Shopping for the right loan is just as important as
choosing the right house. Your challenge is to select
the loan terms that are most favorable to your situation.
In selecting the loan that's right for you, you'll need
to understand:
Basic Components of
a Mortgage Loan
A mortgage requires you to
pledge your home as the lender's security for repayment
of your loan. The lender agrees to hold the title
or deed to your property (or in some states, to hold
a lien on your title or deed) until you have paid back
your loan plus interest.
The following are the basic
components of a mortgage loan:
Mortgage Amount and Term
The mortgage amount is the amount of money you borrow
from a lender to pay for your house. The term is
the number of years over which you can pay back the
amount you borrow.
TIP: The length of your
mortgage repayment period will directly affect your
monthly mortgage payments.
The most popular mortgage
term is 30 years. By extending payment over 30 years,
you keep your monthly housing costs low. If you can
afford higher monthly payments, you can select a mortgage
term that is shorter. There are 20-year, 15-year, and
even 10-year fixed-rate mortgages available from most
mortgage lenders. The longer your repayment period is,
the lower your monthly payments will be, but the total
interest you pay over the life of the loan will be more.
Amortization
Over time, you will repay your mortgage through regular
monthly payments of principal and interest. During
the first few years, most of your payments will be applied
toward the interest you owe. During the final years
of your loan, your payment amounts will be applied primarily
to the remaining principal. This type of repayment method
is called amortization.
Fixed or Adjustable Interest
Rates
Interest rates are usually expressed as an annual
percentage of the amount borrowed. You can choose
a mortgage with an interest rate that is fixed for
the entire term of the loan or one that changes throughout.
A fixed-rate loan gives you the security of knowing
that your interest rate will never change during the
term of the loan. An adjustable-rate mortgage (called
an ARM) has an interest rate that will vary during
the life of the loan, with the possibility of both
increases and decreases to the interest rate and consequently
to your mortgage payments.
Down Payment
The down payment is the part of the purchase price the
buyer pays in cash and is not financed with a mortgage.
Your down payment will reduce the amount you'll need
to borrow. So, the more cash you put down, the smaller
the size of your loan, and the smaller the amount of
your mortgage payments.
TIP: Lenders often view mortgages with larger
down payments as more secure because more of your own
money is invested in the property. However, there are
other loans
that require as little as 3% to 5% of the purchase price
for a down payment.
Closing Costs
The closing
(or, in some parts of the country, settlement) is the
final step, during which ownership of the home is transferred
to you. The purpose of the closing is to make sure the
property is ready and able to be transferred from the
seller. The closing costs (which vary from state
to state) are usually expressed as a percentage of
the sales price or loan amount. Typically, costs
range from 3% to 6% of the price of your home and
can include transfer and recordation taxes, title insurance,
the site survey fee, attorney fees, loan discount points,
and document preparation fees.
TIP: Sometimes you
can negotiate to have the seller pay some of
your closing costs.
Discount Points
In the special vocabulary of mortgage lending, "points"
are a type of fee that lenders charge. (The full
term to describe this fee is "discount points.")
Simply put, a point is a unit of measure that means
1% of the loan amount. So, if you take out a $100,000
loan, one point equals $1,000. Discount points represent
additional money you can pay at closing to the lender
to get a lower interest rate on your loan. Usually,
for each point on a 30-year loan, your interest rate
is reduced by about 1/8th (or .125) of a percentage
point.
TIP: Usually, the longer
you plan to stay in your home, the more sense it makes
to pay discount points.
Conforming and Nonconforming
Loans
The term "conforming," as opposed to "nonconforming,"
is sometimes used to explain loans that offer terms
and conditions that follow the guidelines set forth
by Fannie Mae and Freddie Mac. These are the two
private, congressionally chartered companies that buy
mortgage loans from lenders, thereby ensuring that mortgage
funds are available at all times in all locations around
the country.
The most important difference
between a loan that conforms to Fannie Mae/Freddie Mac
guidelines and one that doesn't is its loan limit.
Fannie Mae and Freddie Mac will purchase loans only
up to a certain loan limit (currently $227,150, but
will be $240,000 as of January 1, 1999).
If your loan amount will
be for more than the conforming loan limit, the interest
rate on your mortgage may be higher or you may have
slightly different underwriting requirements, particularly
in regard to your required down payment amount.
Check with your lender about this if you are taking
out a large loan amount.
TIP: Nonconforming
loans are sometimes called jumbo loans.
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Fixed-Rate
Mortgages
The interest rate may be your
main consideration if you expect to stay in your house
for a long time. With a fixed-rate mortgage, you
can be sure that your interest rate will stay the same
for the entire life of your loan. Fixed-rate mortgages
are available in a variety of repayment terms, with
15, 20, and 30 years the most common.
30-Year Fixed-Rate:
The easiest fixed-rate loan to qualify for, the 30-year
mortgage, gives you an excellent opportunity to keep
mortgage payments reasonable by making monthly payments
over a long period of time. This mortgage loan may be
ideal if you plan to remain in your home for years and
wish to keep your housing expense low and use any extra
cash for other purposes. This loan also provides maximum
interest deduction for tax purposes.
20-Year Fixed-Rate:
For those who want a lower interest rate and want to
own their homes free of debt sooner, this shorter mortgage
amortizes principal and interest over just 20 years,
saving a considerable amount of total interest paid
over the life of the loan.
15-Year Fixed-Rate:
This shorter-term mortgage will save you a significant
amount of interest over the life of the loan. By paying
off the mortgage more quickly, you also build up equity
in your home sooner. This may be important if you are
approaching retirement or have other large expenses
to cover, such as financing your children's education.
However, the monthly payments you make on a 15-year
mortgage will cost you more than those you would make
on a 30- or 20-year loan.
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Adjustable-Rate
Mortgages (ARMs)
With an adjustable-rate mortgage
(ARM), the interest rate you pay is adjusted from
time to time to keep it in line with changing market
rates. When interest rates go down, so might your
mortgage payments; but keep in mind that your payments
could go up when interest rates are raised.
ARMs are attractive because
they may initially offer a lower interest rate than
fixed-rate mortgages. Since the monthly payments
on an ARM start out lower than those of a fixed-rate
mortgage of the same amount, you can qualify for
a larger loan. The chief drawback, of course, is
that your monthly payments may increase when interest
rates rise.
You may want to consider
an ARM if:
- You are confident
your income will rise enough in the coming years
to comfortably handle any increase in payments;
- You plan to move
in a few years and therefore are not so concerned
about possible interest rate increases; or
- You need a lower
initial rate to afford to buy the home you want.
An ARM has two "caps"
or limits on how large an interest rate increase is
permitted. One cap sets the most that your interest
rate can go up during each adjustment period, and the
other cap sets the maximum total amount of all interest
adjustments over the life of the loan.
For example, a typical ARM
that adjusts annually may have a yearly cap of 2%, meaning
that the adjusted interest rate can never be more than
2% higher than the previous year. And such an ARM may
have a lifetime rate cap of 6%, meaning that the interest
rate on your loan will never be more than 6% over the
original rate. So, if you are looking at an ARM with
a current introductory rate of 5%, a lifetime cap of
6% tells you that the highest interest rate you could
ever pay would be 11%.
TIP: Before applying
for an ARM, be sure you know how high your monthly payments
could go - the "worst-case scenario."
Only you can determine if you would feel comfortable
paying this interest rate sometime in the future.
Your lender can tell you which
ARMs offer a conversion feature that allows you
to convert from an adjustable rate to a fixed rate at
certain times during the life of your loan.
One important thing to know
when comparing ARMs is that the interest rate changes
on an ARM are always tied to a financial index.
A financial index is a published number or percentage,
such as the average interest rate or yield on Treasury
bills.
The following are the most
common types of ARMs:
- CD-Indexed ARMs (Certificate of Deposit):
After an initial six-month period, the initial
rate and payments adjust every six months. These ARMs
typically come with a per-adjustment cap of 1% and
a lifetime rate cap of 6%.
- Treasury-Indexed ARMs: These are tied to
the weekly average yield of U.S. Treasury Securities
adjusted to a constant maturity of six months, one
year, or three years. Likewise, the interest rate
on your ARM will adjust once every six months, once
each year, or once every three years, depending on
the schedule you choose. Per-adjustment caps and lifetime
rate caps also vary.
- Cost of Funds-Indexed ARMs: Indexed to the
actual costs that a particular group of institutions
pays to borrow money, the most popular of this type
is the COFi for the 11th Federal Home Loan Bank District.
COFi ARMs can adjust every month, every six months,
or every year, and the per-adjustment caps and lifetime
rate caps vary.
- LIBOR-Based ARMs: The London Interbank Offered
Rate is the interest rate at which international banks
lend and borrow funds in the London Interbank market.
The six-month LIBOR ARM typically has a per-adjustment
period cap of 1% and is offered with either a 5% or
a 6% lifetime rate cap.
- Initial Fixed-Period ARMs: As protection
against rapid interest rate increases in the early
years of your loan, interest rates for these ARMs
don't adjust until several years after you take out
the loan. You can choose from three, five, seven,
or 10-year fixed terms. At the end of your chosen
fixed-rate period, your interest rate would adjust
every year.
- Two-Step MortgageŽ: This special type of
ARM provides the benefit of initial low rates with
the stability of longer term financing because it
adjusts only once - either at seven years or at five
years. After that initial adjustment, the mortgage
maintains a fixed rate for the remaining 23 or 25
years of a 30-year mortgage repayment term. For example,
if your initial interest rate were 8%, you would pay
that rate for the first seven (or five) years. Then,
for the remaining 23 (or 25) years, you would pay
an interest rate that is indexed to the value of the
10-year U.S. Treasury security on the adjustment date.
(At the adjustment date, there is no additional refinancing
cost, no forms to complete, and no re-qualification
necessary.) This new rate can never be more than 6
percentage points higher than your old rate. There
are no limits on how much lower the adjusted interest
rate can be.
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Government
Loans and Programs
The Federal Housing Administration
(FHA), the U.S. Department of Veterans Affairs
(VA), and the Rural Housing Services (RHS)
are three agencies that offer government-insured loans.
To obtain these loans, you apply through a lender that
is approved to handle them. All require that the properties
being purchased meet certain minimum standards.
Various types of government
loans include:
- FHA Loans:
With FHA insurance, you can purchase a home with a
very low down payment (from 3% to 5% of the
FHA appraisal value or the purchase price, whichever
is lower). FHA mortgages have a maximum loan limit
that varies depending on the average cost of housing
in a given region.
- VA Loans: The
VA guarantee allows qualified veterans to buy a
house costing up to $203,000 with no down payment.
Moreover, the qualification guidelines for VA loans
are more flexible than those for either FHA or conventional
loans. To determine whether you are eligible, check
with your nearest regional VA office.
- RHS Loans: The Rural Housing Service, a branch
of the U.S. Department of Agriculture, offers low-interest-rate
homeownership loans with no down payment requirements
to low and moderate-income persons who live in rural
areas or small towns. Check with your local
RHS office or a local lender for eligibility
requirements.
- State and Local Loan Programs: A number of
states sponsor programs to help first-time home buyers
qualify for mortgages. Local housing agencies also
offer, in some areas, attractive loan terms, such
as low down payments or low interest rates,
to home buyers who meet specified income guidelines.
Some state and local programs may also offer down
payment and closing cost assistance. Check with your
state housing authority. You can find
the office nearest you online or look
in the government "blue pages" of your phone
book.
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Balloon
Loans
Balloon loans offer lower
interest rates for shorter term financing, usually five,
seven, or 10 years. At the end of this term, they
require refinancing or paying off the outstanding balance
with a lump-sum payment. Balloon mortgages may
be suitable if you plan to sell or refinance your home
within a few years and want a fixed, low monthly payment.
The advantage they offer is
an interest rate that is lower than that of a fully
amortizing fixed-rate mortgage. For example, your
initial interest rate may be 7.5%, and you would pay
that for the first five, seven, or 10 years (depending
on the term of your balloon loan). Then, your entire
outstanding loan balance would be due to the lender
or you might have to pay a fee to refinance your loan
at the prevailing interest rate.
Be sure to ask about all the conditions for a refinance
option at the end of the balloon term. With some
balloon mortgages, the lender doesn't guarantee to extend
the loan past the balloon date. If you don't feel you
will be able to meet all the refinance conditions or
think the balloon term may be up before you are ready
to move, this type of loan may not be appropriate for
you.
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Other
Affordable Housing Loans
Fannie
MaeŽ offers a variety of low and moderate-income
households mortgage loan options that help overcome
common barriers to homeownership. Fannie Mae loans require
less cash at closing and for a down payment, in addition
to flexible underwriting ratios, making it easier for
qualifying individuals to get into a new home sooner
and use more of their monthly income toward housing
costs than permitted by other mortgage loans.
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