What is pre-approval? It's basically a quick-and-dirty look from a lending institution at your creditworthiness. With a pre-approval or pre-qualification letter in your hand, you're immediately in a stronger negotiating position with any seller.
There are two types of "pre" letters:
Check out our Foolish calculators to find out how much you can borrow and how much your payments will be. It's very Foolish to know what to expect.
]]>What exactly is a mortgage? Simply put, it's a loan from a financial institution to you. In return, you pay interest on the amount loaned. The lender also has first dibs on your house in case you neglect to pay back the loan.
Francophiles and wordsmiths will recognize the root word "mort" in there. No, that's not your Uncle Mort; that's the French word for "dead." The idea is that you're going to kill off that loan, by paying back the money you borrowed. You amortize the loan, over time. Yes, it's a slow death, but it must be carried out.
A loan has three facets:
The first one is self-explanatory (although there are choices you can make with regard to the down payment, which we'll investigate in a little while).
The other two are more complicated. Let's look first at the interest rate.
The annual percentage rate is a method developed under federal law to disclose to loan applicants the actual amount of interest that will be paid on a given loan, over the life of that loan. It makes it easy to compare one mortgage to another by making it an apples-to-apples comparison. You should, however, use the APR as just one tool in evaluating a loan, not as the sole factor in making your decision.
To understand APR, you must first understand the concept of points. A point is 1% of the loan amount. If the loan is for $100,000, one point is $1,000.
There are two types of points: origination and discount. Origination points are the fees normally charged by a lender, and sometimes by a mortgage broker, for originating, or starting up, your loan. Discount points are charged to lower your interest rate, and this lowers your payments. In other words, if you pay some more money up front, the bank will let you pay less over time.
Both types of points should be considered interest that you pay up front. Therefore, you must figure points into the cost of your loan repayment. If you take out a loan for $120,000 at 9% interest for 30 years, and you pay one origination point and one discount point, you're paying a total of two points, or $2,400. Your payment will be $965.55 per month.
To get the proper APR on your loan, then, you have to add that $2,400 to your starting balance, since (remember?) it is interest, albeit prepaid interest. This makes your total loan $122,400. Figure the new payment on that balance, which works out to $984.00. Now return to the original loan amount and (ready, mathematicians?) compute the polynomial backwards to reach the interest rate it would take to equal the payment on the total loan. It works out to roughly 9.23%.
In paying points to lower your rate, a good rule of thumb is that it will take you about five years to make up the additional point(s) paid; then you will begin saving money over the remaining term of the loan.
By federal law, lenders are required to send you a TIL (no, that's not something you get your hand caught in when you're stealing -- it stands for Truth in Lending) statement within three days of applying for a loan.
The most common term for a fixed-rate mortgage is 30 years, with 15 years the next most common.
A 30-year vs. 15-year mortgage debate rages, but one thing is sure: You will pay much more interest over the term of the loan (in most cases double) on a 30-year mortgage. On the flip side, a 30-year mortgage will offer lower monthly payments. You'll be getting a tax write-off for the interest portion of your payments, which could be substantial. On the other hand, in the first 15 years of your loan, you will be unFoolishly lining someone else's pocket with interest, while not building up significant principal for yourself.
Example: Let's say you buy a $150,000 home. You put down 20%, or $30,000, which leaves you $120,000 to finance. If you get a 30-year loan at 8.5%, your payments are $922.70. After five years of payments, your balance owed is $114,588. If, on the other hand, you obtain a 15-year mortgage at 8.00% (rates are lower with shorter-term loans), your payments are $1,146.00 ($224.00 more each month). After five years in this loan, however, your balance is only $94,000. That's quite a difference when it comes time to sell.
In sum, a 30-year loan is good for long-term stability. If you can afford a 15-year mortgage, you will build principal faster. Another option would be to pay what would be equal to the 15-year payment on a 30-year loan, enabling you to pay it off in about 15 years (slightly longer due to the higher interest rate), while still having the cushion of the lower payment should money problems arise.
There's one other loan categorization that has to do with size. A conforming loan is less than the Federal National Mortgage Association's legislated mortgage amount limit, which is currently $322,700 for a single-family home. A jumbo loan, also known as a nonconforming loan, exceeds that amount. Since such jumbo loans cannot be funded by the agency, they usually carry a higher interest rate.
]]>Not any more.
These days, it's downright easy to overcome what experts have long dubbed the "biggest obstacle" to buying. Lenders have dramatically eased their down payment requirements while allowing more types of government assistance, grants and gifts to be used in place of a borrower's own money. As a result, even customers with little or no spare change shouldn't be afraid to talk to a lender and see if they can take advantage of today's low rates to buy.
"A lot of people, when they go to purchase a home have the money for the mortgage and they have good credit, but they don't have the opportunity to save for a down payment," says Lori Reed, a spokeswoman for the Nehemiah Corp. of California in Sacramento. The nonprofit group runs a down payment assistance program that has provided more than $421 million in aid to some 120,000 borrowers in the past five years.
"The industry has seen that people need help to get into homes, that there's obviously a need there."
Time for change
Borrowers and lenders alike used to lament the difficulty of coming up with a down payment and its impact on homeownership. For many years companies wouldn't even give mortgages to people who couldn't pay at least 20 percent of the purchase price of their homes. But since the mid-1990s, the down payment barrier has all but crumbled.
Lenders routinely loan money out at 100 percent loan-to-value, meaning borrowers can obtain mortgages for the full price of their homes. Some go even further, offering loans at an even-higher LTV so consumers can finance their closing costs too. They've eased their restrictions on where the down payment money comes from too. Throw in assistance programs run by nonprofit groups, such as churches or community organizations, and state and federal housing agencies and it becomes even easier to solve the down payment dilemma.
Savvy consumers seem to be taking notice. Of borrowers polled for the 2001 Fannie Mae National Housing Survey 53 percent said coming up with enough money for a down payment and closing costs was a "not an obstacle." That's up from 48 percent in 1999.
"You're not going to have to wait while you're trying to save $150 a month to get that down payment" anymore, says Matt Miller, director of affordable lending at McLean, Va.-based Freddie Mac. "There are ways to get into a home earlier."
Consider that Minneapolis-based GMAC Residential Funding rolled out a 107 percent LTV program in mid-2000. It allows borrowers who visit one of the wholesale lender's mortgage bank or broker clients to get first mortgage loans that cover the full value of their homes, plus closing costs. That's even more generous than the 100-percent and 103-percent financing offers available for a couple of years.
It "benefits both qualifying first-time home buyers with limited funds and borrowers who have sufficient funds for down payment but prefer to leave those funds in other, more flexible investment vehicles," Eric Scholtz, the company's managing director of capital markets, said in a recent release discussing the product. "We are offering borrowers more options."
New ways to borrow and pay down
Borrowers can use money from third parties in ways that weren't allowed before too. Investor Freddie Mac buys loans from lenders and sets standards that the mortgages it purchases have to meet. In the past, the agency wouldn't buy loans from lenders unless their borrowers put at least 3 percent down, using their own money. Since consumers generally have to pay another 3 percent or so of a home's purchase price in closing costs, the out-of-pocket tab for a $100,000 property was something like $6,000.
Now, Freddie Mac will buy loans up to 100 percent LTV. Borrowers still have to put at least 3 percent of the purchase price "into the transaction." That 3 percent can be used to cover the closing costs. If the closing costs are less than 3 percent, the difference is put toward the down payment. But because the customer no longer has to come up with a down payment too, the out-of-pocket cost on a $100,000 home falls to $3,000. As a further concession, Freddie Mac allows the borrower's contribution to be a gift from a related person, rather than the person's own money.
"If you take the relatively short past, the 90 percent loan, the 95 percent loan was sort of the norm, the highest level people were going to," Miller says. "But we've been moving into higher loan to values now.
"And probably one of the biggest changes we have seen over the past couple years," he adds, is "the ability to use flexible sources for that down payment."
There are other innovative ways to avoid down payments, too.
Nehemiah works by first convincing sellers to list their properties with the nonprofit company, offering greater visibility and more buyer traffic. In exchange, sellers agree to pay 4 percent of whatever price they get to Nehemiah. Nehemiah then recruits buyers, offering to pay 3 percent of their purchase prices out of the pool of money it generates from those sellers.
Borrowers end up getting into homes for no money down as a result, though they usually pay full market price for their properties since sellers typically aren't willing to accept reduced offers on top of the 4 percent fee. The Department of Housing and Urban Development has expressed some reservations about the way Nehemiah operates. It fears that Nehemiah buyers -- who often use Federal Housing Administration loans when purchasing -- will default more frequently since they don't have to put any of their own money into their transactions. But for now, it's business as usual.
"This is not a loan. This is a gift," says Nehemiah's Reed. "It allows them the opportunity to pursue the American dream of becoming a homeowner."
Miller says that's exactly what people should do too -- even if they don't think they have enough down payment money squirreled away.
Today's programs "keep people from being shut out of the market."
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But the decision between a 15-year mortgage and a 30-year mortgage isn't always simple. The 30-year mortgage has lower monthly payments, yet ultimately costs more; the 15-year mortgage mortgage requires higher monthly payments, but builds equity faster.
It can be a tough call.
"It's never a bad idea to pay off debt faster. It's never a bad thing," says George McReynolds, a certified financial planner and vice president of lending at Warrington Mortgage Corp. in Feasterville, Pa. "But sometimes, there's a second right answer. Sometimes there are better things that can be done with the money.
"They have to look at the bottom line," he adds. "They can't just look at it in a vacuum."
Weighing the benefits
The 30-year vs. 15-year debate has been around almost as long as the mortgage itself. With 30-year loans, borrowers generally get lower monthly payments even though their rates are higher. That's because the longer amortization schedule spreads the additional cost of the rate differential -- which was roughly 30 basis points in mid-September -- over twice as much time. People can buy larger houses or keep their payments on smaller homes affordable as a result.
Fifteen-year mortgages, on the other hand, help buyers own their homes sooner. Even though their payments are larger, they build equity faster because more of each payment goes toward principal rather than interest. The lower interest rate and shortened term make the loans cheaper by lowering the overall interest bill.
"You get a substantial benefit on a 15 from the lower rate. And because it's a shorter payoff period, you're paying down the balance at a much more rapid clip," says Jack Guttentag, a syndicated columnist who also runs the Mortgage Professor Web site. "But people who are on a strict budget and are focused much more heavily on the payment are going to gravitate toward the 30."
In recent years, planners have tried to get consumers to consider their loans in a broader context. Instead of just looking at which has higher payments and which has lower rates, a borrower should consider how the loan will fit into a broader financial plan, they say.
People who want to build equity as quickly as possible generally will go with 15-year loans. That's great for consumers who have reserve cash stored away somewhere, but it can be dangerous otherwise. If the higher payment leaves the borrower with hardly any money to save each month or if the borrower starts out with no savings at all, even a minor family or financial emergency could cause major problems.
McReynolds recalls what happened to a good friend of his who worked as a utility lineman. In 1990, he had to go into a manhole to repair damage done by a contractor, but because someone had inadvertently flipped a switch, he got burned. In the past, he never had trouble making his 15-year loan payments because of all the overtime pay he earned during the harsh Northeast winters.
But he had to spend two months in a local burn unit as a result of the accident. While savings and workers' compensation checks kept the friend from getting behind on his mortgage payments and losing his house, it was a close call. Less-prepared borrowers facing the same crisis could very well end up in the street.
"Because of savings and disability insurance, it made up the gap," McReynolds. "But I know it was a financial strain. Had he not done the other things, it would have been tragic.
"You don't have to get electrocuted to run into that difficulty either," he adds. "It could have been his mother going into a nursing home."
If you're on the financial fringe
People close to the financial edge should therefore take the 30-year loan and make extra payments whenever possible. After all, nothing prevents a borrower from paying a long-term loan like it's a short-term one.
"Take the 30-year. Establish your payments accordingly," says Randolph J. Shine, a certified financial planner with Shine Financial Inc. in Deerfield Beach, Fla. "Then if you wish and can afford it, I then would advise making principal-only payments of 'X' amount in essence to duplicate the 15-year loan."
At the same time, borrowers choosing between the two loans need to do a gut check. People who have the discipline to take the money they save because of the lower 30-year payments and sock it away should go with the long-term mortgage. That way, they'll have cash for big-ticket purchases and can avoid using credit cards or taking out large auto loans down the road. But consumers who will just spend any monthly savings should probably take the shorter-term mortgage.
"There are people that unless you put a stick in their back, they're not going to do what's right," Shine says "If your personality is the type that needs that discipline, then it's a no-brainer. Go for the 15."
Taxes not a factor
One thing to watch out for is lenders or brokers who push the 30-year loan aggressively because of tax reasons. While it's true a 30-year borrower will generally get larger tax deductions than a 15-year borrower, that's because the 30-year customer pays more tax-deductible interest in the first place.
"I have it written literally in stone in my office: 'Never let the tax tail wag the dog,'" says Shine. "If you're buying a house for the write-off, you're buying it for the wrong reason. The tax considerations are an afterthought.
"In my mind, you always take the minimum loan you can get at the lowest interest rate to minimize your long-term risk. If you lose a couple bucks in the write-off, fine."
Regardless of other considerations, planners say the most important thing to remember is not to tie up too much money in the home. Borrowers who choose 15-year loans should make sure they can still afford to save some money in an IRA, 401(k) plan or college savings account.
"They should have a regular funding plan for their financial goals," McReynolds says. "If it's a goal to fund their child's education and they're doing that on a regular basis and what they're doing for their retirement is on track or whatever their other financial goals are -- and they have adequate cash reserves -- then at that point, I think it's just a matter of personal preferences.
"You can afford to be debt free."
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Pay out over time
Because mortgages are such large loans, consumers pay them off over long periods -- usually 15 to 30 years. Their monthly payments gradually whittle away the principal balance.
A monthly mortgage payment is sometimes called a PITI payment. That's because each one covers a portion of the following four costs:
Principal -- the loan balance
Interest -- interest owed on that balance
Real estate taxes -- taxes assessed by different government agencies to pay for school construction, fire department service, etc.
Property insurance -- insurance coverage against theft, fire, hurricanes and other disasters
Borrowers can choose to pay their real estate taxes and insurance in lump sums when they come due, rather than in monthly installments to their escrow accounts. Depending on the kind of mortgage a borrower has, the monthly payment may also include a separate levy for private mortgage insurance (PMI) or government-backed mortgage insurance premiums.
The breakdown of each payment (the amount that goes toward principal, interest, etc.) changes over time because mortgages are based on a repayment formula called amortization. That's a fancy term meaning the lender spreads the interest you owe on the mortgage over hundreds of payments so that the overall loan is as affordable as possible.
How does amortization work? Here's how the principal and interest change over the life of a loan:
|
Here's how the principal and interest change over the life of a loan (30-year, 7.5% fixed-rate mortgage of $150,000) | |||||
|
Payment number |
Principal balance |
Payment amount |
Interest paid |
Principal applied |
New balance |
|
1 |
$150,000 |
$1,048.82 |
$937.50 |
$111.32 |
$149,888.68 |
|
60 |
$142,086.93 |
$1,048.82 |
$888.04 |
$160.78 |
$141,926.15 |
|
120 |
$130,426.14 |
$1,048.82 |
$815.16 |
$233.66 |
$130,192.48 |
|
240 |
$88,851.22 |
$1,048.82 |
$555.32 |
$493.50 |
$88,357.72 |
|
359 |
$2,078.14 |
$1,048.82 |
$12.99 |
$1,035.83 |
$1,042.3 |
On a 30-year, $150,000 mortgage with a fixed interest rate of 7.5 percent, a homeowner who keeps the loan for the full term will pay $227,575.83 in interest. The lender can't possibly expect that person to pay all that interest in just a couple of years, so the interest is spread over the full 30-year term. That keeps the monthly payment at $1,048.82.
But the only way to keep the payments stable is to have the majority of each month's payment go toward interest during the early years of the loan. Of the first month's payment, for instance, only $111.32 goes toward principal. The other $937.50 goes toward interest. That ratio gradually improves over time, and by the second-to-last payment, when we're all driving hovercars and have colonized the moon, $1,035.83 of the borrower's payment will apply to principal while just $12.99 will go toward interest.
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Now for the bad: It's going to take a lot of patience, restraint and some careful planning to get there. That loan officer sitting across the table won't look kindly on the new Lexus you bought or the stack of credit card bills on the kitchen counter. And if you've only managed to put away $1,000 in savings by then, it'll be time to forget about the $300,000 beach house.
To pull the purchase off, try heeding some of the guidelines below that our experts suggest. It may not always be fun, but doing so will help get you where you want to go.
Pay your bills and start saving
"No. 1, pay your bills on time. There is no single element that can so dramatically impact the success of an application as your credit history," says Brian Israel, vice president of Chicago-based Harris Trust and Savings Bank's residential mortgage division. "Another thing, of course, is savings. People should have a good disciplined savings pattern."
"That's the kind of behavior that's going to make them a successful homeowner."
Everybody comes into the real estate market with a different perspective and level of experience. The fact that online mortgage applications, new loan products and rising interest rates are competing for attention these days makes it all the more difficult to give foolproof advice. But some general rules apply to pretty much anybody when it comes to getting the money to buy a home. So here are some of the do's and don'ts that buyers will want to consider.
Five do's
1. Make loan and other debt payments on time, especially over the months leading up to the filing of your mortgage application. It sounds simple, but every 30-, 60- or 90-day delinquency on a loan or credit card is going to reduce the credit score the lender ends up considering as part of the loan file. That score, in turn, will determine how good a loan you get -- if you get one at all.
"If you had to prioritize -- and we would hope you wouldn't be in that situation -- pay your mortgage loans, pay your installment loans, pay your revolving loans," Israel says.
3. Consider paying off more debt and putting down a smaller amount at closing. The move leaves borrowers with larger mortgages, but it will allow them to replace non tax-deductible, high-interest rate debt with lower-rate mortgage debt that features deductible interest.
"We see that trend in the marketplace, whether it's a refinance transaction or a purchase transaction," says Larry Hamilton, chief executive officer of SouthTrust Corp's mortgage lending division in Birmingham, Ala. "They are putting less equity in their homes, borrowing more against the homes and they're paying off consumer debt, at least for a while."
4. Get the mortgage first if multiple financial obligations are going to pop up in the near future. Numerous credit inquiries, such as new applications for credit cards, can hurt a borrower's credit score, especially if they're filed in the months prior to the home loan review process.
5. Increase the size of the down payment you're able to make by saving as much as possible, as often as possible. Don't put the savings into something volatile, such as an individual stock. But evaluate money market or other accounts that offer reasonable rates of return, automatic payroll deductions or other financial incentives to save.
"It depends on how much you have saved already, but I think it's important to take a portion of each month's income and set it aside for the down payment," says Brad Blackwell, senior vice president for retail mortgage banking at Seattle-based Washington Mutual Inc.
While these are all good steps to follow, borrowers have to think of what they shouldn't do as well. Resisting the temptation to splurge or slip-up in the credit arena are at the top of the list.
Five don'ts
1. First off, don't make any big purchases over the next couple of months. Besides the obvious fact that it makes less money available for the down payment, it might require you to get yet another loan. A significant debt such as a $15,000 auto loan will look bad to the mortgage lender's credit scoring systems. Plus, the human underwriter won't want to see you adding a couple of hundred dollars per month to your monthly expenses.
"Generally, as a rule of thumb, you want your total debt obligation to be no more than 36 percent of your gross monthly income," says SouthTrust's Hamilton. "You certainly don't want to load up on consumer debt if you're anticipating purchasing a home and you're unsure of what your mortgage payment is going to be and if you think you're within the range of exceeding that 36 percent requirement."
2. Don't try shooting for that six-bedroom house in the Hamptons if it's going to be too much of a stretch in your current budget. Lenders consider what's known in the industry as "payment shock" when approving loans. Somebody who goes from a relatively small monthly housing payment to a huge one either won't qualify for a mortgage or will end up having to cover too much loan with too little money.
"If you've paid all your bills on time, but you've been paying $450 in rent with a roommate and now you're going to have a $1,650 principal and interest and insurance payment on a house, how would you handle your monthly payment?" asks Israel of Harris Bank. "You have to make sure you're comfortable about that kind of a debt load."
3. Don't just get pre-qualified for a mortgage, get pre-approved. To get pre-qualified, a borrower need only submit credit, income and debt information voluntarily to a mortgage broker or lender. That means the resulting estimate of the maximum mortgage and home that's affordable is exactly that -- an estimate. Before they can get pre-approved, however, home buyers must allow their lenders to pull credit reports, check debt-to-income ratios and perform other underwriting steps. That puts a borrower much closer to obtaining a loan and locking in a rate and term.
4. Don't forget what kind of money personality you have when getting a mortgage. By taking out a 30-year fixed rate loan rather than a 15-year mortgage and investing the money saved on monthly payments, you might earn a higher return on your money in the long run. But that approach won't work for people who spend any extra cash laying around on dinner and a movie twice a week. They can force themselves into saving and accumulating equity faster by going with the shorter term and higher payment.
5. Last but not least, don't forget that homeownership brings with it many burdens. The cost of defaulting on a loan is much greater than the penalty of missing a rent payment. Too many black marks on the financial history and it will be 23 percent interest credit card mailers that show up in the mailbox rather than the 9.9 percent ones your neighbor gets.
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