The Impact of Credit on Your Ability to Buy a Condo, Co-op, or Townhouse
Much has changed over the years with regard to credit and how it affects a buyer's ability to purchase real estate. One's debt ratio may be in line or one may have a good-sized down payment, but if there is a problem with a buyer's credit, then having good income with a good down payment won't matter.
Credit can impact the interest rate you get on a mortgage. And perhaps more important, it can determine whether you can get a mortgage at all.
First though, exactly what is credit? Simply, it's the ability and the willingness of a person to repay a debt.
Ability is having the necessary income or assets available to pay back a loan. You have to have a job of some sorts or have income from other sources such as interest and dividend income or spousal support, for instance.
Ability is sometimes expressed as a percent, as we discussed when explaining debt ratios. Typical debt ratios, front and back, historically have been somewhere around 33/41, meaning 33 percent of your gross income can go toward housing and 41 percent of your gross income can go toward housing and all other installment and revolving debt.
If your debt ratios were, say, 90, then a lender would determine that in fact you don't have the ability to repay the debt because you don't have enough money. What is the highest debt ratio a lender will allow?
Some loan programs have specific ratio guidelines, say, 45; but many don't have a specific percentage for a debt ratio. Rather, they factor in the debt ratio as part of the overall approval process.
Higher income borrowers can have higher allowable debt ratios than lower income borrowers. I've approved mortgage loans with debt ratios in the 60s, for example. It's not necessarily that rich people are getting a favor and others are getting the shaft. Instead if s due to disposable income.
Disposable income is the amount of money left over every month to goof around with — go to the movies, fill up the car with gas, or invest in a retirement fund. Higher income folks will have more disposable income to pay the phone bill or have the dog groomed.
Say that a debt ratio is at 60. Let's apply that ratio to someone who makes $40,000 per year and someone who makes $250,000 per year.
The amount $40,000 per year works to $3,333 per month. A 60 debt ratio means that 60 percent of $3,333 is already allocated to bills, or about $2,000. That leaves us with $1,333 for other things. If you subtract approximate withholdings for federal and state income taxes and Social Security, you might have $2,500 left for bills. If $2,000 were reserved for debt, that would leave only about $500 for the borrower to pay for food, gasoline, and utilities (not to mention the occasional pizza or movie).
Lenders won't allow borrowers who are not rich to have such a high debt ratio.
Now examine a debt ratio of 60 on a $250,000 income. Monthly, that's $20,833 and 60 percent of that is $12,499 per month. Even after taxes, there's still more discretionary income available for things such as pizza, parties, and movies.
The other side of the credit coin is the absolute willingness to repay a debt. The borrower has the money, but does he pay his bills on time, every time?
I recall a client that was a vice president of a publicly traded corporation. He made a lot of money. But he had damaged his credit by letting bills slip by and not paying them on time. He was never really in debt; he could certainly pay his bills, but for whatever reason he would let some slide every now and then. And it hurt his credit. He probably should have hired an accountant to take care of all his personal stuff.
He certainly had the ability, but not necessarily the willingness, to pay his bills on time.
How do you establish credit? You may hear something such as, “You have to have credit to get credit,” and that's partially true. If you've never applied for credit anywhere, then perhaps the easiest account to establish would be one from a department store such as Sears or JCPenney.
You're likely to get approved with a small credit line of, say, $500. Then the department store will sit back and see how you handle your new responsibility. Charge something and then pay it back when you get your first statement. That's pretty much about it.
After about 12 months, the department store will review your payment history and see that you have used the card and paid back the balance responsibly. Then if 11 offer you a higher credit limit. That's how you can start a credit history.
Credit unions are also a good way to start a credit profile. They have programs to help their members obtain and establish a credit history.
For those who do not have current credit accounts and are just starting out, FHA allows for “nontraditional” credit. This form of credit is not reported on any credit report. Rather, if s a review of other items that will show a pattern of paying bills on time.
If you have no credit accounts whatsoever, a lender can evaluate timely payment with things such as your telephone bill, utility bill, or cable bill. Most important, the lender will want to see 12 months of consecutive timely rent payments by reviewing copies, front and back, of your rent checks or money orders.
Credit histories are stored in three major databases (also called repositories) run by companies called Experian, Equifax, and Transunion. These companies store and report the credit histories of consumers in the United States.
Prior to these repositories, when a business was considering extending credit to a customer, the business would go through a painstaking process of contacting other businesses that had extended credit to their potential customer and get a report on their credit history.
The business would ask the following questions:
• Did you extend credit to this person?
• Did she pay you back on time?
• How much credit did you give her?
• What is the current balance owed to you?
• What is the minimum monthly payment that she makes?
• How long has she been a credit customer?
• Is the account currently in good standing?
• Has she ever been above her credit limit?
These are just a few of the questions a business might ask. The business would then repeat the process, typically by mailing a form to be completed, to other businesses where the potential customer had opened credit.
But with a repository, the business only has to make one stop to collect the data reported by other businesses. Everything you've ever done when opening a credit account is reported to these credit repositories by the business that issued you credit.