You're Killing Me Here Ramsey

I recently talked to a young couple that is considering buying a home this summer.  As I reviewed their information, I saw that they were remarkably well prepared for the step.  Both had stable employment, their monthly bills were negligible, they had great credit scores and the savings for a 20% down payment.  With buyers like that, most lenders would just do a happy dance and hand over a pre-approval letter.

I'm not most lenders though.  To protect them from unpleasant surprises, I reviewed their credit report more deeply and saw a problem lurking in their future.  They had been diligently following Dave Ramsey's Financial Peace process and, over the previous several months, had paid off and closed all debt under the husband's name. While the wife had a couple of credit cards still open, the husband had closed his last trade-line in December.  

So why does this matter, you ask?  Good question, and one I had to answer for this sharp young couple as well.  Let's take a minute to talk about how trade line's impact credit scores.

The 6 Month Rule

Mortgage lenders use the FICO model to pull credit scores for potential home buyers.  This FICO model gives the buyer a score based on several factors, such as balances, length of credit history, and historical late payments.  The lender uses that score to gauge the type of credit risk they are taking with that client.  

One key thing that many people don't know about credit scores is that FICO won't give a score to a person unless they have recent, active credit items.  You could have had all the credit history in the world two years ago, but if you've paid it all off and closed it down, your score goes away with it.

So what is considered recent?  Six Months.  The current FICO scoring model requires that you have one undisputed account that has been reported to the credit bureau within the past six months or you will not have a credit score.

When You Need A Score

This raises the question then, do you actually have to have a score?  Not always.  For a conventional mortgage loan, you do need a credit score.  FHA financing will allow a buyer to get a mortgage based on a 'non-traditionial' credit report though.  A non-traditional report can be created for a lender by verifying things that aren't normally reported to the credit bureau, like rent payments, car insurance payments, utility bills, etc.  If a buyer has a 12+ month history of several of these types of items and they've paid them on time, they could likely qualify for a FHA loan even without a traditional credit score.

FHA's Downfall With Ramsey

Even though a FHA mortgage would fit with a Ramsey lifestyle, David Ramsey would never encourage a FHA loan for one primary reason - mortgage insurance.  While Ramsey's preference is that people save up enough money to pay cash for their home, he has said that he can understand getting a mortgage sometimes.  His rule is that you get a 15 year term though and put at least 20% down to avoid mortgage insurance (MI).

With the changes to FHA's mortgage insurance taking effect later this year, all FHA loans will have monthly mortgage insurance.  It won't matter if you take a 15 year term or if you put 20% (or 50%, 60% or even 90%) down.  All FHA loans will have monthly MI for at least 11 years.  If the borrower puts down less than 10%, the monthly MI will stick for the life of the loan.  Seeing Ramsey hates MI, he'd very likely disapprove of this option.

Final Advice To My Buyer

So where does this leave my clients?  I personally dislike debt and wouldn't encourage a buyer to rack debt up just for a credit score.  This buyer's score is going to disappear in June, though, if he doesn't take some action.  Seeing he doesn't have enough saved yet to pay cash for the home and FHA is not a good choice, he'd be wise to take some minor steps to keep his score intact.

The easiest thing would be to add himself to his wife's credit cards.  They already exist so there is no 'new' debt being incurred.  If those cards are gone now too, though, then he will want to take the further step to open something new in his name to keep his score in place.

The key word here is OPEN.  Not use.  Not carry a balance.  Simply opening a credit card and, at least once every 6 months, doing something with it that would make the credit card company report the activity, should keep his score intact.  It can be a $1 charge for a pack of gum that he pays off as soon as the bill arrives.  Truly - carrying debt balances is not needed for this.  Taking this step will help this home buyer stay true to the heart of the Ramsey principles while giving him the credit score that leads to better mortgage options when the time comes to buy his home.

Is Conventional Better For Your FHA Buyer?

The deadline is in sight for the increase in FHA’s monthly mortgage insurance.  Any buyer trying to avoid the higher monthly premium should be in contract this week to get a case number assigned by the April 1^st change date.

Not all buyers will find their home this week though, and FHA is not necessarily the best option even if they do.  Many FHA approved buyers would actually be better offer using a 3% down conventional mortgage.

Wait – Buyers can use conventional financing with only 3% down?
Yes, they can.

Will it cost them more?
More than what?  More than a conventional loan with a larger down payment?  Yes, it will cost them more than that.  Depending on the market, the interest may be a touch higher (currently 0.125% more).  The monthly PMI will also be a bit more per month. 

But more than FHA financing?  Typically not.  The annual cost for PMI for a 3% down conventional buyer with a 740 credit score is over 0.5% less per year than for the same FHA buyer. 

So how do they compare side to side?

You want math?  Yea!  I love math.  Let’s compare some numbers: 

 In this chart, I'm assuming that your borrower is buying a $120,000 home with taxes of $1,200 per year and home insurance costs of $720 per year.  I'm also assuming that your borrower would qualify for a conventional loan with a credit score of 740 or higher. 

As you can see, with the conventional 3% down option the loan size, cash needed and monthly payment amount are all lower than the FHA option.  For the borrower who can scratch together the additional $1,800 in down payment money, the savings goes up even more.

What are the drawbacks of the 3% down conventional?

The biggest drawback of it is the impact of credit score.  The example above assumes strong credit.  If the credit score was 684 instead of 740, the interest rate would be 0.125% higher currently and the PMI would cost $12 more per month for the 3% conventional option, making the total 3% down conventional payment $5 higher per month than the FHA payment.  The cash needed would still be lower though, as would the loan size, so the conventional option is still the best choice.

Aren’t there additional drawbacks with conventional options?
There were in the last several years, but those are quickly fading as the PMI companies begin to get their flexibility back. 

Up until just a few months ago, most PMI companies were placing additional rules on the conventional buyer, including that that had to have 2 months of savings left after closing and a certain number of trade lines on their credit report.  The market is getting competitive again, though, and the PMI companies are responding by loosening these rules.  Currently, two of the four top PMI companies have removed these additional requirements, making it much easier to get approved for a conventional loan.

So what is this telling me?

Bottom line, not only COULD your FHA buyer likely go conventional, your FHA buyer SHOULD likely go conventional.  Many lenders won’t tell them about the 3% down option though, either because they aren’t aware of it or because they haven’t used it much and they’re not comfortable with it. 

Your buyer deserves to be working with a lender who will share with them the best options for them.  It’s your job to make sure that they are.  Feel free to forward this to anyone considering FHA financing for their home purchase along with my contact information (Lori Hiscock - lori.hiscock@ruoff.com) and I'll gladly help them compare their options to make sure they're getting the best terms possible for their home financing.

30% Credit Declines - YIKES

Last Friday, I took an off-site planning day to work on some of the proactive things that make business and life better.  One of my goals was to conduct a thorough review of the referrals I received in 2012 to see where my business is coming from and where it’s going.

I’ve gotta say - the ‘where it’s going’ part was surprising.  I hadn’t realized it, but 30% of the buyers who were referred to me last year were not able to get a mortgage due to credit issues. 

WOW.  30%.  Clearly credit challenges are a bigger roadblock than I’d realized.  Given that, you're going to see more of a focus on credit scoring and credit repair in my educational efforts. 

My YouTube channel now has a playlist dedicated entirely to those topics: Credit Scoring & Credit Repair.  It contains two videos added today that talk about the first steps of credit repair - Knowing Your Rights and Filing a Dispute.  More will come as I continue researching this topic and carving out time to record what I’ve learned. 

For now, feel free to enjoy the first video in the Credit Repair series and – better yet – feel free to share it!  It’s becoming clearer to me that many, many people in our community need this information.