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When Evaluating A Loan - Make Sure You Can Handle the Worst Case

During the go-go days of real estate and mortgages - 2003 to 2005 - many first time home buyers got themselves into mortgage loans that they shouldn't have because they took into consideration only the possible future upside. Rising market prices and falling interest rates led many first time home buyers to overlook the possible downside of the mortgage loans that they were committing themselves to - and that was a major mistake.  

The market has done a u-turn since 2005 that has caught many first time home buyers by surprise. Prices in many areas have fallen since 2005 although that seems to be stabilizing. Interest rates have steadily risen from the middle of 2004 until the middle of 2006. Since July of 2006, interest rates have held steady. There is even a possibility of rates dropping depending on how much negative effect the subprime meltdown has on the overall market. Minimum credit requirements for most loan programs have also risen dramatically since the beginning of the subprime meltdown in January of 2007. 

Many first time home buyers purchased homes between 2003 and 2005 using subprime loans (loans with high rates for people with low credit scores). These first time home buyers had expected to improve their credit to the point where they could refinance their subprime mortgage into a prime mortgage with a much lower interest rate. 

Five obstacles have prevented many of these first time home buyers from refinancing out of their subprime loans:  

1) They did not improve their credit sufficiently to qualify for a better loan,  

2) Interest rates went up to the point that a prime loan would not provide the reduction in monthly payment that was originally expected, 

3) Credit requirements have been tightened up so much due to the subprime meltdown that only first time home buyers with good credit are now qualifying for loans with good rates,  

4) Many first time home buyers made only interest-only payments and paid nothing toward principal, 

5) Home prices in some areas have dropped leaving some first time home buyers owing more than the home's market value. 

The real estate market has a lot of short-term volatility in it. When evaluating loan possibilities, error on the side of safety. Try to avoid the follow mistakes that many other first time home buyers made between 2003 and 2005 when purchasing their first homes: 

- Get your credit in order before purchasing a home. Get your credit to the point that you can obtain a good rate during your initial purchase. Check your credit early on and fix any problems.  

- Determine what is the maximum total housing payment you can afford and stick with that number. Inform your loan officer and Realtor right away. The total housing payment should include mortgage payment, monthly property taxes, monthly HOA dues (if a condo) or hazard insurance (if a detached house), and PMI if applicable. Don't forget to take into account the tax advantage that you will receive right away as a new homeowner. This can provide you with several hundred extra dollars of after-tax take-home pay each month that can be applied directly toward the mortgage. 

- Find out what your maximum price range is. This will be based entirely on the maximum monthly payment you've established and the amount of down payment that you have available. Don't let your Realtor show you homes that exceed your price range. You'll fall in love with something you can't afford. 

- Don't stretch yourself. Establish your maximum monthly payment at a point where you have an income cushion in case anything unexpected happens. It is best to use the old debt ratios. This was a 36 percent debt ratio. That meant that the total anticipated housing debt and other debt showing up on the credit report would not exceed 36 percent of the gross income. Not stretching yourself is one of the most important rules for the first time home buyer.

- Save up as much down payment as possible. Your down payment and the resulting equity in your home is your cushion against any possible drop in home prices. Try to have a 5 to 10 percent down payment on your own. This is first time home buyer's cushion against a price drop.

- Pay down principal as much as possible. If possible, pay your mortgage through a bi-weekly payment plan. This alone will reduce a 30-year mortgage down to abort 23 years. 

- If you take an adjustable rate mortgage, make sure that the fixed period exceeds the length of time that you intend to stay in your first home by at least two years. Two and three-year fixed mortgages are dangerous. You will probably be in your first home longer than that and you will be hit by an interest rate adjustment. A general rule for first time home buyers is to only purchase a home if they plan to live in it for at least five years.

- Make sure that you can pay the fully amortizes (principal and interest) payment and not just the interest-only payment. If you are only paying the interest-only payment, you are not building equity if prices don't rise.

- Save a large cash cushion in case something unexpected happens. The first time home buyer should never go into a real estate transaction with the possibility of being just one paycheck away from missing the mortgage payment. You will definitely not sleep well if that is the case.

- Try to avoid prepayment penalties unless you know that you will be living in a property for at least five years. A prepayment penalty can benefit a buyer in the long term between a lender will be able to offer a lower rate if a prepayment penalty is accepted.

- Try to get the seller to buy your rate down. If your buyer's agent can convince the seller to contribute an extra one point (1% of the purchase price or loan amount) toward buying your rate down, you might be able to get between 0.25% and 0.5% lower rate. This will lower your permanent monthly payment in a big way. 

- See if you can qualify for any first time home buyer assistance programs in San Diego County. If your loan officer is not expert on first time home buyer assistance programs, you need to find a loan officer who is. You could be losing thousands of dollars of free money if you are not dealing with a loan officer who can provide first time home buyer assistance programs. 

- Try to avoid buying in areas that are currently seeing major price drops. If a current area that you are considering has had a lot of recent short sales happening, be wary of that area. Short sales occur when homeowners have to sell their properties at market values less than is owed on the mortgage. Short sales occur more often in areas that have had big price drops. Be wary of purchasing in such areas until prices there have stabilized. 

First time home buyers who follow the above advice will purchase in safety, enjoy their homes, and be able to sleep at night.
































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Brought To You By
Mark Harmon, Realtor

CalHFA Preferred Loan Officer
USA Realty and Loans

Brokerage Main Office
3994 Carson St.
San Diego, CA 92117