Here’s another great way to protect yourself from the current meltdown in the housing market. If you own a home and have an adjustable rate mortgage (ARM) set to adjust higher (and it will go higher) you need to:
- Know your credit score.
- Know the contents of your report.
- Clean your credit report up and remove inaccuracies.
- Do everything you can in your power (legally, ethically) to maximize your credit score.
With the recent changes to the housing market the lenders have made changes to underwriting guidelines. Underwriting guidelines are based on your credit. When underwriting guidelines get more stringent it is the people with the better credit that continue to qualify for good home loans. Consider the following:
- Home prices have dropped reducing the equity in your home.
- Your loan amount has remained practically the same.
- This phenomenon has raised a key underwriting component called loan-to-value (LTV) to much higher levels than in your recent borrowing transactions.
- The higher the LTV, the more restrictive the lending guidelines become – some to a point where you cannot borrow at all.
- The higher the LTV, the fewer mortgage products available to you and the higher the interest rates.
The higher LTV loans are only available (for the most part) to those people with good-to-excellent credit. It then makes a lot of sense for your average home owner who is in an adjustable rate mortgage to work hard to achieve the best possible credit score to qualify for the best possible high LTV loan.
Let’s look at a HYPOTHETICAL example to make this easier:
- In 2005 you have a 570 mid-FICO score and a loan to value of 65% – you decide to refinance your loan and take out some cash to 80% LTV with a low 2 year teaser rate ARM. (This describes a huge portion of America.)
- Now you receive notice that in 45 days your home loan is going to adjust by up to 5% points in interest rate – catapulting your payments in to the stratosphere.
- You go to refinance to find that your home value has declined $30,000 and your credit has remained about the same – 570. The LTV of a new loan is now above 85%.
- The new underwriting guidelines at 85% LTV loans make the interest rate 3.5% – 4% higher than your current 2 year teaser loan.
- You are either (1) unable to qualify at the higher payment because your income is inadequate for underwriting requirements or (2) looking at a big lifestyle change to simply remain in your home.
Now – let’s say that you are the savvy homeowner and realize how important your credit score is to procuring a loan (to say it’s very important is a ludicrous understatement). Let’s look at that scenario again:
- In 2005 you have a 570 mid-FICO score and a loan to value of 65% – you
decide to refinance your loan and take out some cash to 80% LTV with a
low 2 year teaser rate ARM. (This describes a huge portion of America.)
- 12 months in to the loan you read and learn about tighter underwriting guidelines and decide that you need to improve your 570 mid-FICO score. You contact a mortgage professional, CPA or financial planner and inquire about your current score.
- You also ask them to run some simulations about possible score improvements by either (1) cleaning up your credit report (2) paying down balances (3) opening new credit lines or (4) a combination of all of the above.
- You determine that with $2,000 you can pay down two credit cards to below 50 percent utilization; remove an old collection and remove a delinquent authorized signer account from your report.
- The simulation tells you that by taking those actions you will improve your scores 30 points to 600.
A 30 point jump makes a huge difference when determining what the interest rate on your loan will be. It could mean more than a full point off of your interest rate at 570. It could also mean that you qualify for more loan options such as an interest only loan, or a 40-year loan which may allow you to keep your home payments in line with your income.
By simply acting with enough time and understanding how you can improve your credit score you’ve saved yourself from running in to the situation that so many Americans are facing right now – dealing with exploding ARMs with out any options except foreclosure.
Work hard on your credit early – 12 months worth of work (or heck even 4 or 6 months) can mean worlds of difference in your housing situation when your ARM adjusts. It can literally mean having your home or losing it.
If you’d like to know more about how your credit score works and would like to review possible credit improvement options, feel free to contact me for a free booklet on managing your credit.
This could be the single most important thing you do before your home loan adjusts.