What is your “social credit score”

Social Credit Score

Your creditworthiness amongst those that you have a relationship with.  The willingness of your friends, family, and acquaintances to lend you money.  An alternate way to think about your credit score that does not reduce you to a three digit number.

Today’s banking industry would have us believe that you are defined by a three digit number … the infamous credit score.  The powers that be have assigned each and every one of us a number that has the power to control much of our destiny.  But do we have to live in a word where we are defined in this way?  Does the system that bestows our credit scores upon us hold the only set of keys to borrowing money?  Increasingly the answer to this question is … NO!  More and more, individuals nationwide are opting out of the system that in the past 5 years (and arguably much longer) has not given them a fair shot at the nation’s wealth.  They are circumventing the system through crowd-sourced lending, local investing, land contracts or lease-options to purchase real estate, bartering, and cash transactions.  The “relationship model”, which has been largely replaced by FICO scores in most banking transactions, is making a comeback.  Although the FICO score (or other similarly calculated credit score) still holds a great deal of weight, for an ever-increasing number of people, it is their “social credit score” that really matters.

Picture with me for a minute an office of 10 people.  Every day for lunch, those 10 people go out either on their own or in groups to get lunch at a restaurant and every day, these 10 people lend and borrow money from eachother.  One day someone forgets cash, the next someone needs to stay back and asks his colleagues to pick something up.  If you’re in that situation, it doesn’t take long to figure out who will pay you back and who will not.  This is social credit.  Eventually those with low social credit scores, in other words those that don’t pay back what they owe or who never offer to buy for others, will have a smaller pool of people willing to buy lunch for them.

Now picture this happening on a larger scale, where in order to borrow money you don’t have to hope and pray that that credit card payment you missed 4 years ago will bring you down to 660 causing you to once again get denied by Bank of America for a mortgage.  Instead, you have to develop some sort of relationship with another individual and convince them that you are worthy to borrow their money.

Crowd Sourcing or Peer-to-Peer Lending

Crowd-sourced lending is a prime example of a marketplace where one’s social credit score matters.  Sure, to get approved at The Lending Club or Prosper.com you will have your regular credit score checked, but that is only part of what qualifies you for a loan.  The other part is the potential borrower’s story or their reason for wanting to borrow money.  The story, although often only a few lines of text, begins a relationship between the borrower and lender.  Here are a few examples of people’s stories from Proper.com …

1.  Purpose of loan:  Pay off four loans/credit cards  |  My financial situation:  I can easily make the payment and will probably pay it off early.

2.  Purpose of loan: To pay off existing high-interest debt and began saving for my son’s              college education.  |  My financial situation: I am a good candidate for this loan because I am an honest, hard-working professional educator who is tenured and never makes late payments to creditors.

3.  Purpose of loan: Rental property purchase.  This loan will be used to complete a purchase of a rental property.  |  My financial situation: Good.  I am a good candidate for this loan because I have my regular income and I also have rental income coming in I have almost completely paid my credit cards and I have had a loan with prosper before and paid it off early.

Unlike going to a bank that is only concerned with whether they will be able to sell your loan to Fannie or Freddie, peer-to-peer lending takes the power of lending money away from the government and puts it back in the hands of individual lenders and at least partially restores the relationship model of lending.

 Land Contracts or Lease Options to Purchase Real Estate

Take a look at your local Craigslist real estate listings (http://yourcity/craigslist.org/reo) and chances are you will find a home seller offering to sell their house via a land contract.  Alternatively, if you list your house to sell in that directory, you will certainly get emails or calls from potential buyers asking if you would consider a land contract or lease-option.  Land contracts and lease options are two ways that real estate ownership changes hands without financing from a bank.  In a land contract, the seller acts as the bank and the buyer makes regular payments straight to the seller for an agreed upon number of years.  In a lease-option, the buyer is considered a “tenant owner” and makes rental payments to the seller that not only cover rent but also pay down the balance on the agreed upon sale price.

Even more so than with with peer-to-peer lending, there is a necessary relationship of trust that is built between the buyer and seller.  As a buyer (or tenant owner) it is your job to convince the seller that you will make your payments and fulfill your part of the contract.  The seller for their part may request W2s, pay stubs, bank statements, or a down payment … just like a bank.  The difference is that the decision whether to lend money is brought down to the individual level.  The Social Credit Score of the buyer is paramount in this transaction whereas the FICO score is secondary or not a factor as all.

Conclusion

The concept of a Social Credit Score is not meant to reduce lending standards but rather to bring the lending decision from a national level to a personal or company level decision.  If your credit truly is bad, then it’s very likely that your Social Credit is as well.  For those of you with a few dings on the FICO score but good financial situations otherwise, consider alternate means of funding your projects that rely on Social Credit.  It’s time to break free from your three digits.

 

Government control of bank lending … non-conforming or “portfolio” loans

Does it bother anyone else as much as it bothers me that the federal government controls who gets loans and who doesn’t. Let me say that again …. the FEDERAL GOVERNMENT sets the lending standards for the vast majority of the loans that get issued by banks. It’s just another example of extreme governmental overreach but don’t get me started. So just how does the government exert this control?

Well, Fannie Mae and Freddie Mac, which are technically “Government Sponsored Enterprises” or GSEs rather than actually governmental agencies, buy up the majority of loans originated by local banks. Why? Well, to provide “liquidity” of course. Liquidity means that any given local bank, or even a “Too Big to Fail” can originate a loan, not forgetting to charge the borrower a healthy “loan origination fee” and other random fees (if you’ve ever read a Truth in Lending Statement, you’ll know what I”m talking about), and then sell your loan off to Fannie Mae or Freddie Mac!

What a deal! The originating banks get to charge the upfront fees, but don’t have to be bothered actually servicing the loan. Even more, they don’t have to take on the risk of a borrower defaulting or runaway inflation taking hold. PLUS …. they get their money (or “capital”, as they like to call it) back once the loan is bought by the GSEs. This lack of accountability in originating a loan is what got us into the sub-prime mess, but that’s a topic for another day.

The topic for today is “non-conforming” or “portfolio” loans. Every once in a while, you’ll come across a bank that doesn’t intend on selling your loan to the GSEs but rather keeping it in their portfolio of loans (hence the name). Sometimes they say they will keep the loan “in house”, meaning that it will remain an asset on their own books until it is paid off.  The “non-conforming” comes in because the qualifications for getting a portfolio loan do not necessarily conform to the lending standards of our friends Fannie Mae and Freddie Mac. Maybe your credit isn’t where it should be, maybe you haven’t been in your job for two years or more, maybe you have more than 5 financed rental properties, maybe you’re a student, and the list goes one. Chances are, if you have been denied by a single bank that intends to sell your loan to Fannie and Freddie, then you will get denied by ALL the banks that intend to sell your loan.

And that’s what bothers me. Personal relationships don’t matter and neither does your reputation. A job doesn’t matter unless you’ve had it for more than two years. That in and of itself disqualifies a huge percentage of otherwise very eligible borrowers. If you own rental properties, or should I say, if you own more rental properties than Fannie Mae and Freddie Mac deem acceptable, then you are considered a credit risk.  All that matters for most banks today is whether they will be able to sell your loan to the FEDERAL GOVERNMENT! That’s it!  They just want to get the loans off of their own books so they can originate another loan with those funds.

If you’ve been denied time and time again but believe yourself to be credit worthy, there is still hope. Non-conforming loans are not easy to find but they do exist. Smaller local banks are far more likely do issue non-conforming loans than the big dogs. Try to establish a relationship with a banker. Back in the “It’s a Wonderful Life” era, trust was the key element in a lender / borrower relationship. Today is all about the numbers. However …. you can still find pockets in the banking industry where trust is still a factor. When you approach a bank, be open about the issues that disqualify you from a conforming loan, state why those issues do not make you a credit risk, and inquire is there’s any chance of getting a portfolio loan. It’s definitely worth a shot.

Lastly, do not despair. The systematic way in which the banking industry is disqualifying worthy borrowers is simply causing more people to “opt out” of the system all together. There are other ways to buy a house than to grovel at the feet of banksters. The rise in peer-to-peer lending, land contracts, lease options, and rent-to-own contracts is an encouraging indication that an ever-increasing number of people are starting to circumvent the banking system all together.

If you have any insights on the banking system, peer-to-peer lending, or portfolio loans, please leave a comment below. Thanks.

College Student Home Buying Guide

AKA – How to buy a house as a college student.

Before you start

If you are in college and have bought a house or bought one while you were in college, I would LOVE to hear your story since I have never talked to anyone else that has done this.  Please either comment at the end of this post or contact me.  Thanks!

Introduction

If you’re in college and want to buy a house, chances are you are in the minority.  It’s rare that you will find a college student that has bought real estate.  Buying a house is so off of the radar for the majority of college students that you’d be hard pressed to even find one other person to compare notes with.  I bought my first rental house in October 2009 while I was a college student at the University of Michigan in Ann Arbor Michigan on a land contract.  No banks were involved, nor were any real estate agents.  Here’s how I did it.

Summary

1.  Searched Craigslist for home sellers willing to sell their house on a land contract and eventually found one that made financial sense (see below for details on land contracts).

2.  Borrowed $5,000 from my parents and used $10,000 that I had saved up as a down payment.  The sale price was $54,000 so the remaining $39,000 was on the land contract.

3.  Since the interest rate on the land contract was 7%, I paid it off as soon as possible using student loans (see below for issues relating to using student loans as a down payment or for paying off real estate purchases).

4.  Found a renter (also using Craigslist) who rented the house for $950 / month.  The $950 covered the land contract payment, property tax, insurance, and the payments on the loan from my parents.

So it’s possible.  I’m not saying that “anyone can do” like those gurus out there would have you believe, or that it’s easy, just that it’s possible.  After that house I repeated the same process (with a few minor changes) two more times and was able to get better interest rates on the subsequent houses.  After all, if it works, why do anything else?  All that said, here are details on how you can buy a house, even if you’re a college student.  (A quick note … If you have questions on more specifics of these deals, or if you have questions about a potential deal that you’re working on, I would be happy to talk  to you about this.  Just drop me a note and I’ll get back with you as soon as possible.)

I’m in college!  Why would I want to buy a house?

What I want to focus on in this post is creating a passive income stream for you.  There are tons of different types of passive income and call me biased, but I would rate rental properties as the best investment option that is available to you and me.  It’s not as easy to set up as say an affiliate or niche market website, but the payouts are far greater, longer lasting, and more consistent.   As a college student you have certain disadvantages when it comes to buying a house but you also have some distinct advantages.  Traditional loans will be tough to come by and you may not have a lot of disposable income for a down payment.  Do not despair!  Later in this post, I will discuss ways to overcome these disadvantages.  Your advantage as a college student is this … you have a bunch of friends who would be more than happy to rent a room from you!  Finding renters with non-student housing can be tough and costly but for you it should be fairly straightforward.  I mean, what student wouldn’t want to live in their friend’s house?

Also, because of the nature of the student rental market, rents of dorms and rooms close to campus end up being quite inflated.  The reason for this is that the person living in the room is rarely the person that actually pays for the room.  In other words, in most cases the parents pay for their students living expenses while they’re in college.  Parents often want the best for their kids and landlords know this and that is why rents around colleges are usually inflated.  It’s the classic “somebody else is paying so why does it matter what it costs” situation that you see in health care and wedding registries.  As a student-landlord, you can benefit by being on the other end of this transaction by being able to charge higher rents.

Is buying real estate really the best investment I can make?

If you’re reading this post, my guess is that you’ve already done quite a bit of homework and are convinced that buying houses is far and away the best investment you can make, not just in college but at any time in your life.  If you haven’t come to that conclusion yet, please check out my post on why there is no better investment than real estate.  The post covers real estate in general so here I will only cover some of the specifics relating to your situation as a college student.

Market Stability in College Towns

College towns rarely see very large shifts in real estate prices and it’s even rarer to see large drops in prices.  Higher education has simply not been hit as hard by the recent downturns as manufacturing or retail and home prices reflect that.  Professors and administrators still have jobs and thousands of students flock to colleges each year with their pockets full of student loan and grant money.  It is this constant influx of money that prevents the real estate market around colleges from seeing the large dips that you see in other areas.  Here in Ann Arbor Michigan, home to the University of Michigan, the city is considered an “economic island” surrounded by areas like Detroit that have been hit very hard by the manufacturing downturn.  Although house prices did drop here, they didn’t drop nearly as much as other places in Michigan, they bottomed out more quickly, and are rising again well before the surrounding cities.

 

Financing

You may think that since you’re a college student, that you have no chance of getting a loan to buy a house.  This may be true if you intend on going the traditional route of applying for a traditional loan from a traditional bank.  The problem with traditional loans through traditional banks is that almost all banks have the same lending standards thanks to the government’s takeover of home finance through the “Government Sponsored Enterprises” Fannie Mae and Freddie Mac.  As a student, chances are that you don’t have income that can be included on your loan application.  For income to be counted, you have to have been in the job for two years of more and the bank has to be relatively certain that you will stay in the job.  Most college jobs do not fall into these categories, even if the pay is really good.

Luckily, there are still ways to get financing, some through relatively traditional means, and some less traditional.  The less traditional sources use what I call your “Social Credit Score“, rather than your FICO score.

1.  Get cosigned by your parents

When you get a loan cosigned by someone else, that person is on the hook if you default on you loan.  It also means that your loan will show up on their credit report.  If you can convince your parents that you are a good credit risk, then asking them to cosign a loan for you is a great option.  With a cosigner, any loan that they can get you can get too.  Plus, you can get the rates that they would get based on their excellent credit.  These days, you could get a loan for less than 4%, depending on their credit worthiness.  The “exit strategy” in this case is to agree to refinance once you get into a stable job after college.  That way the loan will be removed from their credit within a relatively short time-frame.

The downside of asking someone to cosign is something I alluded to above.  The loan will be included on their credit and will be used in calculating their debt-to-income ratio.  This comes into play if they want to buy a house themselves during the time when they are cosigned on your loan.  My advice is to simply be sensitive and open about this when you have the conversation with them.  Remind them that their credit-worthiness will be affected even if you make your payments on time.  If they are thinking of moving soon, asking them to cosign could be asking too much since it could prevent them from getting another loan.

2.  Find a seller willing to sell on a land contract

This is the method I used when buying a house as a college student.  Getting a cosigner is much easier and cheaper but cosigners are not always easy to find.  In short, a land contract is an agreement between a buyer and a seller where the seller effectively acts as the bank.  The buyer puts down a down payment and then makes monthly payments TO THE SELLER, not to the bank.  Again, no banks are involved.  If you as the buyer default on a payment to the seller, the seller has the right to foreclose on you and take the house back, just like a bank.  Land contracts (or contracts for deed) have been used for a long time but have traditionally been used for purchases of farmland rather than rental homes.

Craigslist is the best place to find sellers willing to offer land contract terms on their house.  When I was searching for houses, I scrolled through the /reo (real estate for sale by owner) Craigslist every day.  For me the URL was http://annarbor.craigslist/org/reo.  You can also do a search of for all land contracts on Craigslist by using the following Google search term:

“land contract site:annarbor.craigslist.org”

If you have a local real estate company, you can search their listings in the same way.  In Ann Arbor Michigan, Reihnart Realtors is the main real estate company in town.  The search term for their site is:

“land contract site:reinhartrealtors.com”

Why pursue a land contract?  Because instead of convincing a bank that you are credit worthy, which as I mentioned earlier is next to impossible in this era of federal government control, you only need to convince the seller that you are credit worthy.  This can still be a hurdle but not an insurmountable one.  Sellers will usually ask for the same stuff as banks do (ie. bank statements, pay stubs, etc) but generally it’s much easier to prove your creditworthiness to an individual than to a bank.

Please note:  One downside of using a land contract to purchase a house is that most houses end up being ineligible for sale by land contract.  If the owner of the house has a mortgage on the house (ie. the house is not fully paid off), then it’s best to pass on that one.  Why?  Because bank loans usually have a clause that allows them to “call in” a loan if ownership of the property that backs the loan changes ownership.  They don’t always exercise this option but it’s a possibility and could be devastating if it happened.

Is it a good deal?

There is tons of literature out there on whether a particular investment is or is not a good deal.  People talk about ROI, cash-on-cash returns, cash flow, net income, gross rent to sale price ratio, and about a dozen other metrics that they use to evaluate a property.  For me, that’s too confusing and ends up causing people to give up the process all together.  Instead of confusing yourself and mystifying the process, use the following sentence when evaluating whether a property is a good investment:

“If you can pay the mortgage with the money you save living in the dorms, then buy the house”.  

Additionally, if you buy a house as a college student and rent rooms to your friends, then if you can pay the mortgage with the money you save, plus their rent, then go ahead and buy the house.  Of course, take into consideration taxes, maintenance, and insurance, but in general, if you can pay the bills then buy the house.  I’ll leave it for another post to talk about what an amazing investment a rental house is, even if it is only cash flow neutral.

Next steps …. by now I’m assuming that you have found a house that you want to buy and are convinced that it will be a good investment for you.  The rest of this guide will go through the nuts and bolts steps of writing up a sales contract and closing on the house.

Getting the down payment 

Most people will tell you that getting out of debt (or not taking on any debt) is of the utmost importance.  My personal thought is that debt is fine as long as it pays for itself.  Don’t use debt for consumption, use it for investment.  Wise use of debt is a key to leveraging the funds you have and leads to higher returns.  You will rarely find a successful business that has not used debt to grow.

That said, here are my three favorite ways to get a down payment for your house.

1.  Earn it

Get a job, save up, sell some stuff, figure it out.

2.  Use your student loans as a down payment

If you’re willing to take on a little bit more risk, this could be a great option.  I realize that this is controversial somewhat.  Most would say that you’re not supposed to use student loans to buy a house, and even if it’s technically allowable, you still shouldn’t do it since it’s “not normal”.  Most college students use their student loans for spring break trips to Cancun, so using it as a down payment is simply strange for most people.  Is case you were wondering about the legality of this, here it is straight from the Department of Education website:

“You may use the money you receive only to pay for education expenses at the school that awarded your loan. Education expenses include such school charges as tuition, room and board …”

And there it is in black and white.  You can use your student loans to pay for room and board.  I would like to see someone try to convince me that buying a house for yourself and a few friends doesn’t count as room expenses.  Just because most people go the easy route and rent their room, doesn’t mean that you should.

Beware though … if you choose to use your student loans as a down payment, treat them as part of the home loan.  You will be using a land contract to buy this house and will have to make payments to the owner.  When evaluating the property based on my very simple evaluation criteria as stated above, you should count your future student loan payment in that calculation.  In other words, the money you save plus rent from your friends should be more than the sum of all expenses, including your student loan payment.  Don’t neglect that portion just because it’s deferred until after you graduate.

3.  Crowd-source your down payment

The great thing about land contracts is that unlike traditional bank loans, you can also borrow the down payment!  Crowd-sourcing is a very exciting and relatively new way to match up lenders and borrowers and to circumvent the banks in the process.  In short, when you apply for a crowd-sourced loan, individual borrowers around the country can lend you small amounts of money so that if things work out, your loan gets financed by dozens of people, each lending you as little as $25.  Two major players in this field are Lending Club and Prosper.com.  You can borrow up to $35,000 from either Lending Club or Prosper.com.  Depending your credit worthiness, your interest rate could be as low as 6.78%.  As with using student loans as a down payment, you should always use your crowd-sourced loan payment in your profitability calculations.

Title companies

Don’t let anyone fool you into thinking that you need a realtor to buy a house … you don’t.  What you do need though is a title company.  A title company will give you a blank sales contract to fill out with the seller, will take this contract once it’s filled out and draw up the closing documents (including the land contract), and they will do a title search for the property to make sure that there are no liens on it.

Do a Google search for “Title Company (enter your city)” and do a little bit of calling around.  The title company I used charged $250 for writing up the land contract and another $250 for doing the title search.  They will usually try to sell you “title insurance” as well.  If you want to be 99.99% sure that there are no liens on the property instead of 99.98% sure, then by all means get the title insurance.  I have never gotten it and don’t recommend it and here’s why.  A title search (which I recommend getting and is probably required by law) will uncover any outstanding liens on your property.  Title insurance covers you if for some crazy reason, there is a lienholder out there that the title search does not uncover.  The thing is, almost nobody ever makes claims on title insurance since the process of doing a title search is so straightforward.

Now here’s the best thing about title companies …. once the title company has your sales contract paperwork, they will tell you what to do from there.  In effect, your work is done and all you have to do from here on out is follow their instructions.  It’s a very freeing feeling.  They will tell you how much money to bring to closing, where and when to show up, and how to file your documents after the sale.  They will draw up the contracts, do the title search, and have everything ready in nice neat folders sitting on the table for you when you show up at closing.  Once they are on the job, they steer the ship.

Sales contact

The title company will be able to provide you with a blank sales contact to fill out.  This is just a document that has blanks for sale price, land contract terms, closing date, and so on.  Sit down with the seller and fill it out.  A land contract will always include a down payment and will often have what is called a “balloon payment” as well.  The down payment is typically around 10% to 20% of the sales price.  A balloon payment means that the loan balance is due in full before the amortization period is done. So for a house that costs $100,000, typical land contract terms might look like this:

Sale Price – $100,000

Down Payment – $12,000 (remaining $88,000 on land contract)

Land Contract Terms – $88,000, 6.0% interest rate, 15-year amortization, 5-year balloon payment

This means that you would have to make payments of $742.59 each month to the seller.  Theoretically, after 15 years that loan would be completely paid off.  However, since this seller in particular wants to get all of his money sooner, there is a 5-year balloon payment required.  That means that you will have to pay off the entire balance of the loan in 5 years.  In 5 years you will almost certainly have a stable job and will be able to refinance with a traditional bank loan.  You will want to refinance as soon as possible because interest rates on land contracts are typically higher than bank loans by a few points.

Once you have worked out the details of the sale with the seller and documented them on the sales contract, bring the completed and signed contract to the title company and set a closing date.

Some words of encouragement

Don’t get bogged down in the details

Of course, at some point you will want to visit and inspect the house.  You can even get a home inspection done if you really want.  Home inspections are required for bank loans but are optional if you’re buying via land contract.  Personally, I don’t get them but I definitely don’t discourage them either.  If you do get a professional home inspection done, I would only focus on the big ticket items as you negotiate with the seller.  Focusing on the small stuff can derail an otherwise good deal.  If you’ve never done much in the realm of home repairs, it’s probably a good idea to go with the inspection.

And don’t let naysayers talk you out of this! 

As with anything where you venture outside of what is considered “normal” or “safe”, you will have people all around you telling you not to go through with this.  I mean, college students don’t buy houses … do they?  What will you do with the hosue when you graduate?  What if your renters don’t pay?  Ok, there will always be naysayers and there will always be another reason not to buy a house … always!  As a college student buying real estate you are moving into almost completely uncharted waters.  Most college students use their student loan money on beer and iPhones, you’re investing in your future and starting your real estate business.  Keep your eyes forward.  This is worth it.

And finally …. closing on your house

Closing is the event when you, the seller, and the title company representative get together, you sign the documents, and walk away owning a house.  There are a few things you will need to remember as closing approaches:

1.  You will need to bring a cashiers check to closing.

The amount of the check will be given to you by the title company and will include the down payment, closing costs, and prorated property taxes owed to the seller.  Remember, the amount will be several hundred or even a few thousand dollars more than just the down payment depending on when property taxes are due in relation to the closing date.

2.  You will need to register the deed after closing.

The title company will give you instructions on where to register the deed and which documents need to be submitted.  Again, just as is the case for the amount of cash needed at closing, the title company will tell you exactly how to go about this very important step.

Summary

Spend your freshman year in college working and saving money, finding an awesome house to buy, and lining up renters.  If you want to use your student loans to buy a house, then take as much as they will give you and save it in a savings account and do not touch it.  Once summer rolls around, you will be well-positioned to actually buy the house.  Don’t let the circumstances overwhelm you and don’t let friends and family talk you out of this.  When you buy this house, you are starting a business.  People who start businesses rarely choose the easy or well-trodden route and you are no exception.  Good luck to you and feel free to contact me if you have any questions on specific specifications of your soon-to-be house.