Borrowers qualifying for mortgages today are paying for the excesses of yesterday. During the go-go years leading to the crisis, underwriting rules became incredibly lax, and now they are excessively restrictive. Mortgage underwriting rules have become increasingly detailed and rigid, with much less room for the discretionary judgment of underwriters.
To help borrowers deal with this problem, I am developing a program for my website that will show potential borrowers whether they qualify, the type of mortgage for which they qualify if they do, and exactly where they fall short if they don’t.
But people using the program who do not qualify invariably ask what they can do about it? To confront this question, with help from Jack Pritchard, I have developed a set of qualification repair articles, focusing on the major areas that may need repair: down payment, income and credit score. The underlying theme is that committed borrowers can repair their own credentials. This is the first of three.
What is the down payment?
On home purchases: The down payment is the difference between the sale price and the loan amount, provided that the property appraisal comes in at or above the sales price. If the appraisal is lower, the down payment in dollars is higher.
For example, the sale price is $100,000 and the required down payment is 20 percent. If the appraisal is $100,000 or more, the down payment is $20,000. But if the appraisal comes in at $90,000, the down payment is 20 percent of $90,000 plus $10,000, or $28,000.
On refinances: The equity requirement on a refinance is the counterpart to the down payment requirement on a purchase. The equity requirement is the property value less the existing loan balance as a percent of the property value. The lender will require an appraisal that establishes the value of the property.
Other cash requirements
Settlement costs: While the down payment typically is the largest component of the cash you will need, other settlement costs have to be paid as well. Unlike the down payment, settlement costs do not protect the lender, who is generally amenable to having them paid by third parties. One such party is the lender himself, who will pay settlement costs in exchange for a higher interest rate. The second such party is the house seller who will pay settlement costs in exchange for a higher sale price.
Monthly payment reserve: The requirement that you have cash sufficient to fund the payment for some specified number of months is not a settlement cost because you don’t pay it to anyone. You need only to demonstrate you have it. The requirement can be met with bank deposits, money market funds, and less liquid assets that may be discounted. For example, 401(k) funds and IRA accounts are discounted 40 percent.
Possible sources of self-help
Savings: Accumulating the cash needed to buy a house by saving it out of income is the traditional way to do it. Developing a savings program, however, is a long-term repair, as opposed to something you can do to qualify now. The upside is that it is entirely in your control, and it is the only option available to those without retirement accounts, securities or helpful friends and family.
Many would-be homeowners lack the discipline required to save for a down payment. The temptations of our society, including credit cards that make it easy to spend, make it difficult to save. On the other hand, Internet-based tools are available that make it easier. One that I like is at www.money-school.net/workbook.pdf.
401(k) funds: While 401(k) plans are designed to fund retirement, the rules allow a withdrawal to fund a down payment in connection with the purchase of the fund-holder’s primary residence. Purchasers using this source are better off borrowing against the account rather than withdrawing funds.
Securities: Homebuyers who own securities can pledge them with an investment bank in place of a down payment, borrowing the full amount of the purchase price.
Possible sources of help from those near and dear
Gift of equity: Some home purchasers buy houses from family or close friends for less than the market value, with the difference comprising a “gift of equity.” If done correctly, the transaction can meet the lender’s down payment requirement and avoid gift taxes.
Cash gifts: Home purchasers can also use cash gifts for all or part of their down payment, but the gifts must be bona fide, meaning that there can be no repayment obligation.
Increasing equity in a refinance
If you don’t have enough equity to qualify for a rate-reduction refinance, or even if you qualify but want a better price, you can increase your equity by paying down the loan balance. Of course, you must have the cash to invest.
Jack Guttentag is a professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.