Financing

How much house can I buy?

Let us first distinguish "can" from "should".  The fact that you could buy a $900,000 home doesn't mean that you should. Consider your lifestyle, your priorities, the space you really need vs the maintenance that will be required.  How often will you realistically have visitors?  Will you use the pool, spa and gym at the clubhouse, or do you need your own?  Instead of paying additional interest in a mortgage, would you rather be saving or investing?  Even though Real Estate tends appreciate as well or better than most investments in the long run, there are no guarantees, and real estate is not a liquid investment.

At the same time, assess your finances, and decide if it's the right time to buy.  Is it likely you will need to move again soon?  Are you considering a career change?  Do you need to keep a safety net in cash in case something happens?  Does renting keep you more nimble, at a time you need to be?  Would it be better to save a bit more for a bigger downpayment and avoid paying PMI?  Will your credit rating look significantly better a year from now, that you'd get better rates and conditions?  Are home prices likely to turn soon?     

Once you form a clear picture in your mind, there are many online tools for assessing your purchase power, and how much to budget for your downpayment and monthly mortgage payments.  These tools emulate a similar analysis that banks will do when approving your mortgage application. 

Many banks use the "28%/36% rule" as one of their criteria for approving loans.  That means limiting your home expenses (mortgage, insurance, property taxes) to 28% of your income, and limiting your total debt repayments (including car lease, school loans, and credit cards to 36% of your income.  

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Do I need a mortgage pre-approval letter?

Yes.  Unless you are paying for your home in cash or have another source of financing that doesn't involve a mortgage, you will be expected to present a mortgage pre-approval letter when you make an offer on a house.  This is because the binding Sale Agreement you will prepare is likely to have a clause making the transaction contingent on you securing financing.  If you make an earnest effort and fail to attain a mortgage, you will likely be able to walk away from the purchase and receive your security deposit back.  The seller would have to relist the property, re-stage it, and go through the showings, offers, and paperwork.  Having to relist the home is a hassle sellers want to avoid.  A mortgage pre-approval letter, from a reputable lending organization, is not a full guarantee, but it is a good source of confidence for the seller, which may tilt their decision towards you in a bidding contest with similar offers.

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Is a pre-approval the same as pre-qualification?

It is not.  A pre-approval letter results from an actual analysis of your finances and credit history; they will verify your information and ask for support documentation.  A pre-qualification has less scrutiny, the bank is saying that based on what you stated about your finances, you may qualify for a loan up to a certain amount.  An informed seller or one assisted by an agent will know the difference, and the pre-approval letter will be far more meaningful for the seller.

Neither the pre-approval nor the pre-qualification, however, absolutely guarantee that you will receive the loan.  Once you actually apply for the mortgage, there will be further investigation into your finances, and things may also have changed that will affect the lender's decision. 

Once you start the process of applying for a loan, avoid any new events that can affect your credit: this is not the time to buy a new car, open a new line of credit, lease a new office, apply for a new credit card, finance new appliances, or buy a boat.  All of these events will trigger a reexamination of your approval, and if you had been pre-approved by a thin margin, you could be at risk.  If possible, delay your job change. Lenders, right or wrong, trust jobs that were held for longer.  A new divorce will also likely have a significant impact on the lending decision.   

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How do I get pre-approved?

Start early.  Don't wait until you find the home you want. 

If you have a good credit history and reliable financial conditions, you may go online to one of the big lenders' websites and apply there for pre-approval.  Their advantage in being big is that they are fast and can usually get your pre-approval processed within 24 hours, often only minutes.  At this point you are not yet shopping for rates and conditions, you will do that later, when you found your desired house, signed a contract, and are ready to actually apply for the loan.  Some of these sites are: Rocket Mortgage, Better, Bank of America, Wells Fargo, Chase, and Citibank.​

If you have concerns about your credit, you may still apply for pre-approval with one of the big lenders, but you may also want to consider contacting a mortgage broker. Your agent can refer you to one.  Mortgage brokers know which institutions may be suitable for your credit profile, and will help you better understand options like FHA and VA Loans, PMI, and sub-prime lending.  Most mortgage brokers will not charge you directly; they receive a commission from the mortgage originator, which is the bank that will lend to you.  This may also mean that they might be motivated to direct you towards the bank that pays a larger commission, not necessarily the one that offers the best rates to you.  Remember, this is an involved process, you can't delegate and be hands-off. 

 

Also note: applying for pre-approval may have a small impact on your credit rate, between zero and five points, depending on how the institution reviews your credit information.  If you apply too many times, it may add up.

Start by gathering and scanning (you can use your phone) the following information:

-  Valid government-issued photo id, like a driver's license or passport, possibly both.

-  Social Security card.

-  Last two paystubs.

-  Last two W2s.

-  Last bank statement from all your banks, checking, savings and investments.  

-  Rent information and payment records.

-  List of debts: car lease, student loan, mortgage, credit card debt, home insurance, medical bills etc.

-  Deed to your current home, if you own it.  

-  Last mortgage statement and insurance policy.

-  Documents from any other source of income: rental property, independent work etc.

They will also ask for your permission to access your credit report. 

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Do I need to stay with the lender where I was pre-approved?

No.  Being pre-approved or even locking a rate doesn't mean that you must marry that lender.  After the seller accepts your offer, you will have some time to shop around.  If your contract allows you 30 days to secure financing, you may spend the first few days researching rates and conditions, with or without a mortgage broker.  The concept you need to learn is APR - Annual Percent Rate:  Because different banks charge different fees and points to originate your mortgage, it is difficult to compare what they are offering based on the interest rate alone, so, in 1968 Congress passed the TILA bill, requiring banks to publish a rate that adds to the interest rate all other fees they will be charging you, so to make their rates comparable.  When you compare the rates offered by the banks for your mortgage, make sure to compare the APR, not just the interest rates.

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What does it mean to "lock the rate"?

It means that you have agreed that, as long as you close within the timeframe in the rate lock document, and there are no changes to your credit or mortgage application,  the bank will lend to you at that rate, no matter what happens in the financial market until then. 

Locking a rate also indicates to the lender that you intend to proceed with the mortgage with them, and they will continue to act on your application.  

At this point, you may still back out of the mortgage after locking the rate, if, let's say you decided to run two mortgage processes in parallel, but, it may cost you.  The lender may charge you for incurred costs in preparing the mortgage, such as title search and appraisal fees.  Think of the rate lock as a serious commitment, which it is, for that rate will be with you for many years.  Think it through before you agree on the lock, because changing it later may be a pain, will probably require a new lender and may cause delays in your closing.

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Fixed Rate or Variable Rate?

If you follow the economy closely and you are expecting the FED to drive important changes in the financial market's interest rates, this is something you may be inclined to pay special attention to.  An adjustable-rate mortgage - ARM loan will allow your interest rate to vary, typically every year, after a fixed rate period.  When you see a 4/1 ARM, it means that the rate will be fixed for four years, then it will be adjusted yearly.  ARM mortgages often have year-over-year and lifetime caps on how much rates may go up.

It is a gamble, it may very well pay off for you, but there's no way of predicting the direction of interest rates in a 30-year mortgage.  If the rates are historically low or high, you may make an educated guess, but it's still a gamble in the long run.  The major risk is that you may end up with a rate significantly higher than the one that was available for a fixed-rate mortgage, and your monthly payments may become much larger than you budgeted for.  To make it a tempting decision, banks often offer initial ARM rates lower than fixed rates.

One scenario where the ARM could be a sound decision is when you know, for certain, you will only need the Mortgage for a short period, but, even then, you never know what may change in your life, or you may find yourself in a real estate market where you can't or don't want to sell your house, and you are stuck with rising interest rates.

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Should I buy Points?

Rule of thumb, points become worthwhile when you plan to keep the mortgage for 7 years or more.  

Let's break it down:  rate points (for reducing interest rates) are different from origination points (which is a fee they are charging for creating the loan), so when the bank tells you that you are getting a 6% rate with 1 point, you need to ask two questions: a) is it an origination point, or a rate point, and b) is that point required by the bank; do I have to pay it? 

They call it a point, because each "point" costs you 1% (one point) of the loan amount, but the interest rate point only reduces the interest rates by 0.25%, or 1/4 of an interest rate percent point.  In simplified math, one rate point on a $400,000 mortgage will cost $4,000, but will only save you about $50 per month.  We remind you to compare the APR, when comparing rates between mortgage offers from the banks.

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What about interest-only mortgages?

Let's first explain what they are: they are usually ARM - adjustable rate mortgage loans where you are only required or may have the option to pay only interests, not the principal, for an initial period, typically of five to ten years.  These loans were surrounded by controversy, having been a contributing factor during the 2008 housing market crash that culminated in 10 Million foreclosures and hundreds of thousands of personal bankruptcies.  Despite efforts to ban these loans, they remain legal and available.

The proposed benefits of these loans are that they allow for a low interest-only payment, often paired with a low introductory interest rate, along with the flexibility of paying as much as you want for the principal during the interest-only period.

Most times, the interest-only payment is a lower amount than you would pay for rent for equivalent housing, so you may think: what do I have to lose?  In fact, the answer is quite a lot.  

You will need to make a down payment of at least 15% of the home value.  Many banks require down payments in the 20-30% for these types of loans, or a PMI.  PMI for ARMs are more expensive, and because you are not paying the Principal, you are likely to be paying PMI for a very long time, until you amortize the principal down to 80% of the property value. 

Let's look at a nightmare, yet plausible scenario:  Imagine that you bought a $400,000 house for which you got an interest-only mortgage that required a $100,000 downpayment, and $300,000 was financed.  5 years later, you haven't paid for any principal but the housing market took a very sour turn, and your home lost 25% of its value, and now, you owe 100% of the $300,000 home value to the bank.   At year 6, the principal payments kick in, almost doubling your monthly mortgage payments.  Your spouse lost their job, and you can't afford the mortgage payments by yourself, and you don't qualify for a refinance.  All possible options are pretty bad:

- If you default on the mortgage, you will be foreclosed, and will not have the option to wait until home prices go back up.

- If you sell your home, after closing costs, you will not have enough to fully pay the bank.

- Whether foreclose or sale, if it comes short, the bank may sue you for the remainder of the debt.

- In all scenarios, you would lose everything you put into the home: the $100,000 downpayment, the closing costs, all interests paid, as well as property taxes, repairs, improvements, insurance etc; the sum of which will likely exceed what you would have paid in rent for a similar setting for the same period.

One aspect that makes these types of loans dangerous is that they allow you to buy a house that is much more expensive than the house you would have been able to buy with a regular mortgage. 

So, while there are scenarios where interest-only mortgages may work to your advantage, allowing you to buy the house you want while having the discipline of saving, diligently making voluntary principal payments, and getting salary increases along the way, some of us find these types of loans simply too risky to recommend.

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What is PMI?

Most mortgage lenders will only finance up to 80% of the value of the house, to reduce their risk, in case your home devalues and to make up for the costs they will incur if they foreclose you.  For those who are unable to come up with the necessary cash to pay upfront, there is insurance that covers the bank's mortgage risk up to a certain percentage of the mortgage, called Private Mortgage Insurance - PMI.  

PMI is an insurance premium, paid monthly, typically through the escrow that your mortgage lender manages for you.  The amount you pay for the premium will depend on the loan-to-value ratio (the size of the downpayment) and on your credit rating.  You may request to stop paying PMI once you've paid enough of your mortgage to reach 20% equity, or the payments will stop automatically when you reach 22%.

For those with bad credit scores but a reliable source of income and a history of paying their debts, and who can only afford as little as a 3.5% downpayment,  there is another option: mortgage insurance by the Federal Housing Administration - FHA.

It works similarly to private PMI insurance but for two major factors: part of the FHA insurance must be paid upfront (can be rolled into your mortgage) and for low down payments your FHA mortgage insurance stays for the life of the loan, no matter how much equity you built.  The only way to get rid of it is by refinancing the mortgage.  So, to be clear, the FHA does not lend you money, it insures your mortgage, which is originated by a regular bank.  To be insurable by the FHA, the Mortgage has to conform to some contractual rules, so most loan contracts are written to conform with them anyway, and there is a cap on the size of the mortgage FHA insures.  

Finally, if you served America in one of our Armed Forces,  you have the option of a Veterans Affairs - VA guaranteed loan.  Similarly to PMI and FHA insurance, the VA will not lend you the mortgage, they will provide protection to the Lender, in that the VA will guarantee up to the first 25% of the Loan.  With a VA guarantee, no downpayment is required for the loan.  Veterans do not pay a monthly insurance premium for this guarantee, but the VA charges a funding fee for the program between 2.15% and 3.3% of the loaned amount, which can be rolled into the mortgage and paid monthly.  In case of default and foreclosure, if the VA will cover part of the Lender's losses. In most cases you will still owe that money to the VA, it's not a gift.

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Are mortgage contracts all standard?

No, they are not.  They are only standard in the sense that banks wrote them and they will not change it just for you.  Yet, even though there is no promulgated mortgage contract, there are several pieces of regulations for mortgage contracts and specific language required along the contract.  Also, because of requirements for mortgage contracts to be sold to Fannie Mae and Freddie Mac, or to be compliant with FHA and VA loans, most banks choose to use just one set of contracts that comply with all federal programs, rather than keeping many different sets of contracts.

Even if you won't be able to request changes to the mortgage and promissory note contracts' wording, it is very important that you read it all, diligently, word for word, as soon as possible, several days before the closing.  It is a good idea to invest in a couple of hours' worth of attorney fees to walk you through it. This is a very serious financial commitment, for many people it is the most important financial commitment of their lives, and you should understand it well.   Here are clauses you will likely find in your mortgage:

- You will promise to repay your loan, pay property taxes and insurance, and to keep the property in good maintenance.

- You will commit to occupying the home if you apply for a primary residence mortgage, which has better interest rates.

- The bank will promise to remove the lien from the title once the loan is satisfied.

- If you are in default, the bank has the right to accelerate, that is, to declare the entire contract as due immediately.

- If you default, you may have the right to return the mortgage to its previous terms, once you bring payments to current.  If the reinstatement clause is missing, ask your lender if they will send you another contract that has it.

- The balance of the loan will be due on the sale of the property, if and when you decide to sell it.

- Sometimes the lender will allow the contract to be assigned, that is, passed on to the party who buys your house, contingent on the bank's approval.  This actually happening is very rare, but if you have a great fixed interest rate, you may want to pass it on to family members or friends who are buying the property from you.

- You may have the right to prepay, without any penalties, in part, or the whole loan before its due date. If this clause is missing, you should insist that the lender sends you another version of the contract that has it.  Pay attention to this, ask about it when you first apply for the mortgage.  Otherwise, there may be a stiff penalty if you want to refinance your mortgage, or simply accelerate the payments, paying a bit extra every month.

- An adjustable-rate mortgage will have a clause detailing how the rates would increase or decrease.  A fixed-rate mortgage may have a clause that allows rates to escalate if you get into default or if you change the use as a primary residence to an investment property.

- The lender will have a clause allowing them to sell your mortgage.  Banks manage a portfolio of loans and they often originate more mortgages than they want to keep.  The bank already made money charging you origination fees and points, and may be happy to sell the asset to someone else and let them earn the interest. 

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What is Seller Finance?

A property owner may offer to finance the sale directly to you, and you would pay for the home in installments, known as an Agreement for Deed, or Installment Sale.  It works like a mortgage, but you don't owe a bank, you owe the property owner.  It may be beneficial to the seller, if they can't find an investment better than the interest they would be charging you, and it can be beneficial to you, if you can't get a loan from a regular lender, or your offered sub-prime interest rate is astronomical. 

This comes with a risk for the seller, as they typically lack the collections and legal resources that a bank would have, and a risk to you, the buyer, because the seller holds the Title until you finish the payments.  This could become a complicated legal issue for you if the seller gets into financial trouble, has a lien on the property's title, or if a creditor receives judgment allowing for the execution of the seller's properties.  If you are buying a property under this arrangement you want to make sure that the contract is recorded by the county's recorder of deeds.  Sale contracts are not typically recorded, but this type of sale contract should. 

Seller Finance is more common with smaller and rural properties and among family and friends. 

The remedies for a buyer default may include the seller suing for the contract balance, or evicting the buyer and retaining all payments up to date. 

We urge you to seek legal representation when considering seller financing, to assure things are handled properly.  Investing a few hundred dollars in legal fees may save you a lot of future headaches.

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Is it a good idea to sign up for a biweekly mortgage?

A biweekly mortgage payment schedule was designed to match the increasingly popular biweekly payroll schedule.  It has the benefit of reducing the total amount of interest you will pay during the life of the contract.  How does it save you money?  You are telling the bank to take the monthly payment of, let's say, $1,200 and make it into bi-weekly payments of $600.  Because the year has 52 weeks, you will be making 26 biweekly payments, which would be the equivalent of 13 monthly payments.  Every year you are paying one extra month of mortgage, therefore accelerating the repayment of the loan. Depending on the rate, you may pay a total of $350,000 in interest over the life of a $400,000 mortgage. Accelerating the payments can bring substantial savings, as much as $70,000, because the sooner you repay, the less interest you will be charged.  In conclusion, it may be very beneficial for a person to commit to a disciplined bi-weekly payment program that matches their payroll schedule.   You may achieve the same impressive interest savings by keeping your monthly payment schedule and making additional payments of $150 every month. If you can afford it, we strongly recommend that you make additional payments, for the savings add up significantly.