Getting A Mortgage
Nearly everyone who buys a home finances the purchase by obtaining a mortgage. Generally, mortgages fall into one of two categories; fixed rate or adjustable rate mortgages. However, in recent years a number of other kinds of mortgages have become available, which we will also discuss.
With a fixed rate mortgage, you repay the lender in equal monthly installments of principal and interest over a specified period. Most fixed rate mortgages are for 15 or 30 years, but there are some 20 year mortgages, and a few lenders even offer 40 year repayment periods. Keep in mind that the longer the life of the loan, the smaller your monthly payment will be, but you will end up paying much more in total. The shorter the term of the loan, the higher the monthly payment, but you'll have paid less interest overall by the end of the loan.
An adjustable rate mortgage, (also called an "ARM") has a variable interest rate which changes on a regular schedule set by your lender. In most cases, an ARM's interest rate can be changed annually, although some lenders offer six month, three year, and five year ARMs as well. Unlike a conventional mortgage, which sets out the monthly repayment for the life of the loan, the payment schedule of an ARM fluctuates with changes in market interest rates. When interest rates go up, your payment will increase; when they decrease, so does your payment.
Generally, the initial interest rate for an ARM is two or three percentage points lower than for a fixed rate mortgage. You get this lower rate in return for assuming the risk that interest rates will rise and that you will end up paying more in the future. In the early 1990s however, as interest rates declined, home owners with ARMs actually saw their payments drop, in some cases pretty significantly. For these buyers, the ARM allowed them to save additional thousands of dollars on the purchase of their homes.
Even when interest rates rise, most ARMs limit the amount of any annual increase, and place a lifetime cap on the total increase in interest you can be charged. But be careful, because some ARMs provide for what's known as "negative amortization." What this means is that if interest rates rise by 4 percent and the annual cap on your ARM is 2 percent, the additional 2 percent increase is added to the balance of your loan as principal.
A few years of negative amortization and you can end up owing a fairly big balance at what you thought was the end of your loan. That may mean making a lump sum payment to the lender, or even obtaining a new mortgage loan. It's best to avoid ARMs that contain negative amortization provisions, no matter how attractive the initial interest rate may be.
Lenders use a number of methods to calculate changes in the interest rates of an ARM. Most financial experts suggest you try to get an ARM that links changes in interest to the rate paid on one year U.S. Treasury securities. ARMs linked to this index seem to average a lower total cost than those tied to other kinds of indexes.
Other kinds of mortgages that combine the features of fixed rate and adjustable rate mortgages are also available. A Graduated Payment Mortgage (GPM) starts out with a relatively small initial payment, which increases each year for a five or ten year period. At the end of this period, you continue to pay a fixed payment with no further increases until the mortgage balance is paid off.
With a so-called "7-23 mortgage" you pay a fixed interest rate for the first seven years of the loan. At the end of the seven year period, there's a one-time adjustment to the interest rate, which you then pay for the remaining 23 years of the loan.
No matter what kind of mortgage you decide on, you'll have to complete a mortgage application provided by your lender. In most cases, this is a standard form designed by the Federal National Mortgage Association (FNMA), popularly referred to as Fannie Mae. The FNMA buys mortgages and then issues securities to investors which are backed by the mortgages, so it wants to be sure that lenders get detailed financial information about borrowers before making a lending decision.
To complete the application form, you'll need to provide detailed information about your current employment and income, as well as your past employment history. If you're self-employed, plan on providing copies of income tax returns and profit and loss statements covering the last three years of your self-employment. You'll be asked about your credit history, including your outstanding credit card debts, student loans, and other obligations, such as alimony and child support. You'll be asked whether there are any unpaid liens or court judgments against you or your property, and whether you've ever declared bankruptcy.
You will also need to disclose how much you have for a down payment, and show where the down payment will come from. If you plan on borrowing some of the down payment from family members, be warned that doing so could disqualify you from receiving a mortgage. This is one case where receiving money as a gift really works in your favor, although the person making the gift will probably need to complete a form acknowledging that the money is a gift and not a loan.
Mortgage lenders are allowed to charge an upfront application fee which usually amounts to several hundred dollars, as well as what's called a loan origination fee, typically one percent of the amount you've applied to borrow. You will also be expected to pay for a credit report, but this fee is usually paid at closing.
If your application is approved, you will receive what is known as a loan commitment letter. This letter will tell you how much the lender will agree to let you borrow, and at what interest rate. It will also contain an expiration date, so if you don't follow through on the purchase within the period of time allotted, you may have to requalify. You should also receive a preliminary Truth-in-Lending Statement, setting out all the costs associated with the loan and the total amount you will pay over the life of the loan. Keep in mind that this is an estimate only and could change if you need to borrow more or if interest rates change; the exact amounts will be provided at closing.
Most lenders will require at least a 10 percent down payment before they will offer to make a loan. And even then you may be required to purchase private mortgage insurance to guarantee payment of your loan if your down payment is less than 20 percent. However, there are several government sponsored programs designed to help you obtain a mortgage when you have little money for a down payment.
The Federal Housing Administration (FHA) insures lenders for up to 95 percent of the value of a home, so with an FHA guaranteed loan you need only make a five percent down payment. And qualified veterans can obtain a guarantee from the Department of Veterans Affairs which will allow them to buy a home worth as much as $203,000 with no down payment at all. Your mortgage lender can provide details and applications for either of these programs.
Obtaining a mortgage is a time consuming and stress inducing process, but on the positive side, mortgage interest is still deductible on your federal income tax return, up to $1 million.