When you apply for a mortgage, you'll need to supply the lender with several documents to verify your debts, income and assets. These documents will be used to calculate how much you can afford to borrow. Only verifiable sources of income may be used in this calculation, so it's important to be thorough and keep good financial records. When supplying debt verification, any debt that will be paid in full within six months need not be included.
If you're a first-timer, the process can be overwhelming. It pays to find out what you need in the way of paperwork well before you start applying for loans. The exact types of documentation required may differ slightly between lenders, and depending on your specific situation.
Once you've decided to purchase a new home, the next step is to calculate how much you can afford. Your price limit will depend on your current financial situation - which means you need to compare your income and expenses to determine how big a mortgage you can take on. You'll also need to calculate how much money you'll have for a down payment, since this will affect the size of the mortgage you can obtain. A small down payment will mean higher monthly mortgage payments, while a larger down payment will allow you to borrow more. When calculating how much you can afford, you must also take into account closing costs, which are normally three to five percent of the property's value.
Calculating Your Income
To calculate your income, include any verifiable regular income. Verifiable means this income must be documented in some way, such as with pay stubs or on your tax return. Unearned income such as alimony or estimates such as income from real estate or stocks can be used, as long as these sources are verifiable. At this stage you should also be thinking about how reliable your sources of income are - job security and investment security are important factors to consider here.
Calculating Your Monthly Debt
To calculate your monthly debt service, include credit card debt, loans, personal debts, and any other ongoing financial obligations. You don't need to include any debts that are scheduled to be fully paid within six months. If this will be your first home, bear in mind that there will be extra associated costs with owning property, such as property taxes and insurance. How much you pay for taxes and insurance will depend on the value of your property. Property tax rates also vary from state to state, and are usually deductible from federal and state income taxes.
Determining Your Price
After you've calculated the maximum amount of money you can borrow, add this figure to your down payment to find your price range. Remember to factor in that three to five percent for closing costs, as well.
Taxes and insurance can be calculated into your monthly mortgage payments, and the lender will then pay these bills on your behalf under a process called escrow. Using escrow for taxes and insurance is not mandatory, though, so if you wish you may take care of these expenses yourself. There are benefits and disadvantages associated with each method. Having your mortgage company escrow the money each month can bring you a little peace of mind, and it's easier to budget for fixed expenses than irregular ones like taxes. On the other hand, paying those bills yourself means you have more flexibility in case you want to change insurance companies.
Finding the Best Mortgage for
Once you've calculated your monthly income and monthly debt service, your next step is talking to mortgage professionals. Get quotes from several different lenders to find a deal that's right for you. To qualify for a home loan, your total monthly debt service should be less than 36% of your gross (before tax) monthly income.
When you're shopping for mortgage quotes, factor in both the interest rate and the length of the mortgage when you're deciding on the terms. Interest rates can be either fixed or variable, and this is one of the best reasons to shop around. Few first-time home-owners stay in their house for the full term of their mortgage, so you may be better off thinking in the short-term and going with a variable interest rate, as these tend to be lower than fixed rates for the first several years. Don't forget that mortgage interest is tax-deductible, too - and even better, there's no limit to the amount of mortgage interest you can claim on your deductions.
Private mortgage insurance has become a common way of offsetting the risk for mortgage lenders when buyers have a small down payment. If your down payment on a property is less than 20% of its appraised value (or sale price, in some cases), your lender will require that you obtain private mortgage insurance. This insurance is protection for the lender against a default on the loan.
How Much and Who Pays?
The borrower is responsible for paying private mortgage insurance, and the insurance payments are added to your mortgage loan total and your monthly mortgage payments.
The cost will vary depending on the size of your down-payment and the size of the loan. Typically the annual cost is about 0.5% of the total loan amount. For example, on a $100,000 property with a $10,000 down-payment, your loan total is $90,000 and your private mortgage insurance would be $450 a year divided into monthly payments.
When Can You Cancel the Insurance?
Typically, you can cancel private mortgage insurance once you have 20% equity in the house. This means that you must reach a point where you have paid 20% of the principal of the loan. In some high-risk situations, such as bad credit loans or reduced documentation loans, some lenders may require that the borrower build up to 50% equity (the maximum amount allowable by law) before allowing them to cancel the insurance.
Under the Homeowner's Protection Act of 1998, lenders are required by law to tell borrowers how long it will take them to obtain 20% equity in the property. Additionally, lenders must cancel private mortgage insurance automatically once the borrower has 22% equity (unless it is a higher-risk loan which requires more than 20% equity). For the above loan example, you could cancel the insurance once your principal balance hits $80,000, and it would automatically be cancelled at $78,000.
Note, however, that this law does not apply if your purchased, built, or refinanced your current home before July 29, 1999. If you are in this situation, you must contact your lender to cancel the insurance because it will not be done automatically once your equity reaches 22%.
Canceling PMI may require that your property undergo appraisal, to ensure that you have 20% equity according to its current value.
Avoid Private Mortgage Insurance with a Piggy-back Loan
Also called an "80-10-10" loan, this involves two separate loans which close simultaneously, and a 10% down-payment. Depending on your situation, it can be less expensive than paying private mortgage insurance.
The first mortgage is for 80% of the property's sale price, and the second mortgage is for 10% of the sale price, which requires the borrower to come up with 10% as a down-payment. The second mortgage will usually have a higher interest rate, but because it applies to just 10% of the loan total, the combined monthly payments are usually lower than payments for one mortgage plus insurance. Additionally, mortgage interest is tax deductible, while the insurance is not, providing a further advantage.
For example: on a $100,000 property, with a single mortgage for $90,000 at 7.5% you'd pay $629 a month, plus insurance of $37.50 a month, for a total of $666.50.
With a piggy-back loan, you pay a $10,000 down-payment. Your first mortgage is for $80,000 at 7.5%, and your second is for $10,000 at 9.5%. Your monthly payments would be $559 and $84 for a total of $643, saving you $23.50 a month.
Adjustable-rate mortgages (ARMs) are risky, but they certainly have their uses. If the interest rate on ARMs is low and you're planning to sell after a few years, it can be a definite money-saver compared to a fixed-rate mortgage (FRM).
How Does Refinancing Work?
Refinancing is simply taking out a new mortgage to pay off the old one. To be eligible for refinancing, you will usually need to have a good credit rating, a steady income, and a certain amount of equity in your home. Bear in mind that taking out a new mortgage will mean another round of closing costs, and you may also have to pay a prepayment penalty on the original loan (check your mortgage documents to find out if you have a prepayment penalty and how much it is). Refinancing can cost between three and six percent of your current outstanding principal.
Reasons for Refinancing
There are three common reasons for refinancing out of an ARM into a fixed-rate mortgage. Believe it or not, it's quite common for people who are refinancing from an ARM to a fixed-rate mortgage to end up with a higher interest rate. For these people, however, it's a matter of thinking ahead and realizing that the benefits of the ARM are highly dependant on both the market and their individual situation.
Should You Refinance?
If you're thinking about refinancing out of an ARM and into a FRM, there are four pieces of information you need.
The fully-indexed rate is the best predictor of how your ARM rate will change at the next adjustment. This rate is made up of the interest rate index that your ARM uses, plus the margin (both of these figures are shown on your note). You can find out the current value of the index online from a few different places, including http://www.mortgage-x.com/general/mortgage_indexes.asp. Add the current index value to the margin to find out what your fully-indexed rate is. At your next adjustment date, your ARM rate will be reset to that figure (assuming the index doesn't change). If you find that both your ARM rate and your FIR rate are higher than current FRM rates, then you've got a very strong case for refinancing.
Buying a house is the most significant purchase that most people will make in their lifetime. It's important to use a reputable mortgage broker that you can trust - don't ignore the warning signs of a bad broker. If you feel uncomfortable with your lender for any reason, then don't be afraid to fire them and look for one that will meet your needs and be more deserving of your trust. With that in mind, here are some things to look out for when you're dealing with mortgage lenders.
Be wary if a broker pushes you to borrow more than you need to or can afford. Borrowing over your limit increases the likelihood that you won't be able to meet your monthly payments, costs you more in interest, and simply lines the pockets of those you're borrowing from.
Similarly, be wary of lenders that press you to accept higher risk loans that allow you to borrow more than you can afford (interest-only mortgages and balloon mortgages fall into this category).
Mortgage companies that promise you no closing costs or points usually have bigger penalties and penalty charges built into their contracts.
Lenders should provide you with a "good faith estimate." This is an estimate of expenses related to closing costs, including inspection costs, taxes, and title insurance. By law you should receive a good faith estimate within three days of your loan application.
Similarly, you should also receive an annual percentage rate. This is the cost of your credit in relation to the amount borrowed, and provides you with a means of comparing offers from different lenders. The annual percentage rate calculation includes origination fees, points, interest, insurance, and other lender fees. The lender is required to disclose the annual percentage rate when you apply for a loan.
Be wary of companies that promise to lock in a low interest rate and then raise it later on. If this happens, find a new lender. If you do decide to opt for a locked-in interest rate, get it in writing and get a copy of the loan commitment letter too.
If your lender encourages you to falsify your application to get the loan, walk away. If they're encouraging you to do something dishonest, you can't trust that they'll be honest with you.
Don't sign blank documents, and be wary if lenders try to delay giving you copies of documents you have signed.
Any of these things can be considered warning signs, and if they happen early in the loan application process, you'll lose nothing by walking away and finding a new lender. But what if you've already spent a considerable amount of time working out the details with your mortgage broker, only to find that they show up at closing time with a different contract, or with terms different from those you've already agreed to?
The problem here is that canceling the contract may put you in breach of contract both with the mortgage lender and the seller of the home you're trying to buy. In these situations, the seller has the right to sue if they wish to. If this happens to you, it might be more prudent to try and negotiate with your lender for lower closing costs, and continue with the purchase with a view to refinancing as soon as possible.
Consumer groups believe that lenders should be held liable if they allow borrowers to take home mortgages that aren't suitable for them. In prior articles in this series, I concluded that a suitability standard was not an effective way to deal with bad mortgage selection, unaffordable loans or refinances that don't benefit borrowers. This article looks at suitability in connection with the problem of overcharges.
Borrowers are overcharged when they pay more for the same service than they would if they had the information needed to shop alternative sources effectively. For example, you pay 6 percent and one point whereas if you had known where and how to shop you could have paid 5.875 percent and one point.
I examine three categories of overcharging: lender steering, excessive broker fees, and loan officer overages.
Lender steering refers to the unsavory practice of soliciting borrowers for loans priced higher than those for which the borrower would qualify. Steering is often associated with prime borrowers targeted by subprime lenders and being charged subprime prices.
No suitability rule can deal effectively with steering. There is no way to monitor and enforce rules barring lenders from charging higher prices to particular borrowers than those available to the borrower elsewhere.
The best way to protect borrowers against aggressive solicitors of high-priced loans is to provide them with better alternatives. Vulnerability to solicitations is high when the soliciting loan provider is the only one the borrower knows about. If the borrower is even dimly aware that there is a group of loan providers that has been certified by a trusted source, vulnerability declines sharply.
I have tried to stimulate the development of certification as an accepted part of the home mortgage market by starting Upfront Mortgage Brokers (UMBs) and Upfront Mortgage Lenders (UMLs). These certified loan providers agree that they will not use their superior information to disadvantage borrowers. UMBs meet that charge by setting a fixed fee for their services upfront. UMLs do it by maintaining Web sites that disclose all the information borrowers need to shop effectively.
At this writing, there are about 200 UMBs and three UMLs. Other certification initiatives are in the works, though none are from the ranks of the consumer groups advocating suitability as a remedy.
Excessive broker fees arise primarily from a lack of transparency in broker pricing. Most broker fees are paid by the lender as a rebate or "yield spread premium" (YSP). For example, the wholesale lender who quotes a rate of 6 percent at zero points might pay a YSP of 1.6 points for a 6.375 percent mortgage. The borrower pays the higher interest rate but no cash out of pocket, and is either not aware of the YSP or becomes aware of it too late to do anything about it.
Dealing with this problem by applying a suitability standard to broker fees means making judgments about whether the fee in any particular case is too high. I find this idea morally repugnant: as long as society is not passing judgment on lawyer's fees or doctor's fees, it has no business passing judgment on mortgage broker fees.
Yet a very high mortgage broker fee differs in an important way from, say, a very high lawyer fee. The lawyer's client always agrees to the fee, whereas, unless the broker is a UMB, the broker's client usually doesn't.
The appropriate solution is not fee-setting but transparency. If borrowers know what the broker will make on their transaction, they will prevent overcharges far better than any suitability-based system for controlling fees.
One way to provide transparency is to require all brokers to operate as UMBs. Another workable remedy is to require that YSPs be credited to borrowers, who would have to agree to sign them over to the broker.
Whatever rule is adopted should apply to any transaction on which the loan provider receives YSPs from a wholesale lender. The legal status of the loan provider should not matter. It thus would cover the so-called correspondent lenders who operate just like brokers, and compete with them, except that they close loans in their own names.
Loan officer overages are an amount above the prices posted by a lender to its loan officers. The posted price is the acceptable price; the overage is gravy. For example, the lender posts a price of 6 percent and one point but the loan officer gets the borrower to agree to pay two points. The additional point is the overage.
Overages should be made illegal. Lenders should remain free to charge what they want, but their loan officers should not be free to take advantage of ignorance and naivet to charge some borrowers more than others just because they can.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania.