Mari Springs’ voice quivers as she relives the tale of raising $4,500 in three months for a down payment on her first home. The 27-year-old needed to get approved for a $98,000 mortgage for a newly built three-bedroom, two-bath ranch in Statesboro, Georgia, but “she assumed her defaulted student loans of $45,000 would stop her from achieving her dream of home ownership. “It was stressful,” says Springs. With a credit score of 600-a score considered poor by industry standards-Springs was determined to forge ahead. “I knew my credit was just fair because three student loans were in default,” she says. “But I also knew that I was tired of renting. I was just throwing money out of the window.”
Springs eventually received 95% of the financing she needed through a Federal Housing Administration loan with GMAC Mortgage in Atlanta. She closed on her house in October. But like millions of Americans who have become recent homeowners Springs wishes she had been more prepared at the outset. “Everything had to be accounted for and re-verified,” she says, referring to the financial documentation lenders require. But now safe and sound in a home of her own, Springs knows opting for home ownership was one of the best decisions of her life.
In part three of our series on home ownership, BLACK ENTERPRISE tells you what you need to know before applying for a mortgage. We’ll highlight important terms, review mortgage options and fees, and show you how to select the best lender. The goal is to arm you with the kind of information that will have lenders knocking at your door instead of the other way around.
GETTING STARTED
A good place to start is to figure out how much mortgage you can afford. That means crunching numbers like your gross income, down payment, monthly expenses, and your credit history by using online calculators at sites like blackenterprise.com and www.bankrate.com.”What most people do, which I think is a complete mistake, is to go out and start looking at homes that are usually way more than they can afford simply because they don’t know any better,” says Ilyce Glink, author of 100 Questions Every First-Time Homebuyer Should Ask (Three Rivers Press; $18). Glink suggests getting preapproved for a mortgage first, which we’ll discuss later. But first, you have to understand the mortgage market.
Kristopher Knight fell in love with the first house he saw, but then decided to do his research. “We didn’t know the housing market, so we started looking around and thought we’d be in a better position to buy now than waiting for prices to go higher,” says Knight, a 25-year-old senior associate with KPMG Philadelphia who bought a $209,000, 3- bedroom, 1- bath Colonial with his 23-year-old fiancé, Lischele Adams.
Knight started surfing the Internet sites like www.realtor.org(the Website of the National Association of Realtors, which offers real estate industry news and statistics) to get a sense of what the market had to offer. “I needed to know more about interest rates and how much my monthly payment would be,” he says. “I used mortgage calculators to find out information on the loan amount, taxes and how they fit in, and even calculated the amount that we would have to put into escrow.”
In general, when lenders look at how much a potential home buyer can afford, they take into account your debt-to-income ratio. Keep in mind, your monthly mortgage payment-including principal, interest, real estate taxes, and homeowners insurance-should not exceed 28% of your gross monthly income. For example, if you make $70,000 in gross income, your monthly housing expense should not exceed $1,633 a month. Otherwise, you may find it difficult to stay afloat financially, unless of course you have other income (i.e., alimony or business income) to cover any excess.
To calculate your housing expense, multiply your annual salary by .28, then divide by 12. The answer is your maximum housing expense. For Springs, her $35,000 salary as a child care program consultant helped her to afford a monthly mortgage payment of $714.
Aside from knowing what you can afford, you must educate yourself about the home ownership process in general. Organizations such as NeighborWorks America (www.nw.org),a national network of more than 240 community development and affordable housing organizations started by Congress, can walk you through the process of home ownership from start to finish. Such organizations can also work on your behalf to find lenders that are suitable for your financial situation.
WHICH LOAN IS RIGHT FOR YOU?
There are generally three categories of loan products: fixed-rate, adjustable rate, and hybrid. “About 20 years ago, you had very few options. You went to your local bank and hoped they would grant you a mortgage,” says Dolf de Roos, a real estate investor and author of Real Estate Riches: How to Become Rich Using Your Bankers Money (John Wiley & Sons Inc.; $16.95). “Today, there are hundreds of mortgage products on the market, so you have to be very judicious and know what you want because it’s so easy to buy the wrong thing.”
People most often choose traditional fixed-rate loans, which offer the stability of a fixed interest rate and fixed monthly payment over the life of the loan. “You really can’t go wrong with a fixed-rate loan,” says Greg McBride, senior financial analyst at Bankrate.com, but he cautions, “It may not be the optimal choice given your circumstances.” Therefore, it’s best to look at all of the options.
For prospective buyers looking for a little more flexibility, especially on the front end, consider an adjustable-rate mortgage, which provides the borrower with an introductory interest rate that adjusts at a later time according to market conditions. “The borrower bears a little more risk because of interest rate volatility, but in exchange, they get a lower initial interest rate,” says McBride, whose site offers a section called “Mortgage Basics,” to walk you step-by-step through the home buying process. “That rate, however, can adjust higher in the future.”
A hybrid loan is a combination of a fixed-rate and adjustable-rate loan. For example, a 7/1 ARM is a hybrid loan where the initial rate is fixed for seven years before becoming adjustable annually.
Springs went with an FHA loan because it offered a down payment assistance program that paid 2% to 3%, and the seller paid a percentage as well. “I ended up with closing costs of only $1,684,” she says. “However, since these are not conventional loans, in which a lender looks closely at your credit, they looked at my debt-to-income ratio. I was required to save about six months’ mortgage in order to get approved for the loan.”
So how do you decide what’s best for you? “It really boils down to how long you think you will be in the home or how long you will have this loan,” says McBride. If you’re buying a starter home, for example, and your family is growing, it’s likely that you’re not going to live there for very long, so you’re a perfect candidate for a hybrid mortgage. “The advantage is if your timetable pans out, you’ll never face the risk of that adjustable. In the meantime, you’re getting a fixed rate that is lower than a traditional fixed-rate mortgage.” For a more detailed description of loan options and the pros and cons of each, see sidebar, “What Type of Mortgage Is Best?”
COMPARING RATES AND FEES
After you determine the type of loan product you want, consider doing background research on lenders. It is important to see what kind of customer service record a particular lender has, so obtain a Reliability Report from the Better Business Bureau at www.bbbonline.com.To check out a lenders financials, J.D. Power & Associates (www.jdpower.com)offers Power Circle Ratings based on the opi
nions of consumers who have used the product.
According to the Federal Reserve, to get the best deal, you have to compare the same loan amount, loan term, and type of loan against different lenders. You can download a Mortgage Shopping Worksheet at (www.federalreserve.gov/pubs/mortgage/mortb_1.htm) to compare terms, fees, and rates. In it, you’ll find information such as the type of mortgage, minimum down payment required, loan terms, and interest rate.
Once you’ve decided on the product and are shopping among lenders, examine the fees involved for the closing. “When you’re shopping for a mortgage, don’t compare loan offers just on the basis of the interest rate or monthly payment,” says McBride, “you have to consider the interest rate and also the fees you will incur. You have to look at the annual percentage rate because this reflects the total cost of the loan, the interest rate, as well as any fees and points you will have to pay.”
In addition, ask each lender or mortgage broker for the current mortgage interest rates and whether those rates are the lowest for that day or week. Ask whether the rates are fixed or adjustable. If your rate is adjustable, ask how it will vary and how the rate is calculated. To find out current interest rates, check the local newspaper or www.bankrate.com.
You should also understand how discount points work. Discount points represent prepaid interest. Typically, the more points you pay, the lower your interest rate on the loan. Ask for points to be quoted to you as a dollar amount-rather than just as the number of points-so you will know how much you have to pay. “If you think you’re going to stay in the home 10 or 15 years and you’re looking at a 30-year fixed mortgage, the idea of paying points is pretty attractive because each point is 1% of the loan,” says McBride. “You benefit from the lower interest for many years, far offsetting the initial cost of the points.”
Remember, the quote you receive will be based on your intended down payment. Some lenders require a down payment of 20%, but with new mortgage options, such as hybrids, many prospective buyers can put less down. Make sure you understand upfront what your down payment terms will be, so that there are no surprises at the closing.
SHOPPING FOR A LENDER
Searching for the right lender can be complicated, so it’s best to get a second or third opinion before you decide. The first rule of thumb is to “go to a reputable lender,” says Peter Greene, director of marketing at Neighborhood Housing Services of New York City (www.nhsnyc.org).”Make sure to go to different lenders-lenders that you’ve heard of before.”
To find a lender you can trust, ask family, friends, and co-workers who have recently bought or sold property. You can also check with local real estate agents to get a list of potential lenders in your area.
“The important thing is to get someone you can trust because that [lender] is going to be the one to sit down and qualify the consumer,” says Thomas
M. Stevens, president of the National Association of Realtors. This is where the prequalification process comes in. When you get loan prequalification the lender tells you how much you can afford, says Glink. “But, then you take [the process] a step further and actually apply for the loan and the lender commits to funding the loan in writing, provided the house appraises out in value.”Our experts recommend speaking to three to five lenders. You should consult with commercial lenders, who offer an array of loan products and mortgage brokers and arrange the loan rather than lending it directly. In other words, a broker is the middleman; he or she will research several different lenders and loan options from which you can choose. According to the Federal Deposit Insurance Corp.’s Website, “Brokers will generally contact several lenders regarding your application, but they are not obligated to find the best deal for you unless they have contracted with you to act as your agent.” So make sure you understand the nature of your relationship before making any decision.
Credit unions have a reputation for offering lower interest rates on mortgages. In addition, try your local bank as well as online lenders such as www.lendingtree.comor www.ditech.com,which offer consumers competitive rates.
A final option may be the real estate agent’s lender. Typically, a good real estate agent or broker will have a list of lenders with whom they have relationships. No matter which type of lender you choose, “you should never take the first deal offered to you,” says Greene. “These days people are so anxious to buy a house because prices are fairly high, so they are delighted when they find a home they can afford, therefore, the finances are an after-thought. If one company will give you a mortgage, it’s likely another will.”
If a lender says: “we don’t care about your credit history,” or a “bankruptcy is no problem,” then think again. If you’re not selective with lenders, says Greene, you could find yourself in a “predatory lending situation, where lenders tell you whatever you want to hear. Then, when you arrive at the closing you find that you are moving into a loan that you hadn’t expected.” That’s why retaining a real estate attorney and asking lots of questions throughout the entire process is critical to obtaining the right loan.
Now that you have the information you need, take your time. It’s more important to buy when it is financially right for you. So, get out there and educate yourself, understand the terminology, talk to the right people and make an informed decision. Do the math and make sure you realize the true costs of home ownership. “The home buying process is such a monster move. When you actually buy and you’re responsible for a home, it’s a huge undertaking,” says Knight. “You’ve really got to take your time and don’t let anybody push you around or make you move faster than you’re ready.”
30-Year FIixed Rate
Benefits: Principal and interest payment remains constant throughout the life of the loan. Lender assumes risk of rising interest rates.
Disadvantages: May require that the borrower have more cash available for a down payment than with other types of loans. Higher overall interest than 15-year loans. May need to refinance if rates fall significantly.
Who should consider this type of mortgage: Good for buyers who want the security of a fixed principal and interest payment and who plan to stay in their home long term.
15-Year Fixed Rate
Benefits: Lower interest rate than 30-year fixed-rate mortgage. Principal and interest payment remains the same over the life of the
Disadvantages: Payments that are 25% to 30% higher can be a burden if income changes. May require that the borrower have more cash available for a down payment than with other types of loans. May need to refinance if rates fall significantly.
Who should consider this type of mortgage: Appeals to buyers who want the security of a fixed principal and interest payment, can afford higher payments, would like to pay off their mortgage quickly, and intend to stay in their home.
Hybrid Adjustable Rate
Benefits: Low interest in the first years of the loan. Allows borrowers to qualify for a higher loan amount than with a 30-year or 15-year fixed-rate mortgage.
Disadvantages: Monthly payments can increase significantly if rates rise, although most adjustable-rate mortgages have annual and lifetime interest rate caps.
Who should consider this type of mortgage: Good for those who know their income will increase over the coming years or those who are moving in a few years and aren’t concerned with a rate hike
.
40-Year Fixed Rate
Benefits: Allows buyers to reduce their monthly payment and qualify for larger loans than with a 30-year or 15-year fixed-rate mortgage. Principal and interest payment remains the same over the life of the loan. Lender assumes risk of rising interest rates.
Disadvantages: The balance of the loan is paid off very slowly, and borrowers pay much more interest than with a 30-year or 15-year fixed-rate mortgage.
Who should consider this type of mortgage: Can help buyers in higher priced regions qualify for a larger mortgage, but the amount by which the monthly payment is reduced is often not very significant, compared to a 30-year fixed-rate loan.
Interest Only
Benefits: Lower initial payments. Allows borrowers to qualify for a higher loan amount than many other types of mortgages.
Disadvantages: Initial payments do not reduce principal. After the interest-only period, payments can rise significantly when principal payments kick in and the interest rate is adjusted.
Who should consider this type of mortgage: May be used by buyers who do not plan to stay in the home longer than the initial interest period and who have a tolerance for risk. If the home decreases in value, the owner is more likely to end up owing more than the home is worth.
Negative Amortization
Benefits: Allows for much lower monthly payments than many other types of mortgages and can help buyers qualify for higher loan amounts.
Disadvantages: The monthly payment is less than the amount of interest owed on the loan. The unpaid interest is added to the loan’s principal amount, increasing the total amount owed. The home must appreciate considerably to realize a gain or to break even at sale.
Who should consider this type of mortgage: Helpful for buyers who have considerable financial assets and would prefer to invest their money in other vehicles and can tolerate risk.
Option Payment Adjustable Rate
Benefits: Gives buyers flexibility in payments from month to month. Buyers may make a minimum payment, an interest-only payment, or a payment calculated to pay off the loan over either 30 or 15 years.
Disadvantages: If buyers make minimum payments, there will be negative amortization, which means the total amount of the loan will increase.
Who should consider this type of mortgage: Useful for buyers who are disciplined with their finances and for those with incomes that fluctuate from month to month (salespeople on commission, for example).