As we reach the holiday season, I can think of nothing more appropriate or important a gift than to give someone the gift of knowledge. Therefore, my simple offering for all of you is more information on the mortgage industry. I am hoping my gift can help you understand this simply complex industry that often has such a profound effect on most people's lives.
It is simple because most borrowers opt for a 30 year fixed, shop for what they consider a good rate, generally overpay by either paying points or getting a "free loan". Down the line, I find they bemoan the fact that things just aren't working out the way they had envisioned when they took the loan in the first place. This column is the fourth of who knows how many columns I have written or will write about the workings of the mortgage industry in an effort to teach those who want to learn about the nuts and bolts of home financing. The first one was "I didn't know that - did you?" on September 21, the second one was "The Next Seven" on October 18, and the last one to date was "More things to know" on November 2, 2006.
We will start with some tax information. The mortgage industry does not share information with the IRS but the IRS does share information with the mortgage industry. If you are asked to sign a form, generally a 4506, it allows the lender to pull your tax returns or information from the return to compare it to what you have supplied the lender. Areas of concern are the adjusted gross income, schedule C and schedule E. There are two important things to know:
1) Don't ever consider giving anything false to a lender, especially tax returns.
2) The lender generally will not pull any of the information unless you miss your first payment on the new loan or you end up in foreclosure in the first year. Realize there are billions of loans done annually and if every lender pulled information from the IRS, it would probably shut them down. (Not a bad idea but not relevant to this discussion)
A next bit of tax information: when taking cash-out of your house, it is not a taxable event. I once had a celebrity give me their tax returns, and I noticed excessive earnings from years where I knew work was scarce. I asked how the income got so large, and they told me that they had pulled a lot of income from their house through cash out loans. The operative word is loans which of course is not income. You might ask how their accountant didn't catch the mistake. I asked him, as he had referred them to me. Each year they were one of the last to come in for an appointment and so he had them give him a figure on their earnings and they did. He didn't question them as most people are trying everything they can to pay fewer taxes not more. (He did send in an amended tax return after the error was discovered.) The moral of the story is that excessive cash out can lead to a problem - (see column of Sept. 21).
Property tax is not subject to change because you received a higher appraisal for a refinance. The taxing authority is not privileged to get the information and probably would be prohibited from doing anything with the information if they received it anyway. Please note that I receive many emails from all over the country that point out that local property tax authorities are ignoring the rules and over taxing their citizens when it comes to property tax. In California, the property tax on a purchase is 1% of the purchase price plus the bonded indebtedness of the county of that property, generally about .1 to .25%. Annual increases are limited to 2% of the existing tax. I have seen the local taxing authority disregard these rules and give much higher property tax bills and each time a hearing was held, the taxing authority lost. The answer is to know the rules in your state or county and be quick to challenge any tax bill out of the norm.
The tax rules on the sale of an owner occupied property were changed years ago from carrying the taxable gain to the next house (If you bought the next house for a higher price than the one you sold). A $250,000 exclusion was made for a single owner or a $500,000 exclusion of the gain for tax purposes was made for a married couple if you have lived in the house for years as your owner occupied house. The balance of the gain, if any would be paid at a capital gains rate.
You cannot use the income from renting a part of your owner occupied house to qualify for a loan, but the rental income should be included on a Schedule E of your tax return. If you have paid a prepayment penalty it is deductible as it is prepaid interest. Please check with your tax preparer as there are limits on the interest deduction. Points paid on a purchase are tax deductible and should come on your interest statement from your lending institution. Points on a refinance aren't deductible but must be amortized over the life of the loan. When you pay off the loan through sale or refinance you can expense the unamortized points in that year.
Please note that all the tax information that I have given is general and may or may not pertain to your situation. Before acting, please check your situation with your tax preparer or accountant.
Low to moderate income borrowers generally get special (lower) rates if they earn 80% or less of the median income of their county. Others who own houses or are buying houses in areas that are designated as low to moderate income areas can qualify for the same rates regardless of the value of their house or their income. States that are particularly benefited are California, Texas, North Carolina, Florida and New York. Many occupations including police, fireman and teachers also have special (lower) rates for certain situations through various lenders and also expanded LTV's (higher loan to values).
Another major area of misunderstanding is how to qualify for a loan. Lenders use gross income, not net in figuring your ratios of debt to income. When you are stating your income for a “stated income loan” which happens because generally you are self employed and cannot easily prove your net income, you should always use your gross income and not attempt to arrive at a net figure. Wage earners are allowed to have a stated income loan with higher credit scores and if you feel you can't qualify with your actual earnings please be prudent with your stated earnings. Most wage earners who use stated income do not wish to disclose how much they make not how little.
Bonuses that are paid on a regular basis are generally averaged over a three year period, as are gains from the sale of stock or real estate for those whose annual income includes these types of activities.
All debt paid off on a conforming loan and most sub prime loans is not counted against the income of the borrower in determining ratios. Installment debt for jumbo loans is counted even if it is paid off with the refinance.
Classical ratios to qualify for a loan were 30% over 40%. This meant that the total housing expense could not exceed 30% of the borrower(s) total income and that the total debt including the housing expense could not exceed 40% of the total income. This has been replaced by just the second ratio (back end ratio) and has increased to 50% in most cases of either high credit scores or sub prime credit scores (under 620). Several lenders have allowed a 70% ratio of debt to income on 15 year loans, realizing that the risk is smaller because the amortization of the loan increases the equity rapidly.
I wish to leave you with the truth about free loans, specifically first mortgages, not home equity lines of credit. I have talked about this in many of my columns but like, Santa and the tooth fairy, some people still believe. There are real costs when it comes to procuring a mortgage. There are "people costs" involved in every real estate transaction such as appraisers who need to be paid, closing agents who work for money, and brokers and bankers who work for a living. There are other costs such as title insurance premiums, mortgage insurance premiums where necessary, and lender costs needed to pay for the overhead of their establishments. Those who offer free loans need money to pay these costs and make a profit, and there is just one way to get it: higher interest rates. Lenders pay more for loans with higher interest rates than the going rate and that is how your free loan works. There are certainly exceptions to the rule such as loans nearing a million dollars or more and special circumstance loans. For the most part, however, if you take a free loan, you are paying for with a higher interest rate for the entire life of the loan. You decide if it makes sense for you. One way to be sure is to ask for a standard cost loan after they give you a quote on a free loan and then you decide.
Remember that the more you know, the better you become as a borrower so continue to seek knowledge before making a decision: it's the surest way to insure yourself when it comes to home financing.