An individual purchasing real estate will almost always use a loan for at least part of the purchase price. A real estate loan is commonly called a mortgage. While it might take a diligent person all their life to save enough money to buy a home in this state, the use of a mortgage allows one to move into the home now, and pay for it over time—allowing the enjoyment of this important asset during the wealth building period. There are hundreds of variations of mortgage loans, and the varieties of loans, which can vary in the number of years it is paid off (the amortization schedule), the rate of interest charged (can be fixed or variable) and the amount of down payment that is required.
For example, there are loans where the rate is not fixed for the life of the loan. A five-year ARM (ARM = Adjustable Rate Mortgage) has a rate that is fixed for the first five years, and then it can adjust each year afterwards, on a scale that follows an agreed index of the financial market as of that time, which would be five years from the loan inception. Although these loans have lower introductory rates, they may not be appropriate for the most conservative Buyers, or particularly for first time Buyers. The lender selling these adjustable-rate products would say that one can just enjoy this rate for five years, and then refinance out of it if the payment rises. However, the problem is that if rates rise five years from now, one might be refinancing “out of the frying pan, into the fire,” since the loans available to refinance into would also be assumed to be at those same higher rates. Mortgage rates change from time to time–in 2005, rates were about 50% higher than today’s rates, at 6% or more. Therefore, the safest loan is always one where the rate is fixed for the life of the loan. If rates go down during the life of the loan, one can always refinance where it makes sense to do so, but a property owner will always want to have the security of having at least the rate originally agreed to, guaranteed for the life of the loan. Therefore, the scenarios below describe in greater detail the most popular kinds of fixed-rate loans, which are the safest and most conservative of the mortgage loan choices.
Conventional Loan
The most common, and least costly, is a loan of not more than 80% of the value. This loan is the lowest risk for a lender, because if you stopped paying the mortgage or abandoned the investment for some reason, the first 20% of the loss would be undertaken by the homeowners themselves. This mitigates the bank’s risk, and results in fewer losses. This is usually referred to as a “conventional” loan. Conventional loans are easy to trade between banks, and to resell to the “wholesale” markets led by FannieMae and FreddieMac, because their risks and terms are developed along standard criteria.
Whenever a person does not have 20% of the purchase price to invest (common for first time Buyers), there are at least two other options. The differences between the two types of loans are slight, but both have the goal of bridging the down payment gap, while compensating the lender for the greater risk–with additional money paid by the Borrower, in the form of either mortgage insurance, or higher rates.
FHA Loans
FHA loans are made by banks, but insured against loss by the federal government’s HUD mortgage insurance plan. FHA loans allow a loan up to 96.5% of the purchase price. The borrower must use their own funds for at least the 3.5% down payment, and additional funds for closing costs (see below) can be contributed from other sources, if necessary. FHA loans have a 1.75%-of-loan-amount fee for upfront mortgage insurance cost, which can be added to the loan amount. They also carry a monthly insurance premium cost, which is .85% of the loan amount per year, or about .07% per month. As of this time, this monthly cost cannot be cancelled until the loan is either paid off or refinanced, even if appreciation or payments bring the balance to less than 80% of value.
Loans With Lender-Paid Mortgage Insurance
The other type of mortgage insurance to compensate for the lower down payment risk is available from programs which carry a higher interest rate than market, which creates additional profit for the lender. The lender then uses this additional profit to purchase its own mortgage insurance, so there is no additional cost for the Buyer outside of their mortgage payment. For example, if you could get a 3.75% interest rate today in an FHA or conventional mortgage, you might pay 4.5% for the same loan with lender-paid insurance. Your higher interest rate produces a higher payment, which compensates the lender for the additional risk.
Closing Costs
In addition to a down payment, the Buyer will have (usually) 1-3% of the transaction price in closing costs, depending on the type of loan. These costs include the cost the lender charges to process the loan, upfront tax and insurance costs for the first year of homeownership, and (in the case of FHA loans) mortgage insurance premiums. The amount of closing costs can be affected by the loan type, the lender’s rate, and even the time of year of the closing, so it is important to compare lender’s estimates very carefully, side by side.
One common way for closing costs to be paid is by the Seller of the home, who may agree to this 1-2% concession in order to obtain the Buyer’s offer. As you would guess, this can sometimes affect the ability of that offer to compete with other offers, so if a Buyer can pay their own closing costs and the down payment, this usually results in a better negotiation leverage position.
Qualifying for a Mortgage
In most cases, a lender will want to see your total housing cost PITIH (Principal loan and Interest payment to the lender, real estate Taxes, Insurance and Homowner Association dues, if applicable) to be at or below 31% of your gross (pre-tax) monthly income. For example, two borrowers making $3000 gross per month each, with a total income of $6000, would likely qualify for a house payment not to exceed $1860/mo. If these fictional Buyers purchased a condo with a $300/mo HOA, they would have $1560 of affordability left for taxes, insurance and the mortgage. This would equate to about a $270,000 loan. Comparatively, if they bought a home without an HOA, while it would perhaps cost more than a condo, the fact that there is no HOA means they could qualify for the higher payment of $1860/mo towards principal and interest mortgage payment, plus taxes and insurance. This would correspond to approximately a $340,000 loan.
In addition to the 31% “front end” debt ratio, lenders also look at the overall debt with the predicted house payment plus other consumer debt, such as credit cards, car payments, student loans, etc. This is referred to as the “back end” debt ratio. Some borrowers may see their ability to be qualified for a mortgage amount reduced, if these other debts are excessive. In these cases, paying off a $500 car payment, for example, might mean the ability to qualify for more than $100,000 higher in mortgage loan amount. For this reason, it is important to carefully consider any new purchases, during the time one is considering taking on a new house payment.
Factors of Loan Costs
Your mortgage interest rate will be determined by a number of factors, but principally it will be affected by your middle FICO score. There are three credit bureaus—Experian, TransUnion, and Equifax. Each of these bureaus records a score of your credit history and likelihood of repayment, which is expressed in terms of a score. The bureaus all have their own scoring model, and then there is also a FICO score for each bureau. That is the one that lenders use. You can get a free copy of your credit report once per year from each bureau, by going through the web portal www.annualcreditreport.com. Reviewing these reports for accuracy is a good way to get started. Once you have done that, you can contact a lender (I can give you a few names if you don’t have someone you feel comfortable working with) to get preapproved.
Paying down debts has a positive effect on your credit scores. Closing accounts actually has a negative effect, so it is better to pay them down but leave them open. If you have any negative credit, the approach for dealing with that varies, depending on the type of tradeline and the age of it. Sometimes paying an old bad debt can make your credit score go down, since it re-ages that debt. Talk to your lender before taking action to pay an old bad debt, or before opening any new credit lines.