Financing Fully Explained

Home Financing Fully Explained

It Pays to Know Your Options

Mortgages are the most common means of buying a house today and being an informed consumer is the best way to ensure you make good mortgage decisions. Making the right choices about mortgages is important because the decisions you make now will affect your life for years to come. The more information you have, the more likely you are to get the best terms and rates for which you are eligible.

Preparing for the Loan Process

A mortgage is a loan.  It will probably be one of the biggest loans you ever have. Applying for a home loan and arranging the related financial matters can seem complex if you’ve never done it before, but it’s really not that bad. If you’re organized, the mortgage application process is fairly simple and straightforward.

The first step is to make an accurate and honest assessment of your budget and how much house you can afford. Lenders generally require that your monthly housing expenses be below 40 to 45 percent of your gross income per month depending on your credit report score and loan-to-value ratio of the mortgage. Your housing expenses include not just your mortgage payment but also associated taxes and insurance. While this ratio is common to most lenders, there are some mortgage types, such as government-backed loans, in which the ratio may vary a bit.

You’ll also want to review a copy of your credit report. Check for any inaccuracies and, if you find any, correct those as soon as possible. It’s important that your credit report portrays an accurate representation of your financial history because that will be one of the primary resources a lender will use to determine your mortgage eligibility.

A lender will also want to see financial documentation. In addition to your bank information, which will include your account numbers and three months worth of recent bank statements, you’ll need to present verification of income. The documents you’ll need for proof of income include pay stubs and W-2 forms or tax returns and financial statements if self-employed. Your current indebtedness is also an important part of your financial picture and a lender will want to see documentation of what is owed and when it is due.  

Once you’ve decided on the approximate amount you are willing and able to spend on your house and have assembled your financial records, you are ready to begin shopping for both your home and mortgage. Shopping for your mortgage can be just as important as shopping for the house itself. You’ll have many choices to make concerning the type and duration of mortgage including the terms, conditions and rates available to you. Taking the time to get maximum education about the options available to you will help you make the right choices for your individual situation.

Basic Home Mortgage Types

The most popular home financing option is the traditional fixed-rate mortgage or FRM. This type of loan is used in nearly 70 percent of home purchase transactions. The characteristic of fixed-rate mortgages that makes them most appealing to many consumers is stability. The interest rate of this loan is established (fixed) at origination and remains constant throughout the term of the loan regardless of changes in the prevailing market rate. This allows borrowers to budget for a level monthly payments of principle and interest throughout the term of the loan which is usually 30 (sometimes 15) years.

Adjustable-rate mortgages, or ARMs, are another option that has become quite popular in real estate transactions. These loans have an interest rate that is tied to an index and changes with prevailing market rates. Usually the interest rate is fixed for a predetermined initial period of 1 to 5 years. After that, the intervals at which the interest rate are adjusted are specified in the loan agreement. If the prevailing market rate has increased from one adjustment period to the next, the monthly loan payments will rise. If interest rates have fallen, the consumer’s payment will fall as well. Often there are caps placed on the amount that the rate can change during each adjustment period. Some ARMs have a lifetime cap that limits the total amount rates can adjust over the term of the loan.

Under the umbrella of the two main categories of home loans, fixed-rate and adjustable-rate, are a number of variations with some of them combining characteristics of both. A few of the most common variations are outlined below (after Government Guaranteed Mortgage Loans).

Government Guaranteed Mortgage Loans

The FHA loan is a fixed-rate mortgage that is designed especially for the first-time home buyer of moderate or low income. Guaranteed by the Federal Housing Administration, these loans can be easier to qualify for than a traditional FRM and allow a smaller down payment than most other home loans, generally about 3 percent. Interest rates are usually lower than standard fixed-rate loans and programs are available for the purchase of single-family homes or multi-family buildings as long as they are to be owner occupied.  FHA loans are currently very popular. The FHA website is www.fha.com.

VA loans are another government guaranteed mortgage. To be eligible for a VA loan, one must have a history of active military service or be the surviving spouse of an active service member. Often, a veteran can obtain a VA loan with little or no down payment, but must demonstrate the ability to make monthly payments.  This program is managed by the Department of Veterans Affairs and the VA specialist in your command can give you further details or you can visit the VA website, www.benefits.va.gov/homeloans.

The USDA Rural Development Guaranteed Housing Loan is another government guaranteed home loan option. This type of home mortgage loan is provided to low- and moderate-income individuals who are purchasing a home in an area designated as a Rural Development eligible area. No down payment or mortgage insurance is required with this loan program and qualification can be much easier than your average home loan, allowing consumers with less than perfect credit to obtain financing for home purchases.

Option ARMs

Also referred to as flexible payment ARMs. Option adjustable-rate loans have an interest rate that adjusts every month with no adjustment caps. These loans allow borrowers to make very low initial mortgage payments but these monthly payments will increase over time – often quite steeply.

Balloon Mortgages

Balloon mortgages are structured with a payment schedule similar to that of a 30-year fixed-rate loan, although the term of the balloon loan is shorter. Usually the term ranges from 5 to 7 years. At the end of the loan term, the outstanding balance must be paid in one lump sum, either out-of-pocket or by refinancing the home.

Interest-Only Mortgages

Interest-only mortgages are loans that allow the borrower to pay only the interest on the loan for a predetermined period of time. The principle of the loan is not paid down during this period at all, leaving the homeowner a lower monthly payment over the short term. However, once this initial interest-only period expires, the payments increase to include repayment of the principle and are steeper than a standard loan because the principle must be repaid over a shorter time period. The longer the interest-only period, the higher the payments will rise after its expiration.

Bi-Weekly Mortgages

Bi-weekly mortgages are loans in which the borrower makes payments every two weeks instead of the typical monthly payment arrangement. The result of this practice is a slightly shorter repayment term. Paying bi-weekly results in 26 payments a year (which is equivalent to 13 monthly payments) rather than the 12 payments made with a standard monthly mortgage payment.

Bi-Monthly Mortgages

Bi-monthly mortgage plans do not require any extra payments but save slightly on interest by advancing the payment by half the month. On average, these types of arrangements only shorten the loan term by approximately 1 month on a 30-year mortgage.

It Usually Comes Down to This

Unless you qualify for a government guaranteed loan, the biggest decision you’ll need to make is whether you want a fixed-rate or an adjustable-rate loan.  Right now, we’re still in an environment where interest rates are very low.  Interest rates are being kept low by the Federal Reserve in an effort to stimulate the economy and bring us out of recession (or slow growth).  The point here is that rates are already as low as they’re going to get and therefore are only likely to go up in the future.  Inflation is also currently low (except for energy and food), but there are signs this could worsen over the next few years.  So if rates are just about as low as they can get right now, it’s more likely they’ll be higher (rather than lower) in the future.  Possibly much higher.

This adds to the risk of adjustable-rate mortgages.  They do have lower initial interest rates than fixed-rate mortgages, but they also have the risk of substantially higher interest rates when you reach the point where the rate can adjust to market.  If you’re not sure how long you’re going to stay in your home (especially if it might be a long time), a FRM might be a safer bet for you.  Alternatively, if you know for certain that you’ll only be in the house a few years and you can get an ARM with a fixed rate over that same time period, then you could probably handle to risk of an ARM.  The ARM would give you lower payments for the time you’re in your home.  But, if you end up staying in your home longer than expected, your rate could adjust upward and may end up being far more than it would have been with a 30-year FRM.  That’s the dilemma in a nutshell.