Can I get a loan with bad credit?

Whether you can get a loan with poor credit depends on the type of loan. Unsecured loans, such as credit cards and bank signature loans, usually require a good credit history. Secured loans, such as home mortgages and car loans, are a bit more f lexible. Lenders are more aggressive and will take larger risks when the loan is secured by collateral. The lender may require a larger down payment and charge a higher interest rate for the risk of lending to an individual with poor credit.

“I Don’t Like Credit Cards—Should I Pay Them Off and Cancel Them?”

Never pay off completely or cancel a credit card! A person with no credit at all is worse off than a person with a bad credit history. You may think that credit cards are evil, but you may not be able to get a phone, a job, or even a utility account without a credit score. A person with an empty credit file looks somewhere between “suspicious” and “scary” to a company inquiring about your credit. Have a credit card or two, and use them once or twice a year, even if it is just to pay to fill up your gas tank.

Your Provable Income

FNMA loan regulations require proof of requisite income to support the loan payments. Proof of income requires strict documentation, such as

• two years of W-2 forms,

• past two pay stubs, and

• two years of tax returns. If you are self-employed, or at least a 25 percent owner of a business, you need to show that you have been in business at least two years. Proof of self-employment requires copies of tax returns showing the business income.

The Property An understated point thus far is the property itself. Part of the lender’s risk analysis is the property they are collateralizing with the loan. The lender has to keep in the back of its mind the worst-case scenario: a borrower’s default and ensuing foreclosure. In other words, the lender asks itself, “Would I want to own this property?”

The appraisal. The first thing a lender will do is order an appraisal. Some lenders have in-house staff, but most use independent contractors. Because the appraiser charges his or her fee whether or not the loan is approved, the lender generally collects the appraisal fee (about $350) from the borrower up front. There are three generally accepted approaches to appraising property: the market data approach, the cost approach, and the income approach.

Market data approach. The market data approach is the most commonly used formula for single-family homes, condominiums, and small apartments. Basically, a licensed appraiser looks at the three most “similar” houses in the vicinity that have sold recently. He or she then compares square footage and other attributes. The number of bedrooms and baths, age of the property, improvements, physical condition, and the presence of a garage will affect the price, but square footage is usually the most important factor. As you might expect, there are exceptions to this rule. For example, the style of house, its location, and proximity to main roads, and whether it has a view or beach access will greatly affect the value. For the most part, however, if you leave these issues aside, square footage, number of bedrooms and baths, and physical condition are the most relevant factors. Keep in mind that bedrooms and baths on the main level add more value than bedrooms and baths in a basement or attic.

The income approach. With income properties, an appraiser will also use the income approach method, particularly if comparable properties are not available for comparison. The income approach is basically a mathematical formula based on certain presumptions in the marketplace (based, of course, on opinion). The formula is as follows: Value = Net operating income ÷ Capitalization rate Net operating income is the potential (not actual) rents the property will command, less average vacancy allowance and operating expenses. Operating expenses include property management, insurance, property taxes, utilities, maintenance, and the like, but not mortgage loan payments. Capitalization rate is a little more subjective and difficult to calculate. Capitalization, or “cap” rate, is the rate of return a particular investor would expect to receive if he or she purchased a similar property at a similar price. The cap rate is derived from looking at similar properties and the net operating income associated with them. Obviously, estimating cap rate is not an exact science but a trained guess.

Gross rent multiplier. For single- family rentals, duplexes, and other small projects, an appraiser may use the “gross rent multiplier” to help determine value. This formula basically looks at similar properties and their rental incomes. By dividing the sales prices of similar properties by the monthly rent received, the appraiser can come up with a rough formula to compare with the subject property.

Loan-to-Value Loan-to-value (LTV) is an important criterion in determining the lender’s risk. In maximizing leverage, the investor wants to invest as little cash as possible. However, the lender’s point of view is that the more equity in the property, the less of a loss it would take if it had to foreclose. FNMA-conforming loan guidelines generally require an investor

to put 20 percent cash down on a purchase, which means an 80 percent LTV. Nonconforming loans may permit as little as 5 percent down for investors, depending on the financial strength of the borrower. Thus, an investor with excellent credit and provable source of income may be able to borrow as much as 95 percent of the purchase price of an investment property. On the other hand, an investor with mediocre credit and who is self-employed for a short period of time may be required to put 20 percent down. There are a hundred variations, depending on the particular lender’s underwriting criteria.

The Down Payment You need to show at least two months of bank statements to the lender to prove that you have the requisite down payment on hand. If the down payment money suddenly “appeared” in your account, you need to show where it came from. If it was a gift, for example, from a relative, you’ll need a letter from that relative stating so. Basically, the lender wants to make sure you didn’t borrow the money for the down payment (although some lenders will permit you to borrow the down payment from your home equity line of credit, discussed in Article 6). If your credit report shows recently high balances or a lot of recent inquiries from credit card companies, this may be a red f lag for the lender. In short, don’t expect to borrow the down payment from a credit card or other unsecured line and think the lender won’t notice.

Income Potential and Resale Value of the Property The particular property being financed is relevant to the lender’s risk. If the property is a single-family home in a “bread and butter” neighborhood, the lender’s risk is reduced. Because middle- class homes in established neighborhoods are easy to sell, a lender feels secure using them as collateral. However, if the property is in a neighborhood where sales are not brisk, the lender’s risk is increased. Also, if the property is very old or nonconforming with the neighborhood (e.g., one bedroom or very small), then the lender will be tighter with their underwriting guidelines. On the other hand, the stronger the local economy, the more likely a lender will be to waive the strictest of their loan guidelines.

Financing Junker Properties One of the major headaches you will run into as an investor is trying to finance fixer-upper properties. Many banks shy away from these loans because a subpar property doesn’t meet the strict FNMA lending guidelines. Also, lenders based their LTV and down payment requirements on the purchase price, not the appraisal. Thus, you are penalized as an investor for getting a good deal.

Example: A property is worth $100,000 in good shape and needs $15,000 in repairs. The investor negotiates a purchase price of $70,000. The lender offers 80% LTV financing, which should be $80,000, right? Wrong! The lender offers 80% of the purchase price or appraised value, whichever is less. So, the lender would expect the borrower to come up with 20% of $70,000, or $14,000, offering $56,000 in financing. Dealing with junker properties requires a lender that understands what it is you do. A small, locally owned bank that portfolios its loans will be your best bet. The lender may even lend you the fix-up money for the deal. An appraisal will be done of the property, noting its current value and its value after repairs are complete. The lender will lend you the money for the purchase, holding the repair money in escrow. When the repairs are completed, the lender will inspect the property, then authorize the release of the funds in escrow.

Refinancing—Worth It? A corollary to financing properties is the concept of refinancing. When and how often should you refinance your investment properties? Should you take advantage of falling interest rates? The rule of thumb is that you should not refinance your loan unless it is a variable rate or your new rate is 2 percent lower than your existing rate (that is, 2 points lower—not 2 percent of your current rate—such as 8 percent down to 6 percent). However, this rule of thumb is just that—a guideline. There are costs involved in getting a loan, and it takes several years of payments at the lower rate to recoup your investment. Also, keep in mind that if your existing loan has been amortized for several years, you are starting to pay less interest and more principal on your current loan; refinancing means starting all over again. The bottom line is to use common sense and a calculator—figure out whether the interest savings is worth the extra cost (and potentially the risk) of refinancing.

Filling Out a Loan Application You should be familiar with FNMA Form 1003, a standard loan application form used by most mortgage brokers and direct lenders to gather information about your finances. You should also have one filled out on your computer that you can provide to your lender (you can download a fillable Form 1003 on my Web site at <www.legal wiz.com/1003.htm>. You should always fill out a Form 1003 truthfully and honestly, but, like income tax returns, there are many “gray areas” when it comes to stating your income, debt, and assets. If you have any doubt, have your mortgage broker review it before submitting it to the lender.

Key Points

• Lenders make their profit in a variety of ways—the key is understanding how they do it, and paying the minimum you need to get a good loan at a fair price.

• Choose a mortgage company that has the requisite experience and can handle your business.

• Understand the basic loan criteria before you apply for a loan. • Refinance only when the numbers make sense.

Creative Financing through Institutional Lenders The power of thought — the magic of the mind! —Lord Byron While having a good mortgage broker or lender on your side is very valuable, you still need to have a few tricks in your back pocket to make things work. One of the main challenges for the investor is to buy properties with little or no cash, yet still have a low enough payment to avoid negative cash f low. This article will discuss some of the ways to do so.

Double Closing—Short-Term Financing without Cash If your intention is to buy a property and turn it around quickly for a cash profit, it is almost a sin to pay loan costs. Known as a f lip, the investor wants to make $5,000 to $10,000 turning a property that he or she buys at a bargain price. This process can be accomplished without traditional bank financing, much less a down payment. If a particular seller and buyer cannot be present at the same time, a closing can be consummated in escrow (an incomplete transaction, waiting for certain conditions to be met, such as the funding of a loan). Thus, the seller can sign a deed and place it into escrow with the closing agent. When the buyer completes his or her loan transaction, the deed is delivered and the funds are disbursed. In many cases, you can buy and sell the property to a third party in a back-to-back double closing (also called double escrow in some states). You do not need any of your own cash to purchase the property from the owner before reselling it to another investor/buyer in a double closing.

The seven-step double-closing process works as follows:

1. Party A signs a purchase agreement with party B at a belowmarket price.

2. Party B signs a purchase agreement with party C, offering the property at market price.

3. The only party coming to the table with cash is party C. Assuming party C is borrowing money from a lender to fund the transaction, party C’s bank will wire the funds into the bank account of the closing agent.

4. Party A signs a deed to party B. This deed is not delivered but deposited in escrow with the closing agent. Party B signs a deed to party C, which is deposited in escrow with the closing agent.

5. Party C signs the bank loan documents, at which point the loan is funded and the transaction is complete.

6. The closing agent delivers funds to party A for the purchase price and the difference to party B.

7. The closing agent records the two deeds one after another at the county land records office. As you can see, no cash was required by party B to close the transaction. Party B’s funds came from the proceeds of the sale from party B to party C. If the second sale does not happen, the first transaction, which is closed in escrow, cannot be completed. At that point, the deal is dead. If you are doing a double closing, you are acting as both buyer and seller. A double closing is actually two separate transactions. If you do not want party C to meet party A, the double closing can be completed in two phases rather than all at once. Obviously, you cannot give the seller funds until your buyer gives you funds. Thus, one of the two transactions must be closed in escrow until the other is complete. Often, this escrow closing may last an hour. The bottom line is you cannot close with the owner if your third-party buyer does not deliver funds to you. If you are interested in more information about the f lipping process, pick up a copy of my article, Flipping Properties (Dearborn Trade, 2001).

Seasoning of Title In recent years, some lenders have been placing “seasoning” (time of ownership) requirements on loan transactions. Some lenders are afraid to fund the second part of a double closing because of the possibility that the buyer’s purchase price is inf lated. The lenders are acting mostly out of irrational fear because of a recent barrage of real estate scams reported in the newspapers.

Property flipping scams. There has been a lot of negative press lately about double closings. Scores of people have been indicted under what the press has called “property f lipping schemes.” Some lenders, real estate agents, and title companies will tell you that double closings are illegal. In fact, they are nothing of the sort. The illegal property-f lipping schemes work as follows. Unscrupulous investors buy cheap, run-down properties in mostly low income neighborhoods. After they do shoddy renovations to the properties, they sell them to unsophisticated buyers at an inf lated price. In most cases, the investor, appraiser, and mortgage broker conspire by submitting fraudulent loan documents and a bogus appraisal.

The end result is a buyer who has paid too much for a house and cannot afford the loan. Because many of these loans are FHA-insured, the U.S. Senate has held hearings to investigate this practice. Despite the negative press, neither f lipping nor double closings are illegal. The activities described above simply amount to loan fraud, nothing more. As a result, some lenders have placed seasoning requirements on the seller’s ownership. If the seller has not owned the property for at least 12 months, the lender will assume that the deal is fishy and refuse to fund the buyer’s loan. There really is no solution to this issue other than to deal with other lenders that don’t have the seasoning hangup. Make sure you stay in control of the loan process and steer your buyers to a mortgage company that doesn’t have a problem with double closings.

Two possible solutions. If the buyer has found a lender that is really stuck on the seasoning issue, you have two options: (1) assign your contract to the end-buyer or (2) have the original owner buy you out of the deal. If you assign your contract to your end-buyer, he or she will close directly with the owner. However, the end-buyer may not have enough cash to pay you the difference between your purchase price with the owner and his or her purchase price with you. You need to trust that the parties involved will pay you at closing from the seller’s proceeds! The safer way to solve the problem is to approach the owner and ask him or her to buy you out of the deal. Buying you out means that the owner is going to pay you to cancel the sales agreement with you so that he or she can enter into a purchase contract directly with your end-buyer. Ideally, it would be best if the owner paid you in cash before he or she closed with your end-buyer. If the owner wants to wait until the end-buyer closes the sale with him or her to pay you the cash, put the agreement in writing in the form of a promissory note, secured by a mortgage on the property. Thus, at closing, you will be paid off as a lien holder.

The Middleman Technique Many foolish investors and unscrupulous mortgage brokers have been known to “overappraise” a property, effectively financing a property for 100 percent of its value. The mortgage broker then passes the buyer’s down payment back to the buyer under the table so that the deal is done with nothing down. Not only is this practice illegal, it is foolish, unless the property can be rented for more than the loan payment. Again, there is nothing special about buying a property with no money down unless it is profitable to do so. If you can purchase the property at a substantially below-market price and with no money down, you then have a good deal. This is buying 100 percent loan to purchase, not 100 percent loan to value.

The problem with buying a property at a below-market price is that conventional lenders tend to penalize you with their loan regulations. As discussed earlier, FNMA-conforming loan guidelines usually require that an investor put up 20 percent of his or her own cash as a down payment. The 20 percent rule applies even if the purchase price is half of the property’s appraised value. A common, but illegal, practice is for the buyer to put up the down payment and for the seller to give it back to the buyer after closing. People may get away with it all the time, but this practice is loan fraud. The middleman technique is a legal way to get around the 20 percent down rule. The process requires the following three important factors: 1. A middleman buyer 2. A negotiated purchase price that is 10 percent to 20 percent below market value 3. A lender that does not require evidence of a cash down payment Use a middleman partner to buy the house from the owner at a discount and sell it to you for its full appraised value. Do a double closing at which time the middleman buys the property and simultaneously sells to you. The reason for the middleman buyer is to increase the purchase price, because most lenders base their LTV on the lesser of the purchase price or the appraised value. Thus, even if you negotiate a 20 percent discount in the purchase price, the maximum loan you can get is based on the purchase price, not the appraised value. Example: Sammy Seller has a property worth $100,000 and is willing to accept $80,000 for an all -cash sale.

Matthew Middleman signs a purchase contract to buy it from Sammy for $80,000. Matthew Middleman then signs a contract to sell the same property to Ira Investor for $100,000. The terms of the contract are $80,000 cash and a note for $20,000, due in ten years. Ira applies for a loan with First National Bank for 80 percent of the purchase price, or $80,000. At a double closing, Sammy signs a deed to Matthew, which is held in escrow. Matthew signs a deed to Ira, which is also held in escrow. First National Bank funds the loan by wiring the money into the account of the escrow agent. The closing agent writes Sammy a check for $80,000. Ira signs a note to Matthew for $20,000. The closing agent records the two deeds back-to-back. Sammy gets his $80,000. Ira gets his property for only a few thousand dollars down (his loan costs). Matthew gets a note from Ira for $20,000. Epilogue: A month or two after closing, Matthew and Ira become partners when Ira deeds a one-half interest in the property to Matthew in exchange for complete satisfaction of the note.

Case Study #1: Tag Team Investing

I stumbled across a property that was bank-owned and offered by auction to the public. Like many foreclosures, the property was in need of repair (approximately $10,000 worth, in this case). The mar ket value of the property in its existing condition was about $180,000. The bank was willing to accept a bid of $134,000, which was 74 percent of its value. I brought in a middleman to submit the bid of $134,000 to the bank. The terms of the offer were all cash, which the lender would receive, as explained in a moment. The middleman then signed a contract to sell the property to me for $180,000. The terms of the sale from the middleman to me were $9,000 cash and a $27,000 promissory note (no payments, interest only, due in five years). The $27,000 note was to be secured by a second mortgage on the property, because I intended to borrow 80 percent of the purchase price ($144,000) and secure the new loan with a new first mortgage on the property. After the double closing, I owned the property subject to a new first mortgage of $144,000 to an institutional lender and a second mortgage of $27,000 to the middleman investor. The bank that owned the property received their $134,000 in cash, and the middleman investor walked away with about $9,000 in cash. I was out of pocket about $11,000, which was the down payment ($9,000), plus closing costs ($2,000). I later sold the property for $185,000, at which time the middleman investor agreed to accept a 50 percent discount on the $27,000 note. I used proceeds from the sale to pay the middleman. In the meantime, the payments on the $144,000 first mortgage note were less than I was able to rent the property for.

Case Study #2: Tag Team Investing

A client of mine (we’ll call him Chuck) used the middleman method to buy a $1.6 million house with no money down. The property was banked-owned as the result of a foreclosure. Chuck set up a simple living trust for himself with his buddy as trustee. The trust signed a contract (executed by Chuck’s buddy, the trustee) to buy the house from the bank for $950,000. Chuck then signed a contract to buy the house from the trust for $1.6 million, the property’s appraised value. Chuck gave the trust $400,000 cash and borrowed $1.2 million from an institutional lender. Because Chuck was the beneficiary of the trust, he received the proceeds of the sale (his $400,000 down payment, plus the $250,000 loan proceeds), netting nearly $250,000 cash in his pocket. Needless to say, he has yet to reach into his pocket for a monthly payment on his new loan!