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What Is A Mortgage, Anyway?
A mortgage is a loan secured by real estate. In exchange for lending you the funds necessary to purchase a home, a lender receives your promise to repay the loan over a specific period at a specific cost. Your home and the land it sits on serve as collateral for the loan. Should you default, or stop making payments on the loan, the lender has the right to foreclose on the property and use the proceeds from the sale to recover the remaining amount owed.
Choices and More Choices...
Gone are the days when the only kind of mortgage available was a 30-year fixed-rate loan. Today, there are a wide variety of mortgage programs to choose from. One of the first choices you'll face when picking a mortgage program is between a fixed-rate and an adjustable-rate mortgage. Both have their own unique advantages and disadvantages.
As the name implies, with a fixed-rate mortgage, the interest rate remains fixed for the life of the loan.
Some advantages of a fixed-rate mortgage:
- Offers predictable monthly payments for the duration of the loan
- Provides protection from rising interest rates. No matter how much market rates increase, your interest rate remains fixed.
Some disadvantages to this type of mortgage are:
- It may be more difficult to qualify for a given loan amount, since the interest rate is higher.
- If interest rates drop significantly, you will need to refinance to take advantage of the new, lower rates.
- Fixed-rate loans are generally a good choice for borrowers who plan to stay in their homes for a long period of time or have a lower tolerance for financial risk.
- On the other hand, if you plan to stay in your home for a shorter period of time or believe interest rates will go down in the future, an adjustable-rate mortgage, with its lower start rate, may make better financial sense. With an adjustable-rate mortgage, or 'ARM', the interest rate fluctuates with changes in market conditions. Many adjustable-rate mortgages have interest-rate 'caps' that limit how much the interest rate can change within a particular period.
Some advantages of an adjustable-rate mortgage:
- The initial, or introductory, rates for adjustable-rate mortgages are generally lower than those for fixed-rate mortgages.
- Some ARM's offer one of the major advantages of a fixed-rate mortgage, by allowing you to lock in the low, introductory rate for several years before any adjustment takes place. For example, some lenders offer 10-year ARM's, which have a lower start rate than a 30-year fixed-rate mortgage, but which do not adjust until the 11th year.
- Because of the lower start rate, borrowers may qualify for a larger loan amount, and therefore, a more expensive home, than with a fixed-rate mortgage.
Some disadvantages to an adjustable-rate mortgage are:
- Although most ARM's have interest rate caps that will protect you from sudden increases in your interest rate, if market rates go up, your payment will likely go up also.
- If your interest rate - and payment - increase enough, your home could be unaffordable.
- Adjustable-rate mortgages are often a good choice for borrowers who think they may want to sell or refinance early, expect their earnings to increase in the future, or are looking to purchase a home when interest rates are relatively high.
- Jumbo loans. Jumbo loans are loans which exceed a specific loan amount, known as the "conforming loan limit". Currently, loans over $333,700 ($500,550 in Alaska and Hawaii) for a single-family home, are considered jumbo loans. Jumbo loans typically require larger down payments, and have somewhat higher rates than "conforming", or non-jumbo, loans.
- Alternative financing. Special mortgage programs exist for borrowers with less-than-perfect credit, or for whom documenting their income may be particularly difficult or burdensome. For example, so-called "no documentation" loans may permit borrowers who are self-employed or who work on commission to qualify for a loan based solely on their credit history and stated income.
- Although the breadth of mortgage options may appear daunting, a good loan officer can help you sort through the options and select the mortgage program best suited for your particular situation.
The Importance of Pre-Approval
Before you begin searching for a home, one of the most useful things you can do is to get pre-approved for a mortgage. By completing a mortgage application prior to choosing a home, you'll not only know how much a lender will be willing to lend you, and therefore, how much house you can afford, but it also shows prospective sellers that you are a serious buyer. In fact, many sellers will require you to provide a "pre-approval letter" from a reputable lender prior to reviewing an offer. Lining up your financing in advance can help move your offer to the head of the pack in a competitive real estate market.
What's in a Mortgage Payment?
A typical mortgage payment is comprised of four items:
- Principal, Interest, Taxes and Insurance (often referred to as "PITI").
Principal is the portion of your monthly payment that reduces the original amount borrowed. In a traditional mortgage, the original loan amount is "fully-amortized", or repaid, over the life of the loan. The interest portion of your monthly payment represents the cost of using the lender's funds for the previous month. In addition to principal and interest, lenders will also frequently collect an additional amount each month to hold in a separate escrow account to cover property taxes, homeowner's insurance, and, if necessary, mortgage insurance, or PMI. These escrowed funds will be used by the lender to pay your tax and insurance bills, as they come due.
Want to get an idea of what your monthly payments would be for a particular loan amount? Click here to use our free online mortgage calculator.
Mortgage Calculator
A program used to help homebuyers determine the monthly payment on a mortgage using principal, interest rate, and term as the variables.
Click here to access our online mortgage calculators.
Private Mortgage Insurance (PMI)
What It Is, and How to Avoid It
- Private mortgage insurance (also known as 'PMI' or 'MI', for short) is required on certain loans to protect the lender against financial loss in the event of borrower default. As a general rule, if your down payment is less than 20% of a home's purchase price, a lender will require you to pay PMI. That is because loans with lower down payments are considered to be riskier, as a whole, than loans with higher down payments. Depending on the loan amount involved and your credit profile, PMI can cost as much as 1.25% of the original loan amount per year. To put that in practical terms, on a $250,000 loan, PMI could cost as much as an additional $260.42 per month! (PMI payments are also generally not tax deductible).
Fortunately, it is often possible to structure your financing so as to avoid having to pay PMI in the first place. The most popular way to do this is to split your financing into two distinct mortgages - a 1st mortgage (also known in some jurisdictions as a '1st trust') and a 2nd mortgage (or '2nd trust'). So long as the 1st mortgage does not exceed 80% of the home's purchase price, most mortgage programs will not require you to pay PMI. Although the 2nd mortgage will frequently have a variable interest rate, or if the rate is fixed, a higher rate than that on the 1st mortgage, the benefits of avoiding PMI usually greatly outweigh any potential drawbacks to structuring your financing in this way.
Qualifying for a Mortgage
Curious what lenders look for when they review a mortgage application? Most lenders look at four basic factors, commonly known as "the four C's": Capacity, Credit, Cash, and Collateral.
Income (Capacity)
- A lender will look to see whether you have a sufficient and steady source of income with which to make the proposed mortgage payments. For example, if you have worked for the same company or in the same line of work for 30 years, your application will generally be considered less risky than the application of someone who has recently started their own business. Lenders will also look at whether the proposed monthly mortgage payments will result in a significant increase in your monthly housing expense, and the percentage of your income that will be necessary to cover the mortgage payments in addition to your other monthly obligations.
Income can come from a variety of sources, including primary, second, or part-time job(s), overtime and bonuses, self-employment, commissions, rental property income, government assistance programs, or interest on asset accounts. In most cases, a lender will ask you to provide documentation of your income. For example, you might be asked to provide copies of your tax returns, W-2 forms, or a recent pay stub. If your income is not easy to document, you may be eligible for an increasing number of reduced documentation and "no documentation" mortgage programs.
Credit History
- Do you consistently pay your bills on time, or do you have a pattern of late payments? Have you previously filed for bankruptcy? Have any judgments been filed against you? A lender may ask you to explain any unfavorable information that appears on your credit report. Some lenders offer special mortgage programs for homebuyers with less-than-perfect credit, although such loans tend to carry higher rates. If you have a limited credit history, a lender may allow you to demonstrate your creditworthiness by documenting a history of paying your rent, utility bills, and other obligations on time.
Cash or Capital
- Do you have any money that can be used for a down payment, and if so, how much? The money you hold in any savings, checking, money market, or retirement accounts can greatly affect the strength of your application. A lender will also look to see whether you will have any reserve funds left after closing to cover unanticipated expenses, or if anything should happen to you or your job.
Property (Collateral)
- Your lender will ordinarily require your home to be appraised to determine its fair market value. This is done by comparing your house to similar homes in the area that have sold within a particular time period. If you haven't decided on a property yet, you can be preapproved for a loan, subject to your finding a home within certain parameters.
How Much Home Can I Afford?
To answer this question, lenders look at all the elements that make up your financial profile: Your credit history, the cash you have available for a down payment and/or reserves, your income, and the amount of your other financial obligations. Then, taking the current interest rate on the mortgage program you have applied for into account, a lender can give you an idea of how much they would be willing to lend you. By adding this figure to the funds you plan to use for your down payment, you will know the price range of homes you will be able to afford.
How Large a Loan Can I Be Approved For?
Two general guidelines are used by lenders to determine the maximum amount that they will be willing to lend you. These guidelines help to ensure that your housing expenses and other monthly obligations don't take up an excessive proportion of your income, as well as ensure that you will be comfortable with the monthly payments after you've purchased your home. The first guideline, known as the housing expense-to-income ratio (or front-end ratio), compares your proposed monthly mortgage payment (PITI) to your total household gross monthly income. The second guideline, known as the debt-to-income ratio (or back-end ratio), compares the total of your proposed monthly mortgage payment and other monthly obligations to your total household gross monthly income. Other monthly obligations included in calculating the back-end ratio include recurrent monthly expenses, such as credit cards, auto loans, student loans, and consumer loans, as well as other financial obligations, including alimony and child support. In the past, most lenders used '28/36' ratios, which meant your monthly mortgage payment could not exceed 28% of your gross monthly income, and your total monthly obligations could not exceed 36% of your gross monthly income. Today, however, many lenders offer expanded qualifying ratios that make it easier to qualify for a mortgage. Your loan officer can help you get a better idea of the maximum amount you can qualify for in light of your financial profile and the mortgage programs that most interest you.
How Important Is My Credit History?
Your credit history is an important factor in determining the kinds of mortgage programs you will be able to qualify for. If you have a history of paying your bills on time, it's a signal to a lender that you are also more likely to make your mortgage payments on time. Your credit history can affect the amount of down payment that will be required, the maximum amount you can borrow, and the interest rate you are offered. That being said, even if you have no established credit history or your credit is less-than-perfect, you may still qualify for a mortgage if there are other favorable aspects to your application.
Down Payment Requirements
How Much Do I Need for a Down Payment?
- In the past, saving money for a down payment was often the largest obstacle to home ownership. Today, however, flexible mortgage programs make this issue less of a challenge. In fact, depending on your credit profile and the loan amount, you may be able to qualify for programs that don't require any down payment at all!
Closing Costs
Closing costs refer to all of the additional fees and taxes associated with closing a home loan. The amount of closing costs you will be required to pay can vary significantly, depending on the lender, type of mortgage, and location of the property. Closing costs generally fall into one of three categories: Out-of-pocket expenses, pre-paid items and points.
Out-of-pocket expenses include fees for third-party services, such as appraisals, attorney fees, credit reports, and title searches.
Prepaid items can vary, depending on the type of property you are purchasing and the settlement date, but generally include a certain number of months' worth of homeowners insurance (unless the property is a condominium) and property taxes. Most lenders require borrowers to pay their real estate taxes and homeowners insurance through the use of an escrow account established by the lender for that specific purpose. With an escrow account, instead of paying your entire homeowners insurance premium or property tax bill every six or twelve months, you pay a portion of the cost as part of your monthly mortgage payment. This helps you avoid the hassle of planning for large lump sum payments, while reassuring the lender that your taxes and insurance will be paid on time.
Points are fees, with each point representing 1% of your loan amount. There are two kinds of points, origination and discount:
Origination points are fees charged by the lender for making, or "originating", a loan. Simply put, any origination points you pay typically represent additional profit for the lender.
Discount points allow you to buy down your interest rate. In other words, in return for paying one or more points upfront, you can receive a lower interest rate on your loan, thereby reducing your monthly payments.
When comparing lenders and mortgage programs, make sure you compare "apples to apples". Make sure that the rates quoted by each lender all have the same number of points, and that you compare the total closing costs charged by each lender.
The Application Process
What information will I need to provide to a lender when I apply for a mortgage?
There are six general kinds of information a lender will want to know:
- Personal Data: The names, addresses, dates of birth and Social Security numbers of all borrowers.
Income: The type (e.g. annual salary or hourly wage), amount, and source(s) of income for all borrowers.
Assets: The current balances of any asset accounts you may have, such as checking or savings accounts or retirement plans, and the value of any other real estate owned.
Debts and Obligations: Information concerning any outstanding debts and financial obligations you may have.
Credit References: Most of this information will be derived from your credit report, which the lender will order as part of the application process.
Property Information: The address and type of property you will be purchasing, if you have chosen one.
The Approval Process
After you've submitted an application, the lender will verify the information you provided and obtain a copy of your credit report. Taken together, this information helps the lender assess the degree of risk involved in lending you money.
If you have excellent credit, sometimes a lender can approve your application within a few minutes. Other times, a lender will need additional information to render a decision. For example, a lender may ask you to explain any unfavorable information that appears on your credit report, or the loan may need to be restructured to meet the lender's underwriting guidelines. If your application is approved, the lender will send you a "commitment letter", outlining any remaining conditions that will need to be met in order for settlement on the property to occur. The lender will order an appraisal to determine the fair market value of the home, order a title search of the property, and give you the option of locking in your interest rate.
Settlement
As the time for settlement approaches, the closing agent will contact the parties to the transaction to arrange a convenient time and place for the closing to occur. At this time, the lender may ask you to furnish documentation that you have secured a homeowner's insurance policy for the property.
The actual closing procedures and associated fees vary, depending on the specific settlement company chosen and the location of the property you are buying whether it is in the District of Columbia, Maryland or Virginia. In addition, your lender will generally require you to pay several additional fees, such as application and credit report fees, appraisal fees, and underwriting fees, which will typically add an additional $1,000 or so to your total closing costs. Within 24 hours of closing, the settlement agent or the lender will contact you to let you know exactly how much money, if any, you will need to bring to closing (most closing agents require that these funds be in the form of a cashier's check, money order, or wire transfer.)
At your closing, ownership of the property is transferred from the seller to you. A closing agent (usually a title agency representative or an attorney you have selected, depending on what is customary in the area where the property is located) coordinates and distributes all of the paperwork and funds in accordance with the terms of the sales contract. Congratulations! You are now the proud owner of a new home!
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