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The Prospective Homebuyer's Guide - Getting the Mortgage

In the last section, we discussed some of the financial planning that is involved in purchasing a house. In this section, we'll go over the most common way of getting that dream home: the mortgage.

Understanding Your Mortgage

A loan has three facets: 

  1. Size (how many dollars you need to borrow); 
  2. percentage rate (how much you pay in interest on the loan); and 
  3. Term (how long it will take to pay off the loan). The first of these is self-explanatory (although there are choices you can make with regard to the down payment, which we'll investigate in a little while).

The other two are more complicated. Let's look first at the interest rate.

The Calculation of APR (Annual Percentage Rate)

The annual percentage rate is a method developed under federal law to inform loan applicants of the actual amount of interest that will be paid on a given loan, over the life of that loan. It makes it easy to compare one loan to another by making it an apples-to-apples kind of comparison. You should, however, use the APR as a tool in evaluating a loan, and not as the sole factor in making your decision.

To understand APR, you must first understand the concept of points. A point is 1 percent of the loan amount. If the loan is for $100,000, a point is worth $1,000.

There are two types of points: origination and discount. Origination points are the fees normally charged by a lender, and sometimes by a mortgage broker, for originating, or starting up, your loan. Discount points are charged to lower your interest rate, and this lowers your payments. In other words, if you pay some more money up front, the bank will let you pay less over time.

Either type of points should be considered as interest that you pay up front, and you must therefore figure them into the cost of your repayment of the loan. If you take out a loan for $120,000 at 9 percent for 30 years and you pay one origination point and one discount point, you're paying a total of two points, or $2,400. Your payment will be $965.55 per month.

To get the proper APR on your loan you have to add that $2,400 to your starting balance, since it is interest, albeit pre-paid. This makes your total loan $122,400. Figure the new payment on that balance, which works out to $984.00. Now return to the original loan amount and compute the polynomial backwards to reach the interest rate it would take to equal the payment on the total loan. It works out to roughly 9.23 percent.

In paying points to lower your rate, a good rule of thumb is that it will take you about five years to make up the additional point(s) paid; then you will begin saving money over the remaining term of the loan.

By federal law, lenders are required to send you a Truth in Lending (TIL) statement within three days of applying for a loan. APR is important, but not always the number one factor in choosing a loan.

The Term

The most common term for a fixed-rate mortgage is 30 years, with 15 years the next most common.

In some quarters, a 30-year vs. 15-year mortgage debate rages, but one thing is sure: You will pay much more interest over the term of the loan (in most cases double) on a 30-year mortgage. On the flip side, a 30-year mortgage will offer lower monthly payments. You'll be getting a tax write-off for the interest portion of your payments, which could be substantial. On the other hand, in the first 15 years of your loan, you will line someone else's pocket with interest, while not building up significant principal for yourself.

Example: Let's say you buy a $150,000 home. You put down 20 percent, or $30,000, which leaves you $120,000 to finance. If you get a 30-year loan at 8.5 percent, your payments are $922.70. After five years of payments, your balance owed is $114,588. If, on the other hand, you obtain a 15-year mortgage at 8 percent (rates are lower with shorter-term loans), your payments are $1,146.00 ($224.00 more each month). After five years in this loan, however, your balance is only $94,000. That's quite a difference when it comes time to sell.

In total, a 30-year loan is good for long-term stability. If you can afford a 15-year mortgage, you will build principal faster. Remember that by paying what would be equal to the 15-year payment on a 30-year loan, it will pay off in 15 years, but you'll have the cushion of the lower payment should money problems arise.

There's one other categorization of loans, which has to do with its size. A conforming loan is less than the Federal National Mortgage Association?s legislated mortgage amount limit, which is currently $240,000 for a single-family home. A jumbo loan, also known as a nonconforming loan, exceeds that amount. Since such jumbo loans cannot be funded by the agency, they usually carry a higher interest rate.

Knowing what a mortgage is, we can now move on to examining in more detail some of the different types. Let's look at your choice of mortgages.

Getting Pre-Approved for Mortgages

What is pre-approval? It's basically a quick-and-dirty look from a lending institution at your creditworthiness. With a pre-approval or pre-qualification letter in your hand, you're immediately in a stronger negotiating position with any seller.

There are two types of "pre" letters:

  • Pre-qualification is an informal agreement between you and your lender. The bank gives their opinion on how much they think they will be able to lend to you based on information that you have provided to them. Your bank doesn't do any background checks at this point. It relies solely on you portraying an accurate picture of your circumstances. Because this is more like a friendly handshake, the lender can decide not to give you the loan if they find out later that you have been less than candid with them. There is no charge to do this and you are under no obligation to get a mortgage with this lender if you find a better deal later.
  • Pre-approval is more serious. The bank will actually check your credit history, Employment information, assets, and liabilities. The only thing they won't check is the property that you plan to buy, because, of course, you haven't found it yet! If you're concerned that you might not qualify for a mortgage, we highly recommend that you go for pre-approval. It will put your mind at ease while you search for your new home and make the entire experience much less worrisome. Some lenders charge for a pre-approval. If you decide to go with one who charges for this service, make sure you're really going to buy a house soon or you'll just be throwing money away.

Types of Mortgages and Loans

VA Loans

The more you know about loan programs, the more you will realize how little red tape there is in getting a VA (Veterans Administration) loan. These loans are often made without any down payment at all, and frequently offer lower interest rates than ordinarily available. Aside from the veteran's certificate of eligibility and the VA-assigned appraisal, the application process is not much different from any other type of mortgage loan. What's more, if the lender is approved for automatic processing, as more and more lenders are, a buyer's loan can be processed and closed by the lender without waiting for the VA's approval of the credit application.

FHA Loans

The Federal Housing Administration (FHA) is a federal agency within the U.S. Department of Housing and Urban Development (HUD). FHA's primary objective is to assist in providing housing opportunities for low- to moderate-income families. FHA has both single family (one to four units) and multifamily (five or more units) mortgage lending programs. The agency does not generally provide the funds for the mortgages, but rather insures home mortgage loans made by private industry lenders such as mortgage bankers, savings and loans, and banks.

Homeowners with FHA loans usually only have to make a small down payment (about 3 percent of the value of the home). They also enjoy a lower interest rate, between 0.5 percent and 1 percent below the interest rates on other mortgages. The down side is that they do indeed have to purchase private mortgage insurance, or as it's called under these loans ? mortgage insurance premium (MIP).

Rural Home Buyers

Special loans also exist for people choosing to locate in a rural area. These loans are given to encourage economic development in depressed regions. The specifics of the program are similar to the FHA loan program but may not be as stringent with the income qualifications.

You'd be surprised, though, at what's considered a "depressed region." You can sometimes find these loans available in very nice areas that for one reason or another have managed to qualify. Be sure to ask if such a program exists in your area.

No matter what kind of loan you end up getting, though, there will be tax implications ? generally positive ones.

Fixed-Rate Mortgage

This is the plain-vanilla loan that most people think of when considering a mortgage. You will owe a certain percentage of the loan as interest to the lender. This amount never changes, and your monthly payment will remain the same over the life of your loan. Loans for homes are usually for 15 or 30 years.

ARM

This is an "adjustable-rate mortgage." The interest rate changes to reflect changes in the credit market out in the great, wide world. The first-year rate (otherwise known as the teaser rate) is generally a couple of percentage points below the market rate. There are also upward limits above which the interest rate isn't allowed to go ? this is called the cap. If your teaser rate is 4 percent, and you have a five-point cap, then the highest that your interest rate could go would be 9 percent.

What's more, the amount that the interest rate can rise each year is limited, usually to one or two percentage points per year. The frequency at which the rate adjusts may vary; make sure you know these features.

If you're considering an ARM, think about the worst-case scenario. What if interest rates go up, and your ARM adjusts to its maximum? What will that maximum be, and when will it kick in? Will you be able to afford the payments?

COFI, Anyone?

One type of ARM is a COFI loan. COFI stands for "cost of funds index." This loan doesn't have any caps, and adjusts monthly. It is, in a sense, the most adjustable ARM of all, since it isn't fixed for a certain time. But the index it?s tied to is the most stable index of them all: It is tied to the rate that banks have to pay their depositors to keep their money (i.e., checking accounts, savings accounts, certificates of deposit). It tends to be a slow-moving index. The COFI loan has certain advantages in that you can vary the amount of your payments as you wish (paying off more or less each month).

Hybrid Loan

Typically, a hybrid loan is fixed for one, three, five, seven or 10 years and then converts to an ARM. This means you get stability for a given amount of time, and then your fate is cast to the winds of the prevailing interest rates.

Two-Step Loans

These loans attempt to have the best of both worlds: the stability of a fixed loan with the lower rates of an ARM.

They appear in their most common forms as 5/25 or 7/23 loans. Math buffs among you will note that the numbers straddling those slashes add up to 30, as in a 30-year loan. This means that your interest rate will be fixed for the first five or seven years, then the loan adjusts in one of two ways: It will either become an ARM, adjusting annually, or a fixed-rate loan. The beginning interest rate for these loans is generally lower than that of a standard 30-year fixed loan.

Balloon Loans

These tend to be short-term loans. You borrow money for, say, three or seven years, and the loan is amortized though it were a 30-year loan. At the end of the three- or seven-year period, you owe the bank the remaining principal, in one lump sum. Again, these loans tend to have lower interest rates than the standard 30-year mortgage. If you're not planning to stay too long in your house, you might be interested in such a loan. The reason: You pay less in interest ? saving potentially thousands of dollars ? over the course of the loan than you would with a 30-year fixed. So you're less out-of-pocket when it comes time to sell.

Keep in mind, that if for some reason your plans change and you want to stay in the house, you're going to have to pay off the loan in full ? by getting another loan, at the prevailing interest rates, and with the attendant costs of getting that new loan. So it isn't for the faint of heart or irresolute of mind.

Saving Money on Your Mortgage

The key to saving money on your mortgage is to get the best possible mortgage for yourself. Sounds so obvious it's silly, right? But the point here is that you don't need to do it the way everyone else does. In fact, if you're willing to educate yourself in the ways of the mortgage world, you can save quite a bit of money by being a little different. Below we introduce you to some of the strategies that other homebuyers have used. But remember, the only person who knows if it's right for you is you.

The 6 Percent Solution

There is something called a seller concession that can save you money. For example, if  you agree on the price of the house at $200,000, then ask the seller for a 6 percent seller concession. What this means is that you add (up to) 6 percent to the price of the house. That's right, you're now going to pay $212,000 for that house ? but the seller is going to give you that $12,000 back when the sale takes place. You're going to use that money to cover all of your closing costs.

If we pretend that those costs add up to precisely $12,000, then what you've done is folded those closing costs into the mortgage. Points, title search, recordation fees ? all of the items that you'll find listed in our "closing costs" article, and most of which are not tax-deductible ? have effectively been included in your mortgage. Since your mortgage interest is tax-deductible, these costs have effectively become tax write-offs.

In addition, you don't have to come up with all that extra cash at settlement. Your down payment will be slightly higher, (if you're putting down 20 percent , then in the current example your down payment would be $42,400, versus $40,000) and, of course, your mortgage payments will be higher, but it ends up saving you money.

The seller has no reason to refuse this ? after all, the agreed-upon price is still the same.

What's the catch? The catch is that the house has to appraise for the higher value. If the appraiser comes back and tells you that this house won't appraise for higher than $200,000, you can't do it.

Let's look into this a little further. Say you buy the house for $200,000. Your $40,000 down payment leaves you needing a loan for $160,000. You get a 30-year loan at 8 percent . Your monthly payments for principal and interest are $1,174.

Now say you decide to use the 6 percent seller concession strategy. You buy this house for the price of $212,000. You put down 20 percent , and this leaves you in need of a $169,600 loan. Your monthly payments will be $1,244, or $70 more per month. Is it worth it?

Initially, many people aren't going to feel an enormous difference between paying the extra $70 per month ? not nearly as much as they would feel over having to fork out an extra $12,000 all at once. But, what about the fact that you have to now pay this extra money over the course of 30 years? Well, over the course of 30 years you're paying $25,200 more for that extra $12,000 ($70 more per month x 12 months in a year x 30 years = $25,200). However, remember that's $12,000 less out of your pocket at the time of closing. If you take $12,000 and invest it at 10 percent (less than the market average has returned over the past 35 years) then your money will grow to over $200,000 (before taxes) at the end of 30 years. So, in this scenario, it's well worth it.

Naturally you'll want to run the numbers for your particular loan to see whether it would be worth it for you.

*Note: There are certain rules under certain mortgages that dictate what the seller can actually pay for at closing. If you get $12,000 from the seller and all of your costs are $12,000, this does not necessarily mean that you won't have to pay anything. Be sure to ask your lender which costs the seller may cover.

Assume an Existing Mortgage

One option is to assume the mortgage on the house you are buying. (That's another way of saying you'll take over the existing mortgage on the house, rather than getting a new one.) This is beneficial if, for example, the existing mortgage has a lower interest rate. You can also avoid some of the administrative costs of taking out a new loan. In order to assume a mortgage, it must be transferable, and you must be able to pay enough cash (or get a second mortgage) to cover the difference between the purchase price and the outstanding debt.

Seller Financing

"Seller financing" means that you can pay the seller directly over a period of time, rather than borrow money and pay at once. With a seller mortgage, you can often negotiate a better interest rate and avoid the various administrative fees charged by lending institutions. Seller financing can be attractive if, for some reason, you can't qualify for a loan. More importantly, it enables you to avoid the dreaded mortgage insurance.

One circumstance in which such financing is available occurs when the seller has had difficulty in selling the house. If that's the case, you'll naturally want to know why. Also, sellers are not in the lending business. They tend to want a short-term mortgage ? usually not longer than three years. After that time, you will have to get a mortgage from a regular lender and pay the seller in full.

There are other reasons why a seller might want to provide financing. It gives him a steady stream of income and return without having to pay capital gains tax. The seller also has collateral ? the house. If the buyer defaults, then the seller can take the house back.

Play With the Points, Play With the Time

Depending on the mortgage, the strength of your finances, and the interest rate environment, it might be to your advantage to pay off the interest or principal sooner than you might otherwise.

Pay Down the Principal

For a very long time, most of the money that you will pay to your mortgage company is going to go to interest payments. That means that you may be in your house for over 20 years before you own more of it than the bank does. But there's a way to speed up the amount that you own. And why is that important (other than the obvious psychological benefits)? Because if you owe less to the bank, you will also owe them less interest.

Be Your Own Best Advocate

Mortgage lenders must compete for your business. That means they will negotiate. Don't assume that their published interest rates are final. Collect information on available interest rates and mortgage features from lenders in your area. Decide which features meet your needs. Be prepared to ask for better terms ? a reduction of at least a quarter percent of the published interest rate is reasonable. You will be in a stronger negotiating position if your credit history is good.

The amount of time between putting an offer down on a house and actually taking possession has its ups and downs. It continues with the serve-and-volley that may ensue after your offer has been received. Then, if your offer is accepted, it continues through the logistics of the loan, the discoveries at the home inspection, and the actual closing. It's a real roller coaster ride, with all the attendant thrills and acceleration.

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