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Financing the American Dream
Buying a home is the biggest financial investment most
of us will ever make. As with any large project or goal, it requires dealing
with a variety of complex issues. The best approach is to divide the process
into manageable tasks. The following deals with the first steps of gathering
your records, determining what you can afford, and understanding mortgage options.
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Put Your Own Financial House in Order
Before you go looking for a home, you should determine how much home you can afford. Most lenders will prequalify you to borrow up to a certain amount. Prequalification allows you to focus in on a realistic price range and makes you a more attractive buyer. Whether or not you want to prequalify, eventually you'll need to complete a loan application and it may take some time to gather and assemble the required information.
It's also a good idea to review your credit report. Contact
local lenders to determine which credit bureaus they use. Then contact the credit
bureaus and request a copy of your credit report (in most states, credit bureaus
are required to provide individuals with a free copy of their report). Review
your report to ensure that all information is correct. If you have past credit
problems, don't lose hope. Be prepared to present a rationale for each slipup,
and demonstrate an improvement in your ability to pay bills on time.
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How Much Mortgage Can You Afford?
The Federal National Mortgage Association (Fannie Mae) is a government-sponsored organization that purchases mortgages from lenders and sells them to investors. Two income-to-debt ratios established by Fannie Mae are standard requirements for conventional mortgages. The first requirement is that monthly mortgage principal and interest payments (P&I), plus insurance and property taxes, cannot exceed 28% of the buyer's gross monthly income (some exceptions may apply to increase this limit to 33%). The second requirement limits total monthly debt payments (housing, credit cards, car payments, etc.) to 36% of gross monthly income. In addition to these requirements, you may have to pay 10% to 20% down on the total purchase price to qualify for a conventional mortgage.
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Types of Mortgages
How much house you can buy also depends on your mortgage's term and interest rate. The term is the length of time (usually 15 or 30 years) over which payments will be paid. The rate can be fixed (meaning it doesn't change over the loan's term) or adjustable (it fluctuates with market conditions). Thirty-year fixed-rate mortgages remain the most popular. The longer term lowers the monthly payment, while the fixed rate provides stability over the life of the loan. Given relatively low interest rates, these mortgages are attractive to buyers planning to stay at least six or seven years in their new home. The drawbacks are low principal payments in the early years, and the risk that market rates will decline over the term. However, if your credit history is sound and you have sufficient income, you can usually refinance your mortgage when rates decline.
A 15-year term lowers the interest rate, reduces total interest payments, and increases principal payments. But it also increases monthly payments. If you can't afford the higher payments now, you might opt for a 30-year mortgage. If there are no prepayment penalties, you can make additional principal payments as your income increases. Making just one extra monthly payment a year will pay off a 30-year mortgage in less than 22 years and can save tens of thousands of dollars in interest costs. If you plan to stay in a home no more than three years, you might want an adjustable-rate mortgage (ARM). ARMs offer initial rates that are lower than fixed mortgages. At some point, usually after the first year, rates are tied to market conditions and are subject to potential rate increases. Most ARMs include a cap on rate increases in any given year, as well as over the life of the loan. Some ARMs offer initial rates at least 2% below fixed rates and limit increases to 1% annually and 5% to 6% over the life of the loan. Many home buyers are attracted by the affordability of an ARM during the initial period. However, you should be confident that your future income will be sufficient if both interest rates and your monthly payments increase.
Another popular mortgage involves a balloon payment. A balloon is a lump-sum payment that pays off the loan in full after a fixed period of time. Generally the rates on balloon mortgages are 1/4% to 3/4% less than on 30-year fixed mortgages, but during an initial period of between 3 and 15 years, payments are similar. After this period, the remaining outstanding principal balance is either due in full or subject to refinancing. This is a good option for home buyers who plan to sell before the final payment is due. But because property values fluctuate, you may not be able to sell when you want. You may also face higher payments if you are forced to refinance at a higher rate, and there is also a risk that you may not be in a position to refinance when the balloon becomes due.
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Interest Rate Points
Points are interest paid in advance to reduce the
rate on a loan. One point is equal to 1% of the mortgage amount. The general
rule is that 1 point is worth 1/8 of 1% off the loan rate. The decision to pay
points for a lower rate is based on how much the seller is willing to contribute
to points, how long you plan to stay in the house, and how important lower payments
are compared to higher closing costs. You will need to calculate the long-term
value of points based on these factors, keeping in mind that points are generally
tax deductible in the year paid.
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Other Alternatives
If you cannot afford a conventional mortgage, there
are a variety of alternatives. An anxious seller will sometimes offer owner
financing. Federal Housing Administration (FHA) loans offer down payments as
low as 3%, but may require the buyer to purchase mortgage insurance. (The FHA
is a government agency responsible for insuring affordable housing mortgages.)
The Veterans Administration (VA) offers no-money-down mortgages to qualified
veterans of the U.S. military. Finally, there are local affordable housing advocates
that offer low-cost, low down-payment loan alternatives. For further information,
contact the FHA, VA, Fannie Mae, or your local mortgage lender or real estate
broker.
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Summary
- The first step in acquiring a home mortgage is to gather the information you'll need to include in a mortgage application.
- Review your credit report by ordering a copy from the credit bureaus used by local mortgage lenders.
- Prequalifying for a mortgage lets you know how much you can afford and makes you a more attractive buyer.
- Conventional mortgages limit housing costs to 28% of gross income and total debt payments to 36% of gross income.
- Mortgage terms are usually 15 or 30 years. The longer the term, the lower your monthly payment, but the higher your overall interest costs.
- Thirty-year loans often permit additional principal payments. One additional monthly payment per year will reduce a 30-year loan to 22 years.
- Interest rates are fixed or variable over the term of the loan. Variable rates may be best for buyers who plan to sell within three years.
- Generally speaking, one point is worth 1/8 of 1% off the loan rate.
- A balloon payment is a lump sum payable at the end of a specified term.
- Points and interest on mortgages or home equity debt are usually tax deductible.
Checklist
- When your credit reports arrive, review them for accuracy. Correct any mistakes immediately.
- Get prequalified for a loan. Paying off debts ahead of time might qualify you for a better mortgage.
- If you're a veteran, contact the U.S. Veterans Administration to find out whether you're eligible for a no-money-down mortgage.
