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Print Pagefrom Oct 2007 issue of Houston Real Estate Experts - FREE subscription
Are You Financially Fit?
by Steven Kaufman, CPA
If you're like everyone else, you think banks and lenders make underwriting decisions based on sophisticated proprietary algorithms. You'd be surprised to know how uncomplicated and simple some of the matrixes really are. So, what are lenders looking for, and what makes you "financially fit" to a mortgage lender or bank?
Before we answer that question we have to briefly review the basics of risk. Risk is commonly defined as the "probability of loss." The higher the risk, the higher the probability a loss will occur. In stocks for example, the risk of buying penny stocks equates to a higher probability that you will lose some or all of your investment. However, the rate-of-return on penny stocks can be significant, which leads us to the second aspect of risk…Reward! In virtually every market, including real estate, the more risk you have with an investment (i.e., the higher the probability of loss) the higher your probable reward. Said another way, risk and reward have a direct relationship.
Lenders operate by this principle to such an extreme that it's so simple it becomes complicated. If they have more risk then they must also have more reward. To a lender, risk is the unknown: their inability to verify information. If your lender can not verify the appraised value of the property you are purchasing, then this is considered high risk because the value of their collateral is unknown.
To a lender, reward is the interest rate. The more risk they have (unknowns) the higher their reward (your interest rate). That simple!
This might help you understand why investment properties (non-owner occupied) have a higher interest rate as compared to the financing of your primary or homesteaded residence (owner occupied). Lenders believe that homes that are actually occupied by the owner (e.g., your homestead) will have a much lower chance of default (i.e., probability of loss) because you live and occupy the property. To a lender, it's "unknown" how you will care for and maintain a property that you don't actually occupy (investment property), and so they give higher interest rates (i.e., demand larger rewards to offset the unknown).
Obviously, allowing the bank to have a higher interest rate (reward) means you pay more over the life of your loan. The easiest way to combat their reward is to reduce their risk. The easiest way for you to this is to provide verification for more of the information you have provided them.
This brings us to the Financial Fitness Pyramid©.
The top of the pyramid represents the lowest interest rate, the lowest down payment, and the lowest credit score requirement, but in tandem requires the most verification of your income and of your assets (i.e., cash and securities). This is technically known as a V.I.V.A. loan. According to nearly all lenders, if you can verify your income and your assets (i.e., full doc-umentation) then you are at the pinnacle of financial fitness. It doesn't mean you can run a 4 minute mile, but it will get you the industry's lowest interest rates, allow you to put little or nothing down, and require a lower credit score compared to the alternatives. The top of the pyramid represents what is often referred to as "full doc" which is short for full documentation.
The next step down the pyramid is the S.I.V.A. loan. Many investors refer to this as a "stated" loan which originates from the idea that the investor who is unwilling or unable to verify his or her income is only required to state their income on the loan application. Industry insiders often refer to this loan as the "liar's loan." People often believe they can arbitrarily create (lie) a dollar amount for their monthly income without any recourse from the lender, because they are on a "stated" loan. This is not true, and many well known investors have learned this mistake the hard/expensive way.
Another area on the S.I.V.A. loan that often confuses investors is the requirement to verify assets. This is referring to liquid assets such as checking accounts, savings accounts, retirement accounts, and brokerage accounts. When you utilize a "stated" loan, you must still verify the liquid assets on your application. Income is stated and not verified. Assets are stated and verified. Real estate investors can still use S.I.V.A. loans to purchase property with zero money down.
Half way down the Financial Fitness Pyramid© is what many people refer to as "stated-stated." The S.I.S.A. loan is for those people who are unwilling or unable to verify their income and their liquid assets. They accept the responsibility to "state" this information on the loan application without it being verified during the loan process. Income is stated and not verified. Assets are also stated and not verified. As we move down the pyramid, the S.I.S.A. loan is the first place that does not enable an investor to obtain 100% investor financing on a long-term (conventional) loan. This can be a significant factor to an investor who plans on using traditional leverage as a paramount portion of his or her business model, and they should plan accordingly.
Moving further down the pyramid, we come to the N.I.N.A. loan. Commonly referred to as "no doc", it allows the investor to omit any information regarding his or her income and assets. The "no doc" loan has the highest interest rate, highest down payment requirement, and highest credit score requirement out of all the previous loans, and because there are no income or assets disclosed on the application, then lenders consider the risk to be significantly higher. It's worth noting that on a "no-doc" loan peripheral information and documentation (e.g., appraisal, title, and credit) often undergo extensive review because there is simply nothing else to look at. Loan-to-values (L.T.V.s) on N.I.N.A. loans are typically less than 90% for investment properties.
If there is one flaw to the Financial Fitness Pyramid©, it is that Hard Money loans are at the bottom. These unique loans offer a versatility that conventional loans simply do not. Hard Money loans give credit to the investor for equity between the purchase price and the after-repaired-value (A.R.V.) which allows an investor to purchase a property with nothing down, including repair/rehab money to fix up the property. Traditionally, Hard Money loans where considered strictly collateral based (i.e., lenders don't review credit, income, or assets). Yes, there are still a few lenders that offer this option, but they often require large cash deposits on every project.
The current trend in Hard Money lending is a hybrid review of credit, income, and assets - somewhere between the traditional collateral based loan and long-term conventional financing. Even hard money lenders strive to eliminate the "unknown" by reviewing your personal information. Despite the fact that current interest rates and fees can often be usurious (above the legal limits), there is a slow moving trend toward state and federal oversight of the hard money lenders that is accompanied by more reasonable competitive rates and fees. Wells Fargo has a department dedicated to hard money lending. Look for other national lenders to soon follow suit.
So, how fit are you? We are not talking about your waist line, but rather you financial bottom line. Knowing exactly where you are on the Financial Fitness Pyramid© will be key to achieving your financial goals. You have now eliminated some "unknowns" that will hopefully decrease your risk and dramatically increase your rewards. Good luck on your climb to the top!
Steven Kaufman, CPA
Steven Kaufman, CPA, with Zeus Commercial, is the only lender specializing in First-Time commercial financing. For a FREE Instant Approval or FREE Deal Analysis, contact 800-840-1900 or visit them online at WWW.ZEUSCOMMERCIAL.COM.