Credit is king. In the mortgage industry credit makes or breaks loans. In this article we’ll look at credit from a variety of angles:

1. Why credit is so important
2. Understanding elements of credit
3. Improving your score organically
4. Improving your score using 3rd party help
5. Managing your score

In a lax credit environment - like the one we’re quickly coming out of - your credit score is relatively unimportant; there is ample money and credit guidelines are lax. You can get money from almost anywhere. In 2005 whether you had a 500 FICO score or a 720 FICO score you were looking a low-to-mid 5% interest rates on a 30-year fixed mortgage. And only the lowest credit graded borrowers were being denied 100% financing. Credit was rarely an obstacle and money was exceptionally cheap.

In a tightening credit market your score becomes precious. Today you can’t get 100% financing unless you have over a 720 FICO score (or qualify for some niche-type purchase products); and even then, the rates on the second mortgage are not pretty. It has become cost-prohibitive to have high-loan to value (LTV) mortgages, even with excellent credit. Subprime borrowers face exceptionally high interest rates and borrowing cut-offs at 90% for refinance transactions. Poor credit borrowers are being squeezed by tightening credit and falling home prices. Prime borrowers in high LTV scenarios are feeling the crunch as well.

If you are a subprime borrower and in the middle of an Adjustable Rate Mortgage (ARM) with a prepayment penalty and are worried about your loan there is one thing you must be doing: improving your credit. Improving your credit is the key to avoiding the ARM Reset Foreclosure Trap.

Why Credit is So Important

1. Get Approved - As automated underwriting (AU) became more popular your credit score was made the driving factor of your interest rate and loan approval.  While it was always a factor in the past - automated systems needed something they could easily incorporate in to simple logic and the FICO score fit that bill.  And with that its importance went through the roof.
2. More Options with Less Equity - As your credit score increases you become eligible for higher loan to value (LTV) loan products.  This is extremely important in a falling property value environment because it allows you to refinance out of adjusting rate mortgage (ARM) loans even with little equity left in your property.  With out a high FICO score it is extremely difficult to refinance out of your ARM loan and in to a new fixed rate product.  The resultant ARM reset can put substantial payment stress on you and your family.
3. Access to Cheaper Money - Late payments on your mortgage can disqualify you from the most consumer-friendly mortgage programs.  Avoiding late payments on your mortgage means a substantially higher credit score and the ability to refuse mortgage products that include prepayment penalties and higher interest rates.  Good credit means cheaper money and more flexible loan terms, in all market conditions.
4. Access to More Programs - Good credit not only makes money cheaper; it also provides you access to credit that isn’t available to all borrowers.  If you are a subprime borrower you can’t get a stand-alone second mortgage these days.  The only option you have is to refinance your complete mortgage.  However, if you have good credit 2nd mortgages are available at competitive interest rates.

Understanding Credit and the ARM Reset Foreclosure Trap

The ARM Reset Foreclosure Trap is one of the biggest culprits for foreclosures in the country today.  Here is how it works:

• Subprime borrower takes out a high-LTV ARM loan (cash out of other) under loose credit guidelines
• Property values decrease reducing equity in the property
• Interest rates rise
• Credit guidelines tighten eliminating high-LTV mortgage products for subprime borrowers
• Subprime ARM loans reset to much higher interest rates and monthly payments
• Borrowers are locked out of high-LTV mortgage products due to poor credit
• Borrowers are faced with payment shock
• Borrower have no option but short sale or foreclosure

The only way to avoid this trap is to short-circuit it by improving your credit score.  It gives you the ability to maneuver at the high loan-to-value limits; your only chance to secure a new loan with out experiencing the pain of super-high payments on your now-adjusting adjustable rate mortgage. Credit is the only thing that can save you if you plan on keeping the home.  It is imperative that if you are in the situation above that you spend however much time you have between now and your rate adjustment date improving your credit score - and don’t stop until you’ve gotten above 720.

If you are in a prepayment penalty period it’s OK.  Work on your credit.  If you have 6 months until your rate resets - start now; same advice applies if you have 2 years!  By improving your credit score you improve your prospects of being able to secure financing at high loan to value ratios.  And that is the key to stemming payment shock and avoiding foreclosure, short sale or other not-so-fun remedies.