Mortgage 101-Back to the Future

When the financial crisis hit, many banks became tightfisted, and plenty of potential borrowers walked away empty-handed. But financial institutions have emerged from the recession stronger and ready to lend. Credit is readily available for those who qualify. Banks want to lend money, but the days of not knowing your income and failing to manage your credit are gone.


Keep in mind that from mortgages to car loans, your credit history and score matter more than they did prior to the crunch. Rates are at rock-bottom levels for borrowers with top-tier credit -- generally credit scores above 720. Before you shop rates, get a copy of your credit report. Make sure that you buy your credit score. With the free reports, you get a copy of the report that contains your tradelines, but it will not give you a credit score. If you do this, you can see where you stand before you apply for a loan.

Mortgages: Stricter Rules

Mortgage lenders want to make loans now, and they may even bid against one another for your business. But lending standards remain tight, and you must be prepared to produce a mound of paperwork to document your income and assets.

Rates are as low as they were in the 1950s, so going through the motions could pay off. In mid September, the average interest rate for a 30-year, fixed-rate conforming loan -- a mortgage of $417,000 or less -- was 4.5%, according to HSH Associates, a mortgage-tracking firm. The initial rate for a 5/1 adjustable-rate mortgage (a fixed rate for five years, followed by annual adjustments) was 3.6%.

Fannie Mae, Freddie Mac and the Federal Housing Administration continue to dominate the mortgage market, setting the standards for the loans that lenders make and sell to investors. So lenders strive to dot every i and cross every t when they qualify you.

If you're buying or refinancing the mortgage on your primary home, you'll need a minimum down payment of 5% to 10% for a conforming loan or 10% to 15% for a conforming jumbo loan (125% of a metro area's median home price, up to $729,750). With 20% or more down, you avoid private mortgage insurance, which typically costs 0.5% to 1.5% of your loan amount per year.

Fannie Mae and Freddie Mac allow a minimum credit score of 620 if you have at least 25% equity in the property or a score of 660 with equity of less than 25%; you'll get the best rate if your score exceeds 720. The FHA will soon require a minimum credit score of 580 to qualify with a down payment of 3.5%, but FHA lenders often impose a higher minimum score of 620. This is important to note that Prosperity Mortgage will accept a 600 score, and a 580 score may be acceptable with extremely strong compensating factors. The key with a 580 score is your proven compensating factors.

In addition to your credit, lenders will also scrutinize your ability to pay, starting with your ratio of debt to income. Monthly housing expenses (principal, interest, taxes, hazard insurance, private mortgage insurance and association fees) shouldn't account for more than 28% of gross monthly income. Total debt shouldn't exceed 41% of gross income, but in some cases lenders stretch the maximum to 41%. FHA has more flexibility with the 41% ratio, with loans receiving an accept automated finding to 50%. With a conventional loan, you are really going to be pressed to exceed the 41% ratio. Exception requests can be made to 45%, however, you must have 20% down and have very strong compensating factors to impress the underwriter to exceed the 41% tolerance.

Prove It.

At a minimum, you must supply your pay stubs for the past 30 days and W-2 forms for the past two years. Lenders will want to see bank, retirement-account and investment statements for the past 60 days. There are three types of borrowers that will face additional scrutiny and requirements. These borrowers are:

If you're self-employed or if 25% or more of your income is from commissions or bonuses, you must provide two years of tax returns. Lenders will average your income over the past two years to figure your debt-to-income ratio. If you have pursued opportunities to reduce your taxable income, you may not have sufficient income to qualify even though you may have a lot of money in the bank. Note, business expenses written off on your tax return are typically dollar for dollar. Be careful here. Remember, “No Taxey, No Usey.” If you don’t pay taxes on the income, you can not use the income for qualifying.

If you want to rent out your home and buy a new one, you must provide a signed lease for a minimum of 12 months. You can use only 75% of rental income to help qualify for the mortgage, and you must have at least 30% equity in your former home. You may also be required to provide copies of your tax return if you leased the property the previous year. If you are leasing the property and not paying taxes on the income, you may not be able to offset the debt with the rents. Again, the “No Taxey, No Usey” guideline applies.

If you and your spouse are relocating for work and your spouse doesn't have a job yet, you must qualify for the loan based on one income unless your spouse has a signed agreement with an employer to begin work within 45 days of closing the loan.

Even if you qualify, you can throw a monkey wrench into the final loan approval if you take on new debt that could affect your credit score or your debt-to-income ratio. Some lenders pull another credit report just before closing. Another possible sticking point is the appraisal. Overly generous appraisals helped to fuel the housing bubble. Now, miserly ones may thwart your closing. Lenders will estimate the value of your home conservatively, and appraisers are generally following suit, especially if the local market is in flux.

Home Equity: Lower Limits

Several years ago, home values were rising so rapidly that you could build a pile of equity practically before the ink was dry on your settlement papers -- and then borrow against it to pay for everything from home repairs to college tuition. But as prices have tumbled, lenders have tightened their criteria for approving fixed-rate home-equity loans and variable-rate lines of credit.

Now in most cities you'll be able to borrow no more than 80% of the appraised value, less the mortgage. This is very important when refinancing a cash our refi. If you bought your home in 2005 and then took an equity loan or HELOC out in 2007, and now you want to refinance both mortgages, you are looking at a cash out refinance and the maximum LTV is 80%. With values slipping and appraisals harder to come by, this may not be an option so make sure to due your homework and get a good value indicator from an agent or appraiser.

You'll need a credit score of at least 720, as opposed to the 650 to 680 you could get away with a few years ago. And as with first mortgages, you'll have to document income and assets. Interest rates depend on the amount you borrow and your location.