately.
- Make sure you get copies of all important papers, such as the loan contract, the Truth-in-Lending Disclosure Statement, and warranties, if you're cosigning for a purchase. You may need these documents if there's a dispute between the borrower and the seller. The lender is not required to give you these papers; you may have to get copies from the borrower.
- Check your state law for additional cosigner rights.
For More Information
You can file a complaint with the FTC by contacting the Consumer Response Center by phone: toll-free 1-877-FTC-HELP (382-4357); TDD: 202-326-2502; by mail: Consumer Response Center, Federal Trade Commission, 600 Pennsylvania Ave, NW, Washington, DC 20580; or through the Internet, using the online complaint form. Although the Commission cannot resolve individual problems for consumers, it can act against a company if it sees a pattern of possible law violations.
This document was written in March 1997 by the FTC.
Types of Home Equity Loans
Fundamentally, there are two types of home equity loans.
- Home Equity Line: When you get a home equity line, you obtain the right to draw money, whenever you want, over a certain period of time. You only pay interest on the amount you borrow. You may borrow, pay off and borrow again against the line of credit. You typically access the line with a check or credit card.
- Second Mortgage (home equity loan): When you get a second mortgage, you obtain a lump sum of money. The interest rate and monthly payments are fixed.
Home Equity Line versus Second Mortgage
|
Home Equity Line |
Second Mortgage |
| Tax Deductible |
Yes* |
Yes* |
| Annual Fee |
Yes (some lenders may waive this) |
No |
| Draw money when needed |
Yes |
No |
| Fixed Rate |
No** |
Yes |
Before deciding which type of loan you want, consider how you'll use the money. If you need funds for a single expense, such as a room addition, remodeling, etc., you'll want to strongly consider a fixed-rate, second mortgage. You receive one lump sum at the beginning of the loan term. You pay it back in equal, monthly installments.
The certainty of a fixed interest rate and equal monthly payments make the fixed-rate, second loan very attractive. Will this type of loan be less expensive compared to an adjustable rate, home equity line? There is no way to know with certainty. One would have to be able to predict interest rates with accuracy. Consider one of the reasons why adjustable rate loans were invented: to shift interest rate risk from the lender to the borrower. When market interest rates rise above the interest rate on your fixed-rate mortgage, the lender is effectively losing money on your mortgage and you're getting a bargain. Lenders wanted a way to protect themselves from this situation--thus the adjustable-rate mortgage.
If you need periodic amounts of money over time, for a child's education tuition, for example, a home equity line may be ideal. You can borrow only the amount you need, when you need it. These loans carry adjustable (ARM) rates, but some banks allow you to convert a portion of your loan to a fixed-rate second. You may pay a premium for the convenience of an equity line, including a transaction fee for each draw and an annual fee if you draw or not.
Deciding in advance which type of loan is best for you helps when comparing the expense of various loans. Since the APR for a fixed-rate second is calculated differently compared to a home equity line, APR comparisons can be difficult when comparing a fixed-rate second to a home equity line. APRs of fixed-rate seconds account for points and other closing charges. APRs for home equity lines don't account for points and other closing costs. When comparing the same types of loans (apples to apples), APRs are much more meaningful.
* Interest may be fully deductible. Consult your tax advisor regarding your particular situation.
** Under certain circumstances, some loan programs let you convert part of your home equity line to a fixed-rate, home equity loan.
What is a Home Equity Line of Credit?
More and more lenders are offering home equity lines of credit. By using the equity in your home, you may qualify for a sizable amount of credit, available for use when and how you please, at an interest rate that is relatively low. Furthermore, under the tax law (depending on your particular situation) you may be allowed to deduct the interest because the debt is secured by your home.
If you are in the market for credit, a home equity loan may be right for you, or perhaps another form of credit would be better. Before making this decision, you should weigh carefully the costs of a home equity line against the benefits. Shop for the credit terms that best meet your borrowing needs without posing undue financial risk. Remember--failure to repay the line could mean the loss of your home.
What is a home equity line of credit?
A home equity line is a form of revolving credit in which your home serves as collateral. Because the home is likely to be a consumer's largest asset, many homeowners use their credit lines only for major items such as education, home improvements, or medical bills and not for day-to-day expenses.
With a home equity line, you will be approved for a specific amount of credit--your credit limit. The credit limit is the maximum amount you can borrow at any one time while you have the loan.
Many lenders set the credit limit on a home equity line by taking a percentage (say, 75 percent) of the appraised value of the home and subtracting the balance owed on the existing mortgage. For example:
|
Appraisal of home
|
$100,000
|
|
Percentage
|
x75%
|
|
Percentage of appraised value
|
$75,000
|
|
Less mortgage debt
|
-$40,000
|
|
Potential credit line
|
$35,000
|
In determining your actual credit line, the lender also will consider your ability to repay, by looking at your income, debts, and other financial obligations, as well as your credit history.
Home equity plans often set a fixed time during which you can borrow money, such as ten years. When this period is up, the plan may allow you to renew the credit line. But in a plan that does not allow renewals, you will not be able to borrow additional money once the time has expired. Some plans may call for payment in full of any outstanding balance. Others may permit you to repay over a fixed time, for example ten years.
Once approved for your home equity loan, you should be able to borrow up to your credit limit whenever you wish. Typically, you will be able to draw on your line by using special checks.
Using a special credit card or other means, some plans allow borrowers to make purchases, in addition to borrowing money. However, there may be limitations on how you use the line. Some plans may require you to borrow a minimum amount each time you draw on the line (for example, $300) and to keep a minimum amount outstanding. Some lenders may require that you take an initial advance when you first set up the line.
Shopping for a Home Equity Line
Is a home equity line what you need?
Before you apply for a home equity line of credit (HELOC), make sure it's the type of loan you want. If you need relatively small amounts of money over time, such as for school tuition, a HELOC may be right for you. If you need a lump sum for a particular purpose, such as building a room addition, a home equity loan would probably be better.
Carefully compare plans
Carefully compare several plans. Examine terms and conditions, annual percentage rates (APR), annual and initial transaction (set up) costs, indices, margins and caps. Some lenders may not charge setup or annual fees, but may charge a higher interest rate in return.
There may be an introductory, or "teaser" rate offered. This is a temporary rate which will have little beneficial value over the life of your loan. Since most HELOCs are variable rate loans, the rate you pay is the sum of the index plus the margin. Indices are expressed as rates and include Prime and T-Bill rates. The margin is explicitly stated in your loan documents and is also expressed as a percentage. For example, if your loan were tied to the Prime rate with a 2% margin, and the Prime rate were 8%, you'd pay 10%. Historical information regarding the behavior of various indices is available on-line and at your local library. A little research will help you determine which index you'd be most comfortable with.
Your variable rate plan will identify a maximum interest rate (ceiling or cap). Your loan may not exceed the rate cap during the life of the loan under any conditions.
Consider a loan which allows amortization--repayment in installments of principal and interest sufficient to retire the debt by the end of the plan. Try to amortize your loan, otherwise, you may incur a balloon payment at the end of the plan.
Negative Amortization
Under certain circumstances, depending on your program, the monthly payments may not adjust adequately to fully account for interest rate increases. In this event, negative amortization may occur. Negative amortization is when in which your loan balance increases. If this condition is a possibility with your loan, discuss with your lender how you can avoid it.
Some lenders may permit you to convert a variable rate to a fixed rate during the life of the plan, or to convert all or a portion of your line to a fixed-term installment loan.
Agreements generally will permit the lender to freeze or reduce your credit line under certain circumstances. For example, some variable-rate plans may not allow you to get additional funds during any period the interest rate reaches the cap.
Borrow Wisely
Perhaps you discover you can borrow much more than you expected, or need. A HELOC may seem to turn your home into a new type of credit card. If you default on a credit card, you may only damage your credit. If you default on a HELOC, you could lose your home.
Closing Costs
Many of the costs of obtaining a home equity line of credit may look familiar to you. From the lender's standpoint, there isn't much difference between a purchase money mortgage, home equity loan, or home equity line. The standard services will be required to protect the lender's interest. Potential services and their associated fees include:
- Property appraisal.
- Loan application. The fee may not be refundable if you are turned down for credit.
- Loan origination fees (points). One point equals 1 percent of the credit limit.
- Attorney, title and escrow, mortgage document preparation, recording documents, property and title insurance.
- Annual membership or maintenance fees.
- Transaction fee for drawing on the credit line.
Establishing a home equity line (plan) can be expensive. If you incur substantial fees to set up the plan, and draw only a small amount against it, the cost of borrowing can be unreasonable. If you plan to use your credit line frequently, the costs of obtaining the equity line will be spread over larger and larger amounts, effectively reducing the cost of the plan. Because the lender's risk is lower for secured loans compared to unsecured loans, the interest rate on your equity line should be low compared to other, unsecured loans. Thus, annual percentage rates for home equity lines are generally lower than rates for other types of credit. (Be careful--the APR is based on the assumption that you're borrowing the maximum amount.) The interest you save could offset the initial costs of obtaining the line. Shop around before signing loan documents. Some lenders may offer zero-point/fee equity lines.
Repayment
Before entering into a plan, consider how you will pay back any money you might borrow. Some plans set minimum payments that cover a portion of the principal (the amount you borrow) plus accrued interest. But, unlike the typical installment loan, the portion that goes toward principal may not be enough to repay the debt by the end of the term. Other plans may allow payments of interest alone during the life of the plan, which means that you pay nothing toward the principal. If you borrow $10,000, you will owe that entire sum when the plan ends.
Regardless of the minimum payment required, you can pay more than the minimum and many lenders may give you a choice of payment options. Consumers often will choose to pay down the principal regularly as they do with other loans. For example, if you use your line to buy a boat, you may want to pay it off as you would a typical boat loan.
Whatever your payment arrangements during the life of the plan--whether you pay some, a little, or none of the principal amount of the loan--when the plan ends you may have to immediately pay the entire outstanding balance. You must be prepared to make this balloon payment by refinancing it with the lender, by obtaining a loan from another lender, or by some other means. If you are unable to make the balloon payment, you could lose your home.
With a variable rate, your monthly payments may change. Assume, for example, that you borrow $10,000 under a plan calling for interest-only payments. At a 10 percent interest rate, your initial monthly payments would be eighty-three dollars. If the rate should rise over time to 15 percent, your monthly payments would increase to $125. Even with payments that cover interest plus some portion of the principal, there could be a similar increase in your monthly payment, unless the agreement allowed keeping payments level throughout the plan.
When you sell your home, you probably will be required to pay off your home equity line in full. If you are likely to sell your house in the near future, consider whether it makes sense to pay the up-front costs of setting up an equity credit line. Also keep in mind that leasing your home may be prohibited under the terms of your home equity agreement.
Glossary
Annual Fee
An amount charged annually for having the line of credit available. The fee is charged regardless of whether or not you draw against the credit line.
Annual percentage rate (APR)
The cost of credit on a yearly basis expressed as a percentage. The APR is distinguished from the "named" or "nominal" rate which is the note rate.
Application fee
An application fee may include the cost of an appraisal and credit report. The fee is charged when applying for the loan.
Balloon payment
A lump-sum payment that you may be required to make under a plan when the plan ends. You should have the option to make payments sufficient to avoid making the balloon payment.
Cap
A limit on how much the variable interest rate can increase during the life of the plan.
Closing costs
Fees paid at the time of closing. Depending on the state in which you reside, these fees may pay for attorney's services, recording documents, real estate taxes, title search and title insurance.
Credit limit
The maximum amount you are allowed to borrow under the home equity plan. The limit can depend upon your income, debts, equity in your home and the bank's program guidelines.
Equity
The difference between the fair market value (appraised value) of your home and the debts claimed against it.
Index
A statistical indicator of a price level expressed as a rate. Examples include Prime, T-Bill, MTA, 11 Dist. COF, LIBOR, etc. The index is the base rate used by the lender to calculate the interest rate you pay on your loan.
Interest rate
The factor applied to the debt to determine the charge for borrowing money. The interest rate is expressed as a percentage.
Margin
The spread added to the index to determine the interest rate you are charged for borrowing money. The margin is expressed as a percentage.
Minimum payment
The smallest amount you are allowed to pay toward your debt. The minimum payment may include principal and interest.
Points
A point is equal to one percent of the amount of your credit line. Points are a closing cost which, under certain circumstances, may be recognized as interest by the IRS.
Security interest
"Security interest" is the type of interest a lender has in the property of the borrower. The borrower's property is set aside so that the lender can sell it if the borrower defaults on the loan. A mortgage and deed of trust are security instruments.
Transaction fee
The fee charged each time you draw on your credit line.
Variable rate
An interest rate that changes periodically. Payments may increase or decrease depending on a particular financial index.
Home Equity Loan Checklist
| |
Loan A |
Loan B |
|
Basic Features
|
|
|
| Fixed annual percentage rate |
|
|
| Variable annual percentage rate |
|
|
| Index used and current value |
|
|
| Amount of margin |
|
|
| Current rate |
|
|
| Frequency of rate adjustments |
|
|
| Amount and length of any discount |
|
|
| Interest rate caps |
|
|
|
Length of plan
|
|
|
| Draw period |
|
|
| Repayment period |
|
|
|
Initial fees
|
|
|
| Appraisal fee |
|
|
| Closing costs |
|
|
| Application fee |
|
|
|
REPAYMENT TERMS
|
|
|
|
During the draw period
|
|
|
| Interest and principal payments |
|
|
| Interest only payments |
|
|
| Fully amortizing payments |
|
|
|
When the draw period ends
|
|
|
| Balloon payment |
|
|
| Renewal available |
|
|
| Refinancing of balance by lender |
|
|
Making the Buying Decision
Assuming you plan to own your home for several years and can afford the payments, you'll likely be better off owning versus renting. Here are some points to consider:
|
Rent |
Buy |
Tax Savings
|
You might receive a state income tax renter's credit, but nothing more.
|
Payments towards interest, taxes and points are tax deductible.
|
Equity Build-up
|
None, unless your rent payment is lower than the cost of owning a home, and you invest the difference in a CD, stock or mutual funds.
|
Even if your home value remains constant, your loan balance should decrease. This results in increasing equity your property.
|
Mobility
|
Most leases are less than 1 year in duration. It's easy to move at the end of a lease. Also, your landlord usually won't have to renew your lease, and you could be forced to move out at the end of your lease.
|
Selling a house can take time and may cost 6% to 8% of the sales price. If you have to sell quickly, it could cost even more. If you don't have to sell, yet must move, consider renting your house. You'll probably receive additional benefits by depreciating your home for income tax purposes. Remember, buying a home makes sense if you plan to hold it for several years.
|
Payments
|
Your rent payments generally increase every year. Rent increases are often tied to inflation.
|
Mortgage payments on a fixed-rate loan will not change. Adjustable-rate loan payments vary according to the terms of the note and economic conditions.
|
Timeframe
|
Renting makes sense if your time frame is less than 2 to 3 years.
|
The longer you plan to own your home, the more sense it makes to buy. Some buyers with plans to move relatively soon may buy if they expect the market to appreciate significantly.
|
Additional points to consider in your decision include:
- What are my reasons of owning a home?
Do you need a bigger home? Do you need a better neighborhood? Are you speculating that prices will increase? Whatever your reasons, it helps to write them down. Seeing your reasons on paper helps create objectivity, and will help you follow through in the event you get the "jitters" later on.
- Do I have enough cash for the down payment?
While this is certainly an important consideration, many lenders today offer zero-down and low down payment loans. However, you may still have to come up with cash for closing costs and moving expenses.
- Can I afford to make house payments in addition to making payments on my other debts?
This is probably the single, most important question to answer accurately. Spend adequate time creating a realistic budget. If you fall too far behind in your mortgage payments or property taxes, you'll probably lose your home and any equity you might have had in it. Generally, you should spend less than a third of your gross income on your total housing expense, including principal, interest, taxes and insurance.
Down Payment
An important step in purchasing is home is determining how much of a down payment you'll make, and from what sources the down payment and other costs will come. For accurate answers to these questions, a current inventory of your assets is crucial.
Begin by gathering all financial statements for all your assets. You may not plan to liquidate all assets, but a complete accounting is important. The assets you keep can serve as collateral for a loan and as reserves which may be required by your lender. If you're going to receive a gift from a relative, try to obtain a letter stating the amount of the gift.
You may be able to borrow from your 401(k) without any tax penalties. If you liquidate your 401(k) or IRA, there may be tax implications. Consult with your tax advisor before liquidating any assets.
If you own stock you want to keep, consider borrowing against it with a margin loan. Consult with your stock broker regarding this option.
This worksheet may help you inventory your assets.
| Checking Accounts: |
__________________ |
| Savings Accounts: |
__________________ |
| CDs: |
__________________ |
| Stocks: |
__________________ |
| Bonds: |
__________________ |
| Mutual Funds: |
__________________ |
| Other Securities: |
__________________ |
| Retirement Funds (401K, IRA, etc): |
__________________ |
| Gifts from relatives: |
__________________ |
| Total Cash Available: |
__________________ |
Determine the total cash needed to close:
| Down payment: |
__________________ |
| Closing costs including points: |
__________________ |
Prepaid expenses
(taxes, prepaid interest, insurance, pmi): |
__________________ |
| Cost of repairs, if any: |
__________________ |
| Total Cash Needed: |
__________________ |
Calculating the total cash needed can be challenging, especially if you're doing this for the first time. Consider getting help from a real estate or mortgage professional. They're usually quite generous with assistance and advice in anticipation of helping you with your transaction. Ask your mortgage company to provide a Good Faith Estimate of closing costs--including prepaid expenses.
If you're short on cash, consider asking the seller to pay your closing costs. Discuss this with your Realtor prior to making your offer.
Ideally, you'll want make a 20 percent cash down payment to avoid Private Mortgage Insurance (PMI) and get the best rate. If you are unable to put 20 percent down, there are many programs available. Here are some of them:
- Zero Down Programs There are many zero down payment programs available. If you qualify for a VA loan, you can get a zero down program. Even if you're not a vet, several lenders offer zero down loan programs. Your mortgage broker can help you find the best one for you.
- Low Down Payment Programs There are numerous FHA and conventional programs that allow you to put as little as 2 to 5 percent down.
- Piggy Back Loans By getting a piggy back loan, you can generally avoid paying PMI, even though you are putting less than 20 percent down. The most common piggy back loans are:
- 80-10-10
- In the case of an 80-10-10, you put down 10 percent and get two loans--a first loan for 80 percent of the purchase price, and a second loan for 10 percent of the purchase price. Even though the second loan rate may be higher than the first loan rate, you generally come out ahead since you don't have to pay PMI.
- 80-15-5
- Eighty percent first loan, 15 percent second loan, 5 percent down.
- 80-20
- Eighty percent first loan, 20 percent second loan, no cash down.
Qualification
Take advantage of our Qualification Calculator to begin the process of determining the home value for which you qualify. You'll also need to discuss your particular financial details with a mortgage company. Like most industries, the mortgage industry uses its own jargon. Understanding the terminology of the industry will serve you well in understanding the process of buying and financing your home. Here is some terminology you will need to understand:
- Application: The loan application is a comprehensive document representing the borrowers income, expenses, assets, liabilities and net worth. It can be considered both an Income Statement and Balance Sheet of the borrower. The application helps the lender determine the borrower's credit-worthiness.
- PITI: An acronym for Principal, Interest, Taxes and Insurance. Principal and interest refer to your monthly mortgage payment. Taxes and insurance refer to 1/12 of the annual property taxes and insurance premium. PITI is designed to represent the monthly cost of home ownership (total housing expense ) for qualification purposes. (Total housing expense can include PMI and association dues if applicable.)
- Gross Monthly Income: Gross monthly income is your monthly income before income taxes. You are usually given full credit for your base salary. Overtime, commissions and bonuses are usually averaged over the previous 24 months. If you are self-employed, the income reported on your tax return will usually be averaged over the previous 2 years.
- Front-Debt Ratio (top ratio): Your front debt ratio is your PITI divided by your Gross Monthly Income. This qualifying ratio is used by the lender in making a decision to grant or deny your loan request.
- Back-Debt Ratio (back-end, bottom, total expense, total debt ratio): Your back-debt ratio is PITI + Other Monthly Debt Expenses divided by your Gross Monthly Income. Other monthly debts include auto loans, credit cards, person loans, student loans, etc. Your phone and electric bills are NOT considered part of your debt expenses. This qualifying ratio is used by the lender in making a decision to grant or deny your loan request.
- Loan to Value (LTV): LTV = loan amount divided by the property value.
Here is an example of how the above information is used:
- Monthly base income: $5,000
- PITI: $1,000
- Other monthly debt (credit cards and student loans): $600
- Home purchase price: $100,000
- Down payment: $20,000
With this information, qualifying ratios and the LTV can be calculated:
- Front-debt ratio: $1,000 / $5,000 = .20 or 20%
- Back-debt ratio: $1,600 / $5,000 = .32 or 32%
- LTV: $80,000 / $100,000 = .80 or 80%.
Mortgage companies and lenders like to see qualifying ratios at or below acceptable levels set by the industry. Acceptable qualifying ratios denote a borrower's ability to repay the debt. A low LTV is also desirable. The lower the LTV, the greater the equity the borrower has in the home, and the more secure the lender's investment. As the LTV increases, acceptable qualifying ratios decrease.
Here is a table of LTV and maximum qualifying ratios used in the industry. These ratios are general guidelines only. In practice, lenders make their own decisions based on a number of additional factors such as your credit history, length of employment, etc. Please check with your mortgage company regarding your particular situation.
| LTV |
Front-Debt Ratio |
Back-Debt Ratio |
| 90.1%+ |
28% |
36% |
| At or Below 90% |
33% |
38% |
Tips and Tricks: You may be able to increase your purchasing power by:
- Paying off debt:This would reduce your back-debt ratio. Many lenders do not count the monthly payment on your installment loans if you have fewer than 10 payments left. If you have a car payment with 12 payments left, you may want to consider making additional payments to reduce your total payments left to under 10.
- Making a larger down payment: This reduces your LTV, total housing expense and provides for higher qualifying ratios. If you make a down payment of 20% or more, you won't have to pay PMI.
- Borrowing against your 401(k): You can sometimes increase your purchasing power by using the proceeds of your 401(k) loan to pay down your other debt, or to use it towards the down payment. This can be a little tricky, so please consult with a mortgage professional.
- Obtaining a margin loan: If you own stocks and do not want to sell them, your stockbroker may be able to arrange a margin loan, using your stock as collateral. Since a margin loan has no monthly payments, this generally does not affect your debt ratios. You may use the proceeds towards the down payment or to pay off debt.
Preapproval
As a potential buyer competing for a property, you'll have a better chance of getting your offer accepted by being as prepared as possible. Consider this hierarchy of preparedness:
- 1. Neither pre-qualified nor pre-approved
-
- 2. Pre-qualified
-
- 3. Pre-approved
The benefits available at each level can be easily understood when viewed from the seller's perspective. Imagine you're a seller in receipt of multiple offers to purchase your property. A complete stranger (buyer) is asking you to take your property off the market for at least the next two to three weeks while they apply for a loan. As the seller, let's consider the type of buyer you'd prefer to deal with.
- 1. Neither pre-qualified nor pre-approved
- This buyer provides no evidence that they can afford to purchase your property. You may wonder how serious they are since they're not at least pre-qualified.
- 2. Pre-qualified
- This buyer met with a mortgage broker (or lender) and discussed their situation. The buyer informed the broker regarding their income, expenses, assets and liabilities. The broker may also have seen their credit report. The buyer provided you with a letter from the broker stating an opinion of what the buyer can afford.
- 3. Pre-approved
- This buyer provided a broker or lender written evidence of income, expenses, assets, liabilities and credit. All information was verified by a lender. As a result, much of the paperwork for this buyer's loan has been completed. This buyer will probably be able to close quickly. They provided you with a letter (pre-approval certificate) from the lender. You're as certain as possible that this buyer can close.
As a potential buyer, you can see that being pre-approved will give you the best chance of getting your offer accepted. This is critical in a competitive situation. |
Start Looking for a Home
You're prepared and ready to purchase a home. Now it's time to go out into the market place and find it. Will you use a real estate agent to help you look, or will you look on your own?
For practically everyone, it's worthwhile to use a real estate agent. The benefits of using an agent are numerous.
Advantages of using a real estate agent
A good agent builds a career by creating repeat customers and earning referrals. To that end, she does everything possible to make your home-buying experience as pleasant as possible. An agent is expert in her market. She knows (or can find) everything you want and need to know about the community.
An agent will:
- Arrange access to homes for you to preview
- Accompany you on your tour of homes
- Research the neighborhood, including market values
- Draft the offer to purchase
- Negotiate with the seller
- Arrange inspections
- Abide by all local, state and federal laws
- Help you obtain financing
- Review all closing documents for correctness
- Follow up after closing to make sure you're move-in is accomplished smoothly
Finding and keeping a good agent
Finding a Real Estate Agent whom you can trust and enjoy working with may require some effort. When you find the right person, stick with them. Give them the same respect and consideration you would expect. When an agent knows that they have your loyalty, they will do their best job for you.
Market Conditions
The price you pay for your home will be affected by prevailing economic (market) conditions. Changes in market conditions can have an immediate and significant effect on property values. For this reason, it's important to be aware of current conditions.
The price of real estate is affected by the supply and demand for credit and real property. The supply of capital is finite. Capital available for lending is shared among government, business, consumer, mortgage and other borrowers. If capital is in relatively short supply, the cost of capital rises. When capital is in relatively great supply, the cost of capital declines.
The supply of money and credit in the economy is regulated by the Federal Reserve Bank. If The Fed makes too little credit available, demand for money can cause interest rates to increase. Borrowing, investing and sales decrease as interest rates rise, which can lead to an economic decline. Alternatively, if there is too much available credit, interest rates can fall. When interest rates are low, price levels for goods and services can increase as people are willing to pay more and more for them, which can potentially lead to inflation. It's The Fed's job to use monetary policy to achieve a growing yet stable economy.
The price you pay for your home can be affected by interest rate levels. Interest rates can change relatively quickly. Conversely, the supply of housing changes slowly. In the short run, the housing supply can be considered fixed.
Consider what can happen in the housing market when interest rates are relatively low. Low interest rates allow a larger number of home buyers (borrowers) to enter the housing market. More buyers competing for a fixed supply of housing can cause the price of housing to increase. This type of market is sometimes referred to as a seller's market . In a seller's market, properties sell quickly, multiple offers are common and property values may be increasing. When interest rates rise, many would-be buyers no longer qualify for mortgages and leave the housing market. This type of market is referred to as a buyer's market. In a buyer's market, property values may be level or decreasing as sellers compete to attract buyers.
As a home buyer, your buying behavior can be influenced by market conditions. If you're in a seller's market, you may feel pressure to act quickly and offer top-dollar for a property. In a buyer's market, you may feel less hurried, more in control of the situation and inclined to offer relatively less for a home.
Architectural Styles
- Cape Cod and Cape Ann Colonial
- Usually small in size with symmetrical windows found on both sides of the front door. These one or one and one-half story homes are usually small. The wood shingle roof is steep gambrel or gable. The exterior is usually wood.
- New England Colonial
- This square or rectangular structure maximizes usable space. It has symmetrical windows on both sides of the front door . This two or two and one-half story home has a wood shingle, gable roof; wood exterior.
- Dutch Colonial
- This home has a stone exterior and a relatively narrow width (50 ft. wide +/-). Its height is either one and one-half or two and one-half stories with a gambrel roof, dormer windows, and a symmetrical front with the front door in the center.
- Georgian and Southern Colonial
- A large home requiring a large plot of land. This brick or wood home is symmetrical, has a gabled roof, elaborate front entrance with columns.
- English Elizabethan
- Requiring a relatively large plot of land, this home has gothic lines and is constructed of brick, stucco or stone. The home has molded stone around the windows and doors. The steep roof is covered with slate or shingle. Leaded metal casement windows are the norm.
- English Half-Timber
- Requiring a large lot, this home has stucco between protruding timber faces. Most often a two story home with a steep pitched roof; heavy masonry composing the first story.
- Regency
- Below a low hipped roof, a centered, octagonal window on the second floor can be found. The front entrance is centered; shutters frame the windows; exterior of brick or stone.
- French Provincial
- This large, one and one-half or two-story home is found on a large lot. The house has large, tall windows with shutters; masonry exterior and very high roof.
- French Normandy
- This unsymmetrical home often has turrets at the entrance; steep pitched shingle roof and exterior of brick or stone.
- True Spanish
- This home has stucco walls (light color) red mission tiled roof, wrought iron decorations with enclosed patios.
- Small California Spanish
- This one story house has a flat roof with mission tile trim in front. The exterior is stucco; no patio and is well suited for a small lot.
- Monterey Spanish
- This light colored, stucco, two story home has a red mission tiled roof, decorative iron railings and second story balconies.
- Modern and Contemporary
- This home has a low pitched or flat roof; concrete slab or perimeter foundation; lots of glass; usually one story and is designed for indoor and outdoor living.
- California Bungalow or Ranch House
- This one story, stucco house has wood trim; concrete slab or perimeter foundation; shake or shingle roof; not symmetrical; often with an attached garage.
Suitability Standards
Ask these important questions about the home's functionality. As much as possible, you want these standards to be true for the home you're considering purchasing.
| Subject Property: |
___________________________________________________________ |
Minimum Standards
|
Living Room:
- Adequate floor space for efficient placement of furniture.
- Traffic pattern doesn't require you to walk the entire length of the living room to reach other parts of the house.
- Fireplace not near flow of traffic.
|
Dining Room or area:
- Kitchen close by.
- Adequate size.
- Shape is nearly square.
|
Bedrooms:
- Master bedroom size is at least 10 ft. x 12 ft.
- Secondary bedroom sizes are at least 9 ft. x 10 ft.
- Adequate ventilation.
- Don't have to walk through one bedroom to reach another.
- Closet space is at least 2 feet deep by 3 feet wide.
|
Kitchen:
- Ample and efficient workspace.
- Centrally located equipment to eliminate excessive foot travel.
- Floor, ceiling and wall surfaces are easy to clean and maintain.
- Adequate lighting and ventilation.
- Kitchen conveniently located in relation to dining and/or family room.
- Kitchen has an exterior entrance.
- Laundry facilities are adjacent to the kitchen.
|
Bathrooms:
- Properly located with respect to other rooms.
- If the home has only one bathroom, it is located off the central hall.
- Bathroom doesn't open into kitchen or living room.
- Bathrooms have exhaust fan or exterior window.
- Floor, ceiling and wall surfaces are easy to clean and maintain.
|
Exterior Grounds:
- Soil is protected from erosion.
- Proper grading provides protection from water damage.
- Walks, walls and other yard improvements are made of adequate materials.
|
Site Location:
- Property doesn't abut commercial or multi-residential uses.
- If a key lot, it doesn't look upon other back yards.
- If a corner lot, no busses stop at the corner.
|
Visit Properties
You'll probably preview several properties before finding the right one. To be efficient in your search, prepare in advance. Consider keeping a tour log. Your log will help you review, compare, investigate and discuss properties, and assist you in making an informed buying decision. Your visit log might contain one or more of these check lists:
- Home and Neighborhood Features
- Identify and rank the importance of various features in your home and neighborhood. Complete this check list prior to meeting with an agent.
Home Features
Rank the importance of these features. Provide a copy to your real estate agent.
| Feature |
Need |
Want |
Don't
care |
Don't
want |
Notes |
| Single Family |
|
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|
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| Condo/Townhome |
|
|
|
|
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| Square Feet |
|
|
|
|
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| No. of Bedrooms |
|
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| No. of Bathrooms |
|
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|
|
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| Living room |
|
|
|
|
|
| Dining room |
|
|
|
|
|
| Family room |
|
|
|
|
|
| Modern kitchen |
|
|
|
|
|
| Full basement |
|
|
|
|
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| Air conditioning |
|
|
|
|
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| Modern heating |
|
|
|
|
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| Modern wiring |
|
|
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| Modern plumbing |
|
|
|
|
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| Fireplace |
|
|
|
|
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| Storage |
|
|
|
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| Garage |
|
|
|
|
|
| Yard |
|
|
|
|
|
| Landscaping |
|
|
|
|
|
| Deck/patio |
|
|
|
|
|
| Swimming pool |
|
|
|
|
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| Disability access |
|
|
|
|
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| Move-in condition |
|
|
|
|
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| Room to add on |
|
|
|
|
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| Quality schools |
|
|
|
|
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| Nearby park(s) |
|
|
|
|
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| Nearby shopping |
|
|
|
|
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| Public trans. |
|
|
|
|
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| Resale value |
|
|
|
|
|
- Suitability Standards
- Today you're a buyer. In the future you may be a seller. Ask these critical questions about a home's functionality. The better your new home measures up, the more attractive it will be when it's your turn to sell.
Suitability Standards
Ask these important questions about the home's functionality. As much as possible, you want these standards to be true for the home you're considering purchasing.
| Subject Property: |
___________________________________________________________ |
Minimum Standards
|
Living Room:
- Adequate floor space for efficient placement of furniture.
- Traffic pattern doesn't require you to walk the entire length of the living room to reach other parts of the house.
- Fireplace not near flow of traffic.
|
Dining Room or area:
- Kitchen close by.
- Adequate size.
- Shape is nearly square.
|
Bedrooms:
- Master bedroom size is at least 10 ft. x 12 ft.
- Secondary bedroom sizes are at least 9 ft. x 10 ft.
- Adequate ventilation.
- Don't have to walk through one bedroom to reach another.
- Closet space is at least 2 feet deep by 3 feet wide.
|
Kitchen:
- Ample and efficient workspace.
- Centrally located equipment to eliminate excessive foot travel.
- Floor, ceiling and wall surfaces are easy to clean and maintain.
- Adequate lighting and ventilation.
- Kitchen conveniently located in relation to dining and/or family room.
- Kitchen has an exterior entrance.
- Laundry facilities are adjacent to the kitchen.
|
Bathrooms:
- Properly located with respect to other rooms.
- If the home has only one bathroom, it is located off the central hall.
- Bathroom doesn't open into kitchen or living room.
- Bathrooms have exhaust fan or exterior window.
- Floor, ceiling and wall surfaces are easy to clean and maintain.
|
Exterior Grounds:
- Soil is protected from erosion.
- Proper grading provides protection from water damage.
- Walks, walls and other yard improvements are made of adequate materials.
|
Site Location:
- Property doesn't abut commercial or multi-residential uses.
- If a key lot, it doesn't look upon other back yards.
- If a corner lot, no busses stop at the corner.
|
|
- Home Inspections and Disclosures
- Some property defects aren't readily seen. If you're not sure about the items in this list, order inspections by licensed professionals.
Inspect the Home
Generally, the seller should inform you of any adverse property conditions of which he or she is aware. This is of no help if there are adverse conditions of which the seller is not aware. The federal Real Estate Disclosure and Notification Rule requires that you be informed of certain adverse environmental conditions affecting the property. Unfortunately, there are circumstances in which you aren't required to receive the disclosure. As a consumer, it is up to you to protect yourself, your family and you investment. While visiting properties, make notes of items possibly requiring investigation in the event you make an offer. Here are some areas of potential investigation to be considered when visiting and buying a home.
- Age and condition of structural components
- Be aware of the condition of plumbing, electrical, heating, or other mechanical systems.
- Required permits
- Have structural additions, alterations, replacements, or repairs been made? If so, were proper permits obtained?
- Topography
- Are there flood, drainage, settling or soil problems on or near the property?
- Common areas
- Are there homeowners' association obligations, deed restrictions or common area problems?
- Neighborhood
- Are there noise or nuisance problems?
- Environmental conditions
- Is there lead-based paint, asbestos, radon gas, fuel, chemical storage tanks, contaminated soil or water affecting the home? You may want to contact the United States Environmental Protection Agency for more information.
-
- Property Comparison
- At a glance, compare features and amenities of many properties.
Property Comparison
Print this form. Use it for describing and comparing properties.
| Property Address |
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| Sing Fam/Condo |
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| Price |
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| Square Feet |
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| Sq. Ft. Price |
|
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| Lot Size |
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| Age |
|
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| No. of Bedrooms |
|
|
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|
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| No. of Bathrooms |
|
|
|
|
|
| Living room |
|
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|
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| Dining room |
|
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| Family room |
|
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| Modern kitchen |
|
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| Basement |
|
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| Air conditioning |
|
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| Heating type |
|
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| Wiring Type |
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| Plumbing Type |
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| Fireplace |
|
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| Storage |
|
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| Garage |
|
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|
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| Yard |
|
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| Landscaping |
|
|
|
|
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| Deck/patio |
|
|
|
|
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| Swimming pool |
|
|
|
|
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| Disability access |
|
|
|
|
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| Condition |
|
|
|
|
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| Room to add on |
|
|
|
|
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| Quality schools |
|
|
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|
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| Nearby park(s) |
|
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| Nearby shopping |
|
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|
|
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| Public trans. |
|
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|
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|
|
- Architectural Styles
- A handy reference for identifying the different architectural styles you might see.
Architectural Styles
- Cape Cod and Cape Ann Colonial
- Usually small in size with symmetrical windows found on both sides of the front door. These one or one and one-half story homes are usually small. The wood shingle roof is steep gambrel or gable. The exterior is usually wood.
- New England Colonial
- This square or rectangular structure maximizes usable space. It has symmetrical windows on both sides of the front door . This two or two and one-half story home has a wood shingle, gable roof; wood exterior.
- Dutch Colonial
- This home has a stone exterior and a relatively narrow width (50 ft. wide +/-). Its height is either one and one-half or two and one-half stories with a gambrel roof, dormer windows, and a symmetrical front with the front door in the center.
- Georgian and Southern Colonial
- A large home requiring a large plot of land. This brick or wood home is symmetrical, has a gabled roof, elaborate front entrance with columns.
- English Elizabethan
- Requiring a relatively large plot of land, this home has gothic lines and is constructed of brick, stucco or stone. The home has molded stone around the windows and doors. The steep roof is covered with slate or shingle. Leaded metal casement windows are the norm.
- English Half-Timber
- Requiring a large lot, this home has stucco between protruding timber faces. Most often a two story home with a steep pitched roof; heavy masonry composing the first story.
- Regency
- Below a low hipped roof, a centered, octagonal window on the second floor can be found. The front entrance is centered; shutters frame the windows; exterior of brick or stone.
- French Provincial
- This large, one and one-half or two-story home is found on a large lot. The house has large, tall windows with shutters; masonry exterior and very high roof.
- French Normandy
- This unsymmetrical home often has turrets at the entrance; steep pitched shingle roof and exterior of brick or stone.
- True Spanish
- This home has stucco walls (light color) red mission tiled roof, wrought iron decorations with enclosed patios.
- Small California Spanish
- This one story house has a flat roof with mission tile trim in front. The exterior is stucco; no patio and is well suited for a small lot.
- Monterey Spanish
- This light colored, stucco, two story home has a red mission tiled roof, decorative iron railings and second story balconies.
- Modern and Contemporary
- This home has a low pitched or flat roof; concrete slab or perimeter foundation; lots of glass; usually one story and is designed for indoor and outdoor living.
- California Bungalow or Ranch House
- This one story, stucco house has wood trim; concrete slab or perimeter foundation; shake or shingle roof; not symmetrical; often with an attached garage.
Private Mortgage Insurance (PMI)
Private Mortgage Insurance (PMI) protects lenders against loss due to foreclosure. Most lenders require PMI when the down payment is less than 20 percent. The PMI premiums are paid by the borrower and the policies are provided by private mortgage insurance companies. PMI is NOT mortgage life insurance. PMI protects the lender against loss. Mortgage life insurance protects your home and family by paying all or a portion of your mortgage in the event of your death.
Methods of paying for PMI have changed over the years. Prior to 1994, borrowers paid twelve to fifteen months' premiums at close of escrow. In 1994, borrowers could pay as few as two months' premiums at closing, and then pay a monthly premium with each mortgage payment. In 1998, a borrower could finance a single lump-sum mortgage insurance premium as part of the loan amount. In 1999, private mortgage insurance companies began borrowing Fannie Mae's new "Lowest-Cost MI" program. The new program allows borrowers to finance or pay up front a portion of premiums and, in return, receive a lower monthly premium rate. With each new strategy, home ownership has become more affordable for more people.
How much does PMI cost? The cost of PMI depends on the percentage of the down payment and the type of loan. Here are some sample PMI charges. These are guidelines only. Payment factors are subject to change. Please contact your lender or broker to get the cost of PMI on your loan.
| LTV |
30 year fixed |
15 year fixed |
30 year adjustable |
| 95% |
0.78% |
0.72% |
0.92% |
| 90% |
0.52% |
0.46% |
0.65% |
| 85% |
0.32% |
0.26% |
0.37% |
Example: If you are getting a 30 year fixed loan, and are putting 10 percent down, the PMI premium is 0.52 percent. If your loan amount is $100,000, your PMI payment will be $100,000 x (.52/100)x 1/12 = $43.33 per month.
Avoiding PMI Payments
The easiest way to avoid PMI is to make a cash down payment of 20% or more. This money may come from your savings or from a gift from a relative. You may also be able to borrow against your 401(k) retirement plan to raise the down payment needed. (However this option may have long term effects to your financial future and may not be your best option.)
In lieu of a 20% cash down payment, consider these options:
Private Mortgage Insurance (PMI)
While it increases your payment, PMI may in fact be your best option to obtaining a house. After all, PMI often can be canceled within two or three years and some PMI programs even allow you to collect a refund of some premiums upon canceling. PMI is especially attractive in areas where the property values are steadily increasing.
Lender-paid Mortgage Insurance (MI)
Another method of buying a house with less than 20% down is Lender-paid MI. With this MI program the lender pays for the MI premium while the borrower in turn often receives a slightly higher interest rate, usually a quarter-percent. While this slightly higher-interest rate is for the life of the loan, it often results in a lower monthly payment than taking out two loans (piggy back loans, described below), and reduces the costs of closing two loans. The interest paid on this slightly higher rate loan would be tax deductible. Lender-paid MI cannot be cancelled.
Piggy Back Loan A piggyback loan structure is another way to buy a home without making a 20% down payment and without mortgage insurance (MI). In effect, the borrower is taking out two separate loans - one “piggybacked” onto the other - so you will have two loan payments each month. For example, the first loan could be 80% of the total amount and the second loan for the remaining 20%, and considered to be your down payment amount. The second loan is generally at a higher rate than the first. Many times, the second loan has a variable interest rate, which means it can fluctuate, causing your payment to fluctuate. The most common piggy back loan combinations are:
- 80-10-10: Eighty percent first loan, 10 percent second (piggy back) loan, 10 percent cash down payment.
- 80-15-5: Eighty percent first loan, 15 percent second loan, 5 percent cash down payment.
- 80-20: Eighty percent first loan, 20 percent second loan, no cash down payment.
Like Lender-paid MI you receive full tax deductibility as the interest on the second mortgage is usually tax-deductible. However, you cannot cancel your second loan – you must pay it off in full or the balance due will be deducted from your proceeds when you sell the home.
Cancelling PMI
The Federal Government passed a private mortgage insurance (PMI) reform law, effective July 29, 1999. Known as the Homeowners Protection Act of 1997, the new law amends the Federal Truth in Lending Act and could save some homeowners more than $1,000 a year in PMI payments.
The key provision in the new law forces most lenders to automatically cancel PMI when a homeowner pays down their mortgage balance to at least 78 percent of the home's original purchase price. Homeowners also may apply to have the insurance removed when the mortgage balance drops to 80 percent of the original value. The appraised value may be determined by the original, or a new appraisal. Both provisions require that the borrower be current with their mortgage payments.
PMI reform not for all:
Only loans written July 29, 1999 or later are covered by the new law, and the small print in many other mortgages could preclude still more consumers from canceling PMI.
If you have questions about PMI cancellation policies, contact your mortgage company.
FHA and VA Loans
FHA
FHA's Title II, Section 203(b) mortgage insurance program is the most commonly used. The program allows a borrower to purchase a new or existing one- to four-family home in an urban or rural area. The program has been essential in helping low- and moderate-income families become homeowners for two reasons. First, the program lowers some of the costs associated with obtaining a mortgage. Second, because lenders are insured against default, they can take greater risks by lending in situations which fall outside of conventional standard underwriting guidelines. FHA charges mortgage insurance premiums for these loans. The premiums are used to pay lenders in the event of the borrower's default on the mortgage. The borrower pays an up-front mortgage insurance premium (MIP) and an annual premium. The up-front premium can be financed into the loan. The Mutual Mortgage Insurance Fund is sustained entirely by borrower premiums. Currently, the up-front MIP is 2.25 percent of the base loan amount, or 1.75 percent for a qualified first-time homebuyer. The monthly premium is 1/12 of 1/2 percent of the outstanding principal loan balance. Unlike Private Mortgage Insurance (PMI), which can be cancelled, FHA mortgage insurance lasts for the life of the loan. MIP is also generally more expensive than PMI. Any Unused MIP is refunded when the loan is paid off.
VA
The U.S. Department of Veterans Affairs guarantees loans made by institutional lenders to eligible veterans. The guarantee helps protect the lender in the event of the borrower's default. The VA charges a funding fee for each loan, which varies with the amount of the down payment and the status of the borrower (reservist/active duty/veteran). The funding fee may be included in the loan amount.
The funding fee for veterans is 2.15 percent for purchase or construction loans with down payments of less than 5 percent, refinancing loans and home improvement/repair loans.
The funding fee for veterans is 1.5 percent for purchase or construction loans with down payments of at least 5 percent but less than 10 percent
Homeowners Insurance
Homeowners insurance is required by the lender to obtain a mortgage. The typical homeowners policy has two main sections: Section I covers the property of the insured and Section II provides personal liability coverage to the insured. It's a good idea to insure your home for the total amount it would cost to rebuild it if it were destroyed. There are three ways to insure your home:
- Replacement Cost: Under this coverage, the policy owner is reimbursed an amount necessary to replace the structure with one of similar type and quality at current prices, subject to a maximum dollar amount.
- Guaranteed Replacement Cost: Under this coverage, the policy owner is reimbursed an amount necessary to replace the structure without a deduction for depreciation and without a dollar limit.
- Actual Cash Value: Under this coverage, the policy owner is entitled to the depreciated value of the damaged property.
To determine the cost to rebuild your home, consult with an appraiser or a local builder. Note: You only need to insure the structure. You do not need to insure the land.
In the event of a serious loss -- a fire, for example -- how would I fare?
In most cases you should insure your dwelling and its contents for their replacement values, which will likely differ from the dwelling's market value and your personal property's depreciated cash value. Also consider getting a policy with automatic inflation adjustments so that the replacement cost keeps pace with the general level of price increases.
Standard coverage insures your possessions at 50 percent of the value of your dwelling. Many people boost this coverage to 75 percent with additional protection. There are individual limits on certain types of personal property (see below).
Freestanding structures on your property (garages, gazebos, tool sheds, etc.) are also covered, with standard protection equal to 10 percent of your dwelling. Trees and shrubbery normally can be replaced up to a limit of 5 percent of your dwelling coverage. As is the case with your personal property, you should assess your needs to determine if you want to pay extra amounts to increase these levels of protection.
Also, pay attention to what might happen if you were to lose the use of your home for an extended period. Loss-of-use provisions are important elements of homeowners policies, and coverage levels up to and exceeding 30 percent of your dwelling's insurance aren't unusual.
If someone not covered on my health insurance was to suffer a serious injury in my home, and I were found liable, how would I fare?
The standard level of liability protection in homeowners policies has been $100,000, but it's rising all the time. Today, $300,000 is not an uncommon amount, and even higher levels are recommended for affluent homeowners with substantial assets to protect. In this situation, "umbrella" policies have become popular. These policies provide excess liability coverage on both your homeowners and automobile policies, and are relatively inexpensive (you normally need to carry both underlying policies with the same insurer).
Can I afford a high deductible--say $1,000--to save money on the premium?
The differences in annual premiums between policies with deductibles of $250 (you pay the first $250 of damage, the insurer pays the rest), $500 and $1,000 may easily be worth twenty to 30 percent of the annual premium. So, if you can afford the expenditure, and want to place a small bet that you won't face a home-related loss, consider a larger deductible.
Homeowners and Renters Claims Tips
- Promptly notify your insurance company or agent of your loss.
- Make a detailed list and description of the damage, including photographs if possible. Collect your canceled checks, receipts and other documents to help the adjuster set a value on damaged or destroyed property.
- Review your coverage. You might not be aware, for example, that your homeowners or renters policy pays for debris removal and for emergency housing and living expenses if your loss forces you to move temporarily. If you can't find your policy, ask your agent or company for a copy.
- Do not make permanent repairs before an insurance adjuster inspects your home. Make only temporary repairs to protect your home from looting or further damage. The insurance company might deny your claim if you make permanent repairs before the adjuster inspects the damage.
- If damage in your area is extensive, take extra steps to help your insurance company's adjuster find you. Make sure your address is visible from the street. Paint your insurer's name, policy number and temporary address on a plywood sign.
- If possible, be present during the insurance adjuster's inspection and take notes. You might want your own contractor/builder present to represent your interests. Take notes on all contacts with your insurance company and adjuster. Your chance of getting a satisfactory settlement improves when you are well prepared with the facts. Write down names, dates, and conversations. Remember, good records help your cause in the event you legally contest your insurance company's decision, or dispute it with the Department of Insurance.
- Don't agree to a final claim settlement until you are satisfied that it is fair. You're entitled to obtain independent estimates if you wish.
- After major claims events (disasters, storms etc), "public adjusters" offer to help victims pursue their insurance claims--for a price. You probably don't need a public adjuster, but if you hire one, be sure about the fee. Usually, it's a percentage of your claim payment.
- Get more than one bid for construction or repair work. Try to use a local contractor with a good reputation. Large claims events like storms often attract fly-by-night operators who do shoddy work or skip town after receiving advance payments.
Tips courtesy of the Texas Department of Insurance
Title Insurance
As a buyer of real estate, you want the assurance that the property you are buying will belong to you and be marketable--that there are no hidden interests in the property which will interfere with its use and ultimate disposition.
The written, public record of ownership of a particular piece of real property is critically important, but not sufficient in determining its ownership. In investigating the ownership of a parcel of property, one could trace the "paper chain of title" back to the original conveyance from the government. The chain of title, however, wouldn't readily reveal incomplete or erroneous shortcomings--forgery, or the mental incompetence of a grantor, for example. Title insurance was developed to help provide compensation for certain faulty guarantees and to assure marketable title.
How does title insurance differ from other types of insurance?
Title insurance is different from other types of insurance in that it protects you, the insured, from a loss that may occur from matters or faults from the past. Other types of insurance such as auto, life or health cover you against losses that may occur in the future. Title insurance does not protect against any future faults. Another difference is that you pay a one-time premium. A title insurance policy will protect you from risks or undiscovered interests. Once purchased, title insurance remains in effect for as long as you own your property.
Standard Policy
The standard policy of title insurance protects real property owners against items on- and off-record. Off-record risks include forgery, lack of capacity to enter into a transaction (incompetence or improper authority), impersonation, failure to properly deliver the deed, etc. The policyholder is NOT protected against title defects known to the policyholder on the date of issuance of the policy.
American Land Association Policy (ALTA for lenders).
This policy was developed to provide additional coverage to lenders who could not physically inspect the property without incurring great expense. It includes the risks associated with the rights of parties in physical possession, patent reservations, recorded notices of zoning enforcement, and unmarketable title.
Extended coverage (ALTA Owner's Policy)
This is a policy that gives buyers or owners the same protection that the ALTA policy gives to lenders.
Earthquake Insurance
Basic homeowners policies DO NOT cover earthquake damage. You may typically purchase earthquake insurance from the same company that issued your homeowners policy. Earthquake insurance is usually not required by the lender when purchasing or refinancing your home. Earthquake insurance is considered catastrophic coverage and most policies carry a very high deductible--often up to 10 percent or more of the home value. The deductible represents the amount you must pay before your policy begins to benefit you.
Geographic areas are graded on a scale from one to five. Insurance rates may vary depending on your particular location. Owners of wooden homes will usually get better rates than owner of brick homes since wood better withstands quake stress compared to brick. Depending on where you live, you may be able to get an earthquake endorsement to your homeowner's policy. Contact your agent or state insurance department for details.
It's important to determine your rights for filing claims prior to purchasing a policy. Find out the time period allowed for filing a claim following a quake. California's Northridge quake occurred in early 1994, yet claims continued to be filed many years afterwards for two reasons. First, in some cases earthquake damage wasn't immediately apparent. Second, as repair costs increased over time, many homeowners exceeded their deductibles and became eligible to file a claim.
Residents in the states of California, Missouri and Washington are the leading purchasers of earthquake insurance. Currently, the majority of earthquake policies in California are sold through the California Earthquake Authority (CEA). The CEA is a privately funded, publicly managed consortium of insurance companies. The CEA was created after the Northridge quake in response to insurance companies discontinuing the sale of homeowners and earthquake insurance for fear of experiencing further losses. The CEA's mini-policy is generally regarded as the industry's standard earthquake policy, and similar mini-policies are sold by insurance companies not participating in the CEA.
Flood Insurance
Flood insurance may be required by the lender if your home is in a low-lying area and vulnerable to flooding. Your homeowners policy will not cover you for any damage due to flooding.
The National Flood Insurance Program (NFIP) defines flooding as "a general and temporary condition during which the surface of normally dry land is partially or completely inundated. Two adjacent properties or 2 or more acres must be affected." According to NFIP's definition, flooding can be caused by any one of the following:
- the overflow of inland or tidal waters
- the unusual and rapid accumulation or runoff of surface waters from any source such as heavy rainfall
- the incidence of mudslides or mudflows caused by flooding which are comparable to a river of liquid and flowing mud;
- or the collapse or destabilization of land along the shore of a lake or other body of water resulting from erosion or the effect of waves or water currents exceeding normal, cyclical levels.
Flood insurance is a special policy backed by the federal government, with cooperation from local communities and private insurance companies. More than eighteen thousand communities have agreed to stricter zoning and building measures to control floods. Residents in these communities are entitled to purchase flood insurance through NFIP. (Those who own property in certain coastal barrier areas are excluded from the federal program.)
About two hundred insurance companies, possibly including the company that already handles your homeowner's or auto insurance, write and service the policies for the government, which finances the program through premiums. The average flood policy premium is about $350 a year; some people in low-risk zones can obtain flood insurance for as little as $106 a year.
Even though flood insurance is relatively inexpensive, most Americans are unprotected against flood loss. According to the Federal Insurance Administration, of the approximately ten million households in so-called Special Flood Hazard Areas - the most vulnerable to flood - no more than a quarter are covered by flood insurance. Yet in these special hazard areas, flooding is twenty-six times more likely to occur than a fire over the course of a typical thirty year mortgage.
Home Warranties
Traditionally, home warranties have protected homeowners from repair costs that aren't covered by home insurance, especially the inner workings of a home--plumbing, heating, air conditioning, and major appliances. Home warranties are often crucial in real estate transactions because they help home buyers as well as sellers rest more easily, safe in the knowledge that an unforeseen problem with a furnace won't spark a financial conflict, postpone a real estate closing, or blow a deal altogether.
While home warranties aren't necessary for every current homeowner, those who benefit most are those trying to buy or sell homes.
When you buy a home, you assume the burden of maintaining a variety of systems and appliances. Sellers are required to disclose known problems, but can't be blamed for passing along a washing machine or an oven that fails six months after the sale. That's when a home warranty goes to work.
The National Board of Realtors describes home warranties as service contracts, typically lasting one year, that cover the repair or replacement of major home systems and appliances that break down due to normal wear and tear. Home warranties don't overlap or replace the homeowner's insurance policy, says Alan Pyles, president of HMS Home Warranty. "They work hand-in-glove," he explains. "The warranty covers mechanical breakdowns, while insurance typically repairs the related damage. Think of it as a cause/effect relationship: If a pipe burst and destroyed a wall in your home, we'd repair the pipe that burst; your insurance would fix the wall."
Similarly, if your refrigerator were to stop working while you were on vacation, there could be spoilage, leakage, or floor damage. Your homeowners insurance might pay for the damage to the linoleum, while the home warranty would cover the mechanical breakdown of the refregerator.
Generally, home warranties cover malfunctions of major appliances such as washers, dryers, ovens, refrigerators, as well as ductwork, plumbing, electrical, heating, and air-conditioning systems. In some cases, or for additional fees, the warranty might extend to garbage disposals, doorbells, paddle fans, garage-door openers, water softeners, trash-compactors, and built-in microwaves.
The age of the home doesn't matter as far as coverage is concerned, as long the covered items are in good working order at the start of the contract, explains John Yacono, vice president of national accounts for American Home Shield, the nation's oldest and largest provider of home warranty contracts.
What is an APR?
The APR, often referred to as the Effective Rate, is a rate which shows the true cost of borrowing. This rate is different from the nominal (named or note) interest rate stated in your loan documents. The Truth In Lending Simplification and Reform Act requires mortgage companies to disclose the APR when advertising a rate.
To begin to understand the Annual Percentage Rate, it helps to understand the standard, fixed rate mortgage loan. A standard loan consists of:
- Loan amount
- Number of payments
- Monthly payment amount
- Nominal interest rate
Given any three of the above four items, the fourth can be determined with the aid of a financial calculator, computer program or algebraic formula. In other words, given any three factors, there is only one correct fourth factor. Here is an example of a fixed rate loan:
| 1. Loan amount: |
$100,000 |
| 3. Number of payments |
360 (12 payments per year for 30 years) |
| 4. Monthly payment |
$804.62 |
| 2. Interest rate |
$9% |
Let's consider a simplified, real estate loan transaction, using the above loan as our starting point. You borrow $100,000 and pay a 1.5 percent loan fee to the bank. For this example, that is the only fee you pay. At the completion of the transaction, how much money do you have? $100,000? No. You have $100,000 less the $1,500 loan fee, or $98,500.
Taking into account the cost of your transaction, let's take a second look at your new loan.
| You received |
$98,500 |
| Number of payments |
360 |
| Monthly payment |
$804.62 |
| Interest rate |
? |
Remember, there can be only one correct interest rate given the other three factors. In this example, the interest rate is the APR--9.17 percent. Since the loan amount was effectively reduced (you didn't get $100,000), and the number of payments and monthly payment stayed the same, the interest rate had to increase.
Fundamentally, that's all there is to the APR in a real estate loan transaction. This simplified example recognized only one fee related to obtaining a loan. You'll incur many other costs when obtaining a loan, some effecting the APR, some not, but the principle is the same.
Theoretically, the APR is a number you can use to accurately compare loans among different lenders. Since the APR takes into account costs of obtaining the loan, you should be able to use APRs to find the best loan. Unfortunately, when calculating the APR, not all lenders include all fees, and some lenders may include fewer fees than another lender. What's a borrower to do?
Ask for a signed and dated Good Faith Estimate of Closing Costs (GFE). A properly prepared GFE will itemize all the costs associated with your loan. Only then can you accurately compare lenders' programs.
What fees are included in the APR?
The following fees are usually included in the APR:
- Points - both discount points and origination points
- Pre-paid interest. The interest paid from the date the loan closes to the end of the month. Most mortgage companies assume 15 days of interest in their calculations. However, companies may use any number between 1 and 30!
- Loan-processing fee
- Underwriting fee
- Document-preparation fee
- Private mortgage-insurance
- Appraisal fee
- Credit-report fee
The following fees are sometimes included in the APR:
- Loan-application fee
- Credit life insurance (insurance that pays off the mortgage in the event of a borrowers death)
The following fees are usually not included in the APR:
- Title or abstract fee
- Escrow fee
- Attorney fee
- Notary fee
- Document preparation (charged by the closing agent)
- Home-inspection fees
- Recording fee
- Transfer taxes
Points to remember
An APR is a starting point from which to begin to compare loans. You must get a signed and dated Good Faith Estimate of Closing Costs with which to accurately compare lenders' programs.
How Do Rate Locks Work?
In most cases when you shop for a loan, the rate and terms you are quoted represent those available that day. The rate quoted probably won't be available next month or next week. Therefore, you should only rely on the rate and terms a lender is willing to lock-in.
A lock-in, or rate commitment, is a lender's promise to close your loan at a certain interest rate and number of points. Depending upon the lender, you may be able to lock in the interest rate and points upon submitting your application, during application processing, upon loan approval, or later. A rate lock protects you against rate increases while your application is being processed. However, a locked-in rate could cost you money in the event rates drop and you want a lower rate.
You will need to lock the rate on your mortgage some time prior to closing. There are five components to a rate lock:
- Loan program
- Loan amount
- Interest rate
- Points
- Length of the lock
You must identify each of the above mentioned items in a rate lock. A rate lock might look something like this: 30 year fixed, $150,000 loan amount, 7.5 percent, one point, 30 day lock period. The document describing the lock will contain the date the lock was made and usually the lock expiration date. The lender must disburse funds prior to the expiration of the lock period, otherwise, the rate lock is invalid.
A loan with a below-market interest rate is less attractive to a potential purchaser of the loan. The longer the lock period, the greater the risk that interest rates will increase before the loan closes. To offset this increased risk, the lender charges increasingly higher points and/or interest for longer lock periods.
If rates increase during the lock period and your lock expires, most lenders will let you re-lock at the new, higher rate or points. If rates decrease during the lock period and your lock expires, lenders usually will charge a penalty to take advantage of the new, lower rates. For a fee, some lenders allow a "float-down" option which allows you to take advantage of decreasing interest rates. Once a lock expires, be prepared to renegotiate the rate and points.
What do you do if the rates drop after you lock?
Unless you have the option to float-down, most lenders will not budge unless rates drop substantially (3/8 percent or more). Lenders incur fees when they lock loans. If lenders were to allow borrowers to cancel a lock every time rates improved, they'd spend too much time re-locking rates, and the increased costs would have to be passed to borrowers.
Lock and Shop programs.
Most lenders will let you lock an interest rate only in connection with a specific property. Some lenders offer lock-and-shop programs which let you lock a rate before you find your home. Both programs can be valuable when rates are rising.
New construction rate locks.
Most lenders offer long-term locks for new construction. Since these locks tend to be relatively long, they can be expensive. An up-front deposit is sometimes required also. Most long-term new construction locks offer a float-down.
Why do Interest Rates Change?
There are several types of interest rates. These include:
- Prime rate: The interest rate banks charge their best (prime) customers.
- Treasury bill rates: Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills, they mature in less than one year.
- Treasury Notes: Intermediate-term debt instruments used by the U.S. Government to finance their debt. They mature in one to ten years.
- Treasury Bonds: Long debt instruments used by the U.S. Government to finance its debt. Treasury bonds mature in more than ten years.
- Federal Funds Rate: Banks with excess reserves at a Federal Reserve district bank charge this rate to other member banks for overnight loans.
- Federal Discount Rate: The interest rate the Federal Reserve charges its member banks for short-term borrowing to meet liquidity needs.
- Libor: London Interbank Offered Rates. Average London Eurodollar rates.
- 6-month CD rate: The average rate that you get when you invest in a 6-month CD.
- 11th District Cost of Funds: A weighted average of the actual interest expenses incurred for a given month by the savings institutions headquartered in the 11th District of the Federal Home Loan Bank System.
- Fannie Mae Backed Security rates: Fannie Mae pools large quantities of mortgages, creates securities with them, and sells them as Fannie Mae backed securities. The rates on these securities influence mortgage rates very strongly.
- Ginnie Mae-Backed Security rates: Ginnie Mae pools large quantities of mortgages, securitizes them and sells them as Ginnie Mae-backed securities. The rates on these securities influence mortgage rates on FHA and VA loans.
Interest rate movements are influenced by the fundamental forces of supply and demand. Given a fixed level of lendable funds, if the demand for credit (loans) increases, interest rates also increase. I.e., when more people (borrowers) bid for a limited resource (money) the cost of that resource increases. Conversely, if the demand for credit decreases, so will interest rates as lenders lower the cost to entice borrowing. When the economy expands there is a higher demand for credit and interest rates increase. When the economy contracts, the demand for credit lessens and interest rates decrease.
A fundamental concept:
- Bad news (i.e. a slowing economy) is good news for interest rates (i.e. lower rates).
- Good news (i.e. a growing economy) is bad news for interest rates (i.e. higher rates).
A major factor driving interest rates is inflation. Higher inflation is associated with a growing economy. When the economy grows too rapidly, the Federal Reserve increases interest rates to slow the economy and reduce inflation. Inflation is the increase in the general level of prices for goods and services. When the economy is strong there is more demand for goods and services, so the producers of those goods and services can increase prices. A strong economy therefore results in higher real-estate prices, higher rents on apartments and higher mortgage rates.
Mortgage rates tend to move in the same direction as interest rates. However, actual mortgage rates are also based on supply and demand for mortgages. The supply/demand equation for mortgage rates may be different from the supply/demand equation for interest rates. This might sometimes result in mortgage rates moving differently from other rates. For example, one lender may be forced to close additional mortgages to meet a commitment they have made. This results in them offering lower rates even though interest rates may have moved up!
Effect of Economic Data on Rates
The number of + symbols indicate the potential effect on interest rates.
| + |
minimal effect |
| +++++ |
maximal effect |
| economic event |
Effect on
Interest Rates |
Significance of event |
| Consumer Price Index (CPI) Rises |
+++++ |
Indicates rising inflation. |
| Dollar rises |
+ |
Imports cost less indicates falling inflation. |
| Durable Goods Orders Increase |
+++ |
Indicates expanding economy |
| Gross Domestic Product Increases |
+++++ |
Indicates strong economy |
| Home sales increase |
+++ |
Indicates strong economy |
| Housing Starts Rise |
+++ |
Indicates strong economy |
| Industrial Production Rises |
+++ |
Indicates strong economy |
| Business Inventories Rise |
+++ |
Indicates weak economy |
| Leading Indicators (LEI) Increase |
+++ |
Indicates strong economy |
| Personal Income Rises |
+ |
Indicates rising inflation |
| Personal Spending Rises |
+ |
Indicates rising inflation |
| Producer Price Index Rises |
+++++ |
Indicates rising inflation |
| Retail Sales Increase |
++ |
Indicates strong economy |
| Treasury auction has high demand |
+ |
High demand leads to lower rates |
| Unemployment Rises |
+++++ |
Indicates weak economy |
|
When do you lock?
You know when rates have hit bottom AFTER they start rising. Deciding when to lock your rate is a bit like gambling--you want luck on your side!
You must lock your rate prior to closing your loan. To help determine when to lock, consider the rate trend. When rates are falling, wait until the last possible moment to lock your rate. When rates are rising, lock your rate as soon as possible. In either case, you're basing your decision on something unknown--the future. Rate trends change quickly and interest rates usually change daily. Here are just a few of the factors affecting interest rates:
- New economic data.
- Supply and demand of debt. Example: The U.S. government sells 30-year bonds; the supply of bonds increases; an increased supply of bonds at a given level of demand causes the price of bonds to fall; falling bond prices create increasing bond interest rates. Conversely, when the demand for bonds increases at a given level of supply; the increased demand bids up the price of bonds, resulting in lower rates.
- Inflation. Actual or expected higher inflation causes rates to climb. When inflation is on the rise, the Federal Reserve Board raises rates to curb inflation.
- Political news and world events. A war in the Middle East could cause higher oil prices and inflation.
- Market sentiment.
Bond rates and prices vary inversely--i.e., when bond prices rise, interest rates fall and vice versa. The 30-year bond is one of the most relevant rates to track, but the yield of mortgage-backed securities is more important. The supply and demand for mortgage securities may be different from 30 year bonds. There are times when bond prices move higher and mortgage security prices move lower.
If you want to follow interest rates, consider the following:
- Find out all the economic news being released over the next two weeks.
- Make a list of news that is most important to interest rates--inflation, industrial production, etc.
- Follow bond- or mortgage-backed prices on a daily basis. These rates influence mortgage rates.
- Follow mortgage interest rates on a daily basis. Bookmark web sites or obtain rates via e-mail.
- In general, Fridays and three-day weekends are bad for interest rates. This is because traders hate uncertainty. In many cases, traders close out positions before a weekend, which often means that they have to sell bonds which causes rates to go up.
|
Loan Categories
The major loan categories are conventional and government. Conventional loans can be further categorized into conforming and non-conforming. Government loans primarily refer to FHA and VA loans.
Conforming Loans
A conforming loan adheres to the guidelines established by Fannie Mae or Freddie Mac. These guidelines establish maximum loan amounts, down payment, credit and income requirements and acceptable property types. Lenders that make loans according to these guidelines may sell them to Fannie Mae or Freddie Mac. Conforming loans make up the majority of loans in the U.S.
Non-conforming Loans
Loans that do not conform to the guidelines established by Fannie Mae or Freddie Mac are called non-conforming loans. A loan that is larger than the conforming loan limit is called a Jumbo loan. Loans that do not meet the credit quality of conforming loans ('A' paper) are referred to ad A- through 'D' paper loans, or subprime loans.
Government Loans
FHA and VA loans are the two most popular types of Government loans. Government loans have different loan limits and qualifying criteria compared to conventional loans.
Portfolio Loans
Loans may be sold on the secondary market to Fannie Mae, Freddie Mac or a select number of conduits (e.g. GE Capital) or they may be kept in the bank's portfolio. Portfolio loans generally have more flexible qualifying criteria, while saleable loans must meet more strict criteria.
Commercial Loans
Loan programs discussed above apply to one- through four-family, residential properties. Loans on residential properties containing five or more units, office buildings, warehouses and other commercial properties are considered commercial loans.
Fixed Rate Mortgages
Fixed-rate mortgages are very popular because the interest rate and monthly payments are constant. Fixed loans are generally amortized over ten, fifteen, twenty or thirty years.
A fixed-rate mortgage is generally preferred when the interest rate is relatively low and one intends to keep the property for more than five to seven years. When rates are relatively high, or if one intends to sell the property in fewer than five to seven years, adjustable loans are generally preferred.
The most common fixed rate mortgage is the thirty-year fixed. Borrowers who want to pay off their loan sooner may opt for a fifteen-year mortgage. If you are trying to decide between a thirty-year and a fifteen-year loan, consider the following:
- Paying your loan over fifteen years can save you thousands of dollars in interest. Paying less interest results in less of a tax deduction. Determine in advance if a larger tax deduction (with a thirty-year loan) will offset the benefits derived from paying less interest (with a fifteen-year loan).
- The payment on a thirty-year loan can be substantially less than the payment on a fifteen-year loan of the same amount. You could obtain a thirty-year loan and invest the difference in mutual funds, stocks, CDs, etc. If you could earn a higher, after-tax rate on your investment than the rate you pay on your mortgage, it may be advantageous to invest the difference.
The final decision you make will depend on your preferences. If your goal is to live debt free, then a fifteen year mortgage may be right for you. If you goal is to maximize your tax deductions, a thirty year loan may be best for you.
Balloon Mortgages
With a balloon loan, at some point you'll be forced to pay off the loan, refinance the loan, or exercise a conversion option to get a new loan on or before the balloon due date. Unlike standard fixed or adjustable loans, balloon loans are not amortized. The entire loan balance is all due and payable in a relatively short time.
One of the most popular balloon programs is the 30/5, commonly referred to as a "thirty-year due in five." The interest rate is fixed and the monthly payment is sufficient to pay off the loan in thirty years, but the outstanding principal balance is due at the end of five years. Some 30/5s have a conversion option which allows you to convert to a twenty-five year, fixed rate at the time the balloon becomes due. There may be a minimal processing fee (typically $250) to convert to the new loan. The conversion rate is normally the FNMA sixty-day rate plus .5 percent. The conversion option may also be conditioned upon:
- Satisfactory mortgage-payment history. If your payments were late, the conversion may be denied.
- If the loan was secured by an owner-occupied dwelling, the dwelling will still need to be owner-occupied. If the house is a rental at the time of loan-conversion, the conversion may be denied, or you might be charged a higher interest rate.
- Secondary financing may not be allowed. If you have a second mortgage, the conversion may be denied unless you pay off the second mortgage.
Terms vary by lender. More information can be found in the loan obligation (promissory note). This is a document the lender will require you to sign at the time of closing.
Another popular balloon loan program is the 30/7. This is similar to the 30/5 except that the balloon comes due at the end of the seventh year.
Adjustable Rate Mortgages
An ARM is a loan which allows for the adjustment of its interest rate according to the terms of the note and as market interest rates change. The ARM interest rate is based upon one of many indices which reflect market interest rates. The borrower assumes the risk that interest rates (and their monthly payment) will rise. By assuming this risk, lenders may charge a lower initial interest rate compared to fixed rate loans. The lower initial rate is the main reason borrowers choose ARM loans--it allows them to qualify for a larger loan and obtain a higher-priced home.
Borrowers considering an ARM should familiarize themselves with standard ARM features. These features include:
- Start rate (Teaser rate): This temporary rate is the starting interest rate. It is often referred to as the teaser rate. The start rate is lower than the fully-indexed rate (sum of the index plus the margin), and lower than the market rate on fixed loans.
- Initial Adjustment Period: The length of time the interest rate is fixed initially. For example, if the initial adjustment period were six months, the interest rate would remain fixed for the first six months. Beginning in month seven, the loan would adjust at regular intervals.
- Regular Adjustment Period: The frequency at which the interest rate adjusts. If the regular adjustment period were six months, the interest rate would adjust every six months.
- First Adjustment Cap: The maximum amount the interest rate can increase when it adjusts for the first time. For example, if your teaser rate and first adjustment cap were 5 percent and 3 percent respectively, the maximum your rate could increase after the initial adjustment period would be 8 percent.
- Regular Adjustment Cap: The maximum the interest rate can adjust up or down each adjustment period.
- Lifetime Cap: The maximum interest rate allowed over the life of the loan.
- Index: The variable index referenced in your note. The margin is added to the index to set the ARM interest rate. The index can usually be found in business newspapers. More information about various indices is available below.
- Margin: A fixed number which is added to the index to arrive at the ARM rate.
- Fully-indexed rate: The fully-indexed rate is equal to the index plus the margin. Your loan always adjusts toward this rate.
- Conversion Options: Some ARMs have an option which allows the borrower to convert the ARM to a fixed-rate loan. Exercising the option usually must occur within a predetermined time frame; the fixed rate is determined by a formula. For example, a one-year T-bill ARM may be converted to a fixed-rate loan during the first five years on the adjustment date. I.e., you could convert during the thirteenth, twenty-fifth, thirty-seventh, forty-ninth or sixty-first month.
Computing the fully-indexed mortgage rate:
The formula to calculate the fully-indexed interest rate is:
fully-indexed rate = value of index + margin
Note: The rate you pay after one or more adjustments may not be the fully-indexed rate. This can ocurr when the interest rate adjustments are limited by a cap.
Examples:
- Not reaching the fully-indexed rate: Your previous rate was 7 percent, your loan has a 1 percent adjustment cap, the index is 7 percent, your margin is 3 percent. The fully-indexed rate is 10 percent. Because of the limiting payment cap, your new interest rate is 8 percent.
- Reaching the fully-indexed rate: Your previous rate was 7 percent, your loan has a 3 percent adjustment cap, the index is 7 percent, your margin is 3 percent. After the adjustment, your interest rate reaches the fully-indexed rate of 10 percent.
Details about the various indices:
- Prime rate: The interest rate banks charge their best (prime) customers.
- Treasury bill rate: Treasury bills are short-term debt instruments used by the U.S. Government to finance their debt. Commonly called T-bills, they mature in less than one year.
- Libor: London Interbank Offered Rate. The interest rate international banks in London charge when lending to each other. Indices are quoted for maturities of one, three, six and twelve months. The most common Libor rate referred to in ARMs is the six-month Libor rate.
- 6 month CD rate: The average rate that banks pay on a six-month Certificate of Deposit.
- 11th District Cost of Funds Index (COFI): The index is the average monthly cost of the interest expenses incurred by members of the 11th District of the Federal Home Loan Bank System. Deposits in checking and savings accounts, certificates of deposit, transaction accounts, and passbook accounts are the primary source of funds for these savings institutions. The COFI moves slowly and lags behind the market. For COFI ARM borrowers, this is an advantage when interest rates are rising, but a disadvantage when rates are falling. When rates are rising, the COFI rate, and consequently the ARM rate, will rise slowly. Conversely, when rates are falling, the COFI rate and ARM rate will decrease slowly.
Popular ARM programs. Some of the more popular ARM programs include:
- One-Year Treasury Bill ARM
Adjusts annually with a two percent annual cap.
- Six-Month Certificate of Deposit (CD) ARM
Adjusts every six months with with an adjustment cap of 1 percent. The CD rate is very volatile and changes quickly with the market.
- Six-Month Treasury Average ARM
This index is relatively stable because it averages the treasury rate over the previous six months. This loan has a maximum interest rate adjustment of 1 percent every six months.
- Twelve-Month Treasury Average ARM
This index is relatively stable because it averages the treasury rate over the previous twelve months. This loan has a maximum interest rate adjustment of 2 percent every twelve months.
- Three-month COFI ARM
The COFI is one of the most stable indices and adjusts very slowly. The three-month COFI ARM typically has a very low start-rate for the first three months, after which time the interest is fully indexed and adjusts monthly.
Intermediate ARMs
The most popular intermediate ARM loans are the 3/1, 5/1, 7/1 and 10/1. These loans are normally amortized over thirty years with the interest rate initially fixed for three, five, seven and ten years respectively. After the initial fixed period, these loans typically adjust annually.
Intermediate ARMs are very popular with borrowers who want the stability of a fixed rate and the benefit of a lower introductory rate. If you plan to sell or refinance your home in three to ten years, you may want to consider an intermediate ARM loan rather than a fixed-rate mortgage. You can save money with the lower introductory rate, but you risk having a higher rate if you are still in your home when the introductory rate period expires and the rate starts adjusting toward market levels.
Graduated Payment Method
In general, GPMs were created to facilitate early home ownership for borrowers who expect their incomes to increase. GPM programs allow homeowners to make smaller monthly payments initially and to increase their size gradually over time. GPMs may also be beneficial for homeowners who plan to move or refinance relatively quickly.
A GPM allows a borrower to qualify at a payment lower than a comparable fixed-rate loan. By qualifying at a relatively lower payment, one can obtain a larger loan and potentially purchase a higher-priced home.
A GPM’s initial payments are lower than the minimum required to amortize the loan. Over a predetermined period of two to seven years, the payments increase by approximately 7.5 to 12.5 percent per year. Since the initial monthly payments are insufficient to amortize the loan, these loans feature negative amortization--the loan balance increases in the early years. A borrower has the option, however, to pay the fully amortized payment and avoid negative amortization.
There is a premium for receiving the benefits of a lower initial monthly payment--the interest rate is approximately .5 to .75 percent higher than a comparable fixed-rate mortgage. GPMs are available for Conforming and Jumbo loans.
FHA Loans
An FHA loan is a mortgage loan insured by the Federal Housing Administration. FHA is part of the U.S. Department of Housing and Urban Development (HUD). FHA insures loans made by banks, savings and loans, mortgage companies, credit unions and other approved institutions. FHA does not originate loans. Since 1934, FHA has offered mortgage insurance programs which help people purchase homes with a modest down payment. Title II, Section 203(b) is the most often used single family program. Under this program a borrower may obtain a ten, fifteen, twenty, twenty-five or thirty year loan to purchase an existing one- to four-family home in a rural or urban area.
In recent years, Fannie Mae and Freddie Mac have introduced low down-payment programs also--the Community Home Buyer program for example. Consequently, FHA loans are less popular than they once were. The loan limits for FHA loans vary geographically.
Mortgage Insurance: In 2000, in recognition of the continued strength and increase in the MMI Fund, FHA revised its Upfront Mortgage Insurance Premiums (UFMIP) policy for all loans closed on or after January 1, 2001. The new UFMIP is 1.50 percent and the borrower does not have to be a first-time homebuyer or to have received homeownership counseling. The refund schedule has also been shortened to a five year time period. The up-front MIP may be financed, and in addition, there is a monthly MIP payment which is calculated by multiplying the loan amount by .5 percent and dividing by twelve. Condominiums do not require up-front MIP--only monthly MIP.
In the past, some FHA borrowers needed to pay annual mortgage insurance premiums throughout the life of the mortgage. The new rule specifies hat annual mortgage insurance premiums will be automatically canceled for all loans closed on or after January 1, 2001 under the following conditions:
- For mortgages with terms of more than 15 years, the annual mortgage insurance premiums will be canceled when the loan-to-value ratio reaches 78 percent. The mortgagor has to pay the annual mortgage insurance premiums for at least five years.
- For mortgages with terms equal or less than 15 years and a loan-to-value ratio of 90 percent or greater, the annual mortgage insurance premiums will be canceled when the loan-to-value ratio reaches 78 percent, regardless of the length of time the mortgagor has paid the annual mortgage premiums.
- For mortgages with terms equal to or less than 15 years and a loan-to-value ratio of 89.9 percent and less, the annual mortgage insurance premiums will not be charged.
The annual MIP for 30 year loans is 0.5%. 15 year loans is 0.25%. 15 year loans less than 90% ltv, Zero.
Down Payment Gifts: One of the key benefits of an FHA program is that you do not have to use your own funds for the down payment. Under certain conditions, gifts are allowed if the donor is a relative, a close friend, an employer, or a humanitarian, welfare, or charitable organization. A gift letter, signed by the donor, is required stating the amount given and specifying that no repayment is expected, (See HUD Handbook 4000.2 REV-2)
Bridal Registry: The Bridal Registry Account allows couples who are getting married to open a bridal registry savings account with a participating Federal Housing Administration approved bank. Family and friends may deposit cash wedding gifts directly into the interest-bearing account.
FHA Streamline Refinance: FHA has made it very easy for borrowers to refinance their existing FHA loans. If your mortgage is currently FHA insured, your payments have not been late, you are not taking cash out, and you are reducing your payment--you may qualify for the FHA Streamline Refinance Program. An FHA Streamline Refinance typically does not require an appraisal
203(k) loan: FHA insures rehabilitation loans for owner-occupants, municipalities and non-profit housing providers to finance 1) rehabilitation of an existing property, 2) rehabilitation and refinancing of a property, and 3) the purchase and rehabilitation of a property.
Investors must have a 15 percent down payment and can purchase (or refinance) and rehabilitate properties for rental purposes or sell the property (and get their profit using the Escrow Commitment Procedure) to a qualified Homebuyer (who assumes the loan).
203(k) can be used with one- to four-family dwellings, condominiums and HUD homes that require a minimum of $5,000 in repairs. CO-OPS ARE NOT ELIGIBLE. Garden apartment style row housing can be converted with 203(k) to fee simple or condominium with the addition of firewalls every four units. 203(k) loans can be used to bring illegal dwellings into code compliance.
Mixed use residential property is acceptable provided the property has no greater than 25 percent for a one story building; 33 percent for a three story building; and 49 percent for a two story building of its floor area used for commercial (storefront) purposes. The rehabilitation funds can only be used for the residential functions of the dwelling and areas used to access the residential part of the property.
Reverse mortgages for seniors: Homeowners sixty-two and older who have paid off their mortgages or have only small mortgage balances remaining are eligible to participate in HUD's reverse mortgage program. The program allows homeowners to borrow against the equity in their homes.
Homeowners can receive payments in a lump sum, on a monthly basis, or on an occasional basis similar to a line of credit. Under certain circumstances, homeowners may restructure their payment options.
Unlike ordinary home equity loans, a HUD reverse mortgage does not require repayment as long as the borrower lives in the home. The reverse mortgage is repaid in one payment, after the death of the borrower, or when the borrower no longer occupies the property as a principal residence. Upon sale of the home, any remaining equity goes to the homeowner or to his or her survivors. If the sales proceeds are insufficient to pay the amount owed, HUD will pay the lending institution the amount of the shortfall.
The maximum amount of the reverse mortgage is determined by multiplying the maximum claim amount by the factor corresponding to the age of the youngest borrower and the expected rate. It is beyond the scope of this document to present the factorial tables required to calculate your particular maximum loan amount.
Home Improvement FHA Title 1 loans: Under Title I, FHA insures loans obtained for repairs, alterations, and improvements to existing structures, and for the building of small new structures for nonresidential use. The property can be non-residential, multi-family, or single-family. Interest rates on these loans are set by HUD-approved lenders.
For answers to your FHA questions, call 1-800-CALLFHA.
Less Than Perfect Credit
Are there loan programs available for borrowers with less than perfect to extremely poor credit? Absolutely. Fundamentally, all the lender wants to be assured of is that 1) one has the ability, and 2) the desire to repay the debt. The worse one's credit, the more evidence of one and two one will need to muster.
If you think you may be "credit challenged", one of the first things you'll want to know is, just how "less than perfect" is your credit? Fortunately, many bright people have dedicated their professional lives to creating methods for answering such questions. Statistical models which balance numerous credit factors provide methods for determining credit ratings. The models generate a single number—a credit, or FICO score—which provides lenders with a starting point for making decisions about lending money.
How do you get your credit score? Currently there is no law requiring that consumers be given their credit scores. Lenders aren't required to give you your credit score—but some will if you ask them. The lender should, however, tell you what factors contributed to your credit score if your score was a factor in delaying or denying your loan application. Credit bureaus don't include credit scores on consumer credit reports.
Assuming you know your credit score—what does it mean? Credit scores fall between approximately 375 to 900. Anything over 670 is considered good credit. Borrowers with good credit are able to get the best financing rates and terms available to the general public.
Lenders classify borrowers into the following credit categories based upon their credit scores. These categories can vary slightly among lenders. For example, a credit score of 620 could be a "B" with one lender, but a "C" with a different lender. The lower your score, the more expensive and restrictive your potential financing choices.
Credit
Rating |
Credit
Score |
| A+ |
670 |
| A- |
660 |
| B |
620 |
| C |
580 |
| D |
550 |
| E |
520 |
It would be confusing at best to present general underwriting guidelines in an attempt to interpret credit ratings and scores as they relate to individual borrowers. In A- through E credit scenarios, dozens of factors are considered in the decision-making process. Your best assurance of getting the best possible loan is to shop among several lenders.
Bi-Weekly Programs
Making bi-weekly (ocurring once every two weeks) payments can shorten the life of your mortgage and reduce your interest expense over the life of the loan. Instead of making a full payment every month, you make a half payment every two weeks. Since there are fifty-two weeks in a year, you make twenty-six half payments, or thirteen full payments. As a result, you are making one extra mortgage payment per year. Making bi-weekly payments can reduce the term on a thirty-year, fixed loan to approximately twenty-two years.
There are several ways to implement a biweekly program:
- Contact your lender. See if they offer a bi-weekly program.
- Locate a company that helps borrowers make bi-weekly payments. The company will deduct payments from your bank account every two weeks, but will only pay your lender once per month. The disadvantage is that you loose interest on your money that you otherwise would have made. The advantage is that it is convenient and automatic. Be sure to fully investigate the company's credentials. There have been scams reported in the industry.
- Do it yourself. Open a bank account and make bi-weekly deposits. Each month, pay your lender from that account. You will earn interest on the money in your account.
- Make monthly pre-payments. Increase the amount you pay each month by one-twelfth (8.33%). By increasing your mortgage payment by just over 8 percent, you shorten the life of your loan and save money effectively the same as you would with a bi-weekly loan.
Ask yourself some questions before committing in writing to a bi-weekly program. Remember, any loan is potentially a bi-weekly loan. If you have the discipline to make the extra payment per month or per year, why enter into a written agreement or pay someone to help you? If you use a third party to help you, ask what their set-up and monthly servicing fees are, then determine what you're really saving. |
Interest Rate Buydowns
Interest rate buydowns are used to help you qualify for a larger loan and obtain a higher priced home. Buydowns allow you to pay extra points up-front in return for a lower interest rate for the first few years. Since the additional points you pay are tax deductible, there is some tax benefit. People relocating due to employment often obtain buydowns. Employers sometimes pay the extra points as part of a relocation package.
The most common buydown program is the 2-1 buydown. With this program the interest rate is reduced 2 percent during the first year and 1 percent the second year. For example, if you obtain a 2-1 buydown on a 30-year, fixed, 8 percent mortgage, the rate is 6 percent the first year, 7 percent the second year and 8 percent thereafter.
Some companies offer a 3-2-1 buydown. This reduces your rate 3 percent the first year, 2 percent the second year and 1 percent the third year.
There are many variations of buydown programs. Some buydown programs result in interest rates changing every six months as opposed to every year.
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