Frequently Ask Questions
FA
1. What is a FICO score?
2. Why do interest
rates change?
3. What is the difference between pre-qualifying and
pre-approval?
4. Can my loan be sold? What happens if my lender goes out
of business?
5. What is a rate lock?
6. What is PMI? Can I get rid of the PMI on my loan?
7. What is an APR?
What is a FICO score?
A FICO score is a credit score developed by Fair Isaac & Co.
Credit scoring is a method of determining the likelihood
that credit users will pay their bills. Fair, Isaac began
its pioneering work with credit scoring in the late 1950s
and, since then, scoring has become widely accepted by
lenders as a reliable means of credit evaluation. A credit
score attempts to condense a borrowers credit history into a
single number. Fair, Isaac & Co. and the credit bureaus do
not reveal how these scores are computed. The Federal Trade
Commission has ruled this to be acceptable. Credit scores
are calculated by using scoring models and mathematical
tables that assign points for different pieces of
information which best predict future credit performance.
Developing these models involves studying how thousands,
even millions, of people have used credit. Score-model
developers find predictive factors in the data that have
proven to indicate future credit performance. Models can be
developed from different sources of data. Credit-bureau
models are developed from information in consumer
credit-bureau reports. Credit scores analyze a borrower's
credit history considering numerous factors such as:
Late payments
The amount of time credit has been established
The amount of credit used versus the amount of credit
available
Length of time at present residence
Employment history
Negative credit information such as bankruptcies,
charge-offs, collections, etc...
There are really three FICO scores computed by data provided
by each of the three bureaus--Experian, Trans Union and
Equifax. Some lenders use one of these three scores, while
other lenders may use the middle score. Frequently Asked
Questions (FAQs) How can I increase my score? While it is
difficult to increase your score over the short run, here
are some tips to increase your score over a period of time.
Pay your bills on time. Late payments and collections can
have a serious impact on your score.
Do not apply for credit frequently. Having a large number of
inquiries on your credit report can worsen your score.
Reduce your credit-card balances. If you are "maxed" out on
your credit cards, this will affect your credit score
negatively.
If you have limited credit, obtain additional credit. Not
having sufficient credit can negatively impact your score.
What if there is an error on my credit report? If you see an
error on your report, report it to the credit bureau. The
three major bureaus in the U.S., Equifax (1-800-685-1111),
Trans Union (1-800-916-8800) and Experian (1-888-397-3742)
all have procedures for correcting information promptly.
Alternatively, your mortgage company may help you correct
this problem as well.
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Why do interest rates
change?
To understand why mortgage rates change we must first ask
the more general question, "Why do interest rates change?"
Long-debt instruments used by the U.S. Government to finance
its debt. Treasury bonds come in 30-year denominations. It
is important to realize that there is not one interest rate,
but many interest rates!
Prime rate: The rate offered to a bank's best customers.
Treasury bill rates: Treasury bills are short-term debt
instruments used by the U.S. Government to finance their
debt. Commonly called T-bills they come in denominations of
3 months, 6 months and 1 year. Each treasury bill has a
corresponding interest rate (i.e. 3-month T-bill rate,
1-year T-bill rate).
Treasury Notes: Intermediate-term debt instruments used by
the U.S. Government to finance their debt. They come in
denominations of 2 years, 5 years and 10 years.
Treasury Bonds:
Federal Funds Rate: Rates banks charge each other for
overnight loans.
Federal Discount Rate: Rate New York Fed charges to member
banks.
Libor: : London Interbank Offered Rates. Average London
Eurodollar rates.
6 month CD rate: The average rate that you get when you
invest in a 6-month CD.
11th District Cost of Funds: Rate determined by averaging a
composite of other rates.
Fannie Mae-Backed Security rates: Fannie Mae pools large
quantities of mortgages, creates securities with them, and
sells them as Fannie Mae-backed securities. The rates on
these securities influence mortgage rates very strongly.
Ginnie Mae-Backed Security rates: Ginnie Mae pools large
quantities of mortgages, secures them and sells them as
Ginnie Mae-backed securities. The rates on these securities
influence mortgage rates on FHA and VA loans. Interest-rate
movements are based on the simple concept of supply and
demand. If the demand for credit (loans) increases, so do
interest rates. This is because there are more buyers, so
sellers can command a better price, i.e. higher rates. If
the demand for credit reduces, then so do interest rates.
This is because there are more sellers than buyers, so
buyers can command a lower better price, i.e. lower rates.
When the economy is expanding there is a higher demand for
credit, so rates move higher, whereas when the economy is
slowing the demand for credit decreases and so do interest
rates.
This leads to a fundamental concept:
Bad news ( i.e. a slowing economy) is good news for interest
rates (i.e. lower rates).
Good news (i.e. a growing economy) is bad news for interest
rates (i.e. higher rates).
A major factor driving interest rates is inflation. Higher
inflation is associated with a growing economy. When the
economy grows too strongly, the Federal Reserve increases
interest rates to slow the economy down and reduce
inflation. Inflation results from prices of goods and
services increasing. When the economy is strong, there is
more demand for goods and services, so the producers of
those goods and services can increase prices. A strong
economy therefore results in higher real-estate prices,
higher rents on apartments and higher mortgage rates.
Mortgage rates tend to move in the same direction as
interest rates. However, actual mortgage rates are also
based on supply and demand for mortgages. The supply/demand
equation for mortgage rates may be different from the
supply/demand equation for interest rates. This might
sometimes result in mortgage rates moving differently from
other rates. For example, one lender may be forced to close
additional mortgages to meet a commitment they have made.
This results in them offering lower rates even though
interest rates may have moved up! There is an inverse
relationship between bond prices and bond rates. This can be
confusing. When bond prices move up, interest rates move
down and vice versa. This is because bonds tend to have a
fixed price at maturity--typically $1000. If the price of
the bond is currently at $900 and there are 10 years left on
the bond and if interest rates start moving higher, the
price of the bond starts dropping. The higher interest rates
will cause increased accumulation of interest over the next
5 years, such that a lower price (e.g. $880) will result in
the same maturity price, i.e. $1000.
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What is the difference between pre-qualifying and
pre-approval?
A pre-qualification is normally issued by a loan officer,
who, after interviewing you, determines the dollar value of
a loan you can be approved for. However, loan officers do
not make the final approval, so a pre-qualification is not a
commitment to lend. After the loan officer determines that
you pre-qualify, he/she then issues you a pre-qualification
letter. This pre-qualification letter is used when you are
making an offer on a property. The pre-qualification letter
indicates to the seller that you are qualified to purchase
the house you are making an offer on. Pre-approval is a step
above pre-qualification. Pre-approval involves verifying
your credit, down payment, employment history, etc. Your
loan application is submitted to an underwriter and a
decision is made regarding your loan application. If your
loan is pre-approved, you are then issued a pre-approval
certificate. Getting your loan pre-approved allows you to
close very quickly when you do find a house. A pre-approval
can help you negotiate a better price with the seller, since
being pre-approved is very close to having cash in the bank
to pay for the house!
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What is a rate lock?
You cannot close a mortgage loan without locking in an
interest rate. There are four components to a rate lock:
Loan program
Interest rate
Points
Length of the lock
The longer the length of the lock, the higher the points or
the interest rate. This is because the longer the lock, the
greater the risk for the lender offering that lock. Let's
say you lock in a 30-year fixed loan at 8% for 2 points for
15 days on March 2. This lock will expire on March 17 (if
March 17 is a holiday then the lock is typically extended to
the first working day after the 17th). The lender must
disburse funds by March 17th, otherwise your rate lock
expires, and your original rate-lock commitment is invalid.
The same lock might cost 2.25 points for a 30-day lock or
2.5 points for a 60-day lock. If you need a longer lock and
do not want to pay the higher points, you may instead pay a
higher rate. After a lock expires, most lenders will let you
re-lock at the higher of the original price and the
originally locked price. In most cases you will not get a
lower rate if rates drop. Lenders can lose money if your
lock expires. This is because they are taking a risk by
letting you lock in advance. If rates move higher, they are
forced to give you the original rate at which you locked.
Lenders often protect themselves against rate fluctuations
by hedging. Some lenders do offer free float-downs--i.e. you
may lock the rate initially and if the rates drop while your
loan is in process, you will get the better rate. However,
there is no free lunch--the free float-down is costly for
the lender and you pay for this option indirectly, because
the lender has to build the price of this option into the
rate.
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Can my loan be sold? What happens if my lender goes out of
business?
Your loan can be sold at any time. There is a secondary
mortgage market in which lenders frequently buy and sell
pools of mortgages. This secondary mortgage market results
in lower rates for consumers. A lender buying your loan
assumes all terms and conditions of the original loan. As a
result, the only thing that changes when a loan is sold is
to whom you mail your payment. If your loan has been sold,
your existing lender will notify you that your loan has been
sold, who your new lender is, and where you should send your
payments from now on.
If your lender goes out of business, you are still obligated
to make payments! Typically, loans owned by a lender going
out of business are sold to another lender. The lender
purchasing your loan is obligated to honor the terms and
conditions of the original loan. Therefore, if your lender
goes out of business, it makes little difference with
regards to your loan payments. In some cases, there may be a
gap between the date of your lender's going out of business
and the date that a new lender purchases your loan. In such
a situation, continue making payments to your old lender
until you are asked to make payments to your new lender.
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What is PMI? Can I get rid of the PMI on my loan?
PMI or Private Mortgage Insurance is normally required when
you buy a house with less than 20% down. Mortgage insurance
is a type of guarantee that helps protect lenders against
the costs of foreclosure. This insurance protection is
provided by private mortgage-insurance companies. It enables
lenders to accept lower down payments than they would
normally accept. In effect, mortgage insurance provides what
the equity of a higher down payment would provide to cover a
lender's losses in the unfortunate event of foreclosure.
Therefore, without mortgage insurance, you might not be able
to buy a home without a 20% down payment. The cost of PMI
increases as your down payment decreases. Example: The cost
of PMI on a 10% down payment is less than the cost of PMI on
a 5% down payment. Your PMI premium is normally added to
your monthly mortgage payment.
The decision on when to cancel the private insurance
coverage does not depend solely on the degree of your equity
in the home. The final say on terminating a private
mortgage-insurance policy is reserved jointly for the lender
and any investor who may have purchased an interest in the
mortgage. However, in most cases, the lender will allow
cancellation of mortgage insurance when the loan is paid
down to 80% of the original property value. Some lenders may
require that you pay PMI for one or two years before you may
apply to remove it. To cancel the PMI on your loan, contact
your lender. In most cases, an appraisal will be required to
determine the value of your property. You will probably also
be required to pay for the cost of this appraisal. Another
way of cancelling the PMI on your loan is to refinance and
to get a new loan without PMI.
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What is an APR?
The annual percentage rate (APR) is an interest rate that is
different from the note rate. It is commonly used to compare
loan programs from different lenders. The Federal Truth in
Lending law requires mortgage companies to disclose the APR
when they advertise a rate. Typically the APR is found next
to the rate.
Example: 30-year fixed, 8%, 1 point, 8.107% APR
The APR does NOT affect your monthly payments. Your monthly
payments are a function of the interest rate and the length
of the loan. The APR is a very confusing number! Even
mortgage bankers and brokers admit it is confusing. The APR
is designed to measure the "true cost of a loan." It creates
a level playing field for lenders. It prevents lenders from
advertising a low rate and hiding fees.
If life were easy, all you would have to do is compare APRs
from the lenders/brokers you are working with, then pick the
easiest one and you would have the right loan. Right? Wrong!
Unfortunately, different lenders calculate APRs differently!
So a loan with a lower APR is not necessarily a better rate.
The best way to compare loans in the author's opinion is to
ask lenders to provide you with a good-faith estimate of
their costs on the same type of program (e.g. 30-year fixed)
at the same interest rate. Then delete all fees that are
independent of the loan such as homeowners insurance, title
fees, escrow fees, attorney fees, etc. Now add up all the
loan fees. The lender that has lower loan fees has a cheaper
loan than the lender with higher loan fees. The reason why
APRs are confusing is because the rules to compute APR are
not clearly defined.
What fees are included in the APR? The following fees ARE
generally included in the APR:
Points - both discount points and origination points
Pre-paid interest. The interest paid from the date the loan
closes to the end of the month. Most mortgage companies
assume 15 days of interest in their calculations. However,
companies may use any number between 1 and 30!
Loan-processing fee
Underwriting fee
Document-preparation fee
Private mortgage-insurance
The following fees are SOMETIMES included in the APR:
Loan-application fee
Credit life insurance (insurance that pays off the mortgage
in the event of a borrowers death)
The following fees are normally NOT included in the APR:
Title or abstract fee
Escrow fee
Attorney fee
Notary fee
Document preparation (charged by the closing agent)
Home-inspection fees
Recording fee
Transfer taxes
Credit report
Appraisal fee
An APR does not tell you how long your rate is locked for. A
lender who offers you a 10-day rate lock may have a lower
APR than a lender who offers you a 60-day rate lock!
Calculating APRs on adjustable and balloon loans is even
more complex because future rates are unknown. The result is
even more confusion about how lenders calculate APRs.
Do not attempt to compare a 30-year loan with a 15-year loan
using their respective APRs. A 15-year loan may have a lower
interest rate, but could have a higher APR, since the loan
fees are amortized over a shorter period of time.
Finally, many lenders do not even know what they include in
their APR because they use software programs to compute
their APRs. It is quite possible that the same lender with
the same fees using two different software programs may
arrive at two different APRs!
Conclusion :
Use the APR as a starting point to compare loans. The APR is
a result of a complex calculation and not clearly defined.
There is no substitute to getting a good-faith estimate from
each lender to compare costs. Remember to exclude those
costs that are independent of the loan.
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