Curious prospective home buyers sometimes turn to Internet-based
services just to see what current interest rates are. But
a faceless web site will not take the prospect’s future
financial planning into consideration or guide the potential
borrower through the many nuances of the loan process.
Below
is a brief explanation of the loan process.
Why
Buy
The financial benefits of owning
your residence versus renting are so extensive that I
almost always recommend the purchase of a home be one
of your top investment priorities.First, there are tax advantages to
owning your home. If you are like most people, you
will borrow most of the money needed to buy your home
and will make monthly mortgage payments to the lender
over a period of either fifteen or thirty years.
Each
mortgage payment consists of interest plus some principle.
Since the interest amount is based on the balance of
your loan, and each payment reduces your loan balance,
the interest portion of each successive payment decreases
slightly while the principle portion grows.
The interest portion of your loan payments
is generally tax-deductible, meaning that after tax savings
are considered, you can afford a substantially larger
mortgage payment than rent payment. For instance, if
you are in a 30 percent federal tax bracket, a $1,000
mortgage payment will cost about the same after taxes
as a $700 rent payment.
Conversely, a mortgage payment
will cost you less on an after-tax basis than a rent
payment of an identical amount.
Second, owning your residence increases
your net worth. The gap between your home's value and
your loan balance is called equity. This gap grows and
your equity builds as your home appreciates in value
and as your loan balance declines with each monthly payment.
Third, your mortgage payments remain
stable for the term of the loan, while rent payments
increase each year. Let me illustrate this with a personal
story. Shortly after graduating from college and living
on starvation wages, I rented a tiny one-bedroom apartment
for $315 per month.
At the same time, my parents, living
in a house they had purchased fifteen years earlier,
paid only $187 per month for a two-thousand square foot
house that sat on a one-acre lot. Somehow, this disparity
did not seem fair but such is the advantage of investing
in a home.
Lenders
So, where do you go to obtain
the best deal on a mortgage? There are three
main types of lenders that vie for your loan business—banks,
mortgage bankers, and mortgage brokers. In the old
days, banks generally made mortgage loans and held
the paper, meaning they loaned money from their own
portfolio, collected the payments, and profited from
the interest earned on the loans. That is no longer
the case, as most banks now act as mortgage bankers.
Mortgage bankers close the loan in their
own names, but instead of keeping the paper, they sell
the loan to a purchaser for a lump sum. The purchaser
is normally a government agency, such as Fannie Mae,
Ginnie Mae (GNMA) or Freddie Mac (FMAC), or an individual
investor.
The buyer pays the mortgage banker a fee to
service the loan, meaning they collect the payments and
keep all the records, but the buyer actually receives
the money.
Mortgage brokers are essentially marketing
organizations that match lenders with borrowers. The
lenders close the loans in their names and either hold
the paper or sell the loans. Mortgage brokers make money
from the fees they collect when the loan is closed and
may also make a premium if the interest rate on the loan
is higher than is generally available in the market.
From which of these three entities can
you generally get the best overall deal? Unfortunately,
there is no set answer, which is why you should compare
offers from each when shopping for a mortgage.
Fees
There are several fees involved
with a mortgage in addition to the monthly payments.
Almost all lenders charge an origination fee, usually
about 1 percent of the loan amount, to compensate them
for their efforts in processing the loan application
and closing the loan. This fee is considered part of
the closing costs and, especially for larger loans,
may be negotiable.
Other costs involved in the process
of closing the loan include the attorney's fees, a title
search (to confirm that the seller holds legitimate title
to the property), an appraisal of the property's value,
and other miscellaneous costs. All the closing costs,
including the origination fee, typically average slightly
around 3 percent of the loan amount, though this figure
may be lower for larger loans.
When shopping for a mortgage,
consider all the fees the lender charges as well as the
interest rate. If you plan to stay in the home for the
entire loan the lowest payment is generally your best
option.
Types
of Mortgages
There are three standard types
of mortgages available: Conventional, FHA
(Federal Housing Administration), Fannie Mae, Freddie
Mac and VA (Veteran's Administration—available
only to veterans of the armed services). The requirements
for a loan are similar among the three, but they differ
in their specific terms.
Conventional, or conforming mortgage
loans, require a minimum 5 percent down payment, though
some lenders will allow you to put less down in exchange
for a higher interest rate on the loan. If your down
payment is less than 20 percent of the loan amount, the
lender will tack on a fee for private mortgage insurance
(PMI), which protects them in the event that you default
on your loan. If you default, the lender will foreclose
on your loan and sell your property to recoup their money.
If your loan amount is less than 80 percent of the value
of your home, they should have no problem recovering
the full balance. Therefore, they are willing to drop
the PMI requirement if your loan-to-value ratio (LTV)
is less than 80 percent.
The premium for PMI varies based on
the size of your down payment. With the minimum 5 percent
down, the monthly PMI premium currently equals (.78 percent
x loan amount)/12. For example, on a $100,000 mortgage,
PMI would cost you $65 per month, or $780 per year. Obviously,
if you can avoid this extra cost by putting 20 percent
down, you are well-advised to do so.
If you cannot pay 20 percent down, you
can still avoid PMI with a 10 percent down payment using
a little-publicized technique. You obtain a first mortgage
for 80 percent of the home's purchase price and then
take out a second mortgage, called a piggyback loan,
for 10 percent of the purchase price.
The second mortgage
carries a slightly higher interest rate, but this combination
allows you to avoid the PMI requirement and saves you
money on your total payment. Recently, some lenders have
even begun offering piggyback loans of 15 percent, allowing
you to avoid PMI premiums with only a 5 percent down
payment. However, there are higher costs associated with
this arrangement.
The good news is that if you can only
afford 5 percent down and you pay PMI premiums, this
cost goes away as the equity in your home grows. When
the loan balance drops to 78 percent of the value of
your home, based on the lower of the purchase price or
the appraisal at the time of purchase, the lender is
required by law to drop the PMI.
If your house has appreciated
significantly since you purchased it, you may order an
appraisal and drop the PMI if your LTV has dropped to
80 percent or lower.
The standard
down payment for a FHA loan is only 3 percent. The
premium for FHA mortgage insurance, FHA's version of
PMI, currently consists of two pieces—an up-front
fee of one-and-a-half points (one point equals 1 percent
of the loan amount), which may be rolled into the loan,
plus a monthly premium of (.5 percent x mortgage amount)/12.
The monthly premium ceases once the LTV drops to 78
percent. FHA does not give you the option of obtaining
an appraisal and making an early request to drop the
PMI.
VA loans actually provide 100 percent
financing for a home. The VA funding fee is their equivalent
of PMI, but it is significantly cheaper.
How
Big of a Loan Can I Afford?
Very early in the process of deciding
what size house to buy, you must determine the largest
mortgage you can afford. Generally, for conventional
loans, lenders require that your total house payment
be no greater than 45 percent of your gross (pre-tax)
monthly income (GMI).
Your total monthly obligations,
including car payments and credit card minimum monthly
payments, must not exceed 45 percent of your GMI. FHA
allows your house payment to be as high as 33 percent
of your GMI, and your total monthly obligations can
reach as high as 43 percent.
However, you may not want to assume
the largest loan for which you can qualify. If you squeak
by the lender's requirements, your budget will be tight.
Are the subsequent sacrifices worth owning the largest
house you can afford?
Maybe, and maybe not. If your income
is relatively secure and rising steadily, it may be worth
stretching initially and growing into your mortgage,
especially for your first home. If you are a commission
salesperson and your income vacillates significantly,
I do not recommend buying the biggest house for which
you can qualify after a couple of exceptionally productive
years.
Paying
Your Mortgage Off Early
Many financial advisors teach
that you should pay your mortgage off as early as possible
by making an extra principle payment each month. The
justification is that you save a tremendous amount
of interest by doing so. While this is true, there
is a second side to this issue.
Extra money used to
pay your principle down becomes illiquid and cannot
be used for other investment endeavors that may offer
a higher return, such as investing in stock mutual
funds. This opportunity cost must be considered.
If you decide to pay off your mortgage
early, I suggest you do not make extra monthly principle
payments. While this does reduce your balance, it does
not reduce your monthly payment. If you experience financially
difficult times, the lender will not allow you to skip
a few payments just because you have accelerated the
reduction of your mortgage.
In fact, if the lender forecloses
on your loan, accelerating the payment of your mortgage
simply reduces the price at which the lender must sell
your house to recover their money.
Had you kept those
extra principle payments liquid, they would be available
to make your mortgage payments during lean times.Therefore, make extra principle payments
into a liquid investment, such as a mutual fund.
Pay
off your mortgage when the balance of this liquid account
equals the balance of your mortgage. By keeping the extra
principle payments liquid, you increase your financial
security, not the lender's.
The benefits of home ownership extend
well beyond the numbers. The extra responsibilities of
a home tend to mature us. Owning a home gives one a sense
of pride that renting does not yield. Do your homework,
and your home-buying experience can be a richly rewarding
experience, both personally and financially. |
Questions?
LendFast.com - Information on buying your first home
