So how do you shop for a mortgage? What does that mean? Think of it like this. Most people don’t have enough cash to pay for a house outright. They need to borrow the money to pay for a home and the fees involved in buying a home. The loan you get to buy a home and finance the charges associated with buying the home is called a mortgage.
Before you walk into your local bank, or set up a meeting with a lender recommended by a friend or professional, it helps to know a little bit about what makes up a mortgage and how much it will cost you. Following are some key things you’ll want to know when you’re determining what type of mortgage you want to choose:
There are two main types of mortgages – conventional and government-backed loans. Let’s take a closer look at these two options:
You can get a conventional loan through lenders such as banks, thrifts, or mortgage brokers. If you obtain a conventional mortgage you’ll be required to put down between 3 and 20 percent of the loan amount. Most likely you’ll also be required to purchase private mortgage insurance (PMI) if you make a down payment of less than 20 percent.
The difference between a conventional and a government-backed loan is that the conventional loan is backed, or financed, by the lender, while a government-backed loan is financed by…you guessed it… the government. You can get a government-backed loan through your local bank…there’s no special government loan office you need to go to first. You’ve probably heard of two types of government-backed loans — FHA (Federal Housing Administration) loans or VA (Department of Veterans Affairs) loans. Let’s look at both:
FHA Loans. FHA loans are typically the easiest loans to qualify for. They have lower down payment requirements than conventional loans (typically between 3 and 5%), and allow you to finance some of the closing costs. FH A loans are also assumable, meaning that when you go to sell your home a qualified buyer can just pick up the monthly mortgage payment instead of having to create a new mortgage loan. FHA loans also frequently offer down payment assistance programs or allow a portion of the down payment to be made through a gift or grant. Visit the U.S. Department of Housing & Urban Affairs (HUD) website for more information on FHA loans.VA Loans. VA loans are for active or former military personnel, or for unmarried surviving military spouses. To qualify you will need to have served active duty for at least 180 days, or 90 days combat duty. If you’re no longer active duty, you must have an honorable discharge. VA loans require very low, or no down payment, and they frequently carry lower than average interest rates. The VA loan, like an FHA loan, is assumable. Visit the Veteran’s Administration website for more information on VA loans.
Okay, so once you’ve decided which type of financing you want to pursue – Conventional or Government-Backed, you’ll next need to decide what type of mortgage structure you’re most comfortable with – a fixed-rate mortgage or an adjustable-rate mortgage. Read on to learn more about mortgage structures.
There are two main types of mortgage structures – fixed-rate mortgages (FRM) and adjustable-rate mortgages (ARM). Let’s look at both:
A fixed-rate mortgage (FRM) means that your interest rate and monthly mortgage payment is fixed, or will not vary. So if you take out a mortgage loan with an interest rate of 6.25% that has a monthly payment of $1,150 it will always remain at that same 6.25% interest rate and that same $1,150 monthly payment. The stability and predictability of fixed-rate mortgages is very attractive to a lot of buyers.
The other, most common option is an adjustable-rate mortgage (ARM). The most important thing to know about ARMs is that first letter: A. “A” stands for adjustable. That means that with an ARM, your interest rate and monthly payment will adjust, or vary, depending on the current financial market.
Your lender will tell you what the loan’s “defined adjustment period” is, which is how frequently the interest rate can change. There will be an initial period, which can vary between 1 and 10 years, and then after that time the interest rate can vary adjust every year for as long as you owe on the loan. If you get an ARM your lender will give you a minimum and maximum rate. That way you’ll know the lowest or highest your interest rate could be, and therefore how little or how much your monthly mortgage payment could be. If the interest rate rises, your monthly mortgage payment will increase. And the reverse is true. If the interest rates drop, your monthly mortgage payment will be lower.
The amount of time you have to pay the mortgage loan back is also known as the mortgage term. The most common fixed-rate mortgage term is typically 15 or 30 years. So if you took out a 30-year loan, you will have 30 years to pay it back.
Just like fixed-rate mortgages come in a variety of terms (15, 20, and 30 years, for example), you can choose a variety of ARM term lengths such as a 5/1 ARM, 7/1 ARM or 10/1 ARM. When looking at the ARM term, the first number (such as 5 in a 5/1 ARM) is the initial period or how long until the interest rate can be adjusted (higher or lower depending on the current financial market.) The second number (such a 1 in a 5/1 ARM) is how frequently your interest rate can be adjusted after the initial period – so in this case you’ll have 5 years where the interest rate will be fixed, but then after that your mortgage can adjust every year (meaning increase or decrease) depending on what is happening with interest rates.
How do you decide what term you want? Well, the longer the term, the lower your monthly mortgage payment (because you’re spreading the full amount that you owe over a longer period of time.) But the longer the term of the mortgage, the more interest you’ll be paying as well. That’s because interest compounds over time, so the longer you take to pay the loan back, the more interest accumulates. To decide what term mortgage you want to take out, consider:
- How much of a down payment,
- How long you think you would likely be in the home before you would want to move/buy another home, and
- How much of a monthly mortgage payment you’re comfortable making.
One of the most important pieces of information you need from a lender is how much interest they’ll charge you on your mortgage loan. Interest is the amount of money they’ll charge you for borrowing their money. And over time that amount of money adds up. How much? Let’s take a look:
Remember that interest rates vary when you’re comparing fixed-rate versus adjustable rate mortgages. Adjustable rate mortgages typically carry a lower interest rate, but that’s because the bank reserves the right to adjust the interest rate at any time after the initial period. But before you jump to sign a loan based on the interest rate alone, you’ll want to take a look to see if the lender is also charging something called points….read on.
Points are a one-time fee that the lender charges for originating, or creating the loan for you, the homebuyer. The all-important question is how much? One point = 1 percent of the loan amount.
Let’s look at an example:
$150,000 mortgage w/2 points = $3,000 in cash you’ll pay at closing
$150,000 mortgage w/3 points = $4,500 in cash you’ll pay at closing
Often lenders will offer you a lower interest rate if you’re willing to “buy it down” by paying additional points. Even though it can be easy to overlook, points are something you need to pay attention to because they add to the upfront cost of buying a home. Be sure to factor them in to your decision about what type of financing to pursue. You don’t want to mistakenly think you’re paying less for a loan because you’re focused just on the interest rate. The general rule of thumb is that the lower the interest rate, the higher the points. Remember that you’ll have to pay those points at closing, or when you sign the final loan and home purchase papers, so factor that cost in when you’re totaling up how much money you’ll have to pay out of pocket.
Here’s where the rubber hits the road. To buy a home, typically you’ll be required to make a cash down payment (meaning you pay it out of your pocket) of between 3 and 20 percent of the home sale price.
Wait a minute…between 3 and 20 percent? That’s quite a wide range. How do you know how much of a down payment to put down? The amount of the down payment required depends on what type of mortgage loan you choose and qualify for. Let’s say you’re considering a mortgage on a $150,000 house. Let’s compare three different loan options and how the down payment varies depending on the loan type:
Scenario 1: Your lender offers a mortgage with a 97% LTV (loan to value ratio). That means you would only have to put down 3 percent and then you’d take out a loan to finance the other 97 percent. What kind of down payment does that add up to?
$150,000 (Mortgage amount)
– $145,500 (97% LTV mortgage amount)
$ 4,500 (3% down payment)
Scenario 2: Your lender offers a mortgage with a 95% LTV (loan to value ratio). That means you would only have to put down 5 percent and then you’d take out a loan to finance the other 95 percent. What kind of down payment does that add up to?
$150,000 (Mortgage amount)
– $142,500 (95% LTV mortgage amount)
$ 7,500 (5% down payment)
Scenario 3: Your lender offers a mortgage with an 80% LTV (loan to value ratio). That means you will be required to put down 20 percent and then take out a loan to finance the remaining 80 percent. What kind of down payment does that add up to?
$150,000 (Mortgage amount)
– $120,000 (80% LTV mortgage)
$ 30,000 (20% down payment)
These three different loans offer a range of down payments required between $4,500 and $30,000! Carefully examine all your financing options to know what you’re looking at when it comes to making a down payment.
The two benefits of being able to put down as much as possible on a home are (1) Lenders like to see you put down as much as possible, because it indicates that you are serious about being a homeowner and are not likely to default (not pay) on your loan, and (2) You will qualify for a smaller mortgage (since you are paying more upfront) which will lower your monthly mortgage payment, or you could get a shorter term loan which means you’ll be paying on the mortgage for a shorter amount of time.
When trying to determine how much you can, or want to, put down on a home, consider:
- How much you currently have saved. Look into your savings and checking accounts.
- What other sources of money you could possibly tap into to raise some cash for a down payment. Do you have a 401(k) savings plan that you could borrow against? Do you have a CD (certificate of deposit) you could sell or any investments you would consider selling such as bonds, stocks, or mutual funds?
- Your other financial concerns. Do you have kids nearing college age? Do you have current or anticipated medical expenses such as a baby on the way or aging parents you’re helping care for?
- If you have enough to make a down payment AND keep a certain amount of money for emergency expenses. A good rule of thumb is that you want to have enough savings to cover 3-6 months worth of expenses.
- Being a new homeowner has costs you may not have anticipated. Especially if you’ve never owned a home before, you may be unprepared for some of the new expenses you’re about to run into. For example, you may have to buy new furniture, landscaping or lawn equipment, tools, appliances, etc. You’re not going to want to drain your savings and then right after moving in to your new home running up credit card debt to buy those things.
Your lender is going to take a look at your total financial picture to see not only how much of a down payment you can afford, but also how much of a monthly mortgage you can afford. Even if you have a substantial amount of cash you could use toward a down payment, your lender is going to need proof that you have enough regular monthly income to make your mortgage payment every month. Before you talk with a lender, get a good idea of how much money you have for housing expenses by creating a budget. It’s also a good idea to take a look at your credit report since your lender will order one before approving you for a mortgage.
If you take on a mortgage that allows you to make a down payment of less than 20 percent of the loan amount, you’ll probably be required to purchase private mortgage insurance (PMI). PMI is not like other insurance policies you may have chosen in the past, such as life insurance or long-term disability insurance. In the case of PMI, you don’t get to decide whether or not you want it. That’s the bank’s choice. That’s because PMI is protection for bank, not for you. PMI guarantees the lender that if you fail to make good on your mortgage payments, they have insurance to recoup the loss.
If you have to take PMI out, you’ll want to know:
- How long you’ll be required to keep the insurance
- How much the insurance costs
- How the lender will require you to pay for the insurance. Some lenders will require you to pay a certain amount at closing and then you’ll pay the remainder off in monthly installments that are rolled into your mortgage loan.
So what is exactly is closing? Closing means closing the loan, or transferring the property from the seller to the buyer. Closing on a loan involves more than just signing a contract – it involves having the property inspected, having it appraised (to make sure it’s actually worth what it’s being sold for), getting a title search done (to make sure the home is owned free and clear by the homeowner), and a host of other professional services. All of those services cost money. Sometimes a lot of money.
In fact, closing costs and the down payment are the two biggest costs when buying a home. Closing costs can be negotiated between the buyer and the seller, meaning that when you buy a home you may be able to split some of the costs between you and the seller. The money is paid to professionals involved in closing the loan, such as attorneys, title companies, home appraisers, termite inspectors, etc.
Closing costs, also sometimes referred to as settlement costs, can add up to be a sizable fee, typically between 2 and 7 percent of the total loan amount. So if you’re taking on a $150,000 mortgage loan and the closing costs add up to 5% of the loan, you’ll either need to pay or to negotiate with the seller to pick up part of the $7,500 in closing costs.