When credit is tight, getting the best loan

Now more than ever it pays to be a prime borrower - here's how to be that guy.

By Carolyn Bigda, Money Magazine writer-reporter

NEW YORK (Money) -- Just as housing prices stall, lenders are making it tougher to borrow.

A recent report from the Federal Reserve shows that 15 percent of U.S. banks began tightening credit standards at the end of 2006 - the most since the early 1990s.

Since then, the belt-tightening has only accelerated as lenders worry about a slowdown in home price growth and borrowers' ability to repay their loans.

In December, for example, EMC Mortgage Corp., a subsidiary of Bear Stearns Companies, as much as doubled the amount of cash savings that loan applicants need to qualify for a loan.

Then in February, the bank announced it would no longer offer so-called "piggyback" loans, which let consumers finance 100 percent of a home's price. Now, you must put down a minimum of 5 percent or 10 percent, depending on other factors in your loan application.

"After analyzing the current market conditions, we decided we needed to get to a lower loan to value ratio," says Mary Haggerty, co-head of Bear Stearns' mortgage finance department.

Residential Capital (ResCap), the real estate finance arm of GMAC, tightened standards last month - had the new rules been in effect last year, some 58 percent of subprime loans would not have been approved.

While those changes can be alarming, not everyone is at risk.

The tightening has occurred primarily in what's known as the subprime and Alt-A markets.

Subprime loans are made to borrowers with a poor credit history. Alt-A is not a well-defined category but typically includes borrowers with higher credit quality who don't want to document their income on a loan application.

But prime borrowers can still get competitive terms.

"There's so much overcapacity in the industry right now that banks are eager to make loans to borrowers with strong credit," says Mark Lefanowicz, president of E-Loan, an online direct lender.

Ideally, then, you want to be considered a prime borrower in today's lending environment. There are clear steps you can take to become one. The key is to start working on your financial profile as soon as possible.

To get going, follow these tips:

Pay Down Balances

Most lenders look at your FICO score when reviewing your loan application. FICO stands for Fair Isaac Corp., which calculates the rating, and the score ranges from 300 to 850.

According to Fair Isaac, the median FICO score is 723. Borrowers with a score of 700 or more generally are considered prime.

Since 30 percent of your FICO rating is made up of how big your balances are compared to the credit available to you - what's called a credit utilization ratio - one of the fastest ways to improve your score is to pay down your debts, says Craig Watts, public affairs manager for Fair Isaac.

There's no magic percentage. However, credit experts recommend you stay below 50 percent. And the lower you go, the better your score will be.

Pay on time

Your payment history, or how often you pay your bills on time (or late), is equally important, making up another 30 percent of your FICO score.

A late payment stays on your credit report for as long as seven years. Its impact on your score, however, gradually fades over time - as long as you get current on your bills.

Your score will gradually move up after as few as six months of on-time payments, according to Evan Hendricks, author of "Credit Scores and Credit Reports." And you'll see a more significant leap after one year.

"At that point, your old late payments start to hurt less," says Hendricks.

Resist new credit

New credit-card and store-card offers can be tempting, especially if you get 20 percent off your purchase at the check-out counter.

But if you're about to refinance or take out a mortgage, don't open any new lines of credit. The number of times you apply for new credit, called inquiries, accounts for 10 percent of your FICO score. And the fewer you have of them, the better.

Otherwise, "It could look like you're going on a credit spree," says Hendricks.

Fix errors

Finally, make sure to check your credit report for errors at least a few months in advance of applying for a mortgage.

Errors are common. A 2004 study from the U.S. Public Interest Research Groups found that up to 79 percent of credit reports may contain a mistake, some serious enough to result in the denial of credit.

Under federal law, you're entitled to receive a free copy of your credit report from each of the three main credit bureaus - Equifax, Experian and TransUnion - every 12 months. To get your copies, go to AnnualCreditReport.com or call 877-322-8228.

You're also entitled to see a copy of the credit report your loan officer or mortgage broker pulls.

If you find a discrepancy, credit bureaus provide instructions on the credit report on how to contest an error.

Filing a dispute by phone or online is fine for simple mistakes, such as a misspelled name.

For more serious errors, however, it's better to have a paper trail of your complaint. Send a certified letter with a return receipt requested to the credit bureau, as well as the creditor. The bureau must investigate your claim within 45 day of receiving it.

The Federal Trade Commission also offers guidance.

Find alternative loans

If you can't wait to improve your credit score, consider a loan backed by the Federal Housing Administration. These loans are approved based on your overall credit history, not just your credit score. They also carry competitive interest rates, today ranging from 6.5 percent to 7 percent, and require only a 3 percent down payment.

The downside: While there's no income cap, you can only borrow as much as $362,790 or lower, depending on where you live. Go to www.hud.gov to see the loan limits in your community.

Some buyers could also turn to their credit union for a HLPR mortgage, which carries similar terms and eligibility requirements as an FHA-loan, but is reserved for first-time buyers. Got to http://www.cuna.org/ for more information.

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.