| Mortgage Basics | 5 items found |
Mortgage Basics
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The key in choosing a loan that best fits your needs is to evaluate your finances and choose the best type of loan that fits your budget and your long- or short-term investment strategy. A mistake that many consumers make is to choose the type of loan that will allow them to buy the house they want without fully understanding the terms associated with lower-interest rate loans. This section is to inform readers about the most common loan types available and to map out the pros and cons. | There are two basic categories of mortgages: the fixed-rate and the adjustable-rate mortgage (ARM). Within these categories, there are many variations. However, in nearly all mortgages, two factors are usually at odds: how predictable the payments are and how low, or affordable, they are at least initially. Borrowers choose fixed-rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. But in so doing, they give up a lower initial mortgage payment. Borrowers choose adjustable-rate mortgages because the mortgage payments are initially lower. A lower initial payment makes the home more affordable at first, but the borrower must also be willing to accept the risk of — and be confident in their ability to afford — an increased mortgage payment, sometimes significantly higher. In some cases, there's even the possibility of an increasing loan balance or negative amortization. To recap, getting a loan with adjustable payments results in lower payments at first but exposes you to some risk of high payments later. On the other hand, locking in steady predictable payments gives you a higher initial payment than the ARM, but you know exactly what you owe in principal and interest at any given time.
Qualifying for a Mortgage
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To some potential buyers, particularly first-time buyers, the prospect of meeting a mortgage lender may seem a little scary. Lenders ask a lot of questions because they want to help you get a mortgage. If you work with a lender before you decide on a home, you will know whether you’ll qualify for a mortgage large enough to finance the home you want. | It may seem that your lender needs to know everything about you for the application, but actually all the lender needs to know about is employment, finances and information about the home you’re buying (but you can be pre-approved before you choose a home). You will, however, need to provide quite a few details about these topics. The goal is to arrive at a monthly payment you can afford without creating financial hardships. Here's an idea of what lenders consider when they are qualifying you for a loan: Your household income and expenses Lenders look at your income in ways other than the total amount; how you earn it is also important. For example, income from bonuses, commissions and overtime can vary from year to year. If these sources make up a large percentage of your income, your lender will want to know how reliable they are. Your lender will also consider the relationship between your income and expenses. Generally, your fixed housing expenses (mortgage payment, insurance and property taxes, but not repairs or maintenance) should not be more than 28 percent of your gross monthly income, although this is not an absolute rule. Your lender will also consider other long-term debts, such as car loans or college loans. It is a good idea to bring the following when you meet with your lender: Income Employment, salary and bonuses, and any other source of income for the past two years (bring your most recent pay stub, previous year’s W-2 forms and tax returns if possible) The most recent account statement showing the amount of any dividend and interest income you received during the past two years Official documentation to support the amount of any other regular income you may receive (alimony, child support, etc.) Employment history Job stability is a factor that a mortgage lender will look for, and two years at your current job helps, but this also is not an absolute requirement. If you change jobs but stay in the same line of work, you should not have a problem — especially if the job change is an advancement or increase in income. Credit score Your credit score also helps to predict how likely you are to repay the mortgage debt.
What's in a Mortgage Payment?
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A monthly mortgage payment includes at least two parts: an amount that goes toward the principal of the loan (the money you've borrowed) and a second amount that goes toward interest (the cost of borrowing the money). | For most homeowners, however, there is also a third part of the mortgage payment: an amount that is paid into an escrow account that the lender maintains for you to pay for things like homeowners hazard insurance, property taxes, condominium and association fees and mortgage insurance (if applicable). This is the element of the monthly payment that can go up or down even in a fixed-rate mortgage. Together, these elements are called PITI: P — Principal I — Interest T — Taxes I — Insurance Your tax and insurance costs Homeowners must pay property taxes and they must have some type of homeowners insurance. Depending on state laws and other variables, most lenders require homeowners to pay into what is called an "escrow account." In this account, the lender or mortgage servicer keeps enough money to cover your property taxes and homeowners insurance. You pay into this account each month as part of your mortgage payment. When your taxes are due, the lender/servicer pays them for you. The same is true for your insurance. The lender/servicer sends you a periodic statement showing how much is in this account. You can compare the statement with your property tax bill and your homeowners policy to ensure that the right amount is being held to cover the payments. The Real Estate Settlement Procedures Act (RESPA), which is enforced by the U.S. Department of Housing and Urban Development (HUD), is the major law covering escrow accounts. It is important to maintain the required property insurance on your home. If you don't, your lender/servicer can buy insurance on your behalf. This type of policy is known as "force placed insurance"; it usually is more expensive than typical insurance, and it provides less coverage. If you're buying a house, most sellers disclose the amount of the annual property taxes on the house when it is listed for sale. If they don't, you can easily get this information from your local property tax assessor. A local insurance agent can give you an idea of the annual insurance cost. Divide each of these numbers by 12 and add them to the principal and interest to get the estimated total monthly payment. What is private mortgage insurance? If a buyer puts down less than 20 percent of the selling price on the mortgage, lenders may require the buyer to buy another type of insurance called private mortgage insurance (PMI). This provides insurance to the lender in case the buyer is not able to repay the loan and the lender is not able to recover costs after foreclosing the loan and selling the property. The annual cost of PMI can vary but usually is between .19 percent and 1 percent of the total loan value, depending on the loan terms and loan type. PMI can be paid up front but most buyers prefer that it be included in their mortgage payment. The cost can vary based on several factors that include: loan amount, loan-to-value ratio, occupancy (primary home, second home, investment property), documentation provided at loan origination, and probably most of all credit score. Once the principal of the loan reaches 80 percent (the owner has 20 percent equity in the home), the PMI is usually no longer required and can be canceled, although you may have to prove your equity by having a new appraisal done to show that the house is worth at least 20 percent more than you owe on it. (Note: Some lenders may require that PMI be paid for a fixed period even if the principal reaches 80 percent.) The cancellation request must come from the servicer (the company you send your mortgage payment to) of the mortgage to the PMI company that issued the insurance. Note: PMI may be waived or avoided through some types of government or other loans. Check with your lender to determine your situation.
Mortgage Types
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Basically, there are two categories of mortgages: the fixed-rate and the adjustable-rate mortgage (ARM). Within these categories, there are some variations. However, in nearly all mortgages two factors are usually at odds: how predictable the payments are and how low, or affordable, they are at least initially. In addition there is the reverse mortgage, a special loan product that enables homeowners over the age of 62 to convert a portion of their home equity into income. | The 30-year fixed-rate mortgage Not long ago, there was only one kind of mortgage: 30-year fixed rate (the borrower has 30 years to pay back the mortgage at a fixed interest rate and the payments are the same over the life of the loan). It is still the most common home loan. Borrowers choose fixed-rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. The payments are the same over the life of the mortgage, regardless of interest rate changes. Initially, both the rate and mortgage payment are higher than those of an adjustable-rate mortgage, but the payment is lower than that of a 15-year fixed-rate mortgage (see below). People who choose a fixed-rate mortgage usually are planning to keep their home and mortgage for several years. The 15-year fixed-rate mortgage This type of mortgage enables you to own your home in half the usual time, meaning you could possibly own it before your children start college or you reach retirement. Because the loan is shorter, you pay substantially less in the total interest over the life of the loan, often less than half the total interest of a 30-year fixed-rate loan. However, because the term is shorter, the monthly payments are higher than those of a 30-year mortgage. For people who can afford the higher monthly payments, this is an excellent choice, with lower total costs and a shorter term. Qualification for this type of loan may be more difficult because the income requirement may be higher. The adjustable-rate mortgage (ARM) In general, adjustable-rate mortgages can offer lower interest rates and mortgage payments at first because the borrower assumes the risk of changes in interest rates. Usually borrowers choose ARMs because the lower initial payment makes the home more affordable at first, but the borrower must be willing to accept the risk of an increased mortgage payment, which can sometimes be significantly higher. After a specified period of time, the interest rate and payments on an ARM are adjusted based on changes to a specific interest rate index (such as the LIBOR rate). These adjustments occur at times specified in the ARM disclosure you receive from the lender and can result in payment increases. There is always a floor cap, payment cap, and life cap on the rate. It's important to understand all the aspects of ARMs before you make your decision. People who choose an ARM usually are intending to sell or refinance before the rate adjusts upward. They also may expect income to increase over time. These borrowers must be confident they could afford the post-adjustment higher payments if they cannot refinance or sell. NOTE: Fluctuations in the economy often determine whether certain types of the loans listed below are available. During times of slow housing markets and high foreclosure rates, some types of ARM loans listed below may not be available. This is because ARMs are riskier to the borrower and lender, and when the economy is slow, they become even more risky. Just like borrowers, lenders do not want to risk handling foreclosures. Hybrid ARM There are two types of hybrid loans: those that begin as a fixed-rate loan and convert to an ARM and those that begin as an ARM and convert to a fixed rate. The first type of hybrid ARM offers the predictability of a fixed-rate mortgage at a lower rate for an initial specified period, such as three, five, seven or 10 years. This ARM starts as a fixed-rate mortgage, then converts to a one-year adjustable ARM at the prevailing interest rate, plus an additional amount or margin. The adjustment from the fixed-rate period to the ARM and subsequent adjustments can result in significant mortgage payment increases at each stage. The rate is capped at specified amount, so mortgage payments will stop increasing when the rate cap is reached. People who choose this type of hybrid ARM usually want a predictable payment for a period of time and plan to refinance or move before the rate adjustment. Borrowers must be confident that if they stay in the home, they can afford higher monthly payments after the fixed-rate period ends.
About Interest Rates
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Lenders provide a great deal of guidance, but you make the final decision about whether you’re getting the best loan you can get. Part of taking that responsibility involves comparing interest rates. Mortgage interest rates change daily based on a number of national and international economic factors. | The current national rate is posted at left on this page. You’ll note that last week’s and this week’s rates are included, indicating whether rates are moving up or down for the week. You can find longer-range forecasts in business newspapers and on Web sites. Use our calculators to see how easily you can check the effect of different rates. You can see what monthly payments may look like on different loan sizes at different rates. However, the total cost of a mortgage involves more than just the basic interest rate. Origination fees, discount points, other miscellaneous costs, and other terms and conditions may affect the ultimate cost of your mortgage. When you are comparing different mortgages, do your best to be sure that you’re taking into account all the factors that can influence your final costs. The lowest mortgage rate may not necessarily be the best choice. Ask lenders these questions: What are costs for origination fees? What are the costs for discount and origination points? What fees does your rate quote include? What is the annual percentage rate (APR) of the loan? The APR is computed based on all the major costs of your loan, not just the loan amount. It usually includes points, origination fees, and other costs associated with the processing of your loan. Be sure to ask lenders which fees are included in their APRs, and try to compare APRs that include the same fees. This will help you determine the most accurate rate you would actually pay. Simple vs. compound interest Virtually all mortgage loan repayment schedules are computed based on a compound interest formula. In the beginning of your repayment period, you are paying little on the principal, so if your annual interest rate, say 6 percent, is added to your balance every month, your principal balance doesn't go down very much. So if your balance is $100,000 and interest is compounded monthly, it's like adding $6000 to 100,000, then adding 6 percent of $106,000 ($6,360) to the 106,000 (112,366) , then adding 6 percent of $112,366 to the 112,366, and so on every month. This example is oversimplified (because you usually do pay a little on the principal at the beginning), but it gives you an idea why it takes so long to pay off a mortgage loan and why you end up paying a lot of interest over a 30- or 15-year period. The moral of the story is it's not just the interest rate you pay that matters but how often it is compounded. (Sometimes these two factors together are called the "effective interest rate.") You should get this information from the lender. If your interest is compounded frequently, such as weekly, you may want to shop around and see how often interest on loans from other lenders is compounded. Discount points By paying a lump sum of money to the lender at the time you close on loan, you can lower the interest rate. That sum is measured in "points." One "point" is equal to one percent of the principal amount of the mortgage. (One point on a $100,000 loan would be $1,000.) You should know how points and other terms and conditions affect the total cost. On most types of loans, lenders offer mortgages with several combinations of points and interest rates. Generally, the lower the interest rate, the more points you will pay at settlement. Interest rates affect your monthly mortgage payment, while the points affect the amount of cash you must have at the closing. For example, if a loan with the current market interest rate has two points, a loan with an interest rate that’s one-half percent higher than the market rate may have no points. Your choice among the various interest rate/points options will depend on how much cash you have available for the closing and settlement. When is your rate set? As you discuss your options among different mortgages, be sure you ask how and when the final interest rate you pay is determined — or when your rate is "locked." Most lenders will quote a rate and fees at the time you apply for a loan, and then guarantee—or lock—the quote for a specific time. While this lock protects you from paying more for your mortgage if interest rates rise before you close on the loan, it also means you will pay the quoted rate even if interest rates fall. Lock periods usually run from 10 to 60 days. Longer periods are sometimes available for an additional fee. You generally will want your lock period to be long enough to get you through closing and settlement. Some lenders, however, will give you the option of letting the interest rate for your mortgage "float," so the rate can change between the time you apply and the time you close (although the rate is usually set after some specific period before the actual closing). Allowing the rate to float enables you to benefit from reduced interest rates if interest rates fall between the time of your application and closing. But before you choose a float, make certain that you have the resources to cover a higher monthly payment if interest rates should go up. Otherwise, you could be denied your mortgage. | |||||||||||||||||||||||
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