Understanding Mortgage Financing

Types of Loans

With a fixed rate mortgage the interest rate and payments remain the same throughout the term of the loan. This offers you the advantage of knowing that the amount you owe each month will never change. However, the lender sets the interest rate on a fixed higher than that on an adjustable rate mortgage as protection against losing money. This increases monthly payments and may make it harder for you to qualify for a mortgage.

Adjustable Rate Mortgages (ARMs)
With this type of mortgage, the loan period is fixed but the interest rate varies as inflation and financial markets fluctuate. The adjustments in the interest rate on the loan are set at regular intervals, typically six months or one year. Often, these loans have a cap on how much the interest rate can be adjusted at each interval and how much it can vary over the term of the loan.

An ARM may also have a payment cap. This guarantees that the monthly payment will not change by more than a preset amount. If the interest rate rises to a point where the total interest per month is greater than the maximum payment permitted by the cap, the payment won't rise, but you still owe all the interest. The interest you do not pay is added to the principal of the loan, increasing the total amount you owe. This is called negative amortization.

Graduated Payment Mortgage

A variation on the fixed rate mortgage, this type of loan has a fixed interest rate and loan period. The payments, however, start low and increase over the first 5 to 10 years of the loan before becoming constant.

If you expect your income to rise significantly in the first few years after your home purchase, you should investigate the graduated payment option. Be warned: you may accumulate negative amortization if your low initial payments do not cover the interest on the mortgage. The total amount you owe may actually increase during the first couple of years!

Hybrid Mortgages

These combine the characteristics of fixed rate and adjustable rate mortgages. Some offer 3, 5, or 7-year fixed terms before reverting to an adjustable rate mortgage.

Loan Periods
Lenders offer a lower interest rate on a loan with a shorter period because they are less likely to lose money due to dramatic market fluctuations. The traditional loan is a 30-year fixed, but 20 and 15 year loans have become popular.

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Choosing a Loan Type

Pros and Cons
The fixed rate mortgage offers stability, but a higher payment. The adjustable has a lower initial payment and enables you to get a larger loan, but it's more risky because you can't predict how interest rates will fluctuate. If you are considering an ARM, ask the following:

(1) Will my income cover higher mortgage payments if interest rates go up?

(2) On what market variable is the loan rate dependent? How volatile is the variable?

(3) How long do I plan to own this home? If you intend to keep it only a few years, the ARM is a good bet because the interest rate can't increase much in a short period. If you plan to stay 10 to 20 years, the fixed rate may be the better option.

Financial Ramifications of the Loan
Ask the lender or mortgage broker to project your financial commitments over the full life of the loan. You need to know your monthly payment, the rate of interest and the total amount of the loan for each type. If you are considering an ARM, ask the lender to project the worst case, with the highest interest rate permitted by the cap and any increase in the principal due to negative amortization.

Sometimes, lenders use financial terms confusing to the layman. Just keep asking questions until you understand. Ask the lender to explain it in plain English. You have every right to do this. Federal law requires lenders to give you this information.

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Alternative Sources of Financing

Assuming a Loan
Sometimes you can get part of your financing by assuming the seller's current loan. You take over the seller's payments. The lender usually requires only a credit report and, perhaps, an administrative fee of a few hundred dollars.

This option is much simpler and less expensive than applying for a loan for all or most of the purchase price of the home. In order to buy the home, you have to make up the difference between the selling price and remaining principal on the seller's loan. You may have to take out a second mortgage on the home. Most lenders look favorably on this situation.

Warnings:
1) As a rule, fixed rate mortgages are not assumable. Banks don't want to continue to be locked into a low rate.

2) If you assume an ARM with interest at the current market rate (the more common case), you will not benefit from the initially low teaser rate many ARMs feature. This may make assuming the seller's mortgage less attractive than getting a new loan.

Seller Financing
The seller may be willing to make you a loan if he or she

1) Owes little or nothing on the home and the loan provides steady income.

2) Considers ownership of the home an investment rather than the source of the large lump sum of usable cash.

3) Is eager to sell and wants to expedite the transaction.
In the case of a new home, the seller is the developer. Developers frequently offer attractive financing to sell homes quickly.

Friends and Family
Perhaps someone you know could be persuaded to make you an outright gift or loan to help you pay for your home. A loan offers advantages to both parties. The friend or relative can usually earn higher interest than on a savings or money market account. You would pay less interest than to a commercial lender.

Make sure the terms and conditions of the loan are clear to both sides. Put them in writing in the form of a letter of agreement, signed by both parties, stipulating:

(1) The amount of the loan

(2) The interest rate, if any

(3) The total amount including interest

(4) The payback schedule.

If the interest rate is significantly lower than the current rate you may be required to report the difference as a gift (and pay taxes on it). Have a real estate or tax attorney look over the paper work before you finalize the agreement.

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Lending Policies

In order to communicate with a lender, you should familiarize yourself with the following terms.

Initial Fees
There are two types of intitial fees you can expect:

1) Loan fees or points: A point is a fee imposed by the lender equal to one percent of the loan amount. If the loan is $100,000 and the lender charges 1.5 points, this represents a charge of $1,500.

2) Processing or origination fees: These cover the administrative costs of processing the loan. These charges vary from lender to lender. Ask what they will be.

Mortgage Payment
This is what you owe the bank each month toward repayment of your loan. The amount is determined by the terms of your loan: principal, interest rate, length of the loan, and periodic adjustments, if any.

Prepayment Penalty
If your financial situation changes, you may want to pay off your loan before the due date. Because some lenders rely on interest payments over a long period to make a profit, they may charge you a penalty fee.

Lock-in
If interest rates are rising quickly at the time you apply for a loan, you should ask about a lock-in. If the rate rises while your loan is in process, the resulting increases in interest and total loan amount may kill your chances of approval.

A lock-in agreement specifies that the rate quoted at the time of application remains in effect for a certain period. Since the loan process can be lengthy, ask for a 60-day lock-in. Some lenders charge a small fee for locking in an interest rate.

Foreclosure
Until you repay your loan in full, a financial institution has a claim to your house. If you fail to make your payments, the lender forecloses or takes ownership of your home, selling it to try to recoup money lost on the bad loan.

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Mortgage Insurance

If you cannot make a down payment of at least 20% of the purchase price or appraised value of the house (whichever is less), you will need mortgage insurance. The insurance is additional protection for the lender, guaranteeing compensation if you fail to repay the loan.

There are three main types of mortgage insurance:

1. Veterans Administration (VA)
VA insured loans are available to military veterans and certain other government workers for a 1% fee. If you qualify, you can get a loan with no money down. However, lenders are unlikely to make very large loans since they are guaranteed reimbursement only up to $36,000.

To apply for a VA loan, you need a "Certificate of Eligibility", available from the local VA office. For more information, contact the VA office in the Federal Government listings in your phone book.

2. Federal Housing Administration (FHA)
Under FHA insurance, anyone can obtain financing with less than 5% down. This is an attractive proposition for first time home buyers. If you are interested in this option, check with your lender. Some lenders will not work with FHA loans because of the tremendous paperwork required by the government.

The maximum loan amounts FHA insurance will cover are geared to the prevailing values in an area but typically do not exceed $125,000. Borrowers must pay a one-time insurance premium of 3.8% of the loan total. This can be paid at closing or added to the amount of the loan.

3. Private Mortgage Insurance (PMI)
Borrowers can get a loan with as little as 5% down through PMI. There is no limit on the amount of the mortgage.

The premium varies from .3% to 1.2% at settlement and .3% to .55% a year thereafter. The rate depends on the size of the down payment and the type of mortgage. The more you put down, the lower the premium. The charge is lower for a fixed rate mortgage than for an adjustable rate mortgage. As an alternative to paying monthly premiums, you can paythe entire fee in a lump sum payment. This amount can also be financed.

Once the amount due on your loan has dropped below 80% of the purchase price or appraised value (whichever is less), you no longer pay premiums. You must tell your lender and insurance provider this has occurred. They do not automatically stop requiring payments.

Your loan officer can provide additional information about private mortgage insurance

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Tax Information

Buying a home offers considerable tax advantages. This is a major factor in the decision to purchase, as illustrated in the Rent vs. Buy Analysis.

Deductions
As a homeowner, you can deduct the following items from your taxable income:

Mortgage Interest: Since most of your mortgage payments during the first few years goes toward interest, this is usually a substantial deduction.

Points: The amount paid to the lender in percentage points in the year of purchase can be deducted as long as the amount is normal for the area and the loan is to purchase rather than re-finance.

Property Tax: Tax assessed against a property by local governments. One of the four basic monthly housing costs (PITI).

Home Improvement Loan Interest: If you take out a loan for improvements on your home, you can deduct the interest paid. Deduction for points must be spread over the life of the loan.

Home Equity Loan Interest: If you use your home as collateral for a loan, you can deduct the interest paid.

Depreciation: If you rent part of your home or use it for business purposes, you may be able to deduct the depreciation value.

You must itemize these deductions, using Schedule A of Form 1040. You also need to file Form W-9 to allow the lending institution to report interest received to the IRS. For the latest information on tax regulations, forms and specific circumstances, contact a CPA, tax attorney, or your local IRS office.

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