All About Home Loans
What is a mortgage? The word is thrown around constantly in terms of house buying, but it is rarely explained. Thankfully, the definition is simple, as it is a type of loan designed to assist you in purchasing a house. When you consider your income and your local housing market, it’s easy to see why a loan is necessary. A house may cost $100,000, or $500,000 or even $1,000,000+. Regardless of cost, chances are you don’t have that kind of cash sitting under your mattress. Mortgages allow you to leverage your income to buy a house in a series of monthly installments.
The monthly cost is the combination of the principal and the interest. The principal is the original amount you borrow. A $100,000 loan has a $100,000 principal. That same loan at a four percent interest rate has roughly $33,000 in interest costs over 15 years or $72,000 over 30 years. The exact amount varies based on interest rates, the amount you pay each month and the term of the loan.
There are primarily two types of mortgage: fixed-rate & adjustable loans. They each have their own advantages and disadvantages.
Fixed-rates are simple. You have a set principal and a set interest rate. The rate never changes for the term of the loan. It starts at four percent day one of year one, and stays at four percent for the remainder of the term. Your monthly payment never changes. You’ll never be surprised by a rate hike.
Adjustable-rates do not have a fixed interest rate. Instead, the rate changes based on what other rates for other financial transactions are doing. If the national rate is on the rise, chances are yours will rise as well, and you’ll end up paying more. On the other hand, if national rates fall, so till will yours, leading to a lower monthly fee for a time.
Hybrid mortgages are those loans that start out with a fixed interest rate and then, after seven, ten or another period of years, convert into an adjustable-rates. This offers an advantage to short-term homeowners looking to convert houses or discharge their debt while the rate is low. Otherwise, homeowners may be surprised when it converts into an adjustable rate and the monthly cost rises.
Interest-only mortgages are the closest a legitimate mortgage can get to fraud. For the first few years of the term — the same sort of periods as in a hybrid note — the monthly cost is very low. This is because it only goes towards paying accruing interest. Once the period runs out, the full principal is still owed, and no progress has been made over the previous years. Monthly payments skyrocket and most homeowners are unprepared. Beware of this reset, and make sure you can handle it before you sign up for one.
The Subprime Bubble
In recent financial news, specifically in the late 2000s, the housing bubble burst. This was mostly caused by the increase in subprime lending. Lenders for years had been increasing the amount of loans they extended to people who perhaps should not have qualified for those loans. This was in part due to extensive government incentives and subsidies for companies that helped people find housing. Jobs were plentiful, housing costs were rising due to the prevalence of new buyers and everything looked strong.
The crash happened in the late 2000s when market prices began to falter. The heaviest hit areas were those full of people holding subprime notes. Monthly interst costs jumped, borrowers defaulted, jobs declined and every factor leading to a strong economy dropped. The cycle continued in a spiral of depression that led to the current recession. Thankfully, government policies are changing to help avoid this issue in the future.
Which to Choose? Fixed or Adjustable?
Fixed-rates are stable. The monthly cost is fixed, the rate is fixed, the principal is fixed. There are no surprises. You always know what your amount due is going to be, and you have an easy time budgeting for that each month.
While that stability can be quite beneficial, these often have higher starting rates than adjustable loans. This is because lenders don’t want to get burned if the economy causes rates to rise. This happened in the 1980s, where many holders of 6% fixed-rates cried with joy while the Federal Funds rate shot up to 15 percent. The opposite is also true, of course. If you’re locked into a six percent interest rate and the market decides interest rates will fall to four percent, you’re still stuck with the higher rate (unless you refinance).
With a fixed-rate mortgage, you are likely signing on for either a 15 or a 30-year term. Lenders will charge you a higher interest rate the longer the term. This is because a longer term gives interest rates more time to rise. It also gives you more time to encounter financial hardship and default.
Adjustable-rates are the bank’s way of maximizing their profits while following the market. They’re volatile, because they change with the level of interest prevalent in the wider market at large. If the market rates rise, so do yours. If it lowers, the same may happen to you. What makes adjustable-rates attractive?
Most of the time, they start at a lower rate than a fixed rate mortgage. A fixed rate may start at seven percent, and an adjustable loan for the same principal and term may be a mere five percent.
Lower interest rates also potentially allow you to qualify for a larger loan. If you have a budget of $150,000, borrowing at six percent will give you a smaller principal than borrowing at four percent.
If you’re buying your home while rates are high, your adjustable-rate may starts off with a lower than market rate. Then, if the market rates drop, so too will your relatively-low rate. This allows you to enjoy lower rates without refinancing to get them. It’s also a benefit for those cases where you may not qualify for refinancing.
Adjustable-rate mortgages have one safety against rising rates. They typically have a clause that identifies the maximum possible rate for the loan. Even if the market rises beyond that cap, your rate will remain capped. You can talk with your lender to identify what this cap is and what the maximum possible payment would be, which helps you plan for the worst-case scenario. Adjustable-rate loans also typically have a periodic adjustment cap, which limits the size of an individual rate jump.
How often does an adjustable-rate mortgage adjust? Typically, the change takes place once every six months or once a year. Some rare loans will adjust monthly, which can be a warning sign of something you want to avoid. Your lender will send you a notice of the coming adjustment, how it’s figured and how much you’ll spend each month.
Before you consider signing for adjustable-rates, consider these factors:
- You need a monthly budget that can withstand a higher monthly payment without compromising your other financial goals. Don’t sign for adjustable-rates if the low introductory rate is the highest you can handle.
- Make sure you have the financial reserves to cover you in the event that your job is lost. Six months of monthly expenses is ideal with adjustable-rate mortgages.
- Can you afford the worst-case scenario, where the interest rate hits the highest possible rate allowed?
- If you’re combining your finances with your spouse or a family member, will you be able to handle it if they suddenly lose a job? Financial hardship is not an acceptable excuse for a financial institution
- Consider whether you’re starting a family. Having children costs money, which will lower your available funds, reducing the amount you can afford each month
- Not knowing what your rate is going to be in the coming months is a lot of stress to handle. Make sure you’re able to take on the psychological strain of an adjustable rate
Mortgages typically come in two term lengths: 15-year and 30-year. Like the different rate categories, these have their advantages and disadvantages.
30-year mortgages typically have lower monthly payments than a 15-year term with the same principal. This makes sense, after all, because you have twice as long to repay the same amount of principal. Your monthly cost won’t be exactly half, because of the interest accumulation, but they will be lower. The lower payments a 30-year offers allow you to save for other financial goals, like retirement. Even if you can afford the higher monthly payments of a 15-year tern, you may want to take the 30-year term and apply the extra money to retirement or other savings.
If you can handle the higher payments of a 15-year and still apply money to retirement or other savings, by all means, grab a 15-year note, as it allows you to accumulate home equity much faster. You’ll have your house owned outright in just over a decade and a half, which can be an awesome situation for someone in their 40s or 50s. Of course, just because you have a 30-year note doesn’t mean you have to pay the minimum. You can just as easily send in more than the minimum each month. Finishing a 30-year in 20 or 25 years will save you a bundle on interest. Extra payments early in a loan will lead to greater savings as they prevent some of the associated interest from accumulating for decades.
Points & Fees
Lenders charge fees for doing the research and paperwork to prepare your loan. These are typically identified as points. A point is an up-front fee in exchange for access to better rates. One point is equal to one percent of the principal of the loan. For a $100,000 mortgage, that is $1,000. Typically, a lender will charge you more than one point.
Points are not all bad. For fixed-rates, the more points you pay up front, the lower your ongoing interest rate. Conversely, if you can’t pay more than a single point or two, you’ll find higher rates. This might be the difference between 7.25 and a 7.75 percent, but it’s still significant — especially for high principals over long terms.
Lenders will charge other fees as well. Before you sign, ask for an itemized list of these fees. This will help you negotiate a lower signing fee. As always, beware any deals that claim to have no fees. Lenders want to make money, and if they aren’t doing it by charging you fees, they will by charging greater interest. Some fees you might see are application and processing fees, credit report fees and appraisals.
Application fees tend to run between $500 and $1,000. Most lenders charge this fee regardless of whether or not you’re approved for the loan or you accept their offer — it’s a test of sincerity. Some lenders will waive this fee if you’re approved and accept their offer.
Credit report fees are relatively minor, typically less than $100. This is simply a way for the lender to obtain a current copy of your credit report. Make sure you’ve pulled it yourself before you waste your time — and the lender’s time — with a low score or problematic report. You’ll lose your fees and you’ll end up declined.
Appraisal fees cover an inspection of the house you’re looking to buy. This helps prevent overpaying for a house with a serious fault. This is a protection for you and the lender. You can factor repairs into the home’s value & the lender knows the collateral is good. The lender risks buyers running off without paying, leaving them holding the property. If the property value declines and you overpaid to begin with, the lender takes a serious loss. An appraisal fee can run from $300 to $1,500, depending on the scale and complexity of the home.
20% is a common down payment. A higher down payment is enticing to lenders and can help get you approved. Putting less down is cheaper upfront, but you need to do some convincing to get it. Additionally, if you are paying under 20 percent, you will be required to get Private Mortgage Insurance. PMI is a type of insurance specifically designed to compensate the lender if you default while having paid a lower-than-usual down payment.
Picking the Best Loan
The hardest part of picking a loan is finding all the possible quotes. You’ll need to know your credit score and financial situation, as mentioned in all the previous talk of financial awareness. Shopping around for home loans is the same as shopping for a good auto loan or good insurance rates. Call lenders, offer them your information and ask for a quote. You can do plenty of research with the power of the Internet at your disposal, but some lenders may not have a significant online presence. You may want to do some good old-fashioned legwork for this one.
What characterizes a good lender?
- A straightforward attitude. Good lenders will explain their terms in plain English. If they start confusing you with technical terms or disregarding clauses as “unimportant” without explaining them, you should consider it a warning sign
- Local approval. Good lenders can approve your loan there in the office. They won’t have to send away and wait for corporate approval. This is an even stronger indicator now with a global computer system
- Market knowledge. Good lenders will know the sort of properties that are available in various areas. They will know the sort of property you’re looking at, and they will warn you about potential surprises
- Competitive nature. Lenders are businesses. Make them compete for your business. If they’re set in their office and secure in their position, be wary. It’s possible they have the best offer and know it, but it’s also possible they’re using their confidence to make you believe that when a better loan is available down the street
- Nationally licensed. As of January 2011, loan officers must be licensed. Avoid any lender that doesn’t have a license
Remember, even if you have a good real estate agent, you don’t need to take their advice for a lender. They might know the best deals in town. They might know the best deals that were in town 20 years ago. Investigate their suggestion, but don’t take their word as gospel.
The same goes for brokers. Brokers attempt to work with a wide selection of lenders to get a good deal, but they can’t work with everyone. A good broker will get you the best deal, and they will charge for it. It’s a steep price, but it’s worth the saved time and hassle of shopping for your loan alone.
Typical Financing Problems
When you’re saving for a home, checking your credit report and working with an agent to find a property, the anticipation builds. Your dream of home ownership is almost here. It’s so close you can feel it. Having the rug pulled out from under you at this stage in the game is incredibly depressing and likely means you have to put your dreams on hold. To help avoid this, here are some of the most common problems and how to handle them.
Low income. If you don’t have enough income, you won’t be able to get financing. If the lender feels you’ve stretched yourself too thin, you’re going to face a declined mortgage. To handle it:
- Have patience. Unless you can immediately get a promotion or a new, higher paid position, chances are it will be a while before you can demonstrate a higher income
- Increase your savings & down payment offer. You can increase your chances of approval by offering 25 or 30 percent instead of the typical 20 percent.
- Cosign. A wealthy benefactor, be they friend or family, can drastically improve your chances of approval. Of course, you have to trust them with your financial situation, and if you default, they are on the hook
Credit history issues. If you happen to have a number of outstanding debts, be careful with your application. A high credit balance and outstanding loans are red flags for lenders, especially if you’re maxing out your credit cards each month. Errors on your credit report may also crop up, though ideally you will have scanned your credit report and fixed any errors before you apply for a mortgage. To cope:
- Work to clean your credit report before you apply.
- Shop around for lenders who understand you’re a person rather than a credit score. Some lenders are more understanding and flexible than others, willing to give you the benefit of the doubt
- Cosign. Again, a cosigner will improve your chances of approval.
- Lower your expectations. If you have a lot of debt and not a lot of income, you might simply be looking at a loan out of your grasp. Shooting for a smaller loan may not get you the home you want, but it could be the difference between approval and denial
- Trim your expenses and apply the savings to your debts. Minimizing your debts in advance of an application will help you get approval — especially since it demonstrates that you’re willing and able to adjust to meet your new obligations.
The appraiser claims a lower value than your offer. It can be a shock to see a professional appraiser set the value of your future home lower than you offered. Thankfully, even reaching this step shows the lender and the seller that you’re interested. You can use the appraiser’s estimate to negotiate a lower purchase price. Of course, make sure your appraiser is a local who knows local prices, otherwise the estimate may not be fitting.
When you’re applying you need plenty of information. If you want the process to go as smoothly as possible, try to have all the documentation available. This helps you avoid running back and forth between homes, banks, deposit boxes, computers and other data stores to find the paperwork you need. Here is a list of what you should bring.
- The sales contract for the home you’re looking at buying
- Paystubs for the last 30 days, or longer if you’re self-employed. Make sure these are originals, not reproductions
- The most recent two years worth of W-2s and tax returns
- Residence history for at least two years
- Three months of bank statements and investment statements
- A diploma or transcript if you’re an active or recent student
- A sales contract for your current home, if you’re selling
- Information for your landlord if you’re renting
- Pink slips for vehicles less than five years old
- Any paperwork relating to bankruptcy, social security benefits or disability
As you can see, banks will ask for virtually anything relating to your financial history. They may ask for documents not on this list. If possible, call them beforehand and ask what paperwork you need to gather. Most lenders will have a list they can provide.