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About
Mortgages
Shopping for the right loan
is just as important as choosing the right house. Your challenge
is to select the loan terms that are most favorable to
your situation. In selecting the loan that's right for
you, you'll need to understand:
Basic Components of a Mortgage
Loan
A mortgage requires you to
pledge your home as the lender's security for repayment of
your loan. The lender agrees to hold the title or deed
to your property (or in some states, to hold a lien on your
title or deed) until you have paid back your loan plus interest.
The following are the basic
components of a mortgage loan:
Mortgage Amount and Term
The mortgage amount is the amount of money you borrow from
a lender to pay for your house. The term is the number
of years over which you can pay back the amount you borrow.
TIP: The length of your
mortgage repayment period will directly affect your monthly
mortgage payments.
The most popular mortgage
term is 30 years. By extending payment over 30 years, you
keep your monthly housing costs low. If you can afford higher
monthly payments, you can select a mortgage term that is shorter.
There are 20-year, 15-year, and even 10-year fixed-rate mortgages
available from most mortgage lenders. The longer your repayment
period is, the lower your monthly payments will be, but the
total interest you pay over the life of the loan will be more.
Amortization
Over time, you will repay your mortgage through regular
monthly payments of principal and interest. During the
first few years, most of your payments will be applied toward
the interest you owe. During the final years of your loan,
your payment amounts will be applied primarily to the remaining
principal. This type of repayment method is called amortization.
Fixed or Adjustable Interest
Rates
Interest rates are usually expressed as an annual percentage
of the amount borrowed. You can choose a mortgage with
an interest rate that is fixed for the entire term of the
loan or one that changes throughout. A fixed-rate loan
gives you the security of knowing that your interest rate
will never change during the term of the loan. An adjustable-rate
mortgage (called an ARM) has an interest rate that will
vary during the life of the loan, with the possibility
of both increases and decreases to the interest rate and consequently
to your mortgage payments.
Down Payment
The down payment is the part of the purchase price the buyer
pays in cash and is not financed with a mortgage. Your
down payment will reduce the amount you'll need to borrow.
So, the more cash you put down, the smaller the size of your
loan, and the smaller the amount of your mortgage payments.
TIP: Lenders often
view mortgages with larger down payments as more secure because
more of your own money is invested in the property. However,
there are other loans that require as little as
3% to 5% of the purchase price for a down payment.
Closing Costs
The closing (or, in some parts
of the country, settlement) is the final step, during which
ownership of the home is transferred to you. The purpose of
the closing is to make sure the property is ready and able
to be transferred from the seller. The closing costs
(which vary from state to state) are usually expressed as
a percentage of the sales price or loan amount. Typically,
costs range from 3% to 6% of the price of your home
and can include transfer and recordation taxes, title insurance,
the site survey fee, attorney fees, loan discount points,
and document preparation fees.
TIP: Sometimes you
can negotiate to have the seller pay some of your closing
costs.
Discount Points
In the special vocabulary of mortgage lending, "points"
are a type of fee that lenders charge. (The full term
to describe this fee is "discount points.") Simply
put, a point is a unit of measure that means 1% of the
loan amount. So, if you take out a $100,000 loan, one
point equals $1,000. Discount points represent additional
money you can pay at closing to the lender to get a lower
interest rate on your loan. Usually, for each point on
a 30-year loan, your interest rate is reduced by about 1/8th
(or .125) of a percentage point.
TIP: Usually, the longer
you plan to stay in your home, the more sense it makes to
pay discount points.
Conforming and Nonconforming
Loans
The term "conforming," as opposed to "nonconforming,"
is sometimes used to explain loans that offer terms and
conditions that follow the guidelines set forth by Fannie
Mae and Freddie Mac. These are the two private, congressionally
chartered companies that buy mortgage loans from lenders,
thereby ensuring that mortgage funds are available at all
times in all locations around the country.
The most important difference
between a loan that conforms to Fannie Mae/Freddie Mac guidelines
and one that doesn't is its loan limit. Fannie Mae
and Freddie Mac will purchase loans only up to a certain loan
limit (currently $227,150, but will be $240,000 as of January
1, 1999).
If your loan amount will
be for more than the conforming loan limit, the interest rate
on your mortgage may be higher or you may have slightly different
underwriting requirements, particularly in regard to your
required down payment amount. Check with your lender about
this if you are taking out a large loan amount.
TIP: Nonconforming
loans are sometimes called jumbo loans.
Fixed-Rate Mortgages
The interest rate may be your
main consideration if you expect to stay in your house for
a long time. With a fixed-rate mortgage, you can be sure
that your interest rate will stay the same for the entire
life of your loan. Fixed-rate mortgages are available
in a variety of repayment terms, with 15, 20, and 30 years
the most common.
30-Year Fixed-Rate:
The easiest fixed-rate loan to qualify for, the 30-year mortgage,
gives you an excellent opportunity to keep mortgage payments
reasonable by making monthly payments over a long period of
time. This mortgage loan may be ideal if you plan to remain
in your home for years and wish to keep your housing expense
low and use any extra cash for other purposes. This loan also
provides maximum interest deduction for tax purposes.
20-Year Fixed-Rate:
For those who want a lower interest rate and want to own their
homes free of debt sooner, this shorter mortgage amortizes
principal and interest over just 20 years, saving a considerable
amount of total interest paid over the life of the loan.
15-Year Fixed-Rate:
This shorter-term mortgage will save you a significant amount
of interest over the life of the loan. By paying off the mortgage
more quickly, you also build up equity in your home sooner.
This may be important if you are approaching retirement or
have other large expenses to cover, such as financing your
children's education. However, the monthly payments you make
on a 15-year mortgage will cost you more than those you would
make on a 30- or 20-year loan.
Adjustable-Rate Mortgages (ARMs)
With an adjustable-rate mortgage
(ARM), the interest rate you pay is adjusted from time
to time to keep it in line with changing market rates.
When interest rates go down, so might your mortgage payments;
but keep in mind that your payments could go up when interest
rates are raised.
ARMs are attractive because
they may initially offer a lower interest rate than fixed-rate
mortgages. Since the monthly payments on an ARM start
out lower than those of a fixed-rate mortgage of the same
amount, you can qualify for a larger loan. The chief
drawback, of course, is that your monthly payments may increase
when interest rates rise.
You may want to consider
an ARM if:
- You are confident
your income will rise enough in the coming years to
comfortably handle any increase in payments;
- You plan to move
in a few years and therefore are not so concerned about
possible interest rate increases; or
- You need a lower
initial rate to afford to buy the home you want.
An ARM has two "caps"
or limits on how large an interest rate increase is permitted.
One cap sets the most that your interest rate can go up
during each adjustment period, and the other cap sets the
maximum total amount of all interest adjustments over the
life of the loan.
For example, a typical ARM
that adjusts annually may have a yearly cap of 2%, meaning
that the adjusted interest rate can never be more than 2%
higher than the previous year. And such an ARM may have a
lifetime rate cap of 6%, meaning that the interest rate on
your loan will never be more than 6% over the original rate.
So, if you are looking at an ARM with a current introductory
rate of 5%, a lifetime cap of 6% tells you that the highest
interest rate you could ever pay would be 11%.
TIP: Before applying
for an ARM, be sure you know how high your monthly payments
could go - the "worst-case scenario." Only
you can determine if you would feel comfortable paying this
interest rate sometime in the future.
Your lender can tell you which
ARMs offer a conversion feature that allows you to
convert from an adjustable rate to a fixed rate at certain
times during the life of your loan.
One important thing to know
when comparing ARMs is that the interest rate changes on
an ARM are always tied to a financial index. A financial
index is a published number or percentage, such as the average
interest rate or yield on Treasury bills.
The following are the most
common types of ARMs:
-
- CD-Indexed ARMs
(Certificate of Deposit): After an initial six-month
period, the initial rate and payments adjust every six months.
These ARMs typically come with a per-adjustment cap of 1%
and a lifetime rate cap of 6%.
- Treasury-Indexed
ARMs: These are tied to the weekly average yield of
U.S. Treasury Securities adjusted to a constant maturity
of six months, one year, or three years. Likewise, the interest
rate on your ARM will adjust once every six months, once
each year, or once every three years, depending on the schedule
you choose. Per-adjustment caps and lifetime rate caps also
vary.
- Cost of Funds-Indexed
ARMs: Indexed to the actual costs that a particular
group of institutions pays to borrow money, the most popular
of this type is the COFi for the 11th Federal Home Loan
Bank District. COFi ARMs can adjust every month, every six
months, or every year, and the per-adjustment caps and lifetime
rate caps vary.
- LIBOR-Based ARMs:
The London Interbank Offered Rate is the interest rate at
which international banks lend and borrow funds in the London
Interbank market. The six-month LIBOR ARM typically has
a per-adjustment period cap of 1% and is offered with either
a 5% or a 6% lifetime rate cap.
- Initial Fixed-Period
ARMs: As protection against rapid interest rate increases
in the early years of your loan, interest rates for these
ARMs don't adjust until several years after you take out
the loan. You can choose from three, five, seven, or 10-year
fixed terms. At the end of your chosen fixed-rate period,
your interest rate would adjust every year.
- Two-Step MortgageŽ:
This special type of ARM provides the benefit of initial
low rates with the stability of longer term financing because
it adjusts only once - either at seven years or at five
years. After that initial adjustment, the mortgage maintains
a fixed rate for the remaining 23 or 25 years of a 30-year
mortgage repayment term. For example, if your initial interest
rate were 8%, you would pay that rate for the first seven
(or five) years. Then, for the remaining 23 (or 25) years,
you would pay an interest rate that is indexed to the value
of the 10-year U.S. Treasury security on the adjustment
date. (At the adjustment date, there is no additional refinancing
cost, no forms to complete, and no re-qualification necessary.)
This new rate can never be more than 6 percentage points
higher than your old rate. There are no limits on how much
lower the adjusted interest rate can be.
Government Loans and Programs
The Federal Housing Administration
(FHA), the U.S. Department of Veterans Affairs (VA),
and the Rural Housing Services (RHS) are three agencies
that offer government-insured loans. To obtain these loans,
you apply through a lender that is approved to handle them.
All require that the properties being purchased meet certain
minimum standards.
Various types of government
loans include:
- FHA Loans:
With FHA insurance, you can purchase a home with a very
low down payment (from 3% to 5% of the FHA appraisal
value or the purchase price, whichever is lower). FHA mortgages
have a maximum loan limit that varies depending on the average
cost of housing in a given region.
- VA Loans: The
VA guarantee allows qualified veterans to buy a house
costing up to $203,000 with no down payment. Moreover,
the qualification guidelines for VA loans are more flexible
than those for either FHA or conventional loans. To determine
whether you are eligible, check with your nearest regional
VA office.
- RHS Loans:
The Rural Housing Service, a branch of the U.S. Department
of Agriculture, offers low-interest-rate homeownership loans
with no down payment requirements to low and moderate-income
persons who live in rural areas or small towns. Check with
your local RHS office or a local lender
for eligibility requirements.
- State and Local
Loan Programs: A number of states sponsor programs to
help first-time home buyers qualify for mortgages. Local
housing agencies also offer, in some areas, attractive loan
terms, such as low down payments or low interest rates,
to home buyers who meet specified income guidelines. Some
state and local programs may also offer down payment and
closing cost assistance. Check with your state housing authority.
You can find the office
nearest you online or look in the government
"blue pages" of your phone book.
Balloon Loans
Balloon loans offer lower
interest rates for shorter term financing, usually five, seven,
or 10 years. At the end of this term, they require refinancing
or paying off the outstanding balance with a lump-sum payment.
Balloon mortgages may be suitable if you plan to sell or refinance
your home within a few years and want a fixed, low monthly
payment.
The advantage they offer is
an interest rate that is lower than that of a fully amortizing
fixed-rate mortgage. For example, your initial interest
rate may be 7.5%, and you would pay that for the first five,
seven, or 10 years (depending on the term of your balloon
loan). Then, your entire outstanding loan balance would be
due to the lender or you might have to pay a fee to refinance
your loan at the prevailing interest rate.
Be sure to ask about all
the conditions for a refinance option at the end of the balloon
term. With some balloon mortgages, the lender doesn't
guarantee to extend the loan past the balloon date. If you
don't feel you will be able to meet all the refinance conditions
or think the balloon term may be up before you are ready to
move, this type of loan may not be appropriate for you.
Other Affordable Housing Loans
Fannie MaeŽ offers a variety of low and
moderate-income households mortgage loan options that help
overcome common barriers to homeownership. Fannie Mae loans
require less cash at closing and for a down payment, in addition
to flexible underwriting ratios, making it easier for qualifying
individuals to get into a new home sooner and use more of
their monthly income toward housing costs than permitted by
other mortgage loans.
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