The ABC's of Mortgage Financing
Everything You Need to Know About The Mortgage Process
When you contact a mortgage professional, they'll determine the amount and types of loans that will be available to you. Some of the factors that lenders use are explained below.
Type of Mortgage Professionals
- Loan Officer/Direct Lender:
- These professionals are employees of an entity that has the funds to actually make the loan, such as a bank, credit union or other financial institution.
- The primary downside to using a direct lender is that they only sell the loan products offered by their company. So, you're limited to what they offer and the rates they provide.
- However, you'll be working with someone within the organization that actually owns the funds, so their loan commitment can be stronger than that of a mortgage broker.
- Mortgage Broker:
- A broker is not an employee of a financial institution and typically does not have the actual funds to lend.
- They shop for the best deal on your behalf and are not tied to one source of financing.
- One drawback, though, is that the mortgage broker needs to find a lender to fund your loan after you make your application. So, a pre-approval letter from a broker may not be as reliable as one from a direct lender. This risk can be overcome by working with an experienced broker affiliated with a well-established company
- In any case, we highly recommend that you use someone who is local. There are lots of offers on the internet or in national print media that look tempting, but will the funds arrive on time? Many of these offers are "teasers" used to get you in the door, then the terms and pricing change dramatically. If you do find a great offer, find out if they have a local office where you can go in person to meet with the individual who is accountable for getting you to settlement. This person can even attend the settlement in case there are any last-minute issues that must be resolved.
- Even if you just want to explore your options online, do not apply for a loan or authorize anyone to run a credit check (you can prevent this by not providing your social security number). Numerous credit inquiries may lower your credit score and make it harder to get the best deal when you're actually ready to go.
Types of Mortgages
- Fixed Rate vs. Adjustable (ARM)
- A fixed rate loan will lock in your interest rate for a set length of time, typically the whole term of the loan. Changes in market interest rates will not result in your rate increasing or decreasing. The longer the rate is locked in, the higher the rate is likely to be.
- The rate of an adjustable rate mortgage is tied to market interest rates and will go up and down with the market. This type of loan will generally provide the lowest rate at the beginning, but comes with the risk that it will increase in the future to a higher rate than you could have locked in with a fixed rate mortgage.
- There are hybrid products that lock your rate in for a short period of time, after which it adjusts to market. For example, a 5/1 loan will be fixed for 5 years then will convert to an adjustable rate thereafter.
- Amortizing vs. Interest-Only
- The payment on a standard amortizing mortgage is comprised of both interest and principal. The payment is usually higher than with an interest-only loan, but the principal component of the payment is being applied to your loan balance. As your loan balance is being paid down, you're accumulating equity in your home.
- The advantage of an interest-only loan is that, without the principal component, the payment is generally lower (as long as the rate is the same). The disadvantage is that you're not paying down your loan balance over time.
- Conforming vs. JUMBO
- A conforming loan meets all the standard requirements established by the Federal National Mortgage Association (also known as Fannie Mae) or the Federal Home Loan Mortgage Corporation (also known as Freddie Mac). These standards include required debt/income ratios, maximum loan to value (LTV), other credit standards and a maximum loan amount (loan limit varies by location). These conforming loans generally receive the best rates.
- When a loan exceeds the maximum loan limit for the area, it is considered a JUMBO loan. These loans are usually a bit more expensive and are sometimes more difficult to obtain. The best way to avoid the need for a JUMBO loan on an expensive home is to have a larger down payment. The conforming loan limit for the Baltimore metro area (includes Howard, Baltimore, Anne Arundel and Carroll Counties) is $560,000. The limit in the Washington metro area (includes Prince Georges, Montgomery and Frederick Counties) is $729,750.
- Federal Housing Administration (FHA). Many lenders are authorized to make loans that will by guaranteed by the FHA. These loans require lower down payments and have different underwriting criteria than the standard loans (also known as "conventional" loans).
- There are dozens of other loan programs targeted to specific groups or geographic areas. These include the Veterans Administration (VA), community development organizations (CDA) and most states, cities and counties. Your mortgage professional should be aware of all loan programs available in your local area.
Income Ratios
- Lenders use ratios between your gross income and debt payments to determine how much you can afford to borrow.
- In addition to your W-2 income a lender may include other sources of income:
- Bonuses and commissions. Lenders may want to be sure that bonuses and commissions have been stable over the past few years and, if they've been erratic, the lender may average them.
- Business expenses. If you receive commissions, a lender may elect to deduct any business expenses that you claim on your tax return from your income.
- Alimony. The lender will want to see that a final written agreement requiring these payments is in place and that the payments continue for at least a couple of years into the future.
- Interest and dividends. As with commissions and bonuses, lenders will want to see that this income has been stable for a few years and they may elect to average the income if it's been up and down.
- The primary types of debt payments that the lender will use to calculate your ratios will be comprised of:
- Front ratio: Principal and interest on the new mortgage, property taxes, insurance (collectively referred to as PITI), homeowners/condominium association fees and mortgage insurance premiums.
- Back ratio: This ratio uses all of the expenses used in the front ratio, but also adds all other debt payments such as a car loan, credit card minimum payments and interest due on revolving lines or other consumer loans. Even if you've only co-signed for a loan and someone else is making the payments, it will be on your credit report and the lender may require proof that you're not paying it.
- Ratios. All lenders use different ratios to determine what you can afford. But, in general, the following maximum ratios are preferred by most lenders.
- Front ratio: Debt payments divided by income less than .28. For example, if your income is $4,000 per month, your monthly front ratio debt payments will need to be less than $1,120.
- Back ratio: Debt payments divided by income less than .36. For example, if your income is $4,000 per month, your monthly back ratio debt payments will need to be less than $1,440.
Other Mortgage Facts
- First mortgage. This is the primary loan secured by your home. If you home was sold at foreclosure, this loan would be paid first. The general term "mortgage" usually refers to this loan.
- Second mortgage. This is a loan that is subordinate to the first mortgage (gets paid off after the first mortgage). Most of these loans are in the form of a home equity loan or a home equity line of credit. These loans are more expensive because they carry more risk for the lender.
- Mortgage insurance (MI or PMI). MI is usually required when your first mortgage exceeds 80% of the value of your home (loan to value or LTV). While you may be able to obtain a "conforming" loan that exceeds 80-% LTV, you'll incur the cost of MI on top of your PITI.
- Down payment. This is the amount of your own money that you'll use to buy the home. For example, if your home costs $100,000 and you borrow 80% LTV ($80,000), your down payment will be the other $20,000 needed. Down payments can come from your own cash or gifts from a family member. If you have the ability to make a significant down payment (such as 20% of the purchase price), you'll have more (and better) loan options.
- Seller note. A seller may elect to finance part of your purchase. For example, if the home costs $100,000, you might borrow $50,000, pay $20,000 in cash and agree to pay the seller the remaining $30,000 over time (under negotiated terms just like a loan).
- Pre-approval letter. Before looking for a home, you'll want to get pre-approved by a direct lender or mortgage broker. This process involves your providing preliminary information, the mortgage professional performing a credit inquiry and issuing you a pre-approval letter. This letter will show you and the seller that you've been pre-approved for the financing you'll need to buy. However, this is not a final approval. After securing a ratified contract, you'll provide detailed information to the lender, the property will be appraised, the title will be researched and the loan will go through formal underwriting.
