A
Critical Guide to Home Loans
Your Options and How They Affect Your Future
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An insider's guide to understanding mortgage
loans
There was a time in the
not-so-distant past when financing the purchase of a home was relatively
uncomplicated. You went to your local savings and loan and signed up for a
30-year, fixed-rate mortgage loan.
Those days are gone, probably forever. Today, you have what seems like an
endless array of choices—different rates, terms, down payments, fees, etc. (One
lender told me there are literally more than 40,000 available loan options on
computer database!) So how do you pick the combination that makes the most sense
for you?
Having spent many years
helping buyers understand the ins and outs of financing a home, we've developed
this guide to assist you in evaluating which mortgage is best for you. More than
any other single factor, choosing the right mortgage will influence whether or
not your investment is a good one. Let's say you get a great price on a home,
but you end up with a mortgage that has high fees and a high interest rate. You
could see the money you saved disappear in a very short time.
Keep in mind that a great
mortgage for one person may be terrible for another. Each of us has different
circumstances that determine whether a particular loan is a good deal or
not—whether you're just starting out or nearing retirement, how secure your job
is, how long you plan to be in the home, etc. You can be sure that the best loan
for a first-time home buyer planning to move up in five years is quite different
from the best loan for a couple who's staying for the next 20 years.
First things first—know
what you can afford. You can save yourself a lot of time and trouble if
you take a few minutes to figure out the loan amount you can afford. The general
guidelines are:
-
No more than 28 percent of
your gross monthly income should be spent on housing expenses (principal,
interest, insurance and taxes). This can vary upwards if you have a good
credit history, liquid assets, or if you're already spending more than 28
percent on your housing expenses.
-
Your total debt (mortgage
and consumer debt) shouldn't exceed 36 percent of gross monthly income. Again,
people with good credit and liquid assets can often creep above this line.
-
As you compare your income
to your potential housing expenses, keep in mind that your mortgage principal
and interest are not your only costs. You also need to allow for any
association fees, property taxes, insurance payments, etc.
Having said this, we should point out that the rules are looser than ever
today. The "28 over 36" rule is no longer the ironclad guideline. Both the
federal government and mortgage lenders have gotten very creative in their
efforts to attract first-time buyers to the market. Today, there's a loan
program out there to put all but the worst-risk people into homes. But for your
own safety and confidence down the road, your best bet is to adhere as closely
as possible to the above guidelines.
Avoid unpleasant
surprises. Talk to your Realtor® or loan officer about
checking your credit history prior to applying for a mortgage. There's no reason
to waste time and money in the application process if you have credit problems
that will cause you to be rejected. Once you know about any potential problems,
you can work on clearing them up before you apply.
Shopping for a mortgage lender. There are several potential
lenders in today's marketplace. They include:
-
Mortgage Banks—a
mortgage banker is a direct lender. He or she qualifies applicants, finds the
best available loan and funds it. Because this is their main business,
mortgage banks can offer very competitive rates—but are not necessarily the
cheapest.
-
Mortgage Brokers—Brokers
don't lend money; they find lenders for a fee in addition to the traditional
application and processing costs. While a good broker might be able to find
you the cheapest mortgage, make sure the fee doesn't offset any savings. Since
most brokers' fees are generally paid by the lender in the form of a
commission, their services often will cost you nothing—that is, no
out-of-pocket costs. Something also to remember—a mortgage broker is the legal
agent of his or her client and does not work for the lending institution. So,
a mortgage broker will have access to the widest spectrum of loan
options—whereas a bank or savings and loan representative will draw from
only "in-house" loan options. Going by this information, a
reputable mortgage broker would most likely be your cheapest source for home
loans and refinancing.
-
Savings and Loans—once
the primary source of home financing, savings and loans hold a much smaller
piece of the market today. But some experts recommend checking their offers
before looking at a bank.
-
Banks—Commercial
banks have come on strong in recent years. Some have made home loans a
significant part of their business.
-
Credit Unions—a good
source often overlooked by borrowers. Credit unions function like brokers
because they generally don't lend their own money.
Whichever route you
ultimately take, be sure to shop around. What lenders charge might differ by as
much as two or three percentage points. That's pretty significant when you look
at the impact on a 30-year fixed-rate mortgage—depending on the size of the
loan; the difference could be a few hundred dollars a month.
What a Realtor®
can do for you. If you're using a Realtor® to help you
find a home, ask to be put in touch with a lender he or she works with on a
regular basis. In most cases your Realtor® is not a loan officer, but
it is his or her job to help people buy and sell homes. A good real estate
professional has long-standing relationships with home mortgage professionals
and can point you in the right direction to answer any questions you may have.
He or she can also share insights into what they've seen work—or not work—for
others in situations similar to yours.
Which loan is right for
you? Adjustable. Fixed. Balloon. It's easy to get lost in mortgage
verbage. Here's a rundown of the most common loans.
Adjustable-Rate Mortgages—your interest rate (and monthly payment)
rises and falls with the index to which it's tied. Because they start out two to
three percentage points below fixed-rate mortgages, they're particularly popular
when fixed rates are high. To protect you against interest rate hikes, the best
loans put a cap on annual rate increases of two percentage points a year, with a
lifetime increase of no more than five percentage points above where you began.
The most popular arm
indexes are those linked to three-month, six-month and one-year Treasury
Bills, the 11th District Cost of Funds (cofi), the prime rate and the London
Interbank Offer Rate (libor).
As a rule, arms make more
sense if you don't plan on staying in your home longer than five years at
most. Which index is good for you depends on two things: the economic
forecast and your personal comfort level.
Libor and T-Bill indexes,
for example, react more immediately to changes in the economy—a good thing
when interest rates go down, not so good when they rise. Whatever happens,
you'll see it pretty quickly in your monthly payment. More conservative buyers
prefer indexes linked to the prime rate or the cofi because they're more
stable and move up (and down) more slowly than other indexes. That's good when
rates are low and rising, less so when they're high and dropping.
Is an arm a good choice for
you? Well, if you need a lower monthly payment to afford the home you want and
you're planning to stay there less than three to five years, then yes. But
make sure you can handle the higher payments that might come down the road. A
prudent approach is to always plan financially for the "worst case" scenario:
Assume that your loan will always rise the maximum amount. If you wouldn't be
able to afford it, then consider another loan. You know your own personal
"comfort level." Use it to make your decision.
Let's say you're buying
your first home. You have a modest income today but a bright future. Even so,
you need to keep your payments low. A long-term arm makes sense even though
your interest rate could rise over time. If you move in the next two or three
years, you won't be around for any significant rate hikes. If you choose to
stay longer, a rise in income will help you keep pace. Or you can always
refinance to a fixed-rate mortgage.
Fixed-Rate Mortgages—People
usually opt for a fixed-rate loan for the security it offers. You know exactly
what you'll be paying each month for the life of the loan. If interest rates
fall, you can refinance at a lower rate. Lenders are offering more loan programs
based on fixed rates, such as lower down payments—that is, five percent down or
less. Adjustable rate loans generally require a larger down payment.
The most common fixed-rate
loans are for terms of 15 or 30 years. If you can afford the shorter term,
it's a good way to build equity fast and save tens of thousands of dollars
over the life of the loan. (However, we can show you how it will be a savvier
move to go with a 30 year fixed and pay an extra payment each month above and
beyond your established mortgage payment. Just be sure to indicate your extra
payment is for principal pay down only, not interest. This way you could even
pay off your mortgage sooner than 15 years and save tens of thousands of
dollars. You also have the "safety net" of paying your lower established
mortgage payment should things get tight one month.)
Fixed-rate mortgages make
the most sense when interest rates are low and if you're planning to stay put
for the next seven or more years. They offer safety to people on fixed incomes
who might not be able to afford a rising housing bill. If you need to lock in
your level and can afford the monthly payments, consider a fixed-rate loan.
Let's say you make a good
salary working for a large company. You're comfortable and job security is
pretty good, but there's not much chance of further advancement. In other
words, you don't anticipate moving anywhere else in the foreseeable future,
and you want to avoid the possibility of higher house payments down the road.
A fixed-rate, long-term mortgage makes sense in this situation. Although
you're probably paying one to two percentage points more than an adjustable
loan, you also have the security of a fixed payment each month. And if
interest rates drop three or more points, you can refinance at the lower rate.
Graduated-Payment
Mortgages—this one is more of a risk. Your early payments are so low that
they don't cover the interest due, which results in negative amortization—which
means you owe more each month, not less. Your monthly payments gradually
increase to cover principal and interest, and you end up paying more than you
would have for a regular loan. Some GPMs are fixed, others are adjustable. Given
the fact that lenders have literally rewritten the rules to get more people into
homes today, we can't think of a good reason to consider a GPM.
Intermediate Fixed
Mortgages—these are a family of 20- or 30-year loans that are fixed for a
set amount of time, such as 5 to 7 years, and then they readjust once for the
remainder of the loan. This readjustment is based on a predetermined index. Some
may refer to these as "balloon" mortgages, but this term is falling out of favor
because of negative connotations associated with balloon mortgages of the
past—which were fixed for 5 to 7 years, at which time the entire balance of the
loan became due.
Today, they are more
commonly known as intermediate fixed loans or extended balloon mortgages. Some
of these loans are not for the fainthearted. You enjoy low fixed payments from
one to seven years, and then the loan readjusts—as long as certain conditions
are met, such as interest rates haven't risen more than five percentage
points, you haven't made any late payments in the previous 12 months, etc. If
conditions aren't met, there are no guarantees, so beware. It's best to
consult your Realtor® or loan officer if you have questions
regarding these loans.
If you're a first-time home
buyer who plans to trade up before the loan comes due, you might want to
consider a balloon mortgage in order to have lower monthly payments. But be
sure to get all stipulations in writing and review them carefully. (There's a
new family of intermediate loans becoming available that are similar to these
other balloon mortgages, but when they become due after 5 to 7 years, they
adjust and become variable rate loans. They also do not carry the rigid
stipulations that balloon loans carry, making them a little easier to live
with if you don't move before the loan is due.)
There are various other loan
types—including roll-overs, wraparounds, zero-interest-rate mortgages and
buy-downs—but the ones we've listed here are most common. If you decide to opt
for something more exotic, discuss it with your Realtor® and loan
officer carefully to make sure you know what you're getting yourself into. If
you get in over your head and can't meet your obligations, you could end up
losing your home and doing serious damage to your credit.
When it's a good time to
refinance. Whatever you decide is the best option for you today may change
as economic conditions or your personal circumstances change in the future. So
how do you know it's time to refinance?
Whether or not you should
refinance usually depends on three things: what you think interest
rates will do in the near future, how much monthly savings you'll
enjoy, and how long you expect to be in your home. Refinancing is not
something you consider lightly because it can be expensive. The total cost of
your loan can rise as much as five percent when you add in the up-front
points, fees and costs.
A good rule of thumb is to
start looking into refinancing when interest rates drop 1 to 11¦2
points below what you're currently paying. The reason is that some lenders
offer loans that cost little or nothing at all. As soon as interest rates drop
below your rate, start talking to your agent or loan broker. Next,
figure out what you'll have to pay up front. Then calculate your monthly
savings. With these two numbers, you can figure out how long it will take you
to cover the cost of the new loan.
For example, if refinancing
costs you $5,000 up front and saves you $200 a month in mortgage payments, it
will take 25 months to cover your costs. If you're not planning to move for
several years, refinancing makes a lot of sense. But if you're going to look
for a new home in two years, you wouldn't really be around long enough to reap
the benefits. In fact, you'd lose money in this situation. If you refinance
today and rates drop even further in the next few months, you'll miss out on
additional savings. If you refinance to save $10 or $20 off your mortgage
payment, then you'll have to stay in your home forever to see it pay off.
Warning: The math is
easy for fixed-rate loans, not so easy when you're talking about arms. If you
don't feel comfortable running the numbers yourself, ask your lender or
Realtor® for help.
Questions to ask while
shopping for your loan. Before you can effectively compare mortgages, there
are a number of questions you'll need to ask the loan officer. Some are obvious,
others are not. Be sure to ask them all.
Kinds of Financing—Fixed?
Adjustable? What about government-backed programs? Any special deals you
should be aware of? Make sure you've got a complete picture of the product
menu.
Interest Rates—Rates
differ not only between different types of loans. The same loan at three
different lenders could have three different rates!
Terms—there are
options beyond 15- and 30-year terms. Find out how different terms affect
interest rates and how they impact the final cost of your home. This is
especially important if you plan to be in the home for a long time.
Down Payment—what’s
the minimum required for different loans? Today's down payment can range
from as high as the old standard 20 percent to nothing at all in certain
programs.
Loan Limits—many
lenders set limits based on a loan-to-value ratio. For example, with an 80
percent loan-to-value ratio (LTV) you can only borrow $80,000 on a $100,000
home.
Loan Qualification—Different
lenders may qualify you using different formulas. Make sure you understand
how you're being evaluated.
Points—Think of
these as prepaid interest charged by the lender. One point equals 1 percent
of the face amount of your loan. In some cases points are paid up front; in
others, they're bundled into the loan. The latter saves you money up front
but costs you more over the life of the loan. No-point loans also save you
money up front, but lenders usually charge one-quarter to one-half point
more than in the case of loans with points. Be sure to look at what your
total costs will be over the life of the loan.
Prepayment Penalty—If
you decide to pay off your mortgage before the term is up, or refinance when
interest rates go down, you may have to pay a prepayment penalty.
Special Deals—some
lenders reduce interest rates for customers who avail themselves of other
services offered. For example, your bank might take a quarter of a percentage
point off if you agree to automatic payment from your checking account.
Time to Approval—Find
out how long it will be before you'll have a decision on whether or not your
loan application has been approved by the lender. A week or two is pretty
normal.
Loan Commitment Period—Make
sure you know how long your lender's commitment is good for. The last thing
you need is to decide on a loan amount at a certain rate, find the right home
and discover your interest rate went up in the meantime. Many lenders now
offer lock-in programs. This means that the lender will
guarantee in writing your loan at a certain rate for a certain period of time.
Common lock-ins are for 10-, 12-, 21-, 30-, 45- and 60-day periods. The longer
the lock-in, the more time you have to shop and iron out hitches in the loan
process. But a lender might charge you more in points for longer periods. Then
again, a short lock-in period can be next to useless given the amount of time
the loan process can take. The lesson here is to be very clear of what a
lock-in offers—and doesn't offer.
Once you have this and other
information on various loan programs from different sources, you can make an
informed decision as to where to shop for the best mortgage.
Don't get stung by
unexpected fees. One of the most common errors we've seen borrowers make is
in not considering the various fees they will end up paying in figuring out the
final cost of a home. Let's take a look at what you can expect.
Loan Application Fee—this
is what the lender charges you for applying. It isn't refundable, even if
you're refused.
Appraisal Fee—this
flat fee is usually charged by the prospective lender to pay an independent
appraiser to inspect the home and estimate its fair market value. This fee is
also nonrefundable whether or not your loan goes through.
Loan Origination Fee—this
charge, which covers the lender's administration costs, can either be a flat
amount or a percentage of the loan amount. It's paid in cash at closing.
Tips for the best deals.
Now that you know a little more about mortgages and where they come from,
we'll share with you our tips for getting the best deal and saving yourself a
lot of headaches in the process.
Pre-qualify Before You
Shop for a Home—Smart buyers make sure to know exactly how much they can
afford to borrow before beginning to look at homes. You can bet that the
seller's agent will ask if you've been pre-qualified; if you haven't, they may
decide you're not a serious buyer. Having a deal in your pocket is always good
ammunition in negotiations. (However, we generally have our buyers
"pre-approve" before they start looking at homes. This is a much
stronger way—you have it in writing, providing you even more leverage when
making offers and during negotiations.)
Lock in a Rate (or not)—In
the time it takes you to find a home and close your mortgage, the interest
rate on your loan could fluctuate upward. If it looks like rates are heading
up, lock it in. If rates appear to be falling, let it float. If your lender
agrees to a lock, make sure you get it in writing. (Get the advice of your
Realtor® or your mortgage broker. Their knowledge and experience
can really help you in this decision.)
Apply for an FHA or Veterans Administration Backed Mortgage—The Federal Housing Administration
and the Veterans Administration don't actually make loans, but they do
guarantee loans offered through traditional lenders. With an FHA loan, you can
put down as little as 3 percent, depending on the value of the property. VA
loans often require no down at all, but they carry eligibility requirements
based on service in the armed forces.
Negotiate the Points—if
you're considering a large mortgage, your lender may be willing to lower the
points charged to get your business. You lose nothing by negotiating. If
you're planning to stay in your home for less than five years, lower your
points paid by accepting a higher interest rate. If you're sticking around
longer, consider more points against a lower mortgage rate. You pay higher
costs up front but can save money in the long run. Just remember there are
three components to your mortgage loan: the interest rate, the points and the
lender's charges.
Watch Out for Prepayment
Penalties—Make sure you won't be penalized for paying off your mortgage
ahead of schedule if you choose to do so. (When making an additional payment
above your regular mortgage payment, always be sure to specify that the
additional amount is toward principal!)
Watch Out for Mortgage
Protection Insurance—Some lenders may offer you mortgage protection
insurance which will make your payments in case you die, become disabled or
lose your job. Check around; you often may find the same kinds of protection
through your regular insurance agent at a lower cost.
Private Mortgage
Insurance (PMI)—Private mortgage insurance is required by the lender on
loans with down payments of 10 percent or less. The cost can run from
one-third of a percent to 1 percent monthly. Once your equity reaches 20 to 25
percent, you may be able to cancel your insurance. While some look at this
required insurance as a nuisance, without it, there wouldn't be loan options
with only 3% down or 5% down—all loans would probably require the more
restrictive 20% down.
Consider the Benefits of
an Early Pay down—there are several benefits to accelerating the payments
on your mortgage. Every extra dollar you put into your mortgage can save you
up to three dollars down the line in interest savings. You'll build equity in
your home more quickly, which puts you in a better position to trade up in a
shorter time period. It also forces you to save money you might otherwise
spend rather than invest. But make sure you verify with your lender that there
won't be a prepayment penalty.
Accelerating your monthly
payments won't save much if you're in your home for only a few years, but for
longer-term situations it makes a lot of sense. (If you refinance your home,
you may consider this option: Continue to pay your old mortgage rate instead
of your new one—stipulating, of course, that the extra money is to pay off
principal. By doing this, you will pay off your loan sooner and save tens of
thousands of dollars.)
The affordable lending
boom In the past few years, lenders have come to realize that they can
safely make loans to people who previously didn't believe they could qualify for
a home mortgage. A recent national study by the Consumer Bankers Association
showed that 96 percent of the 130 institutions surveyed have cut their down
payment requirement—the single biggest obstacle to home ownership for many
Americans. Where once a 20 percent down payment was the standard, today 5-, 3-
and even zero-percent downs have become commonplace. Loans up to 90, 95 and even
97 percent of the purchase price are quite common today.
Lenders have also adopted
much more lenient standards in terms of debt-to-income ratios. The standard 28
percent has moved up to 33 percent, and even as high as 38 percent in some
programs. In addition, lenders are more flexible in their assessments of
creditworthiness, employment histories and other factors that used to result in
rejection for many. The point is simple—there's never been an easier time to
qualify for a mortgage.
There's enough information out there on mortgage loans to fill several
books. But we hope this provides you with
a good general overview of what to look for and what to expect as you shop for
the best home loan.
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