Investing News

Understanding Your Mortgage

One of the biggest financial decisions in life is buying a home. Homeownership allows one to build home equity and deduct mortgage interest from their taxes. A home could potentially increase in value over time, and there are intangible benefits such as having greater control over renovations. When an individual buys a home, monthly expenses usually increase. Nevertheless, owning your home can be rewarding if you make the right decisions from the start.

Key Takeaways

  • Make sure your credit rating is the best possible before you start shopping for a mortgage
  • Keep an eye on the lender’s fees. Some are unavoidable and some are negotiable.
  • You may get saddled with a PMI fee. If so, get rid of it as soon as possible.

Step One: Polish Your Credit Rating

Preparation is half the battle in getting a mortgage. The first step is to obtain your credit report and find out your FICO score, meaning whether you will be considered creditworthy. Your score will be somewhere between 300 and 850.

Since 2010, the Federal Housing Administration (FHA) has required a credit score of 580 or above to qualify for an FHA loan with a 3.5% down payment. Those with a credit score between 500 and 579 must put down 10%, while borrowers with scores below 500 do not qualify. Other programs such as Fannie Mae set a higher minimum of 620 to 640 for mortgage applicants.

What to Do About It

If your score is low, work on paying down any high-interest debt. Pay your bills on time. Don’t apply for another credit card. Don’t close out any unused credit cards, though. Having credit available to you but not using it actually improves your credit score by boosting your credit utilization ratio. Also, check for any mistakes or discrepancies on your credit report and follow through to get them corrected.

Step Two: Shop for a Lender

Once your credit score is where you need it to be, shop for a lender. Assuming you are a good prospect, let three or four lenders compete for your business. Do not give each lender approval to access your credit report. Obtain a Loan Estimate (previously called the Good Faith Estimate) and analyze every charge. Only when you have selected a lender should you allow them to check your credit.

Mortgage points are an upfront interest charge. Avoid them if possible.

Lenders’ fees to the borrower can be highly creative and negotiable. Fees such as loan origination, processing fees and underwriting fees can often be negotiated down by at least 50% or even waived by the lender if they want your business.

Refuse to Pay Points

Avoid points if you can. When you pay points, you pay interest in a lump sum upfront to get a lower rate on a fixed-rate mortgage. One point equals 1%. That basically increases the amount of your down payment. Points are unnecessary additional charges by the lender. Refuse to pay them, or take your business elsewhere.

In some cases, it may be worth it to hire a real estate attorney to identify unnecessary costs. A knowledgeable real estate agent can tell you which costs are customary and which could potentially be eliminated. For example, title insurance costs in some counties in Florida are the responsibility of the buyer (unless the seller agrees to pick up the costs). If you’re buying there, those costs should appear on your Loan Estimate. In any case, you don’t want any big surprises when you get the Closing Disclosure before the closing.

Step 3: Understand the PMI

Most lenders charge private mortgage insurance (PMI) if you make an initial down payment of less than 20% on your home. This insurance protects the lender, not you, in case of default on your loan. The PMI may be unavoidable if you can’t meet the 20% threshold. If you’re applying for a $200,000 loan with a 10 percent down payment, you can expect to pay at least $100 per month for the PMI payment. It’s not unusual to see PMI payments in the range of $150 to $200 a month.

Cancel PMI Payments

However, you should know that when you reach a certain equity percentage in your home, usually 20%, you can cancel the PMI. And you’ll want to. Over 30 years, a $150 monthly PMI payment can add up to over $54,000. The lenders will not remind you that you can cancel the additional payment.

How to Avoid Paying PMI

Say you are looking at a $200,000 home and you have $10,000 for the down payment. Most lenders will require a PMI payment if you do not put at least $40,000 down, excluding the lending fees. For many first-time homebuyers, a $40,000 down payment is out of the question.

However, you can try to “piggy-back” your loans so that two lenders take part in the loan. This could resemble an 80-15-5 type plan: you finance 80% on a primary mortgage, 15% on a second mortgage or home-equity loan, and 5% as your down payment. By using the home-equity loan plus your down payment, you can leverage that amount against the purchase price of your home and cover the 20% down requirement, thus avoiding the PMI.

The home-equity or second loan will most likely have a variable rate or a rate higher than your primary mortgage, so you’ll need to keep an eye on this loan and try to pay it off first. Home-equity loan interest is also deductible on federal taxes if the loan was used to buy, build or substantially improve a taxpayer’s home. However, a married couple is limited to deducting interest on up to $750,000 in total mortgage debt.

Types of Loans

The 30-year fixed-rate loan is still the most common mortgage loan. Most homeowners prefer this type of loan because their monthly payments will remain steady over the years.

A 15-year fixed loan is becoming more popular because it reduces the time horizon of the loan, which decreases the amount of interest paid over the life of the loan. These shorter-term loans typically have a higher interest rate because the lender is giving up the opportunity to make money, particularly if the interest rate is rising.

An adjustable-rate mortgage (ARM) offers a low-interest rate for a set period of time. The interest rate can then be adjusted annually, or they may be listed as “3-1,” “5-1,” or “7-1.” With a “7-1” adjustable-rate loan, the amount of the loan will be fixed for the first seven years and then will be adjusted beginning in the eighth year based on current market conditions. Those are usually based on the one-year Treasury index.

How ARMs Work

Initially, the interest rates on ARMs can be anywhere from one to three percentage points below the conventional fixed mortgage. Whether an ARM is right for you often depends on how long you plan to stay in the home. In the case of the “7-1,” if you only plan to stay in the home for seven years, this may be the perfect loan for you. However, if you plan to stay in the home for longer and interest rates start to rise, your monthly costs can rise significantly.

It’s worth the extra effort to review your Closing Disclosure and compare with the with Loan Estimate before the closing date of your new home. If the figures are inflated or you see new charges, contact the lender and ask them to explain or correct the mistakes. Purchasing a home is a long-term commitment, so you want to fully understand all the terms of your loan and not overlook any hidden charges.

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