Welcome back to the Theopetra Testament. Subscribe now so you don’t miss our weekly educational posts bridging the gap between cryptocurrency and real estate. This post, composed by our Self-Repaying Home team, will give you a brief update of financial markets in relation to housing before diving into the third part of our series on getting ready to purchase a home.
Market Update:
Current Mortgage Rate: 4.25% 30-year fixed rate, a new 12 month high (bankrate.com), but get ready for that rate to go down as...
“Everyone has a plan until they get punched in the mouth” - Mike Tyson
And just like that the whispers of an emergency rate hike are wiped out as geopolitical tension in Ukraine with Europe’s largest ground invasion and war since WW2 rock capital markets. Taking a look at the scorecard:
The Dow suffers its worst single day point drop of the year
10 year yields drop 35+ basis points from the highs to the lows in a ~3 day span
Rate hike bets to stem inflation are scrapped, with markets pricing in just 4.5 hikes
(down from 7 hikes) over next 12 months
Oil surges over $100/barrel on supply concerns while gold shines on safe haven status
Currency markets go berserk as the Russian Ruble becomes worth less than 1 cent.
It’s unclear if traditional economic data/market moving events even matter at this point, with macro markets taking their cue from the changing developments in Ukraine. With that said, over the next 10 days, we get a slew of Fed speak (Powell, March 2nd - 3rd), the March jobs report / unemployment rate (March 4th), and an update on inflation with the latest CPI report (March 10th).
Hold on tight!
Interesting Housing Headlines
“According to the latest study by real estate portal Point2 Homes, Generation Z currently can’t afford a median home in any of the country’s 100 largest counties.” (thestreet.com).
Lesson Three: Underwriting & Fees
Ok, so you have determined how much money you may need to save for a down payment and considered different mortgage types. We are now going to go deep into the science basement and nerd out a bit. While we think it is very worthwhile to know how lenders and guarantors are assessing and charging you based on your perceived risk – if you don’t care as much about the deets proceed to the tables in the TLDR section at the end.
Underwriting- The Basics
Underwriting is just a fancy term for deciding how risky you are as a borrower and then charging you for that risk. There are even times where a lender may flat out decline the loan altogether, leaving you scrambling to find another lender.
This is often one of the most frustrating parts of the mortgage process as it results in a ton of paperwork and waiting.
What factors into underwriting?
Credit: Lenders will pull credit reports and look at your FICO score searching for any
late payments, bankruptcies and more. There are tons of resources that discuss how to try to improve your FICO score so we’ll leave that to them. GSEs (Fannie, Freddie) generally look for at least a 620 FICO score, while a score above 700-720 is considered above average.
Debt-to-Income (DTI): The ratio of your total debt vs gross income. The lower the number the more easily you can afford the loan.
To calculate, we first sum the: expected monthly cost for your new mortgage: (principal + interest + insurance + taxes)
Then, add in the sum of: any previous debts like auto loans, student loans, credit cards etc
Combining these two totals gives us a borrower’s total debt load. This is the sum of payments that a borrower is on the hook to pay for, every month. From here, we look at this number as a percentage of a borrower’s gross income (ie, a borrower’s income before taxes and 401k, etc, are taken out); thus, we just divide it by total monthly gross income. Typically loans with DTI > 45% are not approved and ideally DTI is < 36%.
Appraisal: The lender wants to make sure the property is worth what you want to pay for it. They will have an appraisal done by a professional to determine the “value”. If they determine you overpaid and it is worth less than you paid you may have to put more money down to get to the same loan-to-value. We are not a big fan of appraisals as one could argue that ‘value’ is what someone is willing to pay and as such, in a “hot market” like now, an appraiser may claim the property is worth far less than the sale price. Unfortunately, this is a game you have to play.
Income & Employment: Lenders will ask for proof of income and employment- this usually consists of a phone call to your company’s Toby (HR) to validate you are employed and copies of pay stubs showing your earnings. This process has become a bit outdated as incomes have shifted away from W2 work to more gig/internet based. Reminder- nobody wants you to be rich. They’d prefer you to be a boring 9-to-5 employee making a steady, predictable salary working for someone else than strike it out on your own and have less predictable but higher overall earnings. With that said, a steady and easy W2 income is a ‘nice match’ versus a steady and easy 30 year fixed mortgage payment. Coincidence?
Confirm Assets: The underwriter will also ask for proof of funds you plan to use for a down payment as well as an additional buffer. This is another area where the TradFi is beginning to fail, as the legacy system generally overweights predictable income (see above, a W2 income stream) vs assets. There are countless stories where borrowers with considerable assets (ie. they could pay in all cash if they so inclined) will get denied because they don’t have a traditional employment income stream. The elephant in the room here is crypto, and outside of a few firms, crypto is unfortunately not included in assets unless it is sold and converted to good ol’ Dollars.
Use for the home: Underwriting varies based on whether the home is your primary residence (ie you permanently live there) vs a second home or investment property. It is preferable for the home to be owner occupied and it be your primary residence - in theory this means you are more likely to pay the mortgage and take better care of the house, and thus collateral, then if you did not live there full time or had constant AirBnB rentals strolling through and wrecking the place. No surprise here that if you are not living in the property full time, you may have to pay additional costs.
Use for the mortgage: It also matters whether the mortgage is being used to purchase a home vs refinance vs cash-out refinance. It is preferable for the mortgage to be used to purchase a home, as rates/fees might be slightly higher if it is a refinance or cash-out refinance.
Mortgage Points
Mortgage points are upfront costs you can pay to lower your mortgage rate. By definition, “1 point” represents 1% of the loan size. For example, 1 point on a $320k loan is $3,200. A lot of times you will see advertised mortgage rates that actually include points. We always recommend asking lenders for their lowest “zero point rate” to make comparisons apples to apples, otherwise the math can get fuzzy.
It may make sense to buy mortgage points if rates are already quite low and you plan to live in the house for a considerable amount of time (ie 10+ years). However, for 90%+ of homebuyers we do *NOT* recommend paying points to lower your rate. Why? By buying points, a borrower is locking up and using cash. Given that over the last three decades long term interest rates have declined, it is hard to argue that someone should pay for a lower rate upfront when history says you will be able to refinance into a lower rate ‘for free’ and ‘without points’ at a later date.
Obviously if you think this is the end of a three decade bullet market in rates, throw this advice and caveat out the window.
Building Costs into Rates
Just as with mortgage points you can pay up front to lower your rate, you can also do the opposite and avoid other costs up front in exchange for a higher rate. Keep in mind, the name of the game in general is to avoid paying for benefits up front in hopes of later refinancing into a lower rate / cheaper monthly payment in the future. As such, this can have some benefits. Let’s look at an example:
If you are refinancing to a lower rate mortgage then building lender origination fees into your rate can make a lot of sense. For example, let’s say you have a 4% 30-year fixed mortgage for $320K and current, zero-point rates are 3%. Rather than paying lender origination fees of 0.5%-1% ($1.6k-$3.2k) to receive the 3% rate, you may be able to have the origination costs built into the rate and pay zero costs up-front to receive a slightly higher rate of 3.125%. Then, in the future if rates fall (again, as they have for the last three decades), to 2.5%, you can refinance lower without repeatedly paying origination fees. Play this game as long as you like.
How Credit Fees are Determined
Fannie Mae and Freddie Mac use complex models based on historic data to determine the risk level of borrowers and loans with certain features. The GSEs then build in an ample margin to remain profitable while holding adequate capital in case there is another apocalyptic 2008 scenario where losses would occur if borrowers defaulted.
Because the GSEs have social missions of helping lower income borrowers purchase a home, the stronger credit borrowers “cross subsidize” these worse credit, lower down payment borrowers. This means that although worse credit, lower down payment borrowers pay more for their loans, the amount is less than what they should based solely on data at the expense of higher credit, larger down payment borrowers. Yay socialism? Yay rising tide lifts all boats?
TLDR- Current Credit Fees
Ok, now let’s take a look at where current credit fees are for the GSEs. While these costs come from the GSEs, the lenders who sell to the GSEs will pass these costs through to borrowers. Knowing what these fees allow you to adjust your purchase or downpayment to minimize fees.
(https://singlefamily.fanniemae.com/media/9391/display)
How to read the chart: The numbers in the rows on the left are FICO scores and the columns across the top are “Loan-To-Value” (LTV) levels. LTV is the value of the home minus down payment, so a 20% down payment is an 80 LTV. The percentages listed are in points, where 1% is the upfront cost needed as a percent of the loan balance. As discussed earlier, these costs can often be built into your mortgage rate rather than needing the cash upfront.
Wrap it Up and Next Steps
In this third installment, we went pretty in-depth on underwriting, mortgage points, building costs into rates and credit fees. Next, we’ll discuss a few housing topics that are more of an art than a science- how much home to buy and paying down the mortgage vs levering (cue the Fat Joe) allllllll the wayyyyyyyy up.