Have you ever loaned anyone money? You might have asked them if they could afford to make payments, and then set up a payment schedule until the loan was paid in full. When you apply for a mortgage loan, the lender does the same thing. The lender is loaning you a very large sum of money and wants to make sure you’re going to pay it back. Lenders can’t just give a loan to anyone; they have to do a little investigating into a borrower’s background to make sure they’re taking a safe risk.

All the previous years of paying your bills (whether on time or late) and running up your credit cards or paying them off every month in full determine whether you get approved for a mortgage now. Past mistakes may come back to haunt you—those bills you paid late when you were fresh out of college could cause the lender to say no to you. Maybe those late bills are so long ago, though, that the lender will overlook it—but you could still be considered a credit risk and offered a higher interest rate.

It’s best to find out your credit score early in your house-hunting process so you know where you stand. This chapter helps you decipher all the details in your credit report and how to correct any mistakes beforeyou apply for a loan.

Most lenders won’t loan you the entire cost for your home, either. They expect you to come up with a portion of the cost. Depending on what mortgage loan you are applying for, you may have to come up with a down payment of as little as 3 percent or as much as 20 percent of the cost of the loan. This chapter helps you figure out how to get that down payment together. This will become even more common going forward as banks are returning to the prudent lending standards of several years ago. As this “return to basics” becomes the standard, it will be the rule rather than the exception for lenders to frequently require 10 to 20 percent of the purchase as buyer’s equity. Only government-guaranteed loans, such as FHA and VA loans, will remain with equity levels permitted as low as 3 percent and nothing down, respectively.

Your credit history helps the lender decide whether you will be a good or bad risk with their money. It lets the lender see how you’ve honored your debts and your obligations to repay them. Have you paid in full and on time? Or have you missed payments—one month here, three months there? Years ago, if you filled out a mortgage application, you would also fill out a credit application and list your debts, including your car payment, house payment, credit card accounts, and other bills. Today the credit application process takes place mostly via Internet and database maintained by the credit reporting companies. It includes the following information:

Your credit history is so important in the mortgage application process that even former landlords are likely to be contacted to see if you paid your rent as agreed. Your lender assembles all this information and makes a final decision about your loan.

An important part of your credit history is your credit score, which ranges from 300 (poor) to 850 (excellent), although it is highly unlikely for an individual to actually score at either end of that axis. Developed by the California-based Fair Isaac Company, these scores are called FICO scores.

Your credit score not only tells your lender whether you’re capable of paying back the loan, but also helps determine the interest rate of the loan. In general, the better your credit score, the lower your interest rate. Scores of 720 and up are superior credit scores and generate what industry sources refer to as A Paper, to denote the highest quality of the loan. A score between 680 and 720 is considered “excellent” and is well regarded. You will likely get a loan on excellent terms as far as interest and fees are concerned.

A score between 620 and 679 is still acceptable to most lenders, but the interest rate and terms offered won’t be as good as if your score were higher. Lending industry members refer to the quality of loans in this score group as B Paper. This category is also referred to as subprime.

Mortgage loans are frequently resold to other lenders in what is called the secondary market. This frees up new lendable funds for the lenders who made those loans, so they can make new loans. Historically, what have come to be called subprime loans were very difficult to resell in the secondary market. However, as the demand from borrowers for such loans exploded in the early part of this decade, more of them were made and, due to their higher rates of return, more secondary market institutions were willing to purchase them from the originating institution. Ultimately, Wall Street investment banks expanded this reselling by securitizing them—packaging many loans together and selling individual shares in the package to investors as if they were stocks or bonds. This was fine until prices suddenly dropped and the homes backing these mortgages were worth less than the loans themselves.

If your credit score comes in between 580 and 619, your options become more limited. Perhaps you missed a few payments on a loan or overextended yourself on your credit card. In that case, you are considered a higher credit risk; although some banks will approve you for a loan, others may not. Your loan fees, broker fees, and interest rates will be higher than they would be if your score were at least in the mid-600s. This is known as a C Paper loan, although this term is used less frequently because these loans become harder to obtain at all. C Paper loans are also referred to as subprime. You can get a mortgage, but it might be a little difficult. If you’ve gotten your finances in order and can afford the payments, take advantage when you get the opportunity.

If your score is 500 to 579, this is considered a poor risk for credit. Unfortunately, almost no lender will extend you a mortgage loan. If you do happen to find one, it will likely be the only one offered to you, and its high fees and interest rate will curl your hair. If you’re able to handle your monthly mortgage payments, home ownership provides you with an opportunity to not only buy your home, but also improve your FICO score. As a result, the next time you decide to finance, or refinance, you may have an easier time of it—depending, of course, on the rest of your payment abilities.

Most loans made to FICOs under 620 are from the part of the lending market referred to as “hard money” lenders. Don’t misunderstand the term. We’re not talking about loan sharks who would break your legs for missing a payment. Hard money lenders are those mentioned in the last paragraph whose rates reflect the lower-quality credit and, accordingly, charge much higher interest rates and fees. Also, their loan limits are usually much more restrictive. You likely won’t be able to borrow more than 50 percent of the cost of the home in this situation.

If your FICO score is under 500, your credit is very poor. Will no lenders take a chance on you? Never say never, but if you can find a lender willing to approve you for a loan when your score is this low, the terms will probably be positively crushing to you and your monthly budget. The best advice for this situation is to forego the home purchase for now, work at fixing your credit in the meantime, and try again in a year or two.

If you’re trying hard to get a handle on your finances, kudos to you. Some people do this by seeking debt counseling and cutting up credit cards. This is a step in the somewhat-right direction. However, both of these steps, while admirable, come with serious consequences that could affect your ability to buy a home. Interestingly, consulting a credit counseling service to help resolve your debt problems might seem like a responsible way of improving your situation, but it can backfire on you. Here’s why: when you sign up for a program like this, your credit score actually drops a few points.

Simply closing a credit card to reduce the number of cards you have can also have serious consequences on your FICO score. It might seem logical that your FICO score would increase because you have fewer accounts and less open credit available. However, when you cancel a card, your debt ratio goes up because the total amount you owe is now a higher percentage of your potential total available credit. This causes your FICO score to go down.

As an example, let’s say you have five credit cards with a total available credit of $50,000 ($10,000 per card). You have outstanding debt among these cards of $35,000. That is a ratio of 70 percent of your total available debt. You decide to cancel one of the cards, to reduce temptation and potential debt load. Now your outstanding $35,000 is 87.5 percent of the total available credit you have access to. You haven’t increased your debt and you’ve reduced your possible debt load, but the ratio of debt has risen because your total debt is measured against a smaller amount of available credit.

Applying for new credit also causes your score to drop. The theory behind this is that you’re seeking new sources of credit and could be digging yourself into a bigger hole. When you’re trying to increase your credit score so you can get approved for a mortgage, avoid applying for new credit.

The lender obtains credit reports from any or all of the three firms that are in the business of providing them. These firms are Equifax, TransUnion, and Experian. Instead of having to get separate reports, you can purchase a comprehensive report of all three agencies. This is known as a tri-merge credit report. These are available from any number of firms across the country. If you go online, you have a multitude of options to choose from.

Thanks to the Fair Credit Reporting Act (FCRA), you are entitled to a free copy of your own credit report if you have received notice within the past 60 days that you have been declined credit, employment, or housing, or if adverse action has been taken against you based on information from a reporting agency. By “adverse action,”

I mean any denial of credit based on your credit report from any of the credit agencies. You can also visit www.annualcreditreport.com to receive one free copy of your credit report every year from each of the three nationwide consumer credit-reporting companies. This will give you a heads-up on any potential problems you may encounter. If you already received your free copy but wonder whether anything has changed since then, you can either pay for another copy of the report or, if you’ve been denied credit, write to each credit agency separately asking for another copy. Include a copy of that denial letter. You can reach the agencies here:

Credit reports include any name you used in your past when filling out credit reports (maiden and married names included) and list the names of each creditor, past or present, that has had a relationship with you. The report provides details about every creditor, when the account was established, your maximum credit limit, your current balance, and your current monthly payment. Information on this report—both positive and negative—stays on your credit report for varying lengths of time. For example, bankruptcieslast 10 years. A past foreclosure also stays around for 10 years, which, in most cases, is longer than it will take before a lender is willing to consider you for a mortgage to buy another home. “Regular” information, positive or negative, usually lasts for seven years. The report lists your high credit on each account, which is the highest amount you have owed at any time to that creditor. The report also gives the status of each account on a month-by-month basis over the last year and whether you missed any payments.

If an account is closed, it’s still on the report, which indicates when it was closed and whether you closed it voluntarily or whether the creditor closed it because of inability to pay, late payments, or something else. If you had an outstanding balance that you never paid when you closed the account, it’s referred to as a charge-off. This means that instead of putting in the extra time and expense trying to collect the amount you owed, the grantor decided it would be a waste of time and money and wrote it off. The report also includes any bankruptcies (more on that later in the chapter), tax liens, unpaid judgments, and so on.

Good credit is pretty basic. For example, you have a credit card for your local clothing retailer. It has a maximum limit of $1,000 and you have paid your balance in full and on time every month. If you handle all your bills in this manner, you have good credit.

Bad credit, on the other hand, is a history of missing payments on debt relationships or a past default on a debt along with such items as defaults, foreclosures, judgment liens, tax liens, charge-offsof debt, and bankruptcy. The more of these situations are in your background, the lower your FICO score goes and the worse your credit will be. Let’s examine a few of them and how they affect your chances of being approved for a mortgage.

Default refers to your failure to pay a debt in full as agreed. For example, let’s say you borrowed $10,000 on a personal loan and had repaid $7,500 when you started having problems making the rest of the payments. As a result, you just stopped making payments, and therefore defaulted on the loan. This will seriously affect your credit rating, and therefore affect your ability to be approved for a home. The bank wants to see that you can pay your debts.

This is particularly important if you’ve ever owned land and have defaulted on the payments. The lender may have filed a formal document saying that you defaulted on the mortgage loan. If you have a previous foreclosure on your credit report, it’s a huge red flag when a lender is looking to grant a new mortgage loan to you.

If you’ve had a previous foreclosure, your best chance at getting a new mortgage now is to just wait until some time passes. However, if you’ve kept your credit in good standing and paid your bills on time since the foreclosure, you have a decent chance of getting financing now. There’s no rule on this, but the general industry standard is that it must be at least five to seven years since the foreclosure before you have a chance of being approved for another mortgage loan.

Then, assuming that everything else in your credit history is satisfactory, lenders may take a chance on you. Because that foreclosure makes you an increased credit risk, you probably won’t get the best interest rate possible, and you may be forced to pay a pointor two up front. You’ll remain a less-than-healthy credit risk until you can prove things have changed. You produce this proof by maintaining a good record of debt repayment going forward and not carrying excessive amounts of debt.

Your best chance to get a loan may be through the FHA or Veterans Administration (see Chapter 6 for a full explanation of these loans). These loans may be more accessible and require lower down payments because they carry federal government guarantees of repayment to the lenders. You may also be required to accept impounds on your loan to cover taxes and insurance premiums until the lender gets comfortable with you. If you’ve faced foreclosure in the past, don’t just throw up your hands and assume that you’re “damaged goods” forever. Fill out that application. If enough time has passed and you’ve kept your credit history clean since then, you may be able to get into your own home again.

If your credit report shows that there is a lien on your property, this means that someone has obtained a legal right to do so because of some sort of debt or obligation from you to them. They have the legal right to do this if you are not paying an agreed-upon debt. Many types of liens can be placed on your credit report, in these situations:

If you currently own a home, a lien can have a legal effect, called a cloud, preventing you from selling it. Clouds prevent the title from being clear and marketable. If your credit report shows liens or clouds, this could become a huge obstacle in being approved for a loan. Why? Because if you can’t sell property because of this lien, it may limit your ability to generate cash for your down payment on your new home. If lenders feel that you cannot produce a down payment, they will be less likely to give you their money.

If you’ve declared bankruptcy before, it will be listed on your credit report. You might have declared bankruptcy to straighten out your financial affairs when you accumulated debts so large that you couldn’t handle them anymore. Under the federal bankruptcy code, various “chapters” specify different forms of bankruptcy filings. The vast majority of all personal bankruptcy filings are done under one of two chapters: Chapter 7 or Chapter 13. Chapter 7 refers to a bankruptcy in which all your property, real and personal, is liquidated and the proceeds are divided among your creditors to pay almost all your debts. Chapter 7 is a more serious bankruptcy because your creditors have decided, with the court’s acquiescence, that there is no other way to resolve your debt situation. As a result, they are willing to accept what is likely to be only a portion of what you owe, to put the debt behind them.

Chapter 13 refers to a bankruptcy in which you avoid liquidation of your assets. It allows you to adjust your legal debts so that you can repay them over a period of time, as approved by the bankruptcy court. This bankruptcy is used when the court decides, and the creditors agree, that the solution is not limited to total liquidation of most or all of your assets. It is also used to avoid a foreclosure.

As for whether you’ll be able to obtain a mortgage with a bankruptcy on your record, it depends on time and history. Each lender has its own standards, but the general rule is that at least two years must have passed since you filed for bankruptcy. In other words, if you’re in a five-year Chapter 13 plan under which you will finish paying off your repayments five years later, your two-year waiting period for a mortgage lender to approve you for a loan begins after the five years are completed. For a Chapter 7 bankruptcy, the two-year rule still exists, but lenders are more hesitant about granting a loan as quickly. That is because, with Chapter 7 bankruptcy, the borrower failed to repay his prior debts in full (in Chapter 13, you eventually pay the whole debt). The key will be how well you have re-established your credit.

If this is your situation, it’s okay if you’re still in your waiting period. Take this time to establish new credit references. Apply for a new credit card, finance a car purchase, buy a cell phone, or open a charge account at a local store—but don’t go overboard and do all those things at once. Also make sure you pay your accounts on time.You are demonstrating to potential mortgage lenders that you are a responsible borrower again and that they can trust you with their funds. Establishing new credit isn’t always easy; it takes time, but if you start slowly with a cell phone or a cash-guaranteed low-limit credit card, pay the bills on time, and go from there, you should be able to rehabilitate your credit over time.

If your credit report has a mistake on it or needs further explanation, you have the right, under federal law, to include an explanation in your record. Use the credit-reporting agency addresses listed earlier in the chapter to contact them. Simply state why you feel that the item reported is erroneous. If you have proof, such as cancelled checks or a promissory note stamped “paid,” send along a copy of these items with your letter.

If the debt in question is correct but there are extenuating circumstances for why it was incurred and was delinquent, you can have this explanation included in your credit report, too. For example, let’s say that seven years ago, you were laid off from your job and were out of work for six months. As a result, you were delinquent on a credit card debt. Once you got another job, you resumed payments and paid it off without further problems. Or maybe your spouse died unexpectedly and you missed a mortgage payment while you were taking care of funeral arrangements. You caught up as soon as things settled down, but your credit report marked you as “30 days late.” In your letter, you would state exactly what happened.

Credit agencies will investigate the situation and, in many instances, will note when an exceptional circumstance prevented you from honoring your obligations in a timely manner or will correct a mistake. The process takes time. Having these explanations on the report will be helpful when your lender is reviewing your application. A reasonable explanation can remove hurdles to getting approved for your loan.

Think of the down payment as a deposit on your home; it’s the part of the purchase price that you’re going to pay out of your own resources. The amount that you put down on a home is called personal equity. The down payment includes the earnest moneydeposit that accompanies your offer, along with the money you bring along to closing to complete the purchase price agreement. The money for your down payment can come from several sources, including personal savings, investments, loans, your IRA, collectibles, and gifts, to name a few—anywhere you have liquid funds to put to use.

Let’s assume you’re buying a nice two-bedroom, two-bathroom home for $210,000 in Kansas City. Your plan is to mortgage the home for 80 percent of the purchase price, or $168,000. You are responsible for coming up with the difference, or $42,000. Now where is that money going to come from?

Let’s say that in your savings account—at your local bank, credit union, or online bank—you have saved $50,000 from hard work, earnings from stock investments, and interest you’ve earned on the account. That money is considered liquid, which means you can access it at any time. You can use this money to pay for your down payment on your home.

Your down payment can also come from money you have saved in a certificate of deposit, or CD, that you have at the bank. The downside to withdrawing the money from a CD to fund your down payment is that, unlike a savings account, you’ll lose the interest earned and pay a penalty if you withdraw before the term is up.

In such a case, you can avoid the penalty for early withdrawal of the CD by planning, if it’s possible. Look at when your CD matures and, assuming it’s not too far off, try to schedule the closing on your purchase to come a day or two after the CD’s maturity date. That way, you’ll not only earn the full amount of interest on the CD, but also avoid any penalty for cashing it in too soon.

Let’s face it—not everyone has thousands of dollars available for a down payment. If you don’t have a rich uncle who can give you a down payment as a gift (which we’ll discuss in more detail later in the chapter), you may have to borrow it from a friend or family member, or from a bank or credit union. Keep in mind, however, that if you borrow from a bank, the loan will be added to your list of debts. This may push your debt percentage over what the bank requires to write the mortgage. As a result, the bank may refuse to write the mortgage, so figure this all out before you actually apply for the loan. If you need some help with the calculation, talk with your mortgage broker beforeyou formally complete the application.

If you are borrowing the down payment from a friend or family member, talk to the person and tell him you’re buying a home and need a loan. Tell him how much you need, how long you will take to pay it back, and what interest you are willing to pay, if any, for the favor.

You could even loan yourself the down payment money through your company-sponsored 401(k) retirement account. Although most financial planners urge consumers not to touch their 401(k), it is an option in this case. If you withdraw the money from your 401(k), you can withdraw up to half the amount of your balance, up to $50,000, and you have up to five years to repay the loan. Check with your tax advisor for any financial advice that’s specific to your situation.

If you do borrow from your 401(k), make sure you can repay the money. Failure to do so could result in having to pay an unplanned tax bill and penalties for early withdrawal. There is one catch, however. If you are self-employed and have your own 401(k), you cannot take out the money for a down payment. The 401(k) must be with a firm in which you are not the only employee. This is to avoid the appearance, or actual fact, of you controlling the 401(k)’s operations as well as investing in it.

If you want to use your individual retirement account(IRA) to fund your down payment, there are penalties for early withdrawals. The typical rule is that you are required to forfeit all the interest your money has earned if you prematurely withdraw funds. You must pay a 10 percent penalty as well. Of course, if you’re 65 or older, you can withdraw from your IRA penalty-free. So if your purchase is for a retirement place and you want to tap the IRA, go for it!

In addition, when you withdraw the funds, they are treated as normal income and taxed at your present normal income tax rate. For example, if your present tax bracket is 28 percent and you withdraw $50,000, you’ll pay the 10 percent penalty, or $5,000, as well as federal income tax of 28 percent, or $14,000. Thus, your total tax liability for the withdrawal would be $19,000.

If you’re a first-time home buyer, though, there is good news: you are exempt from these penalties if you use the money to purchase your home. You will pay income tax on the money you have withdrawn, but you will not be charged the 10 percent penalty. If you have a basic IRA, not a Roth IRA, you may make a withdrawal of up to $10,000 for the purchase of your first home. If you are married and your spouse has an IRA, both of you may make the same type of penalty-free withdrawal, for $20,000 total. The taxes due will be at the higher of your two tax brackets.

This is a once-in-a-lifetime benefit, but there is wiggle room in the law. Even though it is said to be used on a first-time purchase, this doesn’t have to be your first actual home. As long as you have not owned a home as your primary residence at any time during the two years before this purchase, the penalty-free withdrawal is allowed. One more important condition: you cannot withdraw the money more than 120 days before the closing date on your home.

If you have a Roth IRA, you must have had the Roth IRA for at least five years before you withdraw the funds to buy the home. If you’ve had it less than five years, you will probably avoid the 10 percent penalty for early withdrawal, but you may have to pay taxes on the withdrawn amount at your current tax rate, depending on what offsetting deductions on the rest of your tax return you have to help you avoid the tax liability. A Roth IRA is a savings account in which you deposit money that has already been taxed, so you don’t get taxed on the funds when they are withdrawn at the proper time. As a result, you may end up paying taxes on funds that otherwise would be tax-exempt. With a regular IRA, your savings are not yet taxed, so this Roth exemption doesn’t exist. Unsure what to do? Check with your tax advisor.

Another source of your down payment can come from the collectibles you may own. Just as some people invest in CDs or stocks and bonds, others put at least some of their investment capital in collectibles. They may be stamp or coin collections, or something more exotic, such as works of art or antiques. Some buyers have even sold a classic car they owned to obtain funds for their down payment. If you have a valuable object that you’d like to sell to earn the money for a down payment, keep in mind that there’s no guarantee it will sell. It all depends on that item’s market. For example, you may have a valuable early Spidermancomic book that you think will fetch thousands of dollars, but if the economy is lagging and comic book collectors aren’t buying, you may have to wait. This doesn’t help if you need your down payment money right away.

Part or all of the down payment can be given to you as a gift from someone else. Perhaps your parents can provide some financial help to you because they don’t want to see you struggle for years to save. This gift money is different from the personal loan we mentioned earlier—in this case, the person who gives you the money doesn’t want it back. That’s okay. You can use gift money for your down payment.

There is no limit on gift money. In most cases, the entire down payment can be a gift. However, if the amount of the down payment is less than 20 percent of the purchase price, you must have at least 5 percent of the down payment from your own funds and the gift must equal the difference. For example, if you’re putting down 10 percent, or $20,000, on a $200,000 house, you must pay at least 5 percent of the price from your own funds—or, in this case, $10,000—and the rest can be a gift. However, although people sometimes try to slip it in as a “gift,” the donation of the so-called gift cannot be from the seller.

In some cases, buyers will try to borrow money from a friend or family member and call it a gift, even though the donor expects to be repaid. Be careful. Banks are aware of how people try to use “gift” money that really isn’t. As a result, lenders have come up with a gift letter for you to submit with your loan application. The gift letter is signed by the donor and states that the funds were nothing more than a gift and that you are in no way obliged to reimburse the donor for any portion of the gift money. Aside from this, there may be some circumstances in which a cash gift could be taxable income. Check with your accountant to avoid possibly receiving “greetings” from the IRS over your gift.

You may also have money invested in stocks and bonds, Treasury bonds, U.S. government securities such as Treasury bonds and Treasury bills, state or local municipal bonds, commercial paper, or banker’s acceptances. Withdrawing your money from time-restricted accounts too early can result in paying interest and penalties, so carefully weigh your options and know the financial consequences before you make any final decisions.

Should you borrow cash from your credit cards to fund your down payment? It’s possible, but it’s a mistake. Even if your credit card charges you only 9 percent on your balances, it can be quite a bit more costly than your mortgage interest rate. Let’s assume that you borrow $25,000 at 9 percent per annum. That means that, in interest alone, you’ll pay $2,250 for those funds—in the first year! Unless you have absolutely no other source of funds for your down payment, don’t do it.

Bottom line when it comes to paying for your down payment—remember to consider where it may come from and the tax implications from withdrawing or borrowing the money.