By Mitch Irwin and Scott Rodman

Over the last 18 months local real estate values have declined, loan programs/sources have contracted, and lending guidelines have tightened.  Gone are the days of virtually everyone qualifying for a loan regardless of income, credit or down payment.  This increased scrutiny has created new specific challenges for divorcing couples with respect to how they handle current and future housing issues.

1. Credit

a.     Credit Score Overview: FICO scores are a standard of measurement for credit worthiness. Depending on the credit bureau, the scores will range from 400 to 850.  The score is a synopsis of payment history, amounts borrowed, length of credit history, type of credit accounts carried and various other factors.  Below is a generalization of score ranges:

740+ Great credit; should get best interest rates available.

680 - 739 Good credit; will still see an interest rate or price adjustment.

620-679 Can probably still get a loan, but most likely has late payments, maxed out credit cards or a short credit history that might deny the file.  Some loan types, such as taking cash out with less than 30% equity, or any financing over 80% will require a 700+ credit score.

580-619 The minimum score required with most FHA lenders is 620.  Borrowers with a score of less than 640 will need compensating factors for a loan to be considered, and should consider credit repair.

b.    Credit Reports: Clients can pull their own credit report from www.annualcreditreport.com.  They can use this to identify joint accounts, confirm balances and see if any new debts have recently been taken out by a spouse.  The client will need to pay extra to receive their credit score.  A word of caution:  consumer reports sometimes pull different than reports pulled by a lending institution like a bank.

Attorneys can also use this information to determine a client's ability to pay.  If they have a long history of missed payments, collection accounts or judgments you may decide to require a larger retainer or demand that a credit card is available for billing.

c. Additional Credit Notes:

Lack of Credit.  In addition to score requirements, most conforming lenders require three active credit accounts (mortgage, credit card, auto loan, student loan, etc) for loan approval.  FHA is the only loan that allows for "non-traditional" credit to be used, which are accounts that do not report to credit but are commonly paid on-time:  utility bills, car insurance, cell phone, etc.

Mortgage History:  Is the mortgage reporting to your client's credit report?  Is the mortgage being paid on time?  These questions may have an impact of whether a loan needs to be refinanced out of another person's name.  It also may impact if a client will be allowed to refinance a loan that they are not currently on.  It is crucial that the party remaining in the home subject to payment of PITI remain current on mortgage payments, as their default will likely affect the other party's ability to qualify for a loan on a new home.

Credit Repair Needed?  With increased credit requirements in today's lending environment, credit repair may be beneficial to raise the score and/or remove inaccuracies.  Credit repair companies are independent of the credit bureaus and banks. They help dispute or remove in-accuracies and coach clients how to increase their credit score.  They average cost is around $500 per individual or $800 per couple.

2. Income

a.     Borrowers must now verify income to qualify for a loan.  In the past, many clients used stated income, no ratio, or no documentation loans to avoid excessive documentation or "glitches" in qualifying formulas.  These loan programs are no longer available.

b.    Debt to Income ratio (DTI) is the standard measure of loan qualification.  A 41% DTI is the most common limit. This is calculated by dividing all (credit reporting) monthly payments by the gross monthly income.  Example; if a client has $1400 in payments and she earns $4000 per month gross, her DTI is 35%. A DTI higher than 41% represents additional risk and may be denied; loans requiring mortgage insurance mandate a less than 41% DTI.

c.     Debt to Income ratio is not to be confused with a monthly budget ratio that looks at all the costs to live (CTL).  A comprehensive budget should be completed to examine if a client passes both the tests of qualifying for a loan and being able to meet all of their living expenses.  Just because a client qualifies for a loan with a 35% DTI - their cost to live may be 108% of their take home income due to expenses that do not report to credit:  daycare, groceries, utilities, entertainment, etc.  It is good practice to request that the loan officer consider CTL as well as DTI.

d.    Child Support & Spousal Maintenance:  In today's lending environment, in order to include receipt of child support and/or spousal maintenance as income for loan qualification purposes, a person must provide evidence that the support or maintenance has been received for a minimum of 3 months and will continue for a minimum of 3 years.

i.     If a child is over the age of 15 this income cannot be used.

ii.     If temporary maintenance is awarded for only three years, there is a chance this income will not be considered because there may only be 2 years and 9 months remaining after it has been received for 3 months.  This should be kept in mind when negotiating temporary maintenance duration.

iii.      In order to be considered, spousal maintenance must be pursuant to an official court order.  Structuring lump sum payouts in lieu of maintenance, property settlements in lieu of maintenance, or entering into agreements to pay bills or the mortgage monthly as informal spousal maintenance, even if incorporated into an order, will not result in the maintenance amount being considered by the underwriter.  Only regular monthly payments of spousal maintenance will be considered.

iv.     Creative wordplay and complex conditions for payment of spousal maintenance may result in the maintenance being excluded from income for loan qualification purposes.  If there are any conditions applied to receipt of maintenance that could result in maintenance ceasing before the end of three years, the underwriter may decide the risk is too high.  For example, if payment of maintenance is contingent on a party remaining in school, the loan application may be denied.

e.     Glitch for Paying Spousal Maintenance:  The IRS allows a person paying spousal maintenance to deduct this expense from their gross income before arriving at net taxable income.  Most lending guidelines do not allow this subtraction from gross, but rather treat it as a payment just like child support or an auto loan.  This impacts clients paying spousal maintenance because they will not qualify for as much if they followed IRS income tax guidelines.

Example:  A client makes $10,000 per month, with a spousal maintenance obligation of $3,000.  The IRS would view his taxable income as $7,000 per month.  With a DTI ratio maximum of 41%, he could have expenses totaling $2,870 and theoretically still qualify for the loan.

However, lending guidelines do not view it this way and will multiply his $10,000 of monthly income by 41%, equaling $4100, and will then subtract the $3,000 spousal maintenance obligation.  Therefore, his maximum remaining debt payments cannot exceed $1,100 or his loan will be denied.  This glitch can result in the denial of loan applications from individuals who can actually afford the loan.

The strategy we would recommend is to work with a lending institution that can portfolio a loan in-house; they potentially provide more flexibility in calculating the income.

f.      If a client returning to the workforce is seeking a loan, this new income can be used assuming he or she can provide an offer letter and paystubs showing 30 days of income.  Commissions, bonuses or overtime cannot be used.  Only regular salary or hourly wages are allowed.

g.    Clients converting their marital home to a rental property and purchasing another home should know that the rental income cannot be used for loan qualification unless there is at least 30% equity in the rental home and 6 months of reserve payments are verified in a liquid account.  If there is not 30% equity in the rental home, the client will need to qualify using both payments and will still need to verify 6 months of payment reserves.

3. Equity / Down Payment Requirements

a. Purchasing:  Almost all of the 100% financing options have disappeared for homes in the metro area.  The USDA allows for 100% purchase financing, but the home needs to be in a qualified area and has income restrictions.  When purchasing a home in the metro area, the minimum down payment requirement is 3.5% via an FHA loan.  Conventional loans require a 10% down payment.   This is due to the current declining market values, and lack of appetite on the secondary market for home equity loans that used to allow for smaller down payments. 

b. Refinancing: The equity requirements for refinancing are slightly more restrictive than a home purchase, depending on the type of loan transaction (cash-out vs. rate & term).

i.     Rate & Term is simply refinancing one loan for another, where no cash is received and no additional debts are paid off.  The interest rates and equity requirements are similar to a purchase loan.

ii.     Cash-out is where additional debts are paid or cash is received in the proceeds of the refinancing.  For example, a refinance to pay off a mortgage, a home equity loan and a credit card is a cash-out transaction.  These transactions typically have higher interest rates or pricing adjustments, can be harder to get approved, and can require more equity in the property.

iii.     Clients refinancing to remove their ex-spouse's name and/or pay them out per a divorce decree can still complete a rate and term refinance.  IT IS NOT CONSIDERED A CASH-OUT REFINANCE as long as the borrower receives no cash, the ex-spouse is paid out on the HUD Settlement Statement, and the equity pay out is per the terms of the divorce decree.

4. Timelines

a.     The days of a vacating spouse being able to purchase a home with no money down prior to the entry of a divorce decree are gone.  Lenders want to know what happened with the previous address/home/mortgage, the loans require a down payment now, and underwriters want to see what the true income, assets and debts will be post decree.

b.    Vacating spouses purchasing a home should be very careful regarding the anticipated timeline of settlement and the decree being signed so they can perform on their contract and close without postponement.

c.      Vacating spouses purchasing a new home CAN buy a home even if the old loan is still reporting in their name.  The divorce decree needs to be signed into order.  It needs to include specific language awarding the other party the home and ordering them to make payments.  The divorce decree removes their obligation from a QUALIFYING standpoint for a new loan.  The old loan will still report to their credit report and represent a credit risk.  We highly recommend requesting that the old loan is refinanced to remove their name, but when that is not possible, it will not prevent them from buying another home.

d.    It is advisable to encourage clients to include a "Divorce Contingency" in their purchase agreement if writing an offer before the divorce is complete.  This is a separate addendum explaining that they are in the process of a divorce, that the client intends to purchase the home, but that they cannot close until a divorce is complete and/or they receive their marital property settlement.  This strategy typically does not work with bank owned properties; it needs to be a seller that understands and is comfortable with the contract.

e.     Refinance clients can start the process prior to the decree being signed.  They can have everything but the signed divorce decree in place and ready to go.  Once the decree is signed the closing can be scheduled within days.  Borrowers sign an affidavit at closing stating there are no divorce proceedings in process.  Refinancing a home without disclosure to a lender and signing this affidavit is considered fraud.  Remember, if child support income is needed to qualify, the borrower will need to show the 3 months of receipt and 3 years continuance as discussed in the Income section above.

5. Marital Liens

a.     A marital lien can be placed on a property for a determined amount to be paid at a future date.  There are multiple reasons or advantages to using a lien in lieu of an immediate pay-out.  Perhaps the client does not qualify for refinancing or wants to keep the payments as low as possible.

b.    A common method of using a marital lien is for the party keeping the house to determine their max loan qualification, then put a marital lien on the property for the remaining amount.

c.     Two different methods of marital liens are a flat dollar amount; the other is a percentage of home equity.  The advantage to a percentage of equity is the amount will be determined based on future equity so the receiver would share in the appreciation or depreciation.  As a lender, I prefer the flat dollar amount; it's easier for lenders and title companies to determine the pay-off amount and alleviates future disputes of appraised value, etc.

6. Assumption / Release of Liability

a.     Many clients are attempting to remove the name of a spouse without refinancing.  This is an option with some lenders.  The client should call the lender and ask if they do allow it.  If the lender allows assumptions, they normally send an application package.  The approval process takes 60-90 days and the costs are about $1,000.

b.    It has been my experience that most lenders will deny the assumption because an important variable has changed from original loan request (income, equity, score), but approve the client for a new loan based on the new criteria from the credit application.

7. Escrow Balance Refund

When a home loan is refinanced the escrow balance is refunded usually within 30 days.  How the check(s) are cut for the refund will vary by individual lender.  If the loan is still in both parties' names because the divorce decree did not require a refinance to pay out marital equity, some lenders will send a joint check in both parties' names, requiring both parties to sign, despite the fact that the escrow funds are derived entirely from the income of the party awarded the homestead by that time.  Some lenders send separate checks for equal amounts.  To avoid controversy of who gets the checks and the cooperation of forwarding to the appropriate party, it would behoove you to include specific language in the decree to address how the check(s) will be handled.

8. Negative Equity Situations

a.     Foreclosure:  A foreclosure is the worst result with respect to credit reporting and will prevent a client from purchasing a home for a minimum of 5 years.   An applicant must disclose a foreclosure within the past 7 years.  Depending on the type of foreclosure, the borrowers may face a deficiency judgment afterward.

b.    Deed in Lieu of Foreclosure:  Normally this is done to avoid extreme credit deterioration and is a faster method to offload property when a client needs to move out of the home.  The clients are basically moving out and giving the keys back to the lender so they can sell it right away, in exchange for an agreement that the lender will not report it as a foreclosure or pursue a deficiency judgment.  Nevertheless, a party will still be required to disclose a deed in lieu of foreclosure for up to 7 years.

c.     Short Sale: A short sale is the sale of a home where the mortgage lender agrees to accept a lesser amount than is currently owed to satisfy an existing mortgage.  The sale is typically completed before a home is foreclosed.  The lenders normally require that the mortgage payment is 30 - 60 days past due before this option is seriously considered.  The credit repercussions include late mortgage payments on credit and the potential of a listing indicating "Paid In Full - Not as Agreed" or "Settled For Less Than Amount Owed."  A minimum of two years must have elapsed since the short sale and re-established credit guidelines must be met in order to purchase a new home.

d.    Modification:  A loan modification is when a lender renegotiates the terms of an existing loan that can include a reduction in principal balance and/or lower interest rates or payments.  This is a very new concept to lending that is getting much attention in the present lending environment.  Additionally, President Obama has unveiled a new home foreclosure prevention strategy, the details of which should be available on March 4^th.  Complete details were not available at time of material submission.

e.     Make Homes Affordable Plan:  Sometimes referred to as the "Fannie Mae DU Refi Plus" or "Freddie Mac Relief Refinance" loan.  This program allows homeowners to refinance even if they have lost equity since their purchase.  The program allows for up to a 105% Loan to Value with an unlimited Combined Loan to Value (assuming the second mortgage subordinates).  Initiatives are also being released regarding assistance to lower rates on second mortgages.  The most important component to this program for divorcing clients is:  The borrowers must be identical to the existing loan.  Thus, divorce refinances to remove an ex-spouse do NOT qualify! This is as of today, it is undetermined if there will be enough influence for this to change.

9.     FHA Advantages

a.     Co-signors: In divorce situations, it is common for a parent to step in and offer to co-sign on a loan.  The only loan program that allows for a 'non-occupying' co-borrower is an FHA loan.  They do NOT have to be first time home buyers.  This is a common misconception.

b.    Hardship Clause:  FHA is also the type of loan that includes a hardship clause, where in the event of an extreme hardship, monthly payments can be suspended for up to one year and rolled to the back of the loan.

c.     Disadvantages:  FHA loans do have some quirks to them that a client should be aware of.  Particularly, the cost of an up-front mortgage insurance policy (1.75% of loan) AND on-going monthly mortgage insurance (.55% factor) can make it appear expensive from a cost and payment standpoint.

10. Non-Traditional Financing

a.     Contract for Deed:  Clients that do not qualify for traditional financing options may consider purchasing a home on a Contract for Deed.  A contract for deed is a contract between a seller and buyer of real property in which the seller provides financing to buy the property for an agreed-upon purchase price and the buyer repays the loan in installments.  Typical terms in this market are 10% down payment and about 6% with a balloon due in 3 - 5 years.  Almost everything can be negotiated.  Not all homes qualify to be sold on contract for the deed.  Most conventional financing has a "Due on Sale" clause that prohibits this and could make the sale null and void.

b.    Lease with Option to Buy:  Similar in terms to a contract for deed, but the sale is not complete until the option has been executed.  The home is basically rented, with an additional payment going towards the principal balance or the down payment.  In 3 - 5 years the purchaser will seek a traditional loan to complete the sale.

BONUS:  Quick Calculations / Rules of Thumb

a.     3x Gross Income:  When asked how much a client can afford in regards to a home loan, a fairly safe rule of thumb is three times their gross income.  As an example, a family that has a gross income of $80k, can normally afford a $240k home - assuming other expenses are not extravagant, they have decent credit for traditional financing, etc.  Clients trying to purchase a home, or more commonly keep a home where the loan is six times their gross income, will eventually be foreclosed upon as the math will catch up with them.

b.    $6/ thousand:  If you are in a hurry, and need to estimate the cost of a higher or lower loan amount - an easy equation to use is $6 / $1000 borrowed.  For example; a $100k loan at 6% on a 30 year loan is $600/month.  Increase the loan to $110k and the payment becomes $660.  In other words, every $10k costs approximately $60.

Authors' Note: This guide is meant to be a brief overview of the most common hurdles divorcing clients face when seeking a mortgage / real estate financing.  The issues discussed are the opinion of the authors based on recent client situations and lending guideline updates.  There may be exceptions to every situation based on each independent lender's policies.  Obviously, the information is as current and accurate as possible, but subject to change at any time.