Chapter 13 – Mortgages

So, you’ve decided that it’s time to buy a home? Wonderful! Let’s talk about how you actually make the leap and buy a home.

The buying process

1. You first step is to assess your credit situation by reviewing your credit report and credit score. This is important because it will help you estimate what kind of interest rate you can get. The interest rate affects how much your mortgage will cost. You will need to have a good estimate of the interest rate that you can qualify for in order to perform the affordability math skill.

2. Next, you must determine the monthly mortgage cost that fits into your budget. Most experts recommend that your mortgage payment should be no more than 30% of your gross income. However, you should look at your budget for yourself. You may be able to afford more or less than this depending on your situation. When in doubt, guess low! Once you know the monthly payment that fits your budget, you can then calculate how much you can afford to borrow using the affordability skill.

3. Get prequalified for the best mortgage possible. You should approach several different lenders to find the one that will offer you the best loan terms. The lender will tell you how much they are willing to lend to you. Prequalifying also helps you as a buyer because it makes sellers more confident that you can actually pay the amount that you offer.

It is important for you to determine for yourself what you can afford before you approach a bank. Bank’s don’t consider how comfortable you will be paying the mortgage when they prequalify your loan. Their objective is to lend you as much money as they think you can afford to pay, regardless of whether or not you will be happy with the payment! If you decide for yourself how much you can afford, then you won’t be in danger of overbuying.

4. Consider if you want to use a real estate agent. Real estate agents charge a fee that is generally about 6% of the sales price of the house. This fee is generally paid by the seller, although almost anything can be negotiated. Real estate agents are very helpful for helping you make sure everything gets done correctly. Their deep knowledge of the local area can be tremendously helpful as well.

However, research suggests that most real estate agents are not effective at getting a better price for their clients. You may not need a real estate agent if you feel confident in doing the paperwork yourself and are well acquainted with the area. You may also wish to consider hiring a low-cost housing broker to perform the transaction to help with paperwork.

5. Search for your home. Be sure to list out everything you want from your home. Be certain to distinguish your needs from your wants. No home is perfect, no matter how large your budget. The "dream home" and "forever home' doesn't exist. All homes have problems and shortcomings, no matter how much you pay for them. Be realistic as you shop. You will need to make trade-offs in the features of the house. Be prepared to sacrifice some of your wants to ensure you get everything you need.

You should also be sure to have the home inspected. No inspection cannot find every possible problem the home might have, but it can be effective at identifying many potential problems.

6. Once you find the house you want, you make a written offer. This offer is a contract; if the seller accepts it then you are obligated to purchase the property according to the terms you offered. If the seller doesn’t like your terms, then they may respond with a counter-offer. Offers are exchanged back and forth until either both parties agree on the terms or either party decides to walk away.

7. Both the buyers and sellers sign the purchase agreement when they have settled on a sales price. At this point, the buyer pays makes a deposit called “earnest money”. This earnest money is intended to help assure that the buyer does not back out of the purchase agreement. The earnest money is held in escrow by a third-party until the deal either is completed or falls through. If the deal is completed, then the earnest money gets applied to the buyer’s closing costs. If the buyer backs out, then the escrow company sends the earnest money to the seller.

8. You can finalize the purchase of the home after the purchase agreement is signed and the earnest money is paid. It is at this point that your lender processes your loan request and you find insurance for the home.

Closing Costs

When it comes time to close the loan, you will face a number of costs. Closing costs are expenses that the borrower pays at the time of purchase. These fees come from the cost of setting up the mortgage. Closing costs typically include application and origination fees, points, title search and upfront insurance costs, and other fees, such as attorney, survey, appraisal, recording/filing, notary, inspections (termite, radon, etc.), and credit reports. These costs, when combined in total, can range from 2%-10% of the loan amount of the home.

Closing costs usually apply to every mortgage that is taken out, even if it a refinancing mortgage.

The largest of cost at closing is the down payment. The down payment is money that you put towards the purchase price of the home. Every dollar you put towards the down payment is a dollar less than you have to borrow.

Most lenders generally require a loan to value ratio of 80%. This means that you have to have contributed 20% of the sales price as your down payment. The loan to value ratio is a standard ratio that can be calculated by dividing the loan amount by the purchase price of the home. It represents the percent of your house that you owe money on. Your lender will require you to buy mortgage insurance, called PMI insurance, if you do not have at least a 20% down payment. This is insurance that protects the lender, not the borrower. The cost of this insurance is usually .25-2.0% of the loan value. If you do get PMI on your mortgage, make sure you keep track and ask for it to be removed when you have an LTV of 80%. You can also often get rid of PMI by refinancing the house several years after purchase.

If you purchased any points you will have to pay those at closing as well. A point is simply a fee that you pay upfront in order to get a lower interest rate on the loan. A point costs 1% of the loan amount. For example, your lender may tell you that your interest rate will be 8%, but if you buy two points, your interest rate will only be 7%. If you are borrowing 148,000 from the bank, then each point cost 1% of that loan amount, or $1,480. So two points will cost 2% of the loan amount, or $2,960.

The Monthly Payment

Every payment that is made each month on the house consists of four components. These components can be remembered by the acronym P.I.T.I. The P and the I stand for principle and interest. These two comprise the mortgage payment as calculated by time value of money calculations. Your calculator will tell you principal and interest when you solve for PMT. These two components go to the lender to repay your mortgage.

The T and the I stand for taxes and insurance. These are collected by your lender as part of your monthly payment. A third-party will hold this money in escrow on your behalf. The escrow company will automatically pay your annual property taxes and property insurance premiums when they come due. They do this using the money you send them each month as part of your regular monthly payment.

The key to remember is that the house will cost significantly more per month than just what you have to pay on the loan. First-time home buyers often fall into the trap of realizing that they can afford the loan payment, but then failing to recognize that the taxes and interest that are also part of their monthly payment is more expensive than they realized. Be sure to consider how much your property taxes and insurance will be before deciding to buy a house!

Types of Mortgages

There are several different varieties of mortgage. The great majority of mortgages are either fixed rate mortgages or variable rate mortgages.

The most common type of mortgage is a fixed rate mortgage. These mortgages have an interest rate, term and payment that does not change for the term of the loan. Be aware that although the principal and interest payments will not change over time, the taxes and insurance can and most likely will change over time. This means that the amount you pay each month is likely to fluctuate each year, but it's usually only by a few dollars. Fixed rate mortgages are typically offered in 15 to 30 year terms.

Adjustable rate mortgages (often abbreviated as ARM) have an interest rate that can fluctuate over the life of the loan. The biggest advantage of an ARM is that you can get a lower interest rate compared to fixed rate mortgages. The biggest disadvantage is that you could land in big trouble if interest rates increase in the future because this will cause your payment to increase. Changes in the interest rate could easily make them payment unaffordable. This type of mortgage is only suitable if you have a good bit of flexibility in your budget or if you plan to move relatively soon.

Adjustable rate mortgages sometimes come with payment cap that prevent the payment from rising above a certain level. For example, the mortgage may allow the interest rate to change every 3 years (called a 3/1 ARM), but the principal and interest payment cannot exceed $1,500 per month.

Borrowers see these caps as benefits, but they can actually be very dangerous. If the interest rate rises enough to push the payment above the payment cap, then the loan falls into a condition called negative amortization, and the balance of the loan begins to RISE instead of falling like normal. This condition is extremely hazardous to the borrower’s financial health and should be avoided if at all possible!

This is an excellent time to watch Lecture 8 from the course pack!

Definitions:

Prequalified: being approved for a mortgage before you begin shopping

Earnest money: money intended to help assure that the buyer does not back out of the purchase agreement

PMI insurance: given you are not able to afford the down payment, you must buy insurance to secure the loan

Point: a fee that you pay upfront in order to get a lower interest rate on the loan, due at closing

Closing costs: expenses that the borrower pays at the time of purchase that can range from 2-10% of the loan amount of the home

P.I.T.I.: principal, interest, taxes and insurance. P and I are the two components of a monthly mortgage payment. T and I are held in an escrow and used to pay your taxes and insurance premiums when they come due

Fixed rate mortgage: mortgages having an interest rate, term and payment that is fixed for the term of the loan

Adjustable rate mortgage: mortgages that have an interest rate that can change over the life of the loan

Negative amortization: when the loan payment is less than the interest charged, the loan balance begins to increase over time