Buying a home is without a doubt the most significant purchase we make in our lives — nearly all of us buy property with a mortgage. There are so many different types of mortgages available on the market that it is difficult to understand the wildly varying terms and conditions. Understanding the relevant terminology behind this very important purchase is the first step towards demystifying the process and allowing you to make the best decisions.
Here we take an in-depth look into the world of mortgage finance.
One of the first steps to owning a home is to plan for the amount of money you want to put down. The down payment serves as immediate ownership or equity in the home. It is a good goal to have saved at least 20% of the home value to pay upfront and then finance or get a mortgage for the remaining 80%.
When a home buyer has less than 20% to pay upfront, a mortgage lender may charge private mortgage insurance or PMI. This is the lender's way of protecting themselves in the event you cannot pay your mortgage. The charge is 0.50% to 1% of the home value per year. This fee is broken down monthly and included with your monthly mortgage payment. Government loans, such as FHA loans for low income and poor credit borrowers, will allow for very little down payment but they will also charge a fee for mortgage insurance.
If you decide to take a loan with PMI, consider adding a little extra to your payment each month so that you can reach 20% equity as quickly as possible. Once you reach the 20%, request the lender to remove PMI. It is best to commit to saving years before a home purchase so that you can avoid PMI fees. Think about what you could do with that 0.5-1%. For a $200,000 home that is $2,000 a year if the PMI is 1%.
Because you will likely be borrowing a significant amount of money to buy your home, lenders will want to examine your credit score. This is used to determine whether a mortgage applicant has a good history of meeting their debt obligations and how much of their outstanding debt is used. Mortgage lenders will have lending requirements in addition to just a good credit score.
Ideally, you want to have your finances in order before you actively look for a home, otherwise it can become frustrating and stressful waiting for a decision when you’ve found the home you’re looking for. By finances we are referring to having the following items copied and ready to send:
- Having a good cash reserve or emergency fund of 3-6 months of expenses with proof through the most recent 2-3 months of bank statements.
- Having excess discretionary income evidenced by a extra money in your checking account, living paycheck to paycheck is not an ideal situation. Have the last 3 months of bank statements available.
- Copies of your most recent investment account statement. The bank wants to see you are saving and not just paying bills.
- List of employers and previous addresses for all applicants.
- Copies of most recent two pay stubs and W-2s for all applicants.
- Copies of the last 2 years of tax returns.
- Any proof of additional income, from investments, child support, or pensions.
- List of all debt balances and minimum payment amounts.
In addition to the above you will be required to sign a form that will allow the lender to receive a copy of your taxes from the IRS. It is very common to get approved for a loan amount more than you should accept. Review your budget and really be comfortable with the monthly mortgage payment you will be making. Don't forget to include money you'll need for home owners insurance, property taxes, home owner association fees, and a sinking fund for home expenses. Zillow.com offers a mortgage calculator and affordability calculator that you can play with to be sure the home price is ideal for you.
The best way to approach any form of lending, particularly a significant sum of money such as a mortgage, is to check that your credit record is in a good enough condition to be approved on the first application, and that you will qualify for an attractive interest rate.
To get the best deals, you need to check your credit score, which you can do by ordering a credit report (refer to this earlier article for more detail about credit scores). Check your score well ahead of even applying for a mortgage so that you have time to fix any inaccuracies you may have discovered.
If you find your credit score is lower than is likely to be acceptable to lenders, take six months to focus on bringing your accounts back in line. You can pay off smaller credit card balances and maintain prompt repayments on the rest of your obligations, while refraining from obtaining any more credit until your mortgage has been granted. Bear in mind that clearing up your credit does not happen overnight and you have to sustain good borrowing behavior for at least six months before a mortgage lender will view your application favorably. Lenders want to know that you'll be able to repay your loan over its multi-decade duration, so it's imperative that you show a healthy history.
If you want to find out how much you can borrow to buy your home, you can pre-qualify for a mortgage and start your search on a much firmer footing. It is also common for sellers to require a bank pre-qualification letter before accepting an offer to purchase their home. The pre-qualification process is similar to applying for the mortgage itself as you need to provide information about what assets you own, how much you earn, and what liabilities you have. Based on the information provided, the lender will make a decision as to how much they are prepared to lend you for your home purchase. That means you know your price range before you start house-hunting.
The main difference between the pre-qualification process and a formal mortgage application is that the lender doesn’t verify any of the information provided. That means it’s really important to be as accurate as possible and if there are any issues you are aware of such as falling behind with existing loan payments that could negatively affect your credit position, you should let the lender know the full details.
Being pre-approved for a mortgage can help you in the negotiating process for a new property as you represent a buyer who is ready to close the deal.
It’s pretty easy to find mortgage providers as they are advertised everywhere!
This is a multi-billion dollar industry and is competitive. You should research all the options available to you, but because there are so many, things can quickly become very confusing. If you want to consult someone about a mortgage directly, it’s recommended to go to a regulated body such as a bank or a recommended mortgage broker. Talk to your friends and real estate agent about who they have experience with.
It’s best to go as close to the source of funding as possible in order to get the best deals. Generally, banks offer the best rates, particularly if you are an existing customer or can transfer your account over. They also offer face-to-face services which allow you to discuss your specific needs and get the best deal for your financial position. The only downside with banks in terms of mortgage finance is that they can offer a limited range of programs and related fees can be expensive.
Conversely, mortgage brokers tend to offer a wide variety of mortgages, giving you tons of options. They are also bound by regulation to protect your best interests. You can consult your broker either in person or online and get equally effective service, making mortgage brokers more flexible to communicate with than banks during the application process. Mortgage brokers do charge a fee, about 1% of loan amount, but they can also help negotiate some of the fees that will be charged by the lending institution.
There are plenty of different mortgage providers although there are only a few generic mortgage types including:
An adjustable rate mortgage does not have its interest rate fixed for the whole term of the loan. For an initial period after it has been taken out, the rate will be fixed at a determined rate for a particular length of time. This is why you will generally see ARMs advertised with the figures 3/1, 5/1, 7/1 or 10/1 and a corresponding rate displayed alongside it (such as 5%, 7.2%, etc.). The first number relates to how many years the initial rate applies for and the second, the number of times the rate is adjusted through the mortgage term.
For example, on a 5/1, the 5% rate will hold for 5 years. After that, the rate will change annually based on a rate index such as treasury securities. These are most commonly known as hybrid adjustable rate mortgages or ARMs.
The Rate Index
One question people ask is how an ARM’s interest rate is calculated once the initial rate period ends. The answer is that lenders refer to a variety of indexes including the London Interbank Offered Rate (LIBOR) and the Cost of Funds Index (COFI). It’s always worth asking what index your potential lender uses and how it has performed in the past. You can also find out where the index is published so you can see for yourself.
There are two parts to the interest rate applied after the initial period has ended:
- The information gained from the indexes mentioned above.
- The margin. This is basically the lender’s profit margin over and above movements on the index. Generally, your repayments should be capped to prevent them from getting out of hand.
With this kind of mortgage, you can end up paying more in repayments if there’s a surge in the related interest indices, but you may also find yourself better off if rates go down. Become educated about the current state of the interest rate environment before deciding to use an ARM.
Interest rate caps
There are two types of interest rate caps:
- A periodic adjustment cap limiting the amount the interest rate can fluctuate after the first adjustment
- A lifetime cap, limiting the interest-rate increase over the life of the loan, which is usually required by law
As mentioned above, it’s also possible to have a cap on your repayment with ARMs, which allows you to calculate affordability better. For example, if your mortgage is capped at 7%, you know your monthly repayments won’t increase by any more than that, even if interest rates continue to rise. Note that interest may still accrue on your loan if it is beyond the cap — your principal balance will increase as a result.
Traditional or repayment mortgages are the most common type of home loan and the easiest to understand too. This kind of mortgage allows you to gradually repay the capital amount borrowed plus interest to buy your home. When the term of the mortgage is over, you own your property completely. Repayments are made up of two parts: one pays interest and the other pays off the money you borrowed. As with other mortgages, you may elect to have your homeowner's insurance and property taxes included in your monthly payment. This additional collection is held in an escrow account until the bills for each are due. The lender will pay the bills on your behalf.
The way repayment mortgages work means that the first few years of its term is focused on repaying interest, with just a small part contributing towards paying off the capital. As time passes, this balance shifts and eventually you’ll end up paying more in capital and less in interest as you approach the end of the mortgage term.
Interest-only mortgages were introduced during the credit boom in the run up to the 2008 financial crisis. They are extremely high-risk vehicles because they focus on paying off interest as it accumulates on the capital amount borrowed rather than the capital itself; the homeowner's equity would accumulate very slowly. Many providers are wary of interest-only mortgages after they were more or less abandoned following the credit crunch in 2008. However, they have stepped up their lending criteria and improved affordability testing and now interest-only mortgages are coming back into fashion.
An interest-only mortgage generally works out to have lower repayments at the beginning of the term. This is because rather than paying off capital and interest on your home, you are paying just the interest. After a specified number of years the monthly repayment is likely to rise or a balloon (lump sum) payment is required at the end of the loan. This kind of mortgage can be difficult to budget, and you will more slowly earn equity in your biggest asset when compared to a traditional mortgage.
For this reason, people with interest-only mortgages generally have some kind of insurance policy in place to provide the funds to repay the capital when the mortgage finishes. Without some kind of safety net for the capital repayment required in the future, things can become complicated and you risk losing your home altogether.
The biggest advantage of an interest-only mortgage is that it reduces your monthly commitments, allowing you to afford more than you could otherwise.
Here’s an illustration:
- You borrow $200,000 on a 30-year term mortgage with an interest rate of 6.25%.
- Repaying your home loan on an interest-only mortgage would cost $1,042 monthly for the first ten years in this example. Normally, interest only loans are structured so that you can only pay "interest only" for the first five to ten years. That period will be determined by the lender. Once the interest only time is up, the loan is recalculated like a traditional mortgage for the remaining period, in this example that is 20 years. A new and increased payment period would begin. Here is how we calculated the "interest only portion" with this online estimator by BankRate:
- 6.25% interest on $200,000 principal = $12,500 interest per year
- $12,500/12 mo = $1,042 payment per month for the first 10 years
- The payment would recalculate for the remaining 20 years, assuming the interest rate remains 6.25%, to be $1,462 per mo.
- Repaying it with a 30 year traditional mortgage would cost $1,231 monthly.
Interest only mortgages are worth considering if you know you will be in your home for the length of the loan and if you are fairly certain your income will increase after the interest only period ends. If you would sell your home before the interest only period ends, you will have built no additional equity in your home during that period.
This is a special kind of mortgage for people who know they will be in the position to pay for their home in full within a short period of time – usually 5 to 7 years. Balloon mortgages are structured to make repayments slightly lower than a standard 30-year fixed mortgage but with an obligation to pay the capital balance in full when the agreed time is up.
Balloon Mortgage Reset Option
If it is not possible to pay of the entire balance after the 5 or 7 years, it is sometimes possible to refinance a balloon at that time with the same lender. If there is no provision made at the beginning of the balloon mortgage to reset the balloon balance, the property can be refinanced with a new lender or the owner will be forced to sell.
Why Get a Balloon Mortgage?
Property investors or people who move around frequently often don’t intend to own a property for more than a few years. In these cases, balloon mortgages have some advantages:
- They generally have lower interest rates than standard mortgages
- They are relatively easy to qualify for
- Lower closing costs
- They can often be reset to a standard mortgage
However, balloon mortgages also have drawbacks including:
- They don’t pay down the principal quickly, therefore they are slow to build homeowner's equity
- Mortgage holders are still left with a hefty financial obligation when the term has ended
- If interest rates rise during the time of the mortgage and you need to take the reset option, you can end up paying significantly more each month
- It’s easier to fall behind with balloon mortgages, particularly if a reset rate proves unaffordable. This can be a threat to your credit record.