For most home buyers, the most intimidating part of purchasing a home is applying for the mortgage. It is a complex subject with a lot of different options, each of which can cost you a great deal of money over the long term. It is important to understand the basics of what mortgages are and how they work, and then find a loan officer that can help you navigate these complex waters.
What is a Mortgage?
A mortgage is simply a loan that uses your home and land as collateral. If you don’t pay back the loan, the lender can foreclose and take the home back, sell your home and use the proceeds to pay off the balance of the loan, returning any remaining equity (which there is seldom any remaining equity) to you.
That doesn’t mean the bank owns the property. In Oklahoma, the home buyer actually owns the property and the bank will have a lien against the property. A lien is the right to take possessions of someone else’s property, sell it, and use the proceeds to pay the debt off. So you are actually a homeowner even if you have a mortgage. You own the home with a lien.
How Much Can You Borrow?
A few years ago it seemed that people could easily borrow far more money than they could realistically repay. Then came the housing crunch of 2008. Banks sold a lot of mortgages to people who assumed the housing market would keep rising, their home values would go up, and they would gain instant equity and later sell or refinance their home for a profit. Of course we know how that ended – a major economic crash when housing prices sank and buyers were upside down on their mortgages, unable to repay their loans.
Today banks are much more cautious about loaning money and diligent home buyers are much more careful to take on debt. With rising home prices it might be tempting to stretch your finances to purchase a home, hoping that the rising prices will make it more comfortable to own – but we recommend that you always purchase a home that you can comfortably afford. Nobody wants to be saddled with a mortgage payment that is a weight around their necks each month.
How Do you Qualify for a Mortgage?
A few years ago it seems if you could fog a mirror you could qualify for a home mortgage. Thankfully those days are past. The biggest factor in qualifying for a mortgage is your debt to income ratio, followed by your past credit history. I have lenders I have worked with for years that can help you determine the amount of loan you can comfortably afford, and if your credit needs a little cleaning up, they can offer guidance on what you need to do to raise your credit rating and lower your monthly interest payments.
What is a Good Credit Score?
Home mortgage credit is based on your FICO score, which range from 300 to 850. Here is a quick guide to determine how your credit score ranks:
- 720 and above – excellent credit. You won’t have any trouble getting a loan.
- 660 to 719 – Very good credit. You can easily obtain a mortgage, but will be paying a bit higher interest.
- 620 to 659 – Fair credit. You can obtain a mortgage but it will be a bit of work, and you will be paying fairly high interest rates for the privilege.
- 619 and below – Poor credit. It will be difficult if not impossible to obtain a home loan with a credit score below 619. However, there are ways to improve your score. I can get you in contact with lenders that will provide you guidance on improving your score. It might take 6 months or so of diligent work, but I have seen many buyers improve their low scores and buy a house – and stop paying rent!
What is the Best Mortgage for Me?
The best mortgage for an individual buyer depends on their home purchase goals. Do you plan to stay in the home forever? Is this a starter home that you plan to sell and upgrade in a few years? How long you plan to stay will help you and a mortgage lender choose the loan that is best for you – fixed or adjustable rate. It also helps you decide whether to focus on mortgage points or interest rate.
What is better? Fixed or Adjustable Rate Mortgage?
If you plan on staying in your home until your mortgage is paid off, then a fixed rate loan will provide you with payment stability over the long term. The interest rate will be a little higher but the monthly payment won’t go up like an adjustable rate mortgage can. The only thing that will change your house payment over time is your homeowner’s insurance and your property taxes.
If you plan to sell your home in a few years, then the lower interest rates of an adjustable rate mortgage might make sense. Even if the rates jump in a few years, you will be selling your home so won’t be impacted by the increased rates. You can also select a hybrid loan that is fixed for a number of years (3,5,7, or 10) then adjusts annually for the remainder of the loan. The risk of an adjustable rate loan is that if you don’t sell your home, the payments may go up and you may not be able to refinance.
What are Mortgage Points?
A point is equal to one percent of your loan. Your lender may offer to sell you points in exchange for a lower interest rate.
So when does it makes sense to “buy points?” How long you plan to keep the home and mortgage determine if it makes sense to buy points. If you plan on moving in a few years, buying points to get a better interest rate may not make sense because you won’t recoup the initial investment. On the other hand, if you plan on staying in your home with the same mortgage for a number of years, points might make sense. You have to make a choice between lower interest rates over the life of the loan versus the cost of the points up front – and of course the ability to come up with the cash to pay the points in the beginning.
In general, it doesn’t make sense to pay more than 1 to 1/5 points to a lender.
What is Amortization and Why Should I Care about it?
Loan amortization is the actual amount of money you are paying against your loan, usually broken out into months and years. You can get a mortgage with a term of 10,15 or 30 years. You pay the loan each month and the principal decreases until the loan is paid off. Each month the payment doesn’t change, but at the beginning of the loan, most of your payment is going towards interest and only a small portion is going towards your principal. By the end of your term, most of your payment is going towards principal each month. In other words, the lender is getting most of their income at the front of the mortgage rather than at the end. When you get close to paying off your mortgage, it usually doesn’t make sense to refinance since most of your payment is going towards principal rather than interest.
Smart Investment Tip: If you pay half your house payment every two weeks instead of one monthly payment, you will end up saving money on your loan. Have your lender run an amortization schedule to see the savings from paying every two weeks. In addition, if you pay even just a little bit extra each month on your mortgage, the length of your loan will drop substantially, since that extra amount each month goes directly to your principal and helps you pay off your loan faster. Even an extra $100 per month can make a BIG difference in the cost of the mortgage over time.
What are Prepayment Penalties?
Paying off debt early is always a good thing, unless there are prepayment penalties. Some mortgages actually have prepayment penalties. These penalties generally are for a specified period of time, normally between one and three years from loan origination.
Why would you get a loan with a prepayment penalty in the first place? Some lenders offer a very low interest rate in exchange for the prepayment penalty. Or in some cases, lenders my only agree to finance a home buyer with poor credit if the buyer agrees to these penalties. There are situations where accepting a prepayment penalty can save you thousands of dollars in interest over the life of the loan. You should analyze any prepayment penalties carefully before making a financial decision.
What is PMI?
Private mortgage insurance (PMI) is required by most lenders if you put less than 20% down on your home purchase. This insurance protects the lender in case you default on your loan. It is a cost to you and is added to your monthly house payment, yet is a benefit to your lender. Some mortgages are backed by the government and do not require PMI.