Since as early as 2004 when I first entered the mortgage industry, my primary mission has to help borrowers obtain the ideal financing option tailored toward their individual goals. It’s not by accident that I have been recognized as in Chicago Agent Magazine’s “Who’s Who in Chicago Real Estate” for the past six years running and the Agent’s “Choice Lender of the Year” for two years in a row. My dedication to my clients is without peer.
I serve as Senior Vice President of Residential Financing for Key Mortgage Services here in the Greater Chicago Area. As a sought-after mortgage broker, I work directly with more than 100 of the nation’s largest financial institutions in order to maximize mortgage product opportunities while at the same time retaining full control of the lending process. The result is to obtain the lowest rate and best terms for my clients. Whether the financing is for a brand new high rise condominium unit or a single family home, I have the solutions you need.
While this book is originally geared toward First Time Buyers, it’s also solid advice for anyone in the home buying process whether it’s a first home or a forever home. Thank you for taking the time to download and read this important book and feel free to share with friends, coworkers and family.
-Anthony J. Marinaccio Anthony.Marinaccio@KeyMortgageServices.com 312-981-2373
Table of Contents
I: Should You Buy? If So, Why? If Not, Why Not?
II: Basic Requirements for a Home Loan Approval
III. Types of Loans
IV: Closing Costs Explained
Glossary of Terms
I: Should You Buy? If So, Why? If Not, Why Not?
If you’re right smack in the middle of the age where you’re most likely to buy your first home, it’s also very likely you’ve entertained the thought of getting out of the rental market and owning your very own home. Lenders have determined the average age of the first time buyer is somewhere around 32 or 33 years old. That’s not by accident as there are specific factors that place the average age in the low 30s. Consumers in their early 30s have been employed for nearly a decade. During that time they’ve been renting. They’ve also established their credit profile well enough in order to receive an approval. Most loan programs ask there be at least three trade lines on an individual’s credit report. That means a car payment or a credit card or an installment loan of some sort.
Those in their 20s and just starting out in the working world can often find their first job in another city. That means a move. Working in a new company can also mean transfers are more likely to occur for the younger set. Renting just makes the most sense and it’s an easy decision, really. There are a lot of things to consider when buying a home and financing it with a mortgage. When renting, it’s really more of a combination of the rent and location.
Renters typically put down their first stakes close to their job, or at least as close to their job as they can afford. Apartment leases typically last for a year and the renter has the option of signing another lease or finding another place to live. Maybe there’s been a raise in the past year and the individual can afford a bigger apartment or one closer to work. Or, maybe living in the same apartment is getting sort of boring.
When buying, there are so many other things to consider.
Should You Buy?
If you’re thinking of buying and you let someone know about it, suddenly your screen is filled with ads. Even if you do a basic search for homes using the internet that search is logged and you won’t be surprised when an ad for a mortgage company or a real estate agency pops up. That’s just the way marketing works in today’s world. But if you’re just toying with the idea and all you’re doing right now is gathering information, you may not want to be blasted with online ads related to your search. You just want information.
But wondering whether or not it’s a good idea to buy basically boils down to who you ask. If you ask a real estate agent who is a friend of yours, do you think the agent will tell you that it’s not a good time to buy? How many real estate agents would last very long in the real estate industry if they told their potential clients that it’s better to stay where you are and sign another lease? Not many. Probably not any if you think about it. That’s not a very good business plan. Imagine if you walked into a shoe store and the owner said to you, “You don’t want to buy any shoes.”
In fact, anyone and any business related to real estate benefits only when someone buys or sells a home. Of course the real estate agent gets a commission and a lender makes money by making a home loan. Then there are other third party services needed such as title insurance, an abstract or survey is required, an appraisal is needed, credit reporting agencies and settlement agents get paid. There are a lot of people involved. We’ll get into more detail about who these people are and why they’re needed.
Should you buy is probably better phrased, “when should you buy.” Over time, real estate values appreciate and that means more equity for you. The difference between your loan amount and the current market value of the property is called equity. It’s your equity and adds to your overall financial profile. For example, let’s say you bought a house this month and the sales price was $200,000 and you made a $5,000 down payment for a final loan amount of $195,000. The difference belongs to you. The $5,000 down payment is the initial equity you own.
Now let’s say that it’s five years later and the property is now worth $240,000 and your loan amount is now closer to $181,000, using a 30 year fixed rate at 4.0%. The mortgage payment is $954. Now let’s take a quick look at your equity. It’s now $59,000. If you took two separate people and one made a $954 mortgage payment and the other a $954 rent payment. In this scenario, the person who owned is now worth $59,000 more than the person who rents. If the buyer decided to sell, that’s how much the seller would receive, less associated closing costs. With the person who rents, it’s the landlord who is getting richer due to equity appreciation while at the same time having the tenant essentially pay the mortgage.
This is the primary case for owning instead of renting. You begin creating wealth.
The numbers when comparing renting vs. buying nearly always outweigh renting and definitely over the long haul. One of the many reasons retirees own their own home and don’t have a mortgage payment is often because they sold their current home, downsized and used the equity from the sale to pay cash for their new homestead.
When Should You Buy?
Okay, so then let’s take the next step. When should you buy?
You’ve already come to the conclusion that it’s time to stop throwing away your rent money and quit making your landlord rich and buy your own place. When is the right time?
That depends upon which point of view is being applied. There are those that will look at a calendar and tell you which time of year it’s best to buy a home. That time frame is usually in the fall and late winter. Why? Because home sellers primarily sell during late spring and during the summer. Simply the weather can bring more buyers out to open houses. It’s more fun to shop for a home in the spring time instead of facing wind chill temperatures in the single digits. Or it’s during the rainy season. Buyers like to buy during the summer when school is out and it’s a good time to transition the kids to new place and a new school.
That said, if late spring and the summer time is best for sellers to get a higher price the opposite would then be true for buyers who want to get a lower price when there is less demand for real estate. One important thing to note here is that with more sellers in the summer there are more homes to choose from. You can look at a calendar to see when it’s a good time to buy but that’s too much of a generalization to be true. You’re buying a home for you, not because of any statistic.
What about interest rates? What are rates doing and should interest rates affect when you should buy? You’ll hear, “Buy now while rates are still low” or “Low rates mean you can qualify for more home!” or something similar. And that’s all true. When financing costs are low it’s a good time to buy a home and you can qualify for more home with a lower rate than a higher one.
Interest rates are a product of the open market. They can change from day to day and sometimes they can even change in the course of a single day but the fact is they change. And no one can predict where rates will be in the future. Period. Let’s say that you’re told that economists expect the economy to slow down later this year. When the economy slows, interest rates for all types of credit can drift downward. If interest rates move down by another 0.50% you can qualify for a bigger place. So, you decide to wait.
Six months later rates didn’t go down by 0.50%. They didn’t go down at all and in fact rose by 0.50%. That rate move alone not only didn’t qualify you for a bigger place but now for a smaller one. Don’t count on the interest rate market for a clue when to buy.
Okay, so if it doesn’t really pertain to a certain time of the year and without much thought given to interest rate predictions, then when?
The answer is when you’re ready, with the emphasis on “you.” Go ahead and dip your toe into the waters of home ownership. You’re certainly not alone but take baby steps at first and get used to the idea of owning and not renting. You’re the boss here and remember that nobody, nobody gets paid anything until you make the decision to buy.
Once you’ve completed your purchase and become a home owner, all the others involved in the transaction and everyone involved will go back to their offices and start all over again with other clients. While you’ve just bought your first home and according to national averages you’ll own your first home for somewhere around seven years or so before life changes or simply the desire to change your surroundings sends you out shopping for a new place to live once again.
There are a lot of things to consider when buying a home and we’ll talk about them in this book but it needs to be said that buying real estate isn’t exactly like buying anything else. It takes two to three weeks to get a loan application to the closing department. And if someone gets a bad dose of buyer’s remorse, real estate isn’t exactly the type of item where you can get a copy of your sales receipt and return it for a refund.
But don’t buy because you think you just ought to because someone told you to. Don’t buy because a co-worker or some friends just closed on their first home.
Take your time. There’s no rush. The more information you have and the more questions you ask will make you more confident as you start your first search for a home.
II: Basic Requirements for a Home Loan Approval
Many wonder at first why there are so many different people involved in the home loan process. After all, if you go to the car dealership and pick out a nice new car, it takes but a few minutes after completing a loan application and before you know it you’re approved for your automobile loan. Why is it so complicated buying a home?
Very good question but as we mentioned in the previous chapter, real estate isn’t like any other purchase. There are so many different factors that need to be reviewed before a lender will place a home loan. If someone defaults on an automobile loan, the bank simply recovers the car. If someone defaults on a home loan, the lender is loath to take back the home but it is a last, albeit expensive, resort.
When applying for a mortgage, the lender really issues two approvals, not just one. The lender approves you and the lender approves the property. Even for someone with absolutely perfect credit and with solid income, if the property doesn’t pass muster, the loan simply will not close. Let’s take a closer look now at how the lender reviews the property, and then we’ll look at how the lender looks at you.
Approving the Property
Lending guidelines require the home under contract is 1: in good condition and 2: marketable. The home is in essence the lender’s collateral and it must be in good shape. The home must also be marketable and similar to other homes in the area. Both can be ascertained with a property appraisal.
A property appraisal is a report that reviews various aspects of the home under contract primarily to reach a current market value of the home. This is done by comparing recent sales of similar homes in the area. The mortgage company places an order for an appraisal through an appraisal management company who then selects an appraiser at random from the management company’s list of approved appraisers. Along with the request, the mortgage company also delivers a copy of the sales contract.
With this contract, the appraiser does some initial work by researching the local multiple listing service and public records. It is here where recent sales will be recorded. How recent, you might ask? Lending guidelines ask that recent sales be no more than 12 months old with at least three of them closing within the previous six months. Pending sales, sales that are under contract but not yet closed cannot be used but can be mentioned in the report. A current listing without an offer may also be included.
The appraiser then makes certain observations about the recent sales, primarily calculating a price-per-square foot amount. If a home sold for $100,000 and the structure measured 2,000 square feet, the price is $50 per square foot. At least three of these “comparable sales” must appear in the report. The appraiser will then make any adjustments to these values based upon things such as the condition of the property or having a better view or backing up to a greenbelt or any other feature that will add to or detract from the value.
Next, the appraiser makes a visit to the property to complete the appraisal process. The appraiser measures the lot as well as the home and notes the square footage of the livable areas of the home. The appraiser will also note the property’s condition on the appraisal report. If the appraiser determines the home is in “poor” condition, it will kill the deal altogether. The appraiser will also make note of any upgrades, remodels or additions to the home that will add value. A high end kitchen will add value to a home. So will a new or upgraded master bath. A deck or a privacy fence adds value. All these individual facets will combine to add to the value of the home. Pictures are taken of the property and included in the report.
The appraiser then returns to the office and completes the appraisal by comparing the subject property with the recent sales. Most always the appraised value is the same as what appears on the sales contract yet that’s not always the case. Sometimes the value will be higher but sometimes the value will be lower.
Lenders will use the lower of the sales price or appraised value when processing a loan application. If the sales price is $100,000 and the value comes in at $105,000, the buyers aren’t awarded that initial equity as the lender will based the loan amount on $100,000, not $105,000. If the sales price comes in at $100,000- and this is important- and the value comes in at $95,000, this complicates matters. Because the lender uses the lower of the two, the value is $95,000, regardless of what the contract says.
When this happens, and it doesn’t very often, the buyers then have some choices to make. The buyers can bring in the extra $5,000 in order to close the loan. Or, the buyers go back to the sellers and renegotiate the price based upon the results of the appraisal. If the seller agrees, the process moves forward with the lowered sales price. But the seller doesn’t have to agree to lower the price. If this is the case, most often the buyers walk from the deal, refusing to come to the closing table with the extra $5,000. Sales contracts typically have verbiage that allows the buyers to cancel the contract should the value come in too low.
As a buyer, an appraiser is an independent assessment of the current value of the property and you want the assurance that the price you paid was the proper one. There are those who absolutely fall in love with a particular property and will place an overpriced offer. An appraisal helps keep emotions in check and assures the buyers they paid a fair price.
Finally, the lender will review the property based upon what appears in a title report. A title shows the chain of ownership of the property from the first owner to the last. Real estate must be exchanged in a legally recorded fashion. When a property changes hands, it’s a matter of public record. A title report is ordered from a title company. Yet beyond the chain of ownership, lenders also want to make sure the property was transferred legally. The title report will also show any current liens against the property. A lien is a public record of a legal interest in the home.
A mortgage is a lien. When the sellers sell the home the mortgage must be paid off before it can be released. Without a release, the buyers can’t get the mortgage because there is an existing lien. Current liens on a property have to be paid off or otherwise settled or the home can’t transfer from the buyers. Usually this happens when the buyers apply for a mortgage and the mortgage company contacts the current mortgage lender for the exact amount needed in order to pay off the mortgage and receive a release of the lien.
There are other types of liens that can be filed upon the property such as delinquent property taxes, income tax, back alimony and child support. A contractor who fixed a roof files a lien on the property and releases it when the work has been done and the contractor paid.
Sometimes though there are liens that are in dispute and can’t be resolved. In this instance, a lender will have to think twice about approving a new loan application. Those with legal liens filed against the property must be paid off prior to transfer or otherwise settled. An existing lien has the ability to force the owners to pay what is owed, otherwise they could lose the home due to a forced sale.
These are all some pretty serious events but because mortgage lenders make sure there are no existing liens that transfer with the new purchase, they’re usually not a problem. But they can be sometimes and why lenders refer to a title report to see if anyone else has a claim against the property. When the lender determines the property is eligible for financing, a title insurance policy is issued. A title insurance policy protects the buyers and lenders from any previous, unrecorded claims.
For example, someone buys a home and moves in. After about a year or so, there is a certified letter from an attorney demanding the new owners move out. Why? Because several years ago a couple who owned the home got a divorce and one of the spouses was awarded the home but the divorce decree was never recorded. With a title insurance policy, the claim will be paid but the new owners keep the house.
Title insurance is a requirement for every new mortgage loan.
We spoke briefly earlier about getting a car loan and a loan for a home. What they have in common however is how the initial loan application is submitted. Instead of a lender manually reviewing a loan application and supporting documentation, most loan applications today are submitted online and delivered digitally to the mortgage company. I will review the application to make sure everything that is needed to obtain an automated approval is on the application and once the quick review is made, the file is uploaded to an automated underwriting system, or AUS.
The AUS will almost instantly issue an “Eligible” answer which means based upon the information presented the file is eligible for financing. This happens within a matter of moments. I will then receive the instructions provided by the AUS to complete the loan approval and submit to the underwriter for a review.
The three basic items reviewed is the credit history, income and employment and assets.
An AUS will review the credit report submitted as well as the qualifying credit score. The score is a three digit number composed using an algorithm designed by a company called the FICO Company. These scores range from 300 to 850 and because there are three main credit repositories, TransUnion, Equifax and Experian, each will provide its own score. The scores will be similar but rarely exactly alike. This is because even though they all review credit history in the same manner, the information reported to the three bureaus by merchants can be delivered at different times. Some businesses may report credit histories on the 1st of the month while others report on the 15th. Or, not all businesses subscribe to all three bureaus.
There is much less attention to the line items listed in the report and more so to the credit scores. If the file has a qualifying credit score, the lender will move forward. Credit scores give more weight to recent credit history than older credit items and there is more emphasis on the previous two years compared to something that happened five years ago. To obtain a qualifying score, the lender ignores the lowest and highest reported scores and uses the middle one.
There are five categories which make up the credit score, they are:
- Payment History
- Available Credit
- Length of Credit
- Types of Credit
- Credit Inquiries
Payment history contributes the most to the total score, accounting for 35% of calculation. When consumers make payments on time over time, scores improve. When a payment is made more than 30 days past the due date, scores will begin to fall. If a payment is made more than 60 and 90 days late, scores will fall further still. If an account goes into collection, more damage will be done.
Available credit compares outstanding credit balances with credit limits. Scores get higher marks when balances are approximately one-third of credit lines. For example, if a credit card has a $10,000 credit limit, the ideal balance would be somewhere around $3,300. As balances approach the credit limit or even go over the credit limit, scores will fall. This category accounts for 30% of the score
Length of credit simply accounts for how long someone has used credit and the longer the credit history the better. 15%.
Types of credit gives consumers higher scores with a more diverse collection of credit accounts such as an automobile loan and a credit card. Certain credit accounts hurt scores such as those from finance companies. 10%.
Credit inquiries looks at how many times a consumer has requested a new credit account. A single inquiry or two over the past year is typically fine but if multiple inquiries are listed on the credit report in the immediate past, it could appear the consumer is facing some potential or current financial problems. 10%.
If someone wants to improve their credit scores, by concentrating their efforts on the first two, Payment History and Available Credit, that’s nearly two-thirds of the total score, scores will rise more quickly.
Income and Employment
Guidelines need to make sure you can afford the new mortgage while still making timely payments on your other obligations, and do so by comparing your total monthly debt payments with gross monthly income to provide a percentage, or ratio. This debt ratio has two parts, a front ratio and a back ratio. The front ratio looks at the new mortgage payment plus a monthly amount for property taxes and insurance. The back ratio is the front ratio plus additional credit obligations the borrower has such as a car or student loan. If the total mortgage payment is $2,000 and gross monthly income is $6,000 the ratio is 30. Most loan programs ask for a front ratio to be around 33-36 and a back ratio around 41.
You will be asked for your most recent pay check stubs covering a 30 day period along with two years of W2 forms.
Can bonus or commission income be used? Yes, but there needs to be a two-year history with the likelihood of continuance for at least three years. If the bonus or commission income exceeds 25% of the total monthly income, the application will then be evaluated as a self-employed borrower.
Self-employed borrowers will provide the two most recent years of federal income tax returns, both personal and business, as well as a year-to-date profit and loss statement. Usually a handwritten P&L along with business bank statements will suffice. The income from year-to-year should be consistent. The lender will add the two years of net income together and divide by 24 (months) to arrive at a figure used to qualify the borrowers. For the employed and self-employed borrowers, there should be at least a two year history of employment.
Assets specifically refers to how much cash you have or will have available for a down payment and closing costs. This primarily comes from your checking and savings account but can also come from a retirement fund such as an IRA or 401(k) loan. Most 401(k) plans allow individuals to borrow against their vested balance and paid back over time, typically over five years. IRAs have a $10,000 exclusion for first time buyers to withdraw the funds to help with a down payment or closing costs. Otherwise, there is a 10% penalty for early withdrawal with an IRA. However, this is your retirement plan and you should consider this option carefully along with your accountant and financial planner.
You may also receive a financial gift from a qualified donor. A qualified donor is a family member or an approved non-profit. The donor will wire the funds to the settlement agent and the borrowers will let the lender know they are receiving such a gift.
Besides down payment funds and closing costs, lenders may also need to verify a certain amount of funds left over after the transaction were to close. This is done by looking for a particular number of months’ worth of mortgage payments called “cash reserves.” The mortgage payment used is the principal and interest payment, property taxes, insurance and any mortgage insurance. If the total mortgage payment is $2,500 and the loan program requires three months of reserves, there should be an additional $7,500 set aside for cash reserves on top of what is needed for the down payment and closing costs.
III. Types of Loans
Okay, so far we’ve talked about whether or not it’s time for you to buy or whether it might be a better option to sit on the sidelines for a while longer. We’ve also reviewed the basic requirements needed in order to be in a position to finance your first home. In this section we’re going to look at the different loan programs available in today’s mortgage marketplace and point out the pros and cons of each for first time home buyers. Let’s get started!
Conventional and Govvies
Mortgage loans can be divided into two distinct groups. Conventional loans are those where the lender is taking on the entire risk of approving a mortgage application. A “govvie” is a lender term for a government-backed home loan. Such loans will guarantee part or all of the loss a lender endures should a home loan go into foreclosure. First, let’s look at conventional loans.
The two leaders in the conventional mortgage market are Fannie Mae and Freddie Mac. These are two taxpayer-owned institutions whose primary goal is to provide liquidity in the marketplace. That’s a fancy way of saying they’ll buy mortgages from individual lenders which would free up cash to make even more loans.
For example, let’s say a mortgage company has $1 million in the bank reserved for the sole purpose of making home loans. The bank proceeds to make 10 loans, each at $100,000. The bank wants to make more loans but has run out of cash and can only get those funds back when the borrowers pay back the mortgage. Fannie Mae and Freddie Mac were established to address this problem. As long as the bank approved the loans using standards set forth by Fannie or Freddie, the loans can be sold either to Fannie or Freddie, depending upon the guidelines used, or to other mortgage companies. When a loan is sold, the lender foregoes the long term interest on the loan and instead sells for a percentage of the loan amount. The lender makes a profit on the sale while at the same time replenishing available funds used to make home loans.
Conventional loans can be used to finance pretty much any residential property. Besides financing a primary residence, conventional loans can also be used to finance a second home or vacation home as well as a rental property. However, first time home buyers will have difficulty using conventional financing to purchase any type of property other than a primary residence.
The minimum down payment for conventional loans to finance a primary residence is 3.0% of the sales price. Fannie Mae has a program called the Conventional 97 which asks for a 3.0% down payment and while not reserved for first timers it’s a good low down payment option for first time buyers. Another 3.0% down program by Fannie Mae is the HomeReady loan which is designed for low-to-middle income buyers finance homes in designated areas.
Conventional loans offer a full range of financing options, fixed and adjustable.
Fixed rate loans are those where the interest rate will never change and the loan terms will range anywhere from 10 to 30 years in five year increments. Fixed rate loan terms can be 10, 15, 20, 25 and 30 years. Shorter loan terms will have lower rates but because the payback period is shorter the monthly payments will be higher. For example if you finance a $200,000 loan over 10 years at 3.50% the principal and interest payment is $1,977 per month while financing $200,000 over 30 years at 4.00% the payment is $954. You noticed the rate was higher on the 30 year loan but the monthly payment was so much lower.
On the other hand, due to the shorter term, even though the payments are higher the amount of interest paid to the lender is much less. Selecting the proper term is a mix of affordability and saving on long term interest. By far the most popular loan term is 30 years as it helps buyers finance a bigger home.
Conventional loans accept down payments as low as 3.0% but with a conventional loan if the down payment is anything less than 20% down, it triggers what is known as “private mortgage insurance,” or PMI. Conventional loans had always required a down payment of at least 20% in order to get an approval. Because the loans had no government-backing the lender assumed all the risk and therefore required more from the buyers at the outset.
In the late 1950s a company introduced the concept of private mortgage insurance. PMI isn’t an insurance policy that makes the mortgage payments on behalf of the borrowers should they suddenly not be able to but instead is a policy that compensates a lender the difference between the 20% threshold and the amount the borrowers actually put down. If the borrowers put down 5.0%, the PMI policy would be for 15% of the sales price of the home.
Buyers can also avoid paying PMI using a structure of two loans, called a first and a second, or a “piggyback.” In this way, the first loan would be at 80% of the sales price and the second loan at the difference between the actual down payment and 20%. Using the example above, lenders refer to this as an 80-15-5 with 80% the first mortgage, 15% the second and 5.0% the down payment. Another piggyback is an 80-10-10 loan. And now you know what that is, right?
Adjustable rate loans today are typically available in what are called “hybrids.” An adjustable rate loan is a mortgage that can adjust at predetermined periods based upon what is listed in the note. An adjustable rate mortgage, or ARM, is based upon an index, margin and caps. The index can be anything the lender uses but one of the more common used today is the London Interbank Offered Rate, or LIBOR and a typical margin is 2.00 and caps of 2.00 and 5.00.
Let’s slow down a little and explain all this a little better.
Let’s say that a loan is coming up for its annual adjustment period. The LIBOR index is 1.75 and the margin is 2.00. Adding the two together provides the interest rate for the following year, or at the next adjustment. 1.75+2.00= 3.75%. That’s the new rate the monthly payments are based upon.
But what if the LIBOR had some bad mood swings and the index actually went to 7.00? If you added 7.00+2.00 you get 9.00%. That’s quite a bit different than the previous year! But these loans have caps, an initial cap, an annual cap and a lifetime cap. If an ARM has an initial cap it means the loan can’t go any higher than a predetermined amount over the previous rate. If the initial cap is 2.0, then in this example the rate could be no higher than 2.0% more than the previous rate, or in this example 3.75%+2.00%= 5.75%. While the “fully indexed” rate wanted to go to 9.0% it could because of the initial cap.
An annual cap is one that limits movement from year to year while a lifetime cap limits how high the rate could ever be compared to the initial rate. If the lifetime cap were 5.0% and the initial rate 3.75%, the rate could be no higher than 5.00+3.75%= 8.75%.
Consumers can choose ARMs because the start rates are a bit lower compared to what’s available for a similar fixed rate term. Today, most ARMs are in the form of a hybrid which is a loan where the rate is fixed for an initial, extended period before turning into a loan that can adjust annually or every six months, whatever is cooked into the note. Common hybrids are 3/1, 5/1, 7/1 and 10/1. A 5/1 hybrid is a loan where the rate is fixed for five years before turning into a loan that can adjust once per year until the loan is paid off.
There are three basic government-backed loans, VA, FHA and USDA mortgage programs. The VA loan guarantees 25% of the loss to the lender should the loan ever go into default while both FHA and USDA loans provide 100% of the loss.
The Department of Veteran’s Affairs, or the VA, provides the guidelines lenders use when approving a VA loan application. VA loans ask for zero down and does not require a monthly mortgage insurance payment. Certain closing costs are restricted and the borrowers are not allowed to pay them. VA loans are reserved for those who have earned the benefit and include veterans, those with at least six years of service in the National Guard or Armed Forces Reserves, active duty personnel with at least 181 days of service and unremarried surviving spouses of those who have died while in service or as a result of a service related injury.
For those seeking the lowest cost loan with competitive interest rates the VA home loan program is likely the best option. VA loans can only be used to finance a primary residence and can’t be used to finance a rental property. VA loans are also available in fixed rate as well as hybrids.
The lender is compensated at 25% of the loss but a VA default is a rarity. Even though there is no down payment, the VA home loan has the highest performance rate of any mortgage program available in today’s marketplace. VA home loans rarely go into foreclosure.
The guarantee is financed by the Funding Fee. The funding fee is based upon the sales price of the home and can vary based upon the nature of the loan and the borrower. For example, veterans using the VA home loan for the first time pay a 2.15% funding fee. This does not have to be paid for out of pocket but is rolled into the final loan amount. There are VA loan limits and they are the same as the loan limits that Fannie Mae and Freddie Mac set based upon the location of the property.
FHA loans are those backed by the Federal Housing Administration and while there is a down payment required it is only 3.5% of the sales price and like the VA program can only be used to finance a primary residence. The FHA compensates the lender to 100% of the loss and there are two separate mortgage insurance policies associated with each FHA loan, an upfront policy and an annual policy paid in monthly installments. The initial upfront mortgage insurance premium today is 1.75% of the loan amount and is rolled into the loan. The annual premium today is 0.80% of the outstanding loan balance. These premiums can change based upon the determination of the Department of Housing and Urban Development, or HUD, which oversees the FHA program.
Unlike the VA program however, FHA loans can be taken by anyone who qualifies under typical approval requirements and not reserved for any class of borrowers. However, because of the low down payment the FHA program provides most first time buyers choose the FHA program compared to say a low down payment conventional loan. FHA approval guidelines are a bit more relaxed compared to other programs. FHA loan limits can change from county to county and calculated at 115% of the median home values for the area.
If you’re not VA eligible and want a low down payment loan, the FHA program should certainly be considered.
The United States Department of Agriculture, or USDA oversees a loan program designed to help buyers finance homes in rural and mostly rural areas. The USDA loan is another loan that doesn’t require a down payment and like the FHA loan has both an upfront mortgage insurance premium rolled into the final loan amount and an annual premium based paid in monthly installments.
USDA loans are limited to certain rural areas and I can provide you with these areas or you can tell me the property address and I’ll provide this information for you. There are also income limits with a USDA loan and is approximately 115% of the median income for the area. All the income from those living in the household will count toward the 115% level, even if the individual is not on the loan application.
If you’re financing a property in a rural area and want a low-cost loan the USDA program is probably your better choice.
IV: Closing Costs Explained
We briefly mentioned closing costs earlier but this final section is dedicated to explaining closing costs, what the major players do and understanding the Loan Estimate. Closing costs can be first be grouped into two categories, lender fees and non-lender fees. Lender fees are the ones the lender charges to cover the overhead lenders incur during the course or originating, processing and approving a home loan application. Non-lender fees mean anything else for needed services.
We’ll talk over the phone and during the course of a prequalification or preapproval, provide you with an initial Loan Estimate. The fees will clearly be listed as ones the lender collects and ones that third parties charge for services needed to close your loan.
Common lender charges might include a processing fee or an underwriting fee. Lenders can also collect funds to pay for a credit report as well as an appraisal. A lender will also ask for an origination fee which is represented as a percentage of the loan amount.
Non-lender charges include funds needed for settlement services, title insurance and attorney fees where required. Don’t be surprised at the number of different charges as there will be more than you might expect but your I will explain these charges and why they’re needed. Most mortgage loans today require certain services and documents in order for the loan to be eligible for sale in the secondary market. A lender can’t “waive” a service if it’s a required one.
Closing costs are also either one-time charges you’ll see at the closing table and “recurring” fees referred to as prepaid or finance charges. A one-time fee is a charge for a property appraisal and you’ll never pay for an appraisal again for the same transaction. A recurring fee is one you’ll pay again and again. Homeowner’s insurance is a recurring charge, for example. So is mortgage interest. And speaking of interest, let’s take a time out to explain prepaid interest.
Mortgage interest is always paid in arrears, except when you close on your first mortgage. Each month when you make the mortgage payment you’re really paying for the previous month’s interest. With rent, you’re paying to live there for the upcoming month. With a mortgage, the interest paid is for last month.
Prepaid interest is collected at your closing based upon the number of days until the first of the following month. This is, in reality, your first mortgage payment and will be made at closing. If your closing is scheduled for the 20th of the month, the lender will collect 10 days of interest up to the first of the following month. You will not make a mortgage payment on the first of the next month because the lender already collected it. For someone who closes on the last day of the month, the lender will only collect one day’s worth of interest.
At the closing table you will also prepay your first year of homeowners insurance. And if you have escrow or impound accounts, accounts set up to make monthly payments toward your annual property tax bill and insurance premium, lenders may ask that you pay one or two months of escrow payments in advance in case taxes are higher than anticipated for the following year.
Can you negotiate closing costs? Not really, no. Lenders can’t give one borrower a discount on a lender fee and not give that same discount to someone else. Further, lenders have no control over fees third party servicers require. There are some services where you do have more control and can select these services on your own. When you get your loan estimate there will be a list of “Services You Can Shop For.”
Your documents will highlight who is responsible for paying what. There will be seller fees and buyer fees. Most of the fees will be yours. So who pays for them? You. That is, unless you negotiated with the sellers to pay part or all of your closing costs as listed on the sales contract.
You can also have the lender pay the closing costs, again some or all. How does the lender pay for your closing costs if lenders are required to offer the same costs to all borrowers for the same type of loan? Lenders can adjust the interest rate on your loan and provide a lender credit at the closing table. Here’s how it works:
When you get interest rate quotes you’ll get a rate without any discount points and you can get a rate quote with discount points. A discount point is expressed as a percentage of the loan amount and reduces the interest rate on the loan. A discount point is a form of prepaid interest, the lender gets some interest upfront when you pay a point or the lender gets the interest over the life of the loan. Yet it’s your choice whether or not to pay points. Using a regular 30 year loan, by paying one point, or 1.00% of the loan amount, the rate on the loan will drop by about 0.25%. The more points you pay, the lower your rate will be. However, we’ll work together to see if points make financial sense in your situation.
Okay, now what if instead of lowering your rate by 0.25% your increase your rate by 0.25%? Why would anyone do that? In this instance, there can be a closing cost credit in exchange for the higher rate. This is how “no closing cost” loans actually work. The lender will agree to pay for some or all of your costs by adjusting your rate. If on a $250,000 loan, paying $2,500 for a point will lower the rate by about 0.25%.
Increasing your rate by 0.25% will provide a credit to you in the amount of $2,500. Again, we’ll work together to find the ideal situation but many times exchanging a slightly higher rate for closing cost credit works out better, especially if someone is relatively short term.
At Your Closing
You’ll receive your Closing Disclosure three days before your scheduled closing. Use this form to compare the initial loan estimate you received from your lender. Lender fees must be the same. If lender fees are higher on the closing disclosure than the original estimate the lender is responsible paying the overcharge.
For third party charges by providers the lender selected, the lender is responsible for amounts greater than 10% of the original quote. For servicers picked out by the borrowers, the borrower is responsible for the additional fees.
You will review and sign your documents and wire the necessary funds to the settlement agent.