Consumer Comeback Blog

Can Good Credit Leave You Homeless?

Forecasters are finally declaring that the housing market has “turned the corner,” as recent data indicates that average home values will increase in the near future. Second quarter reports from Zillow’s show a 2.1% increase from the first quarter of this year. From June 2011 to June 2012, home values rose by an average of 0.2%, the first yearly increase in five years.

It’s a positive trend for sellers, but competition is increasing for buyers, who need every edge to land the home of their dreams. In June, the Los Angeles Times reported that reduced inventory had created a frenzy among many buyers who have incentive to act now because of low interest rates and inexpensive home prices. At the same time, investors have entered the market with the purpose of turning homes owned by banks into rentals, and home building is at its slowest since the Census Bureau began recording data almost four decades ago.

The LA Times article quoted Coldwell Banker agent Frank Casarez, who summarized the current market. “There is such a high buyer demand,” Casarez said. “Even with the economy the way that it is, with job losses, there are quite a few people who thrive on this setting, who have been saving for a long time and have been saving to get a deal on the property.”

Good Credit? Not Good Enough

Buyers who are entering the housing market with no or bad credit may be discouraged about their chances. Stricter credit requirements for mortgage qualification have been a reality of the recent environment. Morgan Stanley recently released a report that shows the average credit score for a consumer getting a mortgage is 762. A majority of Americans, 65%, have a credit score below 750, meaning the average American with a respectable credit history may not qualify for a mortgage. According to Experian, a leading credit report company, “a score above 700 usually suggests good credit management.”

“Basically, access to credit for borrowers with less than spotless credit is severely limited,” the Morgan Stanley report states. This is due in part to regulations put in place by the government in response to the housing meltdown that began late last decade. Lenders have taken on the burden of mortgage defaults, which, combined with the presence of an unstable labor market, has led them to compensate by reducing risk.

Even loans provided by the Federal Housing Administration, which are geared toward prospective buyers with low income or less-than-stellar credit, have become more difficult to secure. A study from the technology firm Ellie Mae Inc. that was released last February indicates that successful applicants had an average credit score of 701, a departure from the FHA’s usual standards.

The occasional recent study has shown that fewer homes have been foreclosed upon because of mortgage default. Some hypothesize that it’s due to the influx of better qualified borrowers, some point to an overall economic rebound, and some attribute it to the increase in short sales, an increasingly common alternative to foreclosures. The long-term outcome of more stringent mortgage requirements is unclear, though. Only buyers with good credit can report any sort of definite impact from the change, and, for them, it has been for the worse.

What Do Lenders Consider?

Long gone are the days when buyers could easily secure a mortgage with average credit. Banks are scrutinizing mortgage applications more closely, and even the most seemingly insignificant flaw on buyer’s financial resume can disqualify them from consideration.

Typically, lenders examine several factors that determine whether or not a buyer is worthy, including credit score, debt-to-income ratio, loan-to-value (LTV) ratio, income and assets, employment history, and property appraisal. Obviously, a perfect credit history foreshadows a perfect relationship with the lender in which the buyer never misses a payment, increasing the buyers’ chances of covering the entirety of the loan in a timely manner.

Weak credit – or what’s deemed weak credit in the eyes of the lender – can affect the interest rate, the down payment amount, and the amount borrowed in relation to income. Because credit is such a significant factor in the lending process, it’s essential that the buyer checks their credit report for errors, which can harm their financial profile. Common credit report errors occur, according to FICO, because reports are incomplete – the person who applied for credit used a slightly different name, a clerical mistake was made while recording a name or address, an inaccurate Social Security number was recorded, or loan or credit card payments were applied to the wrong account.

Wells Fargo, the largest U.S. home lender, states that “lenders prefer that the proportion of your combined debt and housing expense be no more than 36% (28% for housing and 8% for debt) of your monthly pre-tax income.” More debt makes a buyer a riskier proposition. The other ratio, loan-to-value, is calculated by measuring the amount of the loan versus the value of the property, determining the amount of equity in a home. Those who borrow with less than 20% equity are often asked to buy private mortgage insurance to protect the lender.

A lengthy and stable income history, an attribute that’s becoming rarer, benefits the buyer. Generally speaking, two consecutive years with a current employer is viewed favorably by the lender. Of course, appraisal of the property is necessary to ensure the market value corresponds with the loan amount.

Fittingly, rental history is another aspect that enters into the equation. Last year, Experian added rent payment as a component in its credit reports after the acquisition of Rent Bureau. FICO and CareLogic plan to follow suit. Previously, negative rent payments were reflected on the report, but consistent, on-time payments were not. Brannan Johnston, the managing director of Experian’s rent bureau, told The New York Times that half of higher-risk consumers saw a 100-point increase in their scores. Now those on-time payments can help build credit for potential first-time buyers.

Compensating for Bad Credit

Although buyers’ chances of securing a mortgage are limited at the moment, they can take steps to enhance their buying profile. Some agencies allow buyers to compensate for an unsatisfactory credit score by accepting a larger down payment or verifying a large reserve of cash. Increased down payments, however, are already a reality of the current environment, so if buyers find themselves in a position to secure a mortgage with an increased down payment, they may be required to drop a substantial sum. Covering a down payment and closing costs is usually the most difficult aspect of purchasing a house, as few people have the money saved to do it all.

Based on the criteria considered by lenders, buyers can figure out which positive attributes of their financial profile to boast to lenders. Assets such as the cash value of a life insurance policy or well-established retirement accounts are signs of financial responsibility. A job that has been maintained for several years, one in which the buyer has received a steady increase in pay and bonuses, shows that they would be able to cover extra, unforeseen expenditures. Proof that the buyer has made important payments on time over several years may help as well. But buying the perfect home may require waiting longer while savings accumulate and the market changes. In the current environment patience and persistence are virtues.