Mortgage Basics: Securing the Right Loan
Once you find a home and make an offer, it’s time to apply for your new mortgage. Securing the right mortgage is essential to your financial stability and lasting success when it comes to your new home. It’s important to understand how mortgage loans work, what types of mortgages you can have, and how each type of mortgage could impact your financial future. A thorough understanding of mortgages helps ensure you choose the right mortgage for your unique financial needs.
Securing a mortgage is one of the most important financial decisions most consumers make in their lifetimes. It’s critical to have the facts you need to make an informed decision. If you have questions or need assistance to better understand mortgage lending, call Consolidated Credit today at 1-800-435-2261 to speak with a HUD-approved housing counselor for free.
What is a Mortgage?
Generally speaking, a mortgage is a loan obtained to purchase real estate. The mortgage, itself, is a lien (a legal claim) on the home or property that secures the promise to pay the debt. This is what makes mortgages a secure type of debt. Since the loan is secured, effectively using the home as collateral, this means that if you fall behind in your payments or fail to pay the loan back, the lender can repossess the home through foreclosure.
All mortgages have two features in common: principal and interest. The principal is the original amount borrowed from the lender. When you secure a mortgage, the lender will assign an interest rate based on the type of mortgage you select and your credit scores. This rate determines how fast interest builds on your mortgage.
Loan-to-Value (LTV) Ratio and Loan Size
The loan-to-value ratio is the amount of money you borrow compared with the price or appraised value of the home you are purchasing. Each loan has a specific LTV limit. For example, with a 95% LTV loan on a home priced at $50,000, you could borrow up to $47,500 (95% of $50,000), so you would need to provide $2,500 as a down payment.
The LTV ratio reflects the amount of equity borrowers have in their homes. The higher the LTV ratio, the less cash homebuyers are required to pay out of their own funds. In this way, to protect lenders against potential loss in case of default, higher LTV loans (80% or more) usually require mortgage insurance policy.
Types of Mortgages
The largest distinction in mortgage lending has to do with the interest applied to the loan. Since you’ll pay hundreds of thousands of dollars in interest over the life of even an average mortgage, it’s essential to get the interest rate that’s right for your financial situation. The right interest rate can help you save money over the life of the loan and avoid financial distress.
|Fixed rate mortgage||Remains the same for the life of the loan||10 years, 15 years, or 30 years||The loan is predictable, with the same fixed payments from the day you start paying, until the day you pay the loan off. Your housing costs are unaffected by market conditions.|
|Adjustable Rate Mortgages (ARMs)||Interest rate changes on a regular schedule (usually every 1, 7, or 10 years)||30 years||You can qualify with lower credit. When interest rates are low, you will pay less money. However, if interest rates go up, you will be required to pay more money.|
|Hybrid / Two-Step Mortgage||Interest rate adjusts once after a specified term, then stays constant||5/1, 7/1, or 10/1 (5, 7, or 10 years)||Your interest and payments are more consistent over the life of the loan, although market conditions could mean you are locked into a high interest rate.|
|Balloon Mortgage||Low interest rate over an introductory period||5 years, 7 years, or 10 years||You have low payments (in some cases, interest only) for a set period, then the full balance is due or the loan must be refinanced.|
In most cases a fixed rate mortgage is usually the better option, because you know exactly what you will need to pay each month, there won’t be any surprises down the road, and you aren’t at the mercy of market conditions. By contrast, an ARM will be linked to a certain index or margin, such as one-year Treasury rate or the LIBOR index. If the rate is high when your interest rate adjusts, your payments will increase.
An ARM may make sense if you are confident that your income will increase steadily over the years or if you anticipate a move in the near future and aren’t concerned about potential increases in interest rates. However, you are taking a gamble in either scenario that you will be able to afford the payments while you own the home and that your interest rates won’t increase to the point that you can’t afford your mortgage payments.
Special Mortgages for First-Time Homebuyers
Lenders now offer several affordable mortgage options which can help first-time homebuyers overcome obstacles that made purchasing a home difficult in the past. Lenders are able to help borrowers who don’t have a lot of money saved for the down payment and closing costs, have no or a poor credit history, have quite a bit of long-term debt or have experienced income irregularities.
Deciding on a Fixed Rate Mortgage Term
The “term” of your mortgage determines how fast you pay off the loan with interest added. So, if you have a 30-year fixed rate mortgage, it will take 30 years to pay off your loan. If you have a 15-year loan, you will own your home in half the time it takes on the 30-year mortgage. However, beyond how quickly you own the home outright there are some important points to note with the term of your mortgage.
If you have a 30-year fixed rate mortgage, for the first 23 years of the loan, more interest will be paid off than principal; this means larger tax deductions for those 23 years. In addition, mortgage payments will take up a lower portion of your income over the years, because as inflation increases your costs of living, your mortgage payments remain constant. By contrast, a shorter term (15 years or 10 years) usually means you will enjoy a lower interest rate, because you’re committing to pay off the loan faster. In addition, equity is built faster because early payments pay off more of the principal.
Repaying Your Mortgage Early
You can pay off your mortgage faster by making extra payments each month or each year beyond your monthly payment requirement. This accelerates the process of paying off the loan. When you send extra money, be sure to indicate that the excess payment is to be applied to the principal. In addition, ask your lender for details on early repayment, since some mortgages include prepay penalties.
Determining Down Payment Size
There are mortgage options now available that only require a down payment of 5% or less of the purchase price. However, the larger the down payment, the less money you have to borrow and the more equity you’ll have. Mortgages with less than a 20% down payment generally require a mortgage insurance policy to secure the loan. When considering the size of your down payment, consider that you’ll also need money for closing costs, moving expenses, and any repair or renovation costs.
Understanding Your Monthly Mortgage Payments
Your monthly mortgage payment primarily pays off the principal and interest. However, most lenders also include local real estate taxes, homeowner’s insurance and mortgage insurance (if applicable). This is why monthly mortgage payments are sometimes referred to as PITI (principal + interest + taxes + insurance). The amount of your down payment, the size of the mortgage loan, the interest rate, and the length of the repayment term and payment schedule will all affect the size of your mortgage payment.
Understanding Mortgage Interest Rates
A lower interest rate allows you to borrow more money than a high rate with the same monthly payment. Interest rates can fluctuate as you shop for a loan, so ask lenders if they offer a rate “lock-in” that will guarantee a specific interest rate for a certain period of time; this allows you to shop for mortgages effectively. Remember that a lender must disclose the Annual Percentage Rate (APR) of a loan to you. The APR shows the cost of a mortgage loan by expressing it in terms of a yearly interest rate. It is generally higher than the interest rate because it also includes the cost of points, mortgage insurance, and other fees included in the loan.
If you have a fixed rate mortgage and interest rates drop significantly, you may want to consider refinancing. Most experts agree that if you plan to be in your house for at least 18 months and you can get a rate 2% less than your current rate, refinancing is a smart option. However, refinancing may involve paying many of the same fees paid at the original closing, plus origination and application fees.
Using Discount Points to Lower Interest
Discount points allow you to lower your interest rate – this is what people mean when they say they paid points off their mortgage. These points are essentially prepaid interest, with each point equaling 1% of the total loan amount. Generally, for each point paid on a 30-year mortgage, the interest rate is reduced by 1/8 (or.125) of a percentage point. So if you have a $200,000 mortgage at 4.5% interest, then you could reduce your interest rate to 4.375% by paying $2,000.
When shopping for loans ask lenders for an interest rate with 0 points and then see how much the rate decreases with each point paid. Discount points are smart if you plan to stay in a home for some time, since they can lower your monthly loan payment. Points are tax deductible when you purchase a home and you may be able to negotiate for the seller to pay for some of them.
What is an Escrow Account?
An escrow account is established by your lender to set aside a portion of your monthly mortgage payment to cover annual charges for homeowner’s insurance, mortgage insurance (if applicable) and property taxes. Effectively, escrow accounts cover the “TI” portion of PITI. Escrow accounts are a good idea because they assure money will always be available for these payments. If you use an escrow account to pay property tax or homeowner’s insurance, make sure you are not penalized for late payments, since it is the lender’s responsibility to make those payments.