By Dennis Martin, Littleton Colorado Real Estate, and Kerry Phillips
(Dennis: ” I have known Kerry Phillips for over 30 years. He has been a leader in the mortgage business and and always a straight shooter. I appreciate his candor and helping me with this article)
Bill and Sue are sharing a cup of coffee and looking around their cramped and dingy apartment and wonder if they will ever be able to buy a home. They have saved a little money for a down payment. They have paid the current bills on time, and they can afford payments that are a little higher than their rent. They would love to take advantage of some of the incredible values that are on the market right now.
But, as they read the paper and watch the news, all they hear about is how the credit markets have dried up, and how there is no money available to borrow. They marvel at how bad their timing has turned out.
So, is that really the true story? No! There is all the mortgage money available that is needed. But then, what about the credit crisis we keep hearing about? While real in some sense in other ways it is all a bunch of hog wash.
So, I am here to tell you the truth and that is you will need to look back to see the future of mortgage lending. Many of you reading this are too young to know what the real estate/mortgage finance business was like a few years back, so let me give you a little background. I began my mortgage career in 1978. Throughout the 70’s and 80’s there were two basic types of mortgages. Conventional Fixed rates, and Government (FHA and VA) fixed rates. Yes, Adjustable Rate Mortgages were introduced in the mid 80’s, but the percentage of mortgages made in ARM type financing was negligible.
So, there is the first truth. The future (next 10 years) of mortgage lending will be dominated by Conventional Fixed, and FHA/VA fixed rate loans. Why not Adjustable rate mortgages you ask? Statistics show that ARM loans default at an exponentially higher rate than fixed rate loans do. And, that is true even on prime loans, not just sub-prime loans. Almost 50% of all sub-prime ARM financing loans are currently delinquent. According to the Mortgage Bankers Association, Prime ARM loans are running around 17% delinquent, which is three times the current rate of Fixed rate delinquency. If the delinquency rate is too high, the people who invest in mortgages are not going to provide the money for the loans.
In other words, the future is that you will only be able to obtain a traditional mortgage in the future.
Here is the second truth that brings the past back to the future: As an industry we used a certain set of criteria when deciding if a borrower was credit worthy, and therefore to determine the risk of the loan going into default. We had the same basic set of criteria from the day I entered the industry until the mid 90’s. As the baby boomers quit booming, the amount of qualified borrowers began to shrink. Our industry is dependent on new borrowers coming in and buying a starter home so that the current owner of the started home could buy a move up home, and so on up the ladder. The pool of first time home buyers had shrunk dramatically over the past 10 years or so. As a result, in order to find new borrowers to: 1. Buy a home, and 2. Get a mortgage; we relaxed our credit criteria.
The long and short of it is that we started making loans to people who really could not qualify for, nor afford to buy the home they wanted to buy. The truth’s behind how that really happened is a whole different blog. But, the bottom line is that mortgage lenders are now only making loans to borrowers who fit more traditional models of qualifying for loans.
Here is the second truth. It is your obligation to prove to the lender that you can afford, and quality for the loan you want (what a concept). As mentioned earlier, the mortgage industry had used a set of underwriting guidelines that served the industry and borrowers really well for about 60 years. Clearly there were a few modifications over the years, but the basic principals did not change. Now, I am sure you are scratching your head right now wondering what those principals were. That is why I am writing this, and that is to share that information with you.
First, you needed a down payment. On the purchase of a new home for an owner occupant, the biggest criteria in determining whether a loan will repay on a timely basis or default is based on how much of a down payment the borrower made. To use an expression that is popular right now, it is how much skin you have in the game that makes the biggest difference. What we found back then is that the bigger down payment the borrower made, the less chance that they would walk away from that investment.
And, no, your daddy giving you a gift for the down payment is not the same as someone who found a way to save a few pennies on their own every month, and waited until they had a small nest egg and then used that money for a down payment. The future will look the same. You will need to make an investment in your home in order to obtain a mortgage.
Secondly, you needed to have demonstrated the ability to manage your finances. What in the world does that mean, you ask? The first piece of that answer is that you have paid all of your bills on time. But it is not only paying your bills on time, it goes deeper than that. It also encompasses what you have borrowed money for, from whom you borrowed it and how much you have borrowed. Contrary to what Maxine Waters thinks, who you borrow money from is an indicator on your ability to manage your finances. As an example, people borrow from Finance Companies typically only because they cannot borrow from a bank. Think higher risk. Another consideration on managing your finances is what is the status of your revolving credit balances. Sure, you can afford the minimum payments, but are those credit lines also tapped out, or is there still credit available? You might think that if a credit card is charged to the max, you won’t be able to borrow anymore, so your risk goes down. Wrong. A responsible use of credit is that you may have some outstanding balances, but you have at least 50% of the credit line still available to you.
Not to be overly redundant, but managing your finances also means saving money. Think of it this way. If you are paying $1,000 per month in rent now, but have no savings, how do you expect that you will be able to pay the $1,400 per month it will cost to have a mortgage payment? Not to mention having a cushion available for unplanned expenses. There is a story of a person who was a life long renter, and they bought a house two years ago. Not too long after they moved in their water heater went out. They called their mortgage company asking them to send the super our to fix the water heater. They were completely surprised to learn that they were responsible for fixing their own heater. In the past (and now in your future) you will have had to be ready for these normal home ownership expenses.
Finally, the person buying the home and borrowing the money had to be able to afford the payments. This is probably the area that the most recent chapter of mortgage lending strayed the farthest away from. Prior to the 1990’s every borrower had to document their income in an acceptable fashion, and be able to prove that they could “qualify” for the payments. There are many components to documenting income and qualifying, so I will attempt to simplify them.
First are the documentation requirements. Standard underwriting for an employed, non-commissioned, non-bonused, W-2 type employee requires the past two years W-2 form along with your most recent one months worth of paycheck stubs. If your income includes a substantial portion (greater than 25%) of your income coming from commissions or bonuses, you will need to provide copies of your complete tax returns for the past two years. If you are self -employed, you will need not only the past two years tax returns, but a YTD Profit and Loss statement as well. The interesting part of the P&L is that no one will count the income shown on it, but you still have to provide it. Don’t ask, it is just one of those dumb rules.
There are two critical factors to remember on how we will review your income. First, we will only count income that is likely to continue for at least three years. As an example, if you are receiving child support, but your child is 17, we will not most likely not count the child support, as in most cases it will end when your child reaches age 19. But, if the child is 12, we will allow the income as usable. The second criteria naturally follows, and that is we will only use income that we can see a track record on the borrower receiving. So, using the same example above, if you have been awarded $600 per month in child support for your 12 year old child, but you can only document that you receive $300 per month from the deadbeat ex, we can only use the $300 as effective qualifying. The same concept would be similarly true for someone changing jobs. If your old job was straight salary, but you took a new job because you were going to get a bonus on top of the salary, we cannot count the bonus until you have received it for two years. Simply, you have to have a history of earning the income you are earning, and you have to have the expectation that the same income will continue.
This topic is way too complicated to cover in a brief expose, but suffice it to say that the future of mortgage lending will look more like the 80’s than the 90’s or what we did around the turn of the century. You will have to be able to document that you indeed make money, and that your income sources are likely to continue.
But, you say, wait! I am self employed and I write everything off that I can so I don’t pay as much in taxes. My net income won’t be enough to qualify. Sorry…. What we have found is that unless you can demonstrate real earnings via verifiable tax returns, you are not likely to make your payments on time. Besides, we would never think that someone might actually overstate their expenses on their tax returns (wink, wink), so we only count what we see on paper.
Here are the important concepts I would like you to take away from this article. First there is all the mortgage money you need, you just need to qualify. Second, in qualifying for a loan, what you have done in the past is what we will assume you will do in the future. Have you paid your bills on time? Have you saved some money? Have you been on your job, and can we count on your income? Great, you will do fine. Third, none of these qualifying factors are mutually exclusive. There are people who are barely on the positive side of all the factors, but are not really very strong on any of them.. Are they good borrowers? Maybe, but maybe not. Any one of the factors could kick you out all by itself, but it will take a combination of positive attributes to allow you qualify.
One last thought. I had someone recently ask me when I thought that stated income, and no down payment loans would come back so people could afford to buy houses again. My answer is basically not in what remains of my mortgage career, which will probably be 12-15 more years. The people who invest in mortgages have long memories, and they are not likely to provide money for speculative mortgages any time in the foreseeable future.
What does this mean as far as the real estate future goes? Will fewer borrowers be able to obtain a mortgage in 2009 than did in 2005? Absolutely. But, with fewer borrowers qualifying, there will be fewer buyers bidding on the property that you want to buy. That is good for buyers. It will then ultimately be better for sellers too, since the more borrowers that qualify will mean fewer loans that go delinquent, and there will be few foreclosures on the market competing for the few true borrowers. But, once we work through this current crisis, values should start going slowly back up. Will there be a huge pent up demand with rapid price appreciation? Probably not anytime soon. With the end of the baby boom, there just is not enough new first time home buyers to create a sustainable rush of potential. That will be the time that houses quit being an investment, and go back to being a home. As I said, look back to see the future.