If you’ve decided to buy a house, a townhouse, condominium or apartment, it’s almost a certainty that you will join the millions of Americans who are bound to their home by one thing — a mortgage.
Although many people believe a mortgage is a loan, a mortgage is actually the lien on the property. When a bank holds a mortgage on a house, it means the lender has a claim to the property in case the borrower defaults on the loan.
A mortgage loan is similar to a car loan. Both are secured by real property and require a monthly payment to cover principal and interest. Mortgage loans are amortized: they are calculated so that the principal and interest payments are spread out over the loan period (usually 10 to 30 years) gradually until the principal is paid off.
A mortgage is generally the largest debt that the average family carries. At of the end of 2012, Americans families had more than $13.1 trillion in total mortgage debt.
It is important to understand all that is involved when you apply for and maintain a mortgage account.
You monthly payment is calculated by a combination of factors:
- The loan amount
- The length of the loan
- The interest rate of the loan
There is also an initial cost of a getting a mortgage. Those costs can involve traditional and non-traditional lender fees. Common questions that prospective borrowers have include: How do mortgages work? What are the different factors to consider? And how do you know if you qualify?
How Does a Mortgage Loan Work?
When you decide on a home you wish to buy, your mortgage lender works with you, your real estate agent and the seller of the property to close the deal. The deal begins by you being pre-qualified to borrow up to a specified amount of money to pay for the house.
Once you are pre-qualified and you have an offer on a home accepted by the seller, you will work with your mortgage lender to ensure that you have the financial ability to pay for the mortgage every month.
When you’ve met all requirements of the transaction, the lender sets a closing date so that you can sign paperwork to finalize the loan. At closing the bank’s agent issues the cash required to buy the home to the seller and distributes all required fees to the other parties as well.
After closing you must begin making regular payments on your account to avoid default. Defaulting on a mortgage loan could eventually lead to foreclosure, where the bank reclaims the home.
In most cases, to close a mortgage loan you must come prepared with a down payment. The amount varies from about 3.5 percent to 20 percent of the home sales price depending on the lender and the loan program offered.
How to Qualify for a Mortgage
Besides being able to make a down payment, you must meet an extensive list of factors to qualify for a mortgage loan. First, your credit score must be good to excellent. A 2010 U.S. Housing and Mortgage Trends report by CoreLogic showed that 60 percent of borrowers who secured conventional mortgages had a credit score of 780 or higher. More than half of FHA borrowers needed a score of 680 or better.
Additional minimum requirements normally include:
- A housing expense debt-to-income ratio of 28 percent (called the front-end ratio)
- A total debt-to-income ratio of 36 percent (called the back-end ratio)
- A job that you’ve held for at least two years
- Employment and salary verification
- Extensive paperwork to document your financial situation
- A professional appraisal
- Cash for closing costs
Also, some lenders require private mortgage insurance (PMI) on mortgage loans, particularly when the down payment is less than 20 percent.
Types of Mortgages: Conventional, FHA and VA
There are a number of mortgage options available to you as a borrower. The three general types are conventional loans, FHA loans and VA loans. Each has specified qualification factors.
Conventional loan: This is a loan that is not backed by a government agency. It is a straight agreement between a bank and a buyer. You usually need very good credit and a substantial down payment of at least 10 to 20 percent to secure a conventional mortgage loan.
A Federal Housing Administration (FHA) loan: This is one that is backed by the federal government. This type of loan is common for applicants with credit problems or who cannot afford a substantial down payment.
A U.S. Department of Veterans Affairs (VA) loan: A VA loan is similar to an FHA-backed loan except the VA is the guarantor. It is available to qualified military personnel who are veterans or on active duty.
Fixed vs. Adjustable Rate Loans
Mortgage loans come in all shapes and sizes. They come with short terms (five years, often with a balloon payment at the end); medium terms (15 years) and long terms (30 and 40 years). They also come with fixed interest rates and adjustable (or variable) interest rates, and there are also reverse mortgages.
A fixed-rate loan is just what the name suggests: An interest rate is agreed upon before the mortgage is signed, and that rate never changes for the life of the loan, no matter the length of term.
For generations, the staple loan of the mortgage industry has been the 30-year fixed mortgage. That means a borrower will make 30 years of payments of the same principal and interest payments. This type of loan is the least risky type of mortgage loan.
The popularity of the fixed-rate loan was two-fold. Lending institutions like banks and credit unions liked it because they could count on long-term income at a specified rate. Borrowers liked the loans because they knew what their monthly payment would be for the life of the loan. There are no surprises.
Adjustable-Rate Mortgage Loans
Adjustable rate mortgages (ARM) loans are more complex than fixed rate loans. The bank offers you a low introductory rate for a period of time (usually one to five years) then the rate begins to adjust. The rate varies depending on certain financial indices — usually the Cost of Funds Index (COFI) or the London Interbank Offered Rate (LIBOR).
ARMs are attractive to borrowers who want to enjoy a low monthly payment for a while, but they can become a major burden when the rate goes up.
Other programs include balloon and buy-down loans. With a balloon loan the borrower agrees to make a large lump sum payment at the end of the loan. A buy-down loan is similar to an ARM except the rate change occurs toward the end of the loan period and the interest may vary up to three times instead of every month, quarter or year like ARMs.
The rate of your mortgage means the interest rate of your home loan. It is one of three key drivers – along with the amount of money you borrow and the length of time for which you borrow – of your monthly payment.
As a result of the Great Recession and the bursting of the U.S. housing bubble, home interest rates are at some of the lowest points in history. Lenders are agreeing to 30-year fixed loans with interest rates of less than 4 percent.
How Interests Rates Are Determined
The federal government has three quasi-government institutions that are the primary agencies dominating the secondary mortgage market.
- The Federal Mortgage Association – aka Fannie Mae
- The Federal Home Loan Mortgage Corporation – aka Freddie Mac
- The Government National Mortgage Association – aka Ginnie Mae
Each agency serves a different function in the mortgage business, but all three help keep money flowing into the market by bundling mortgages. These mortgages are purchased with funds borrowed from investment banks. Fannie, Freddie and Ginnie sell to other investors and large financial institutions, such as pension funds and insurance companies.
In this way, money is continually being pumped back into the lending system. The three agencies provide the funding to individual lenders so they can continue to offer mortgages to new homebuyers. In effect, then, the real supplier of your mortgage is not your bank, which is merely servicing your loan, but the agencies and financial institutions that buy and sell the mortgage-backed securities in an endless cycle of commerce.
It is in this secondary market that interest rates for mortgages are set. These rates are constantly fluctuating based upon the amounts that the various players in the game – the three primary agencies and their customers – set as their profit margins, or “spread,” when buying and selling mortgage-backed securities.
Your Monthly Mortgage Payment
When negotiating a mortgage, it is important to understand that the interest rate does not truly reflect your total monthly costs. The Truth in Lending Act requires all lenders to state on loan documents the Annual Percentage Rate, also known as the APR. The APR is defined as the cost of credit to a borrower in relation to the amount borrowed, expressed as a yearly rate.
Your APR will most always be slightly higher than your interest rate because it includes other items associated with obtaining a mortgage, such as origination fees, any points purchased, prepaid mortgage interest, mortgage insurance premiums, and various other lender fees.
What is most essential to remember is that your interest rate is only one piece of the borrowing puzzle and must be considered in context when applying for the most appropriate and affordable mortgage you can find.
The modern mortgage industry offers a huge array of products. There are also many government-backed mortgage programs, which have their own sets of qualifications and conditions. Take the time to explore all options and don’t believe lenders who advertise unrealistically low interest rates. These are the ones who make up your “savings” in exorbitant lending fees.
Your mortgage payment will likely be a considerable part of your monthly expenses for some time to come. It pays to use your head before signing on the dotted line. Compare offers, be prepared to ask many questions and take the time to do the math, so that your dream home is not accompanied by a nightmare of a mortgage.
HOW MANY POINTS
SHOULD YOU BUY?
Interest rate: 7.5 percent
Monthly payment: $629.30
Each point costs $900 and will lower your interest rate by one-quarter of a percentage point.
If you purchase two points for $1,800, you are left with:
Interest rate: 7 percent
Monthly payment: $598.78
Monthly savings: $30.52
Now divide the cost of the points by the monthly savings.
$1,800 / $30.52 = 58.98
This means it will take 59 months to break even. If you plan on staying in your home for five years or longer, you would be saving money by purchasing those two points.
Although there are many diverse offerings among mortgage lenders, you will find some similarities no matter where you turn. For instance, every mortgage offer will come with an interest rate, a payback period (term), processing fees and the option of paying “points” on the loan.
A point is equal to 1 percent of the principal amount of a mortgage. For example, if the mortgage is for $100,000, each point is worth $1,000. By paying more points on a loan, future home owners can get negotiate down their interest rate, thereby lowering their monthly payment.
One type of points — origination points — is actually a fee that you may be charged when you take out a mortgage. These points do not provide any value to the borrower and should be avoided if possible. Discount points, on the other hand, can be paid to a lender in order to obtain a loan at a lower interest rate.
Depending upon the lender and the daily fluctuations in the mortgage market, each point you pay will reduce your interest rate from one-eighth to one-quarter of a percentage point. You may have the option of paying for up to four discount points or more.
When deciding whether to pay for points — or how may to buy — you need to consider how long you plan on staying in the home. That will determine your break-even point, the length of time you’ll need to stay in your house to make the purchasing of points an economically advantageous choice. The longer you stay in your house, the more money you save with a lower interest rate.
Tax Rules and Negative Mortgage Points
In addition to lowering your interest rate, discount points are considered pre-paid interest by the Internal Revenue Service and are tax-deductible. Origination points are not deductible.
But you can only deduct discount points in the year they are paid, and only if several requirements are met, including:
- Your main home secures the loan.
- The points you paid conform to established rates and practices in your area.
- The points were not paid for inspection, appraisal, title, attorney fees or property taxes.
- The points were computed as a percentage of the principal amount of the mortgage.
- The amount is shown as points on your settlement statement.
Buyers cannot pay points on Federal Housing Administration (FHA) or Veterans Administration (VA) loans, but on most mortgages, either the buyer or the seller can pay the points or split the cost between them. Points work in a similar fashion in the refinancing of a mortgage, but those points must be deducted on your taxes over the life of the loan and not all at once.
While less common, a lender may also offer you negative points. In that case, a bank would pay you points so that you would agree to pay a higher interest rate. This cuts down on your closing costs, which usually run several thousand dollars, and increases your monthly mortgage payment. This option would only be attractive if you could not come up with the necessary cash at closing.
It’s important to remember that just because a loan is advertised with “no points” does not mean it is the best loan for you. Points are just one item in a complex set of circumstances that you will have to consider when negotiating for a loan. Make sure you understand points and how they relate to the other details in your mortgage application, and compare several offers and combinations before making a final decision.
A reverse mortgage is a loan that allows you to take advantage of equity in your home. Instead of you paying the bank, the bank pays you a monthly stipend that depends on the value of the home and other factors.
Older borrowers who have paid off most or all of the mortgage balance on their homes and need additional income to cover basic needs commonly apply for reverse mortgages.
The FHA has a special program called the Home Equity Conversion Mortgage (HECM) to help homeowners in need who are over the age of 62. However, it is important to note that the lender has a claim on the property and unless the loan is paid off the homeowner may have to sell the home in the future.
Other Key Mortgage Terms
If you’re new to mortgage loans, here are a few more key terms that you should be aware of before talking to a lender or broker:
Fixed rate loan: A mortgage loan that maintains the same rate throughout the loan period
ARM (adjustable rate mortgage): A mortgage loan that starts off fixed and then varies
Discount points: Up-front payments made to the lender to get a discount on your mortgage interest rate; one point is equal to one percent
Origination fee: A processing cost commonly charged by the lender; included in closing costs
LTV (loan to value): The amount of the loan divided by the value of the property
Seller’s assistance: A program that allows the seller to contribute up to 6 percent of the purchase price toward your closing costs
Appraisal: A valuation of the home you wish to buy
Closing costs: Fees and expenses due to the lender and other parties to the loan
Escrow: An amount held by the lender to pay for property taxes and hazard insurance; built into monthly payment
Private mortgage insurance (PMI): An insurance policy to protect the lender in case of default; built into your monthly payments if required as a condition of the loan
Amortization schedule: Shows the breakdown of interest and principal you pay with each monthly installment payment over the course of the loan
Underwriting: The process of carefully evaluating a loan application to decide if the borrower is a good credit risk