Choosing the Right Mortgage
(Long Version)
Warning! This is an extremely detailed explanation of mortgage issues. It’s like a long class on an important subject with a boring instructor. We recommend the short version. It will get you to the same place in the end. However, if you want the details, you’ll find them below.
Choosing the right type of mortgage can, many times, be a very easy task. At other times, especially if you are considering an Adjustable Rate Mortgage (ARM), the choice may not be very clear. You may have to do some homework to evaluate your personal financial situation and then determine the features of available loan programs to analyze how they correspond with your needs.
Start by asking yourself these questions:
Budget: What is my current financial situation: income, debts, other expenses? How will that change with a new house?
Income: What do I think my future income will be? Are there any plans to change my income stream. Will I be able to absorb future mortgage payment increases?
Assets: What types of assets and how much are available for a down payment and closing costs? What will be my other purchase needs when I buy a house and where will those assets come from?
Housing needs: How long do I plan on staying in this house? How fast do I want to build equity? What are my long-term equity needs (retirement funds, college tuition, etc.)?
Economic outlook: What do I feel will be the direction of future interest rate movements? How confident am I in that view?
Tax situation: Would I benefit from making a "prepaid interest" payment in the form of discount points? What will be the impact of this purchase on my tax situation?
Risk: What is my risk tolerance for payment changes? Will I have enough cushion to absorb a 15 to 20% payment increase?
The answers to these questions should assist you in determining which type of loan program you need. A loan program that has a fixed interest rate and a fixed payment for the term of the loan is the most conservative. With an adjustable rate mortgage (ARM) you have the risk of payment increases. However, you may have a lower initial payment and would be able to take advantage of reduced payment if the interest rates fall. Most ARMs have caps that restrict the amount your rate can increase of decrease at the scheduled Change Dates as well as caps that restrict the overall maximum rate. To fully evaluate an ARM, you must understand the terminology used in describing its features.
A glossary of real estate or mortgage terms is located at the back end of this paper.
Key features with an ARM program which should be analyzed include the type of index, life and payment change caps, margin, fully indexed rate, negative amortization, start rate, discount points, conversion to fixed rate options, and payment change frequency. There are many loan programs available, including a variety of fixed rate mortgages, ARMs, and other variations. For example, a fixed rate mortgage may have payments that change or an adjustable rate mortgage may have payments that are fixed for a specified period of time. Or there can be mortgages with numerous combinations of these features. Because of the many different options available, the best resource to help you evaluate your loan needs will be an experienced and trustworthy loan officer.
COSTS
Downpayment
Downpayments vary depending on the type of loan program selected. The FHA downpayments are included in the enclosed chart and are relatively minimal, designed for a first time buyer. FHA will permit the downpayment to be a gift from the family.
The minimum down payment on Conventional loans requires 3-10%, depending upon the program. The borrower must demonstrate that at least 3% of the downpayment is his own money, unless he is receiving a gift of 25% of the sales price. At 20% down, most conventional loan programs do not require insurance against default.
VA loans may be financed with zero downpayment if the correct guidelines are met.
Points
Points are dollars paid to lending institutions at the time of closing to allow lenders to make loans at rates lower than existing money market conditions warrant. Points balance the yield or rate of return lenders get on money they loan.
One point equals one percent of a new loan amount. So, if a new mortgage calls for 5 points, it means that 5% of the amount of the loan needs to be paid to the lender at closing. Note that the points are calculated on the amount of the new loan, and not the selling price of the property.
The cost of borrowing money fluctuates according to the demand for money and the supply of money available at any given time. Heavy demands have a major effect on the availability of money. The result is that the supply of money for the home mortgage market is lessened, as it competes for available funds. As the availability of money fluctuates, so do the points necessary to allow lenders to place their money in the home mortgage area.
Points needed to obtain FHA, VA or Conventional financing may be paid by either the buyer or the seller, and are therefore negotiable. FHA, however, limits the seller contribution to a maximum amount of points. Even though negotiable, in many instances buyers cannot afford financing a given house if they must also pay points. Therefore, sellers often see their best interests being served by agreeing to pay some or all of the points needed to make the sale. There are some limitations to the amount of seller contribution under all programs. Consult your lender.
Points are tax deductible for the borrower whether they are buyer or seller paid.
Closing Costs
Closing costs vary slightly with various loan programs. The enclosed chart will illustrate the breakdown of items included. Please note that some of the costs are based on loan amount and will vary dramatically (i.e. origination, title insurance and mortgage registration tax).
Prepaid Expenses
The prepaid expenses include interest paid from the day of closing to the end of that month. This category also includes the first year's homeowners insurance, the first year’s private mortgage insurance premium on an insured conventional loan, and any tax and/or insurance escrows.
THE FOUR ELEMENTS OF A LOAN APPLICATION
Income
A borrower must show through verification that he has stable and sufficient income to support the proposed loan payment as well as his other monthly obligations. The borrower's income must be such that the payments fall within prescribed ratios for a particular program. For example, on a Conventional loan, generally the house payment, including principal, interest, tax and insurances must not exceed 28% of the borrower's gross monthly income. The borrower's total obligations including the proposed house payment and any other monthly obligations; such as installment loan payments, minimum balance payments on credit cards, child support, etc., may not exceed 36% of the borrower's gross monthly income. On an FHA loan, these ratios are 29% and 41%.
Two years of employment history on a job or occupation is usually required. The form of the income is looked at carefully. It is derived from hourly wages, salary, bonus and/or overtime, commissions, incentives, etc.
In most cases, if the income is not reasonably guaranteed or certain (i.e. salary or hourly wages) the loan applicant must demonstrate a track record of receiving other forms of income such as overtime, bonuses, commissions, etc.
In addition to the more common forms of income, some other sources of income considered in the qualifying process are:
· Part Time Income - if proper stability is demonstrated
· Retirement Income
· Social Security Income
· Alimony and Child Support - Proof of receipt is necessary
· Notes Receivable
· Interest and Dividend Income
· Rental Income
· Common forms of incomes we are not able to use for qualifying purposes are:
· Auto Allowances
· Expense Account Income
· Income From Roommates or Boarders
· Any other Unverifiable Income Source
Credit History
As common as credit use is today, its reporting process remains a mystery to most people. However, the amount and quality of credit is a major factor in obtaining a mortgage loan.Since a mortgage is usually the largest loan most people apply for, lenders are strongly interested in how well smaller credit lines have been repaid. A typical credit report will show several years of payments and balances paid to banks and credit card companies, even landlords. Public records of judgment, bankruptcies and tax liens are also checked.
Asset Verification
The lender will check through written verification that the borrower has adequate funds to close the transaction. The lender will check for the balance of the down payment, closing costs, prepaid expenses, as well as any cash reserves that a particular program may require. Typical forms of these liquid assets are:
· Earnest Money - Source of funds must be shown
· Checking and savings accounts
· Stocks and bonds
· Borrowed funds - Secured by a real asset
· Equity from existing home
· Sale of a real asset - Must be verifiable
· Gift funds - Must be a bona fide gift and the ability of the donor to give the gift must be shown
· Bridge Loans
· Secondary Financing
· In most cases the following sources of funds are not acceptable:
· Cash on Hand
· Sweat Equity
· In the case of a Rent/Purchase situation only the difference between market rent and actual rent can be applied toward downpayment.
Appraisal
The property used as the collateral for the loan must also fall within the guidelines prescribed by a particular program. For example, the property must have sufficient value to warrant a loan. The appraisal, however, is not a guarantee for the buyer, as respects function or future value of the home.
Aspects of value such as location, neighborhood, zoning, and age are applied to the property in the determination of value.
The greatest emphasis in determining the value of a property is generally placed on the "Market Approach" or the Comp system. The Market Approach entails comparing the subject property to a series of similar properties (comparables or "comps"). Values of comps are adjusted to the subject property based on various parameters. Therefore "comps" must meet certain requirements (with exception):
· Sold and Closed
· Proximity to subject - Usually within 1 mile
· Similar sales price and price per square foot
· Should be less than 6 months old
· Similar type of home - (style, living area, room count, etc.)
Value adjustments are made to the comparable properties to more closely conform to the subject. However, these adjustments should not exceed 15%.
GLOSSARY OF REAL ESTATE FINANCING TERMS
Interpreting real estate financing jargon is a struggle sometimes. But, don't worry about it. With this glossary you'll quickly learn to speak it fluently!
Adjustable Rate Mortgage (ARM): A mortgage in which the interest rate is adjusted periodically according to a pre-selected index.
Amortization: The systematic and continuous payment of an obligation through installments until the debt has been paid in full.
Annual Percentage Rate (APR): A term used in the Truth-In-Lending Act to represent the percentage relationship of the total finance charge to the amount of the loan. The APR reflects the cost of your mortgage loan as a yearly rate. It will be higher than the interest rate stated on the note because it includes, in addition to the interest rate, loan discount points and fees, and mortgage insurance.
Appraisal: A report made by a qualified person setting forth an opinion or estimate of property value. The term also refers to the process by which this estimate is obtained.
Assessed Valuation: The value that a taxing authority places on real or personal property for the purpose of taxation.
Assessment: A charge against a property for purposes of taxation. This may take the form of a levy for a special purpose or a tax in which the property owner pays a share of the cost of community improvements according to the valuation of his or her property.
Borrower: A person (also known as Mortgagor) who receives funds in the form of a loan with an obligation to repay principal with interest.
Buy-down: A payment to the lender from the seller, buyer, or third party, causing the lender to reduce the interest rate.
Closing: The consummation of a real estate transaction. The closing includes the delivery of a deed, financial adjustments, the signing of notes, and the disbursement of funds necessary to complete the sale and loan transaction.
Closing Costs: Money paid by the borrower in connection with the closing of a mortgage loan. This generally involves an origination fee, discount points, appraisal, credit report, title insurance, attorney's fees, survey and prepaid items such as taxes and insurance escrow payments.
Closing Statement: A form used at closing that gives an account of the funds received and paid at the closing, including the escrow deposits for taxes, hazard insurance and mortgage insurance.
Co-Borrower: Additional borrower(s) whose income contributes to qualifying for a loan and whose name(s) appears on all documents with equal legal obligations.
Commitment (Loan): A binding pledge made by the lender to the borrower to make a loan, usually at a stated interest rate within a given period of time for a given purpose, subject to the compliance of the borrower to stated conditions.
Conforming Loan: Conventional home mortgages eligible for sale and delivery to either the Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC). These agencies generally purchase traditional fixed rate level payment first mortgages up to loan amounts mandated by Congressional directive.
Conventional Mortgage: A mortgage not obtained as under a government insured program (such as F.H.A. or V.A.).
Credit Report: A report detailing an individual's credit history.
Deed of Trust: A legal instrument conveying title held in trust by a third party. In such cases, a trustee retains the title until a loan debt is repaid. In some regions, it is used in place of a mortgage.
Default: The failure to perform an obligation as agreed in a contract.
Depreciation: A loss of value in real property brought about by age, physical deterioration, functional or economic obsolescence.
Discount Point: Amount payable to the lending institution by the borrower or seller to increase the lender's effective yield. One point is equal to one per cent of the loan amount.
Earnest Money: A portion of the down payment delivered to the seller or an escrow agency by the purchaser of real estate with a purchase offer as evidence of good faith.
Equal Credit Opportunity Act (ECOA): A federal law requiring lenders and other creditors to make credit equally available without discrimination based on race, color, religion, national origin, sex, age, marital status, receipt of income from public assistance programs or past exercising of rights under the Consumer Credit Protection Act.
Equity: The ownership interest - that portion of a property's value over and above the liens against it.
Escrow: A procedure whereby a disinterested third party handles legal documents and funds on behalf of a seller and buyer.
Fair Credit Reporting Act (FCRA): A federal law which requires a lender who is rejecting a loan request because of adverse credit information to inform the borrower of the source of such information.
Federal Home Loan Mortgage Corporation - FHLMC (FREDDIE MAC): A corporation authorized by Congress to purchase conventional home mortgages. It sells participation certificates whose principal and interest are guaranteed by FHLMC.
Federal National Mortgage Association - FNMA (FANNIE MAE): A tax-paying corporation created by Congress to support the secondary mortgage market. It purchases and sells residential mortgages insured by the Federal Housing Administration or guaranteed by the Veterans Administration as well as conventional home mortgages.
First Mortgage: A real estate loan that has priority over any subsequently recorded mortgages.
Fixed Interest Rate: An interest rate which does not change during the loan term.
Foreclosure: A legal procedure in which property mortgaged as security for a loan is sold to pay the defaulting borrower's debt.
Gift Letter: A written explanation signed by the individual giving the gift stating, "This is a bona fide gift and there is no obligation expressed or implied to repay this sum at anytime."
Hazard Insurance: A contract whereby an insurer, for a premium, undertakes to compensate the insured for loss on a specific property due to certain hazards.
Interest: Consideration in the form of money paid for the use of money. Also a right, share or title in property.
Lien: A legal claim or attachment against property as security for payment of an obligation.
Loan-To-Value Ratio: The ratio between the amount of a given mortgage loan and the lower of sales price or appraised value.
Market Value: The highest price which a ready, willing and able buyer would pay and a willing seller will accept, both being fully informed under no pressure to act. The market value may be different from the price a property can actually be sold for at a given time (market price).
Mortgage: The conveyance of an interest in real property given as security for the payment of a loan.
Mortgagee: The lender in a mortgage transaction.
Mortgage Insurance Premium (MIP): The consideration paid by a mortgagor (borrower) for mortgage insurance - either to the FHA or to a private mortgage insurer.
Mortgage Note: A written promise to pay a sum of money at a stated interest rate during a specified term. The note contains a complete description of the conditions under which the loan is to be repaid and when it is due.
Mortgagor: The borrower in a mortgage transaction who pledges property as security for a debt.
Occupancy: The use of property as a full-time residence, either by the title holder (owner-occupancy) or by another party thorough formal agreement (rental).
Origination Fee: The amount charged for services performed by the company handling the initial application and processing of the loan.
PITI (Principal, Interest, Taxes and Insurance): The most common components of a monthly mortgage payment.
Preliminary Title Report: The result of a title search by a title company prior to issuing a title binder or commitment to insure clear title.
Primary Residence: A residence which the borrower intends to occupy as the principal residence.
Principal Balance: The remaining balance due on a debt.
Private Mortgage Insurance: Insurance written by a private company protecting the mortgage lender against loss resulting from a mortgage default.
PUD (Planned Unit Development): A planned combination of diverse land uses, such as housing, recreation and shopping one contained development or sub-division. A major feature of a PUD includes areas of common land for use by the housing unit owners; the association of unit owners generally owns, pays fees and maintains the common areas.
Purchase Contract (Agreement/Offer): An agreement between buyer and seller of real property, setting forth the price and term of the sale. Also known as a sales contract.
Real Estate Settlement Procedures Act (RESPA): A federal law requiring lenders to provide home mortgage borrowers with information on known or estimated settlement costs. It also establishes guidelines for escrow account balances and the disclosure of settlement costs.
Refinancing: The repayment of a debt from the proceeds of a new loan using the same property as security.
Satisfaction of Mortgage: The recordable instrument issued by the lender verifying full payment of a mortgage debt.
Second Home (Vacation Home, Weekend Home): A residence other than the borrower's primary residence which the borrower intends to occupy for a portion of each year. Must be suitable for year-round occupancy-Second Mortgage: A loan on property which already has an existing mortgage (the first mortgage). The second mortgage is subordinate to the first.
Secondary Mortgage Market: A market where existing mortgages are bought and sold. It contracts with the primary mortgage market where mortgages are originated.
Survey: The measurement and description of land by a registered surveyor. Term: The time limit within which a loan must be repaid. Title: The legal evidence of ownership rights to real property.
Title Insurance Policy: A contract in which an insurer, usually a title insurance company, agrees to pay the insured party a specific amount for any loss caused by defects of title on real estate in which the insured has an interest as purchaser, mortgagee, or otherwise.
Title Search: An examination of public records to disclose the past and current facts regarding the ownership of a given piece of real estate.
Truth-In-Lending Act: A federal law requiring a disclosure of credit terms using a standard format. This is intended to facilitate comparisons between the lending terms of financial institutions.
Underwriting: Analysis of risk and setting of an appropriate rate and term for a mortgage on a given property for given borrowers.
