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The Dangers of a Bad Credit Mortgage

Posted by  on Apr 16, 2009
 
When a mortgage lender evaluates your eligibility for a mortgage, they look at two main criteriayour ability to pay, and your willingness to pay. Your ability is based on your monthly income to debt ratio, and in general, if your total monthly debt does not exceed 36-40% of your total monthly income, you will meet the requirements of this section of the evaluation. Your ability to pay, however, is based on mostly on your credit rating, and even if your income to debt ratio is good, a low credit rating can affect your eligibility for a favorable interest rate. In the worst situations, you may be eligible only for a sub-prime mortgage, also known as a bad credit mortgage.

Know the Risks before Getting a Bad Credit Mortgage

If a bad credit mortgage is your only option, it is important to understand the risks before applying. One of the most significant dangers of the bad credit mortgage is simply the higher cost of getting the loanin most cases, you will end up with an interest rate between two and five percent higher than with a conventional mortgage. If your credit rating is poor because finances have been tight in the past, that higher interest rate could lead to problems paying your mortgage in the future.

Another significant danger of bad credit mortgages is the fact that if you need such a mortgage, you are more likely to come into contact with a predatory mortgage lender. Most conventional mortgage institutions simply do not offer bad credit mortgages, and this means that you must choose your bad credit mortgage lender with particular care.

To a mortgage lender, your poor credit rating means you are a high-risk prospect, and they quote mortgage rates accordingly. If your poor credit rating is a reflection of your inability to pay your debts, rather than your willingness, the increased cost of the mortgage can mean that the loan is a very risky prospect not only for the lender, but also for you. Simply put, if your financial status means that a bad credit mortgage is your only chance at getting a home loan, it much more likely that you will end up in a position where you cannot afford mortgage repaymentscausing you to default on payments, and possibly resulting in foreclosure.

Refinancing out of a Bad Credit Mortgage Comes at a Price

Most people who take out a bad credit mortgage do so with the intention of refinancing as soon as possible, and plan to repair their credit in the mean time to qualify for a better interest rate. If this is your intention, you must take into account the costs of refinancingclosing costs apply when you are refinancing just as they do for the first mortgage. These costs are payable in cash, and you should also take into account whether or not you plan to move in the near future. If you are planning to move in five years or less, the costs of refinancing may not be offset by the lower interest rate on the second mortgage.

In addition, you should not apply for refinancing until you know for certain that your credit rating is high enough to qualify you for a conventional mortgage. A rejected application will hurt your credit rating, leaving you back at square one.

Most importantly, if you take out a bad credit mortgage with the intent of refinancing, its crucial that you check your contract carefully. Up to 80% of bad credit mortgages have very hefty early payment penalties which can extend for three years or more, or cost you more than six months worth of interest if you pay early.

How to Minimize the Risk

If the poor credit rating you have accumulated requires you to consider a bad credit mortgage, you may be able to score points with a lender if you have a stable work history, a good income to debt ratio, or a larger down payment. Any of these factors may allow you to negotiate a slightly more favorable interest rate.

You can also minimize the risk of your bad credit mortgage by choosing your mortgage lender and your mortgage carefully. Avoid any mortgage lender who does the following:

Attempts to charge excessive fees for your mortgage. Bear in mind that the average conventional prime loan does not entail more than 1% of the loans value in fees.

Tries to sell you products or services you dont need, such as unnecessary insurance.

Offers a loan with mandatory arbitration. This clause means that you are not allowed to take the case to court if your home is threatened.

Tries to steer you into taking out a larger loan than you can affordfor example, offering a 100% or higher mortgage. These are extremely risky, because if the property market hits a slump, you can end up owing more than the house is worth.

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