So You Are A First Time Home Buyer
Starting with the basics, a mortgage is a loan that you obtain to bridge the gap between the amount of cash payment that you are willing or able to put down towards the purchase of a home and the total purchase price of that home. The promissory note is the actual agreement signed at the closing wherein you commit to repay the funds that the lender has loaned you to buy the home. The Mortgage is the legal document that secures the note and, when recorded in the county real property records, creates a first lien on your property in favor of the lender. Mortgages require monthly payments to repay the debt. These payments are comprised of interest (the charge for the use of the money) and principal (the repayment of the original amount borrowed). Typically, the majority of the payment is applied to interest with a relatively small amount being applied to the reduction of principal. This ratio slowly changes over time.
Learning how to select a mortgage to meet your needs ensures that you will be a satisfied homeowner for years to come. Time spent shopping for a mortgage is time well spent. A good deal can yield dramatic dividends in the short run and over time if monthly savings are invested elsewhere. Before you rule out one loan or another, read through this chapter and give some thought to your particular needs and aspirations.
In the text below you will learn the pros and cons of fixed-rate and adjustable-rate borrowing, become acquainted with the jargon of the mortgage business and hopefully, feel prepared to ask lenders the right questions and compare confusing offers before committing yourself to a particular lender. We believe that your real estate agent should be a valuable source of information on lenders and their ability, or lack thereof, to provide a high level of professional service and to deliver on the commitments made to you as the borrower.
The amount of the down payment is equal to the difference between the cost of the home and the amount of the loan. The standard down payment for a mortgage loan is 20%. Sometimes, you can put down as little as 3% to 10%. If your down payment is 20% or more, you will have a smaller loan, thus you will pay less interest over the life of the loan and you will avoid the additional monthly cost of private mortgage insurance (PMI). A down payment of 10% or less will result in higher monthly payments and you may incur PMI charges. These factors should be weighed against the the desirability of keeping funds available for other purposes.
Apples to Apples
There are two basic ways mortgage lenders charge you for using their money. First, through the interest charges you pay each month over the life of the loan. Second, through “points”, a one-time sum of money (one point equals 1% of the loan amount) that you pay up front in connection with the loan. When you are shopping for the best loan, you must be careful to take both types of charges into account. Compare interest rates by asking for the annual percentage rate of the loans you are considering. While there are many ways to state interest rates, the APR includes the cost of points and other fees such as mortgage insurance, making it a useful tool with which to compare loans. Lenders are required by law to give you a truth in lending statement which will provide you with information on the APR of the loan.
A point is prepaid interest that raises the effective yield to the lender without raising the interest rate on a note. From your perspective, points discount the value of a loan. If you pay two points, or $1,800, to borrow $90,000, you’ve really borrowed only $88,200. But you will pay back the full $90,000 face, value of the loan, plus interest. Paying points to a lender is a standard part of the mortgage business. One point is roughly equivalent to an additional one-eighth of one percentage point on the interest rate of a 30-year fixed-rate mortgage; so the APR of a 7%, 30-year fixed-rate mortgage with no points is equivalent to the APR of a 6.75% loan with two points.
In addition to points, lenders may charge an “origination” fee, usually calculated as 1% of the loan amount. Don’t confuse the origination fee with the separate loan application fees you’ll pay to cover paperwork and loan approval. Application fees are not tax-deductible, but an origination fee is a charge for the use of borrowed money and, as such, is deductible.
Types of Loans
With a fixed-rate mortgage loan, the interest rate stays the same and your monthly mortgage payment amount does not change. No surprises, no uncertainty, and no anxiety for you over interest-rate changes and changes in your monthly payment. Your mortgage interest rate and monthly payment remain locked for the life of the loan. The most common long-term mortgage loans last twenty or thirty years. Predictability is the big plus. You know exactly how much interest you will pay over the term of the loan. payment of principal and interest is fixed, and in early years it consists primarily of tax-deductible interest. Mortgages without prepayment penalties permit you to shorten the term of the loan at will, and lower ultimate interest costs, by making periodic payments against principal. Stability comes at a price. Interest rates on fixed-rate loans are usually higher than starting rates on adjustable-rate loans.
On the other hand, adjustable-rate mortgage loans (ARM for short) have an interest rate that varies (or adjusts). The interest rate on an ARM typically adjusts every six to twelve months, but it may change as frequently as every month. As we discuss later in this chapter, the interest rate on an ARM is primarily determined by what’s happening overall to interest rates. If interest rates are generally on the rise, odds are that your ARM will experience increasing rates, thus increasing the size of your mortgage payment. Conversely, when interest rates fall, ARM interest rates and payments generally fall.
If only the world were so simple that only pure fixed-rate and pure adjustable-rate loans were available. But one of the rewards of living in a capitalistic society is that you often have no shortage of choices. Hybrid loans start out like a fixed-rate loan – the initial rate may be fixed for 3, 5, 7, or even 10 years – and then the loan converts into an ARM, usually adjusting every 6 to 12 months thereafter. Loans called 7/23s (which are fixed for the first seven years and then have a one-time adjustment and remain at a fixed rate for the remaining length of the loan term) are also available.
So how do you choose whether to take a fixed-rate or an adjustable-rate loan? As with many things in life that give you choices, trade offs and pros-and-cons apply to each option. In this section, we talk you through the pros-and-cons of your mortgage options; but as we do, please keep one very important fact in mind: In the final analysis, which mortgage is best for you very much hinges upon your personal and financial situation. You are the one who is best-positioned to make the call as to whether a fixed or an adjustable loan better matches your situation and desires.
Fixed or Adjustable?
It stands to reason that, because the interest rate does not vary with a fixed-rate mortgage, the advantage of a fixed-rate mortgage is that you always know what your monthly payment is going to be. Thus, budgeting and planning the rest of your personal finances is easier. That’s the good news. The bad news is that you will pay a premium, in the form of a higher interest rate, to get a lender to commit to lending you money over many years at a fixed rate. The longer the mortgage lender agrees to accept a fixed interest rate, the more risk that lender is taking. In addition to paying a premium interest rate when you take the loan out, another potential drawback to fixed-rate loans is that, if interest rates fall significantly after you have your mortgage, you face the risk of being stranded with your costly mortgage. That could happen if (due to a deterioration in your financial situation or a decline in the value of your property) you do not qualify to refinance (get a new loan to replace the old). Even if you do qualify to refinance, doing so takes time and usually costs money for a new appraisal, loan fees, and title insurance. Another possible minor drawback to be aware of with some fixed-rate mortgages is if you sell your house before paying off your fixed-rate mortgage, your buyers probably won’t be able to assume that mortgage.
Fixed-rate mortgages aren’t your only option. Mortgage lenders were intelligent enough to realize that they couldn’t foresee interest rates, and thus were born adjustable-rate mortgages. Although some ARMs are more volatile than others, all are similar in that they fluctuate (or float) with the market level of interest rates. If the interest rate fluctuates, then so does your monthly payment. And therein lies the risk. Because a mortgage payment is likely to be a big monthly expense for you, an adjustable-rate mortgage that is adjusting upwards may wreak havoc with your budget. Why would anyone choose to accept an adjustable-rate mortgage? People who are stretching themselves, such as some first-time buyers or those trading up to a more expensive home, may financially force themselves into accepting adjustable-rate mortgages. Because an ARM starts out at a lower interest rate, such a mortgage enables you to qualify to borrow more. Just because you can qualify to borrow more doesn’t mean that you can afford to borrow that much, given your other financial goals and needs. Other homebuyers who can qualify for both an adjustable-rate and fixed-rate mortgage of the same size have a choice, and some choose the fluctuating adjustable. Why? Because they may very well save themselves money, in the form of smaller total interest charges, with an adjustable-rate loan instead of a fixed-rate loan. Because you accept the risk of a possible increase in interest rates, mortgage lenders cut you a little slack. The initial interest rate (also sometimes referred to as the teaser rate )on an adjustable should be less than the initial interest rate on a comparable fixed-rate loan. In fact, an ARM’s interest rate for the first year or two of the loan is generally lower than a fixed-rate mortgage. Another advantage of an ARM is that, if you purchase your home during a time of high interest rates, you can start paying your mortgage with the artificially depressed initial interest rate. If interest rates then decline, you can capture the benefits of lower rates without refinancing. Another situation when adjustable-rate loans have an advantage over their fixed-rate brethren is when interest rates decline and you don’t qualify to refinance your mortgage to reap the advantage of lower rates. The good news for homeowners who are unable to refinance and who have an ARM is that they probably already capture many of the benefits of the lower rates. With a fixed rate loan, you must refinance in order to realize the benefits of a decline in interest rates. The downside to an adjustable-rate loan is that, if interest rates in general rise, your loan’s interest and monthly payment will likely rise, too. During most time periods, if rates rise more than 1 or 2 percent and stay elevated, the adjustable-rate loan is likely to cost you more than a fixed-rate loan.
Words of Wisdom
Far too many homebuyers, especially first-timers, take out an adjustable-rate mortgage because doing so allows them to stretch and borrow more and buy a more expensive home. Over borrowing is also encouraged by some real estate and mortgage salespeople. After all, these salespeople’s income, in the form of a commission, is a function of the cost of the home that you buy and the size of the mortgage that you take on. If you’re at all considering an ARM, you absolutely, positively must understand what rising interest rates (and, therefore, a rising monthly mortgage payment) would do to your personal finances. Only consider taking an ARM if you can answer all of the following questions in the affirmative:
Is your monthly budget such that you can afford higher mortgage payments and still accomplish other financial goals that are important to you, such as saving for retirement?
Do you have an emergency reserve (equal to at least six months of living expenses) that you can tap into to make the potentially higher monthly mortgage payments?
Can you afford the highest possible monthly payment on the ARM? The mortgage lender can tell you the highest possible monthly mortgage payment which is the payment that you would owe if the interest rate on your ARM went to the lifetime interest-rate cap allowed on the loan.
If you are stretching to borrow near the maximum the lender allows or amount that will test the limits of your budget?
If you are fiscally positioned to take on the financial risks inherent to an adjustable-rate mortgage, by all means consider taking one – we’re not trying to talk you into a fixed-rate loan. The odds are with you to save money, in the form of lower interest charges and payments, with an ARM. Your interest rate starts lower (and stays lower, if the overall level of interest rates doesn’t change). Even if rates do go up, as they are sometimes prone to do, they will surely come back down. So, if you can stick with your ARM through times of high and low interest rates, you should still come out ahead. Also recognize that, although ARMs do carry the risk of a fluctuating interest rate, almost all adjustable-rate loans limit, or cap, the rise in the interest rate allowed on your loan. We certainly wouldn’t allow you take an ARM without caps. Typical caps are 2 percent per year and 6 percent over the life of the loan. (We cover ARM interest rate caps in detail later in this chapter.) Consider an adjustable-rate mortgage only if you’re financially and emotionally secure enough to handle the maximum possible payments over an extended period of time. ARMs work best for borrowers who take out smaller loans than they are qualified for or who are consistently saving more than 10 percent of their monthly income. If you do choose an ARM, make sure that you have a significant cash cushion that is accessible in the event that rates go up. Don’t take an adjustable just because the initially lower interest rate allows you to afford a more expensive home. Better to buy a home that you can afford with a fixed-rate mortgage. (And don’t forget hybrid loans if you want a loan with more payment stability but aren’t willing to pay the premium of a long-term, fixed-rate loan.)
How long do you expect to stay in your home? If you don’t plan or expect to stay in your home for a long time, you should consider an ARM. Saving money on interest charges for most ARMs is usually guaranteed in the first two to three years, because an ARM starts at a lower interest rate than a fixed-rate loan does. Should interest rates rise, however, you can end up paying more interest in subsequent years with the adjustable-rate loan. If you’re reasonably certain that you’ll hold onto your home for fewer than five years, you should come out ahead with an adjustable. As we explain earlier in this chapter, a mortgage lender takes more risk when lending money at a fixed rate of interest for many (15 to 30) years. Lenders charge you a premium, in the form of a higher interest rate than what the ARM starts at, for the interest-rate risk that they assume with a fixed-rate loan.
If you expect to hold onto your home and mortgage for a long time -more than five to seven years -a fixed-rate loan may make more sense, especially if you’re not in a position to withstand the fluctuating monthly payments that come with an ARM. If you don’t plan on keeping your home and mortgage for.
We believe that one of the most important first steps in the home buying process is to meet with a quality mortgage lender, discuss in depth your personal financial situation and to reach an agreement on your mortgage qualifications. If you are pre-qualified before house hunting, you are ahead of the game. Financial papers are at hand and up to date, and you know the general parameters (size and types) of mortgages for which you qualify. In addition to providing you with peace of mind, a letter of pre-qualification is an absolute must when you submit an offer on a property.
Click Here for our Mortgage Qualification Calculator to assist you in determining the amount of mortgage loan for which you may be qualified. Once you have determined whether or not you meet the standard lender front and back ratio guidelines, you must decide whether you qualify for a loan that is more than you want to pay. Make sure your loan payments leave you with enough money to meet other important needs such as college funding, saving and retirement goals.