In recent years, mortgages have been in the news constantly. Especially high risk home loans for people with poor credit, called sub-prime mortgages, have figured prominently in news about the recent housing market crisis. Now more than ever, it is important to understand how the mortgage industry works before applying for a home loan, especially true for the more than one third of Americans who have a bad credit rating.
While it is now more difficult to get a high risk mortgage when you have bad credit, it is not impossible. With an unsure economy and many people moving, changing jobs and downsizing, the housing market and mortgage credit industry have felt the pain of economic downturn just like every other major market. One of the ways to make a turn-around and get their business back on the mend is to bring in clients and make more loans.
High Risk Loans
A high risk mortgage is a loan to borrowers who are considered having a riskier than average chance of not following through on the terms of their mortgage loan. These potential borrowers have low credit ratings, which leads to difficulties, if not the absolute impossibility, of being able to find conventional mortgages. High risk mortgages are harder to find and more difficult to get, and generally charge much higher interest rates than conventional loans to compensate for the higher risk they are accepting.
In order to justify the risk of loaning money to high risk borrowers, mortgage companies must charge higher interest rates for these loans. These lenders consider many factors to determine the terms and rates of a high risk mortgage, and this process is called risk-based pricing. The most important determination of risk-based pricing is the borrower’s credit score. This determines how high the interest rate of the loan will be set. Other considerations include the types of delinquencies reported on the credit report and the borrower’s debt to income ratio.
High risk mortgage loans are more likely to have a balloon payment penalty, pre-payment penalty, or penalties for both. A pre-payment penalty is a charge or fee that the homebuyer must pay for paying the loan before the end of the original term. Borrowers normally pay a loan off early when they sell the home or refinance their mortgage. A loan that includes a balloon payment means that the borrower will have to pay off the entire remaining balance in one lump sum after specified period of time as elapsed. The normal balloon payment period is five years. If the borrower is unable to pay off the entire balloon payment, or balance of the loan, the must refinance, sell their home, or lose it to the bank.
Steps to Take Before Looking for a High Risk Mortgage Loan
Since the interest rate of a high risk mortgage is based mainly upon the credit score of the borrower, one of the most important things a borrower can do to prepare to apply for loans is to get a copy of their credit report to review and correct if needed..
Lenders request credit histories from a variety of credit bureaus, which allows the lender to make a more informed decision regarding loan qualifications. This credit report includes the applicant’s credit score, also known as the FICO score. Frequently used credit bureaus are Experiean, Equifax and TransUnion. The FICO score represents the statistical summary of all data contained in that credit report, including bill payment history and the ratio of outstanding debts to the borrower’s income.
Reviewing Credit Report
Credit scores range from 350 (worst) to 950 (best). The higher the credit score, the easier it is to obtain a mortgage loan. The lower the credit score, the more risk the lender assumes they will be taking when loaning money, and the higher the interest rates will be to compensate for this risk. Careful scrutinization of the credit report can find errors and point to ways to raise the credit score of a borrower, so this is an important first step in the mortgage process.
Improving Credit Score
When reviewing credit reports for errors, special attention should be paid to every transaction. Each entry affects the credit score. Removing even one erroneous bad credit entry can raise a credit score several points. When errors are found, each credit bureau has different procedures for correcting these errors.
A borrower can also improve their chances of obtaining a lower interest loan by reducing their debt to income ratio. This ratio is determined by creating a ratio of total monthly debt (minus household utilities) divided by the total gross monthly income. A figure about 35% is far too high to justify the risk of a mortgage loan. An ideal score would be around 26%. The debt to income ratio can be lowered by paying and closing low limit credit cards before applying for mortgage loans.
Another way to improve the chance of qualifying for a mortgage loan and getting the lowest rate possible is by lowering credit scores in general. Paying bills on time, especially mortgage or rent payments can quickly bring up credit scores by several points. Keeping balances low on credit cards, and avoiding approaching credit limits can also dramatically raise credit scores. Closing unused credit cards can be helpful in raising scores as well.
Taking the time needed to improve the credit rating can save a borrower thousands of dollars in interest rates over time, and make monthly payments much more affordable. The simple act of paying bills on time, paying off delinquent accounts and improving the dept to income ratio can easily raise a credit score and put the borrower in a better position when approaching mortgage lenders.
Finding Appropriate Lenders
Applying to several mortgage lenders who each check a borrower’s credit history can itself have a negative effect on their credit rating Before applying, borrowers should choose a few lenders to apply with, and do their homework before meeting with them.. Being aware of credit rates will help to understand the type of loan to be looking for, usually a high-risk (formerly sub-prime) loan.
When looking for a high-risk lender, there are many things a borrower should be considering. A home mortgage loan will likely be the largest and most important financial commitment ever made. A borrower who is looking for a high risk lender often settles for the first lender to offer them a deal, without considering whether that deal is the best one for their situation. Any mortgage borrower should be very particular about whom they choose to finance their home loan, regardless of their credit rating.
A reputable mortgage lender will offer the best rates and terms for the situation of the borrower. To be certain they are receiving the best deal available, borrowers must compare rates and terms with other lenders. This can usually be done online, and is an important step in considering the merits of an offer from a lender. Rather than quickly and thoughtlessly signing with the first lender to offer a deal, consumers should be cautious and particular when it comes to choosing a mortgage lender.
Borrowers should be certain they understand all fees and rates associated with their loan proposal, and should never be afraid to ask for clarification. A good mortgage lender will be happy to take the time to explain terms, rates, fees and contracts until their client, the borrower, is clear and understands them all.
Having a clear understanding of how mortgage lenders determine risk can help borrowers best prepare themselves for taking the step of applying for a mortgage. High risk mortgages are more costly and difficult to obtain, but they are available and should be considered carefully, just like traditional mortgages. Due to their already difficult financial situations, high risk borrowers are often in a position to be taken advantage of and should take care to be as informed and prepared as possible before applying for or accepting a high risk mortgage loan. By taking simple steps, such as raising credit scores, lowering debt to income ratios and researching expected interest rates and terms, borrowers can arm themselves with knowledge and access to the best rates and terms available to them. High risk borrowers may be a gamble, but those willing and able to pay the higher mortgage rates and payments required for them to buy a home should be able to find a suitable offer from a reputable, trustworthy mortgage lender.
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