Unless you’re planning to make an all-cash purchase (in which case you’ll be a very popular buyer!), you’re going to have to secure a mortgage. Though the process can be complex and daunting, it helps to understand what to expect and to take the time up front to really sit down and know what you want and need from your lender. This section is devoted to helping you reach both those aims.
In exchange for your mortgage, you will pledge your home as security for repayment of your loan. The lender agrees to hold the title to your property until you have paid back your loan plus interest. A mortgage loan is composed of two major components: principal and interest.
Principal is the actual amount of money you borrow. If you borrow $150,000, your mortgage principal is $150,000.
Interest is what you pay for the use of the money you borrow. How much you pay depends on a number of factors, including the interest rate, the type of loan and other factors, which are outlined in this guide. Interest can be deducted from your taxes, making it one of the most attractive practical benefits of home ownership. Your tax advisor will be able to provide more details about the tax savings benefits.
Amortization refers to the way in which the balance of principal versus interest changes over time. During the first few years of your mortgage (typically for the first 2 to 3 years of a 30-year loan) most of your payments will be applied toward interest. During the final years of your loan, your payments will be applied almost exclusively to the remaining principal. This process is called amortization.
How should I choose a lender?
Carefully! Look for financial stability and a reputation for customer satisfaction. Select a company that gives helpful advice and that makes you feel comfortable. It is best to select a lender that has the authority to approve and process your loan locally, so you can more easily monitor the status of your application and ask questions. Plus, it helps when the lender knows about local home values and conditions. Do research — ask your agent, family and friends for recommendations.
What is the best way to compare loan terms between lenders?
Speak with companies by phone, in person, or search the Internet. In addition to your research, I can provide a variety of proven lender and mortgage options. While competitive rates are important, remember that most lenders get their money from the same sources and therefore essentially have the same rates. As a result, the decision often comes down to other factors.
The Interest Rate
Interest Rates are most important when you lock a loan. What is important is that you have a loan program that fits your particular financial situation and needs at the time you purchase your home. Remember that each 1/4 point (0.25%) may not have as much impact as you think.
There are four main sources from which you can obtain a home loan:
- Savings and loan associations
- Commercial banks
- Mortgage bankers
- Mortgage brokers
Savings and loan associations (S & Ls)
Historically, Savings and Loan organizations have concentrated on home loans. However, with deregulation, the U.S. government has opened the door for S & Ls to provide checking accounts, savings accounts, personal and business loans, etc. Nevertheless, their primary lending focus still is on home loans.
The largest and most diverse of all finance institutions, commercial banks offer a wide variety of services including savings accounts, investments, charge cards, as well as commercial, personal, residential and business loans, among others.
Mortgage bankers typically use their own money to fund mortgages; however, they ultimately sell the loans to another entity such as a bank, a savings and loan, pension or retirement funds, private investors or government agencies such as FNMA (“Fannie Mae”) or GNMA (“Ginnie Mae”), which purchase residential mortgages. When mortgage bankers sell a block of mortgages, they often will continue to service the loan and will be responsible for the collection of your payments. The mortgage banker is paid a small percentage of the interest (usually 1/4 % to 1/2 %) for this servicing agreement.
Unlike mortgage bankers, mortgage brokers do not loan their own money. Mortgage brokers will arrange financing for a borrower from a lender, which could be a bank, savings and loan, a private individual or a credit union or pension fund. As the liaison between borrowers and lenders, they are paid a commission or a fee, which is paid by the borrower, the seller or even the lender.
While there seem to be hundreds of different mortgages available, they all fall into a few basic categories. Some may fit your needs well, while other programs may be unwise or unattainable. It’s important to realize that the best product depends on where you are in your life. The best choice is the loan program that best fits your needs at the time you purchase a home.
In recent years, lenders have developed a greater variety of loan programs, mainly because they have found that homebuyers have a variety of different needs. First Time buyers, families “moving up” into larger homes as they need more space, or moving into smaller homes after children have gone on to start their own families; all have different needs. There are so many different individual loan programs available that to compare them all would be impossible. The following provides brief descriptions of the most common categories of mortgage loans.
Fixed Rate Mortgages
Fixed-rate mortgages are the most popular type of mortgage. With this mortgage, the interest rate will remain the same for the entire term of the loan. Typically, the longer the term of the mortgage, the more interest is paid over the life of the loan.
Adjustable rate mortgages all have certain similar features. They have an adjustment period, an index, a margin, and a rate cap. The adjustment period is simply how often the rate changes. Some change monthly, some change every six months, and some only adjust once a year. An Adjustable-rate mortgage (ARM) is a mortgage in which the interest changes periodically according to corresponding fluctuations in an index. All ARMs are tied to indexes. Indexes are simply an easily monitored interest rate that moves up and down over time. Adjustable rate mortgages vary and are tied to different indexes.
This is a “traditional” mortgage, not directly insured by the Federal Government. Most conventional loans under $300,700 are administered through Fannie Mae or Freddie Mac (private corporations but regulated by the government). Loans greater than this amount are called “jumbo loans” and are funded by the private investment market.
These loans are insured by (but not funded by) the Federal Housing Administration (FHA) a division of the U.S. Department of Housing and Urban Development (HUD), and designed for, in general, low- to middle-income borrowers and many first time buyers. There are, however, limits to the maximum loan amount which will vary from county to county. FHA loans have somewhat more relaxed qualifying standards and ratios than conventional loans and have the availability of both 15 and 30 year fixed as well as 1 year adjustable mortgages.
For those qualified by military service, the Veteran’s Administration (VA) insures (but does not fund) 15 and 30 year fixed as well as 1 year adjustable mortgages with lower down payment requirements and somewhat more lenient qualifying ratios.
No/Low Down Payment Mortgages
Sometimes having enough funds for the down payment and closing costs as required by a basic fixed-rate mortgage is not achievable. There is an array of no and low down payment mortgages. These types of loans are designed for homebuyers’ varying needs and take into account the many other factors that qualify the financial condition of the borrower. Some loans are designed for buyers with good credit histories, some offer more flexible qualifying requirements and may be helpful for limited incomes, and others balance a low down payment with a higher interest rate.
Some adjustable rate mortgages allow the interest rate to fluctuate independently of a required minimum payment. If a borrower makes the minimum payment it may not cover all of the interest that would normally be due at the current interest rate. In essence, the borrower is deferring the interest payment, which is why this plan is called “deferred interest.” The deferred interest is added to the balance of the loan and the loan balance grows larger instead of smaller, which is called negative amortization.
Mortgage hybrids are a cross between a fixed rate and an adjustable-rate mortgage. They generally have fixed rates for the first three, five, seven or ten years and then they convert to adjustable-rate mortgages (ARMs) for the remainder of the loan term. With hybrid loans the fixed rate is established up front. Once the fixed-rate portion of the loan ends, the mortgage then behaves like an ARM with rate changes and monthly payments moving up and down each year as interest levels change. The attractiveness of these types of loans is that a borrower can sometimes find a 5/1 ARM rate at up to a full percentage point below a comparable fixed rate loan, and for several years the homeowner can benefit from a lower rate. Generally, the shorter the fixed-rate period, the better the up-front discount, the longer the fixed-rate period, the smaller the discount when compared to 30-year financing.
Loan Terms: 15, 20 or 30 Years
As the term of the loan (period over which the loan is paid) decreases, so does the amount of total interest paid. It is a good exercise to make a comparison between a 15 year term monthly payment and a 30 year term monthly payment. The monthly payment difference is often smaller than anticipated. The savings over the term of the loan, however, can be substantial. If you cannot qualify for a shorter term loan, try to add at least the amount of 1 additional payment per year—this will take nearly 10 years off a 30 year loan.
Points or No Points
A large component of your mortgage decision has to do with one of the first charges associated with the loan. This is the “points” attached to the mortgage. A point is equal to 1% of the loan amount, and is paid to the lender or the mortgage broker at closing. Each loan product and buyer situation is different. You will need to understand your options and make the best decision based on your situation.
Thirty-year fixed rate loans are what most people think of when they hear the word “mortgage.” Fixed rate loans are also referred to as “fully-amortized” loans. One of the aspects that buyers like about fixed rate loans is that the payments stay the same for the life of the loan. Generally, these loans are offered in a 15- or 30-year duration.
A 30-year loan will provide larger tax deductions, as you will be paying more interest than principal during the first 23 years of the loan. A 15-year loan, on the other hand, is paid off twice as quickly and usually has a lower interest rate. You build more equity because your payments pay more principal. As mentioned earlier, you (or the seller) also can “buy down” your loan by paying more tax-deductible points up front, to lower your fixed interest rate.
A fixed loan that is amortized over a 30-year period but becomes due and payable at the end of a shorter term (i.e., 5, 6, 7 or 10 years). Some of these loans have an option to be extended with a new rate or rolled into another type of loan. Usually, the rates of these loans are lower than those for a regular 30-year fixed rate loan, but they are not recommended if you plan to stay in the home for a longer period of time.
Graduated Payment Mortgage (GPM)
A fixed-rate loan that has payments starting lower than the payments on a standard fixed rate loan, which increase by a predetermined amount each year for a specific number of years, usually five years.
Adjustable Rate Mortgages (ARMs) are attractive to many homebuyers for one reason: lower payments in the first years of the loan. Typically, an ARM will have a low introductory rate, sometimes called a “teaser” rate. This rate is usually much lower than the fixed rates available at that time.
Adjustable rate mortgages (ARMs) have payments that increase or decrease on a regular schedule, and are linked to specific economic indexes or margins. These indexes measure borrowing and lending costs throughout the United States and are independent of the lender and can be independently verified at any time. (Many ARMs are indexed to Treasury bills or securities, Certificates of Deposit and other rates.)
How and When do ARMs Adjust?
When comparing ARMs that have different indexes, look at how the index has performed recently. Some indexes are published in newspapers, making them easy to track. Lenders are required to provide you with information on how to track the index and a 15-year history of the index, but keep in mind that past performance is not necessarily indicative of future performance.
An ARM will have a low Initial Interest Rate, sometimes called “teaser” rate. The loan will begin to adjust at a certain interval, usually every six months or annually. When the loan adjusts, the lender will use three things to determine the new interest rate: the index, the margin and the cap(s).
The index is a benchmark by which changes in the market interest rates are gauged. Common indexes include the 1 Year T-bill, the 11th District Cost of Funds, Prime, LIBOR, or even Certificate of Deposit (CD) rates.
In order to determine the new rate on the adjustment date, the index is added to the margin. The easiest way to understand the margin is to put the word “profit” in front of it. It is the amount of excess of the index that the lender is going to charge in interest; it is essentially the lender’s profit margin.
To insure that your payments do not change dramatically in any given six-month or one-year period, adjustable rate mortgages provide protection in the form of interest rate caps. There are two kinds of interest rate caps: periodic (annual, semi-annual, etc.) and lifetime. For example, a loan may have a semi-annual rate cap of 1%, or an annual rate cap of 2%. The loan will also have a lifetime rate cap, frequently 6% over the initial rate. The caps insure that even if interest rates rise rapidly, the monthly mortgage payment will not be as dramatically affected.
Is an ARM for You?
Would you like a loan with an interest rate below a 30-year fixed rate mortgage and pay zero points? A loan for which you do not have to document your income, savings history or source of down payment? These benefits can all be possible with an Adjustable Rate Mortgage. There are numerous advantages to ARM loans. Some common advantages are:
- The ability for borrowers to qualify when they might not do so with a fixed rate mortgage;
- The possibility of obtaining a larger loan and a more expensive home;
- The chance that the rates may go down without refinancing; and,
- Often, there are less costs to obtain the loan.
However, with an ARM, there is the likelihood that your rate and payment will increase during the life of the loan. Adjustable Rate Mortgages all have an adjustment period, an index, a margin and a rate cap. The “adjustment period” simply indicates how often the rate changes. Some rates change monthly, some change every six month, and some only adjust once a year. Indexes are monitored interest rates over time. ARMS have different indexes. The margin does not change during the life of the loan.
How do I choose the best loan program for me?
Your personal situation will determine the best kind of loan for you:
- Do you expect your finances to change over the next few years?
- Are you planning to live in this home for a long period of time?
- Are you comfortable with the idea of a changing mortgage payment amount?
- Do you wish to be free of mortgage debt as your children approach college age or as you prepare for retirement?
Your lender can help you use your answers to questions such as these to decide which loan best fits your needs. The remainder of this article will outline for you why these questions – and the answers you provide to them – are a crucial part of your loan search.
How large of a down payment do I need?
There are mortgages now available that only require a down payment of 5% or less. But, generally speaking, the larger the down payment, the less you have to borrow, and the more equity you’ll have. Mortgages with less than a 20% down payment generally require a private mortgage insurance policy (PMI), which can be expensive.
Nevertheless, PMI is a fact of life for many homeowners. Even if you begin your mortgage with PMI, with time and appreciation, you often can reach 20 percent equity – at which time you can have the PMI removed. Often, removing PMI is just a matter of asking the lender, paying for an appraisal, paying a fee to the lender (approximately $300 – $600) and providing the necessary paperwork.
What does the interest rate really mean to me?
A lower interest rate allows you to borrow more money than a high rate with the same monthly payment. Interest rates fluctuate from day-to-day, so ask lenders if they offer a rate “lock-in,” which guarantees a specific interest rate for a certain period of time.
Remember that a lender must disclose to you the Annual Percentage Rate (APR), which shows the cost of a mortgage in terms of an annual interest rate. Because it includes the cost of points, mortgage insurance and other fees, the APR generally will be higher. It will provide you with a good estimate of the actual cost of the loan.
What happens if interest rates drop after I finalize my fixed-rate loan?
If rates drop more than two percentage points or so and you plan to be in your home for the next 18 months, you may want to consider refinancing. However, since refinancing may require you to pay many of the same fees paid at the original closing, plus origination and application fees, you should make this decision carefully.
What are discount points?
Discount points (or just plain “points,” as they are frequently called) allow you to lower your interest rate by paying prepaid interest up front. Each point equals 1% of the loan amount, and generally, each point paid on a 30-year mortgage will reduce the interest rate by 1/8 (or.125) of a percentage point. Sometimes lenders will provide you with the opportunity for a “buy down” – which literally offers you a chance to buy down the cost of the loan by paying more points up front.
When you shop for a loan, ask lenders for an interest rate with no points. Then, ask them how much the rate decreases with each point paid. Discount points are smart if you plan to stay in a home for some time since they can lower your monthly loan payment. Points are tax deductible when you purchase a home and you may be able to negotiate for the seller to pay some of them.
What’s considered a reasonable loan fee?
In most cases, loan fees should not exceed 5 percent of the loan amount, unless you are paying for a lower interest rate. However, there may be exceptions. I can help you evaluate loan fees and to understand exactly how much the entire loan will cost. It’s important to know all your loan costs up front.
Once you have selected the type of loan you prefer and qualify for, the lender will ask you to complete a loan application, which will require a great deal of personal and financial information, including the following:
1) Your residence history
- Your previous addresses for the past two years
- The length of time you’ve lived at each address
- If you currently rent, your landlord’s name and addresses (for past 12 months)
2) Your employment history
- The names and addresses of all your employers for the past two years
- The dates you worked at each place of employment
- If there have been any gaps in your employment, explain why
3) All outstanding loans and credit cards
- The creditor’s name(s) and address(es)
- Your account number(s)
- The current total balance you owe and the months left to pay
- The amount of the monthly payment
4) Savings, checking or investment accounts
- The names and addresses for each financial institution
- Your account numbers
- The current balance or value
5) Real estate you currently own
- The property address(es)
- The estimated market value
- The outstanding loan balance
- The amount of your monthly payment (including taxes, insurance, homeowner’s association dues)
- The amount of your rental income (if applicable)
6) Personal property you own
- The net cash value of your life insurance
- The make, year and value of your automobile(s)
- The value of your furniture, jewelry and other personal property
7) Tax records
Some lenders may require copies of your tax records from the previous two years
Being prepared with the necessary documentation will expedite the mortgage loan process. Here’s a checklist, so you don’t forget what you’ll need to efficiently move the loan process along:
Real Estate Contracts
____ Purchase Agreement (for the purchase of your new home).
____ Sales contract (if you are selling a home).
____ Past 24 months of residence with complete addresses.
____ Length of time you lived at each address.
____ Name of landlord and his/her address (if currently renting).
____ All original pay stubs for past 30 day period.
____ Employers for the past two years with complete addresses.
____ Dates of employment for each job.
____ W2s for most recent two years.
____ Most recent tax returns (with all schedules) for past two years.
____ If there have been any gaps in employment, prepared explanations.
____ Copies of most recent monthly statements for all loans and credit card balances.
____ Copies of most recent three months’ bank statements for all accounts, stock brokerages, mutual funds, IRAs, Pensions, etc.
____ If you are self employed or received a 1099, your most recent tax returns for the past two years with all schedules and a year-to-date profit and loss statement and balance sheet.
____ If you own 25% or more of a corporation, the most recent corporate tax returns for the past two years with all the schedules and a year-to-date profit and loss statement and a balance sheet.
Current Real Estate
____ Property addresses.
____ Estimated market values of property.
____ Amount of monthly payment and outstanding loan balances (bring copy of most recent loan statement).
____ If you own rental property, your most recent tax returns for the past two years with all schedules and a current agreement.
____ Net cash value of your life insurance.
____ Year, make and value of all vehicles.
____ Value of your furniture and personal property.
Bring your federal tax forms for the past two years, along with a profit and loss statement.
Separated or divorced
Bring a copy of your divorce decree and separation agreement, plus documentation of any alimony or child support payments you are required to make. If you are receiving alimony or child support and want it to be considered as income, you’ll need proof of this income such as the court clerk’s history of payments or cancelled checks for the past 12 months.
Including pension, disability, Social Security or any other form of public assistance with your income. Bring a copy of an award certificate or a check from the issuing agency.
If you have had a bankruptcy, a foreclosure or judgments against you over the past seven years, bring information on the proceedings. Information on bankruptcies should include a copy of the bankruptcy discharge and schedule of both debts and assets. Judgments against you should include an attorney’s letter that discusses the outcome of the proceedings.
Applying for a Department of Veterans Affairs (VA) loan
Bring your DD214 form (discharge) papers or your certificate of eligibility.
When your loan is submitted for underwriting, it goes directly into the hands of an underwriter whose job is to determine your “creditworthiness” or your ability to repay the loan. An underwriter takes into consideration the following aspects when deciding whether or not to approve your loan:
Your work history
A stable history of employment in the same line of work is considered ideal. Job-hopping is not. However, if you have switched jobs within the same line of work for advancement in your field, it should not be a problem.
In looking at your ability to repay the loan, your job stability and gross income (in relation to your expenses) are critical. Most income must be verified as having been received for at least two years to be used for qualifying purposes.
Your credit history
Via your credit report, the underwriter looks at your past payment history. A consistent pattern of late payments, collections, etc., obviously is not looked upon favorably – and you will be asked to explain about your bad credit conditions. Bankruptcies generally must be discharged for at least two years, the reason explained, and you generally must reestablish credit to be considered.
The underwriter wants to see your net worth, determined as: the money you have available for a down payment, closing costs, cash reserves (money left over after closing of escrow to cover 2-3 months mortgage payments) and other liquid assets. The underwriter also will want to see the “source of funds” – where the money for the down payment and closing costs is coming from. Don’t move money around (pay off bills, receive a gift, etc.) without first consulting your loan officer about the best way to do it, since it may affect the underwriter’s view of your loan.
The underwriter will be concerned with the amount of debt you have because it affects your qualification and ability to repay the loan. Excessive use of credit may not be looked upon favorably.
Because the property is the lender’s collateral for the loan, the value, marketability and condition of the property are extremely important. The underwriter looks at the appraisal for this information, and generally verifies that the appraisal and the purchase price are in the same ballpark.
Your monthly mortgage payment is made up of several components. This housing expense is commonly referred to as “PITI” or principal, interest, taxes and insurance. PMI (see below) and homeowner’s association dues may also make up a portion of your total payment:
The original balance of money loaned, excluding interest. Also, the remaining balance of a loan, excluding interest. Interest is calculated based on the principal.
The charge, in dollars, for the use (loan) of the money.
The county assessor determines the property tax based on the value of your home. There are two tax installments due each year. Taxes may be impounded, depending on the amount of your down payment. (A down payment of less than 20% usually requires an impound account).
An impound account, set up by the lender, is a trust account to which a portion of the monthly payment is credited so that funds will be available for the payment of taxes and insurance when they’re due. This way, the lender actually pays your tax bill for you. (Supplemental taxes usually are still the responsibility of the homeowner.)
An insurance policy pays for the loss of a home from certain hazards, including fire. You obtain homeowner’s insurance from your own insurance agent. The standard policy pays replacement costs, minus depreciation based on actual cash value. Talk to your insurance agent about the different types of insurance available. Hazard insurance expense may also be impounded in the trust account with taxes.
Private Mortgage Insurance (PMI)
Depending on the amount of your down payment, you may be required to have PMI. A down payment of less than 20% usually requires PMI. Because loans with small down payments involve substantially more risk for the lender, they need protection in case the loan goes into foreclosure. Mortgage insurance helps cover the lender’s loss in the event of a foreclosure. Because of this insurance, lenders are able to offer loans with lower down payments.
PMI premiums are collected monthly as a part of your mortgage payment. The cost of PMI varies with the amount of your down payment. Can you pay off your loan ahead of schedule? Yes. By sending in extra money each month or making an extra payment at the end of the year, you can accelerate the process of paying off the loan. When you send extra money, be sure to indicate that the excess payment is to be applied to the principal. Most lenders allow loan prepayment, though you may have to pay a prepayment penalty to do so. Ask your lender for details.
In addition to the right to view your credit report and know your FICO score, you also are protected by RESPA, the Real Estate Settlement Procedures Act passed by Congress. RESPA requires your lender to provide you with a “Good Faith Estimate of Settlement Costs” early in the loan process. Be aware, however, that the amounts contained are only estimates. Keep your Good Faith Estimate so you can compare it with the final settlement costs, and ask the lender questions about any changes.
Through a Servicing Disclosure Statement, which will be given to you by your lender, RESPA also requires your lender to tell you if it expects someone else to be servicing your loan. Your lender will have three days from the time you apply for the loan to let you know about this.
RESPA regulations also require all parties involved in your transaction to disclose affiliated business arrangements. If anyone involved in your transaction (your lender, agent or title officer, for example), refers you to another service provider (including lenders, title officers, inspectors, etc.), the “Servicing Disclosure Statement” indicates that you generally are not required to use these providers, and are free to shop for other affiliates.
HUD-1 Settlement Statement
The U.S. Department of Housing and Urban Development also provides protection via the HUD-1 Settlement Statement. One business day before closing, you have the right to inspect this statement, which itemizes the services provided to you and the accompanying fees charged. Be sure to call the settlement agent if you wish to inspect this form. The form generally must be delivered or mailed to you at or before the settlement.
Escrow Account Operation and Disclosures
Your lender may require you to establish an escrow or impound account to insure that your taxes and insurance premiums are paid on time. You probably will have to pay an initial amount at the settlement to start the account and an additional amount with each month’s regular payment. Your payments may include a “cushion” or extra amount to ensure that the lender has enough money to make the payments when due. RESPA limits the amount of the cushion to a maximum of 2 months of escrow payments.
At closing or within the next 45 days, the person servicing your loan must give you an initial escrow account statement. That form will show all of the payments which will be expected to be deposited into the escrow account, and all of the disbursements that are expected to be made from the escrow account during the year ahead. Your lender or servicer will review the escrow account annually and send you a disclosure each year, which shows the prior year’s activity and any adjustments necessary in the escrow payments that you will make in the forthcoming year.
For more information on RESPA
Visit the web page at http://www.realtor.org or call (800) 217-6970 for a local counseling referral.