There are so many different kinds of mortgages. Learn mortgage basics so you can decide what type is best for your situation.
If you are going to purchase a home with financing, it helps to get some of the mortgage lingo down and prepare yourself for the paperwork onslaught. In this article I explain what is included in your monthly payment, define escrow and points, and explain the different types of mortgages.
What Is A Mortgage?
A mortgage is a type of loan that is secured by real estate. Since it is an asset backed loan, if you fail to make your payments, the bank is able to take back the property as a foreclosure.
What is included in your monthly payment?
* Principal: the amount you borrowed in order to purchase the property.
* Interest: what the lender charges to borrow the money.
* Taxes: property taxes for the city and/or county the property is located in (if escrowed).
* Insurance: protection for the home from fire, hurricanes, etc (if escrowed).
* Private Mortgage Insurance (PMI) or Mortgage Insurance Premium (MIP): if necessary.
What Is Escrow?
During the home buying process an escrow account is a third party (title company or real estate attorney) that holds money until all the conditions of the sale are met. When going into contract on a property, the buyer will put a “good faith deposit” into escrow, generally $1,000-$5,000 depending on the purchase price, and that money will be applied to the closing costs at the end of the transaction.
Once you purchase the property using a mortgage, a new escrow account is opened and becomes a way for your mortgage company to ensure you are making property tax and insurance payments. For example, if the annual property tax and insurance bill equal $3,000, the monthly escrow payment would be $250.
The mortgage company would add this $250 to the principal and interest payment to determine your total monthly mortgage payment. The mortgage company will then pay the property taxes and insurance bills for you when they come due. This is very nice for homeowners who do not budget well and find it hard to plan for a large annual expense like a $2,500 property tax bill.
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Down Payment And PMI/MIP
When you purchase a property, banks like to see you pay at least 20% of the purchase price from your savings. If you are unable to pay 20% you are considered a riskier investment and the banks want some protection against the risk you will default on the loan.
They get that protection in the form of a monthly fee called Private Mortgage Insurance (PMI) or Mortgage Insurance Premium (MIP). PMI/MIP is an insurance policy that pays the lender for a portion of its losses if you default on your loan. Once you reach 78% loan-to-value ratio (current loan principal balance divided by the home’s appraised value) lenders must automatically cancel PMI.
Closing Costs, Points, Rates And Terms
In addition to the down payment needed to buy a home you need to budget for closing costs. Typical closing costs for a buyer are 3-5% of the purchase price and will vary depending on specific lender fees and the city or county where the property resides.
Closing costs are made up of many different fees or services such as loan origination (fee for processing the loan), home inspections, appraisals, surveys, title insurance, recording fees with the city or county, points, etc.
What is a point? One point is equal to one percent of the loan amount. So a one point fee for a $100,000 mortgage would be $1,000. This is yet another fee the lender can charge you to obtain financing. Not every loan has points and sometimes people even choose to “buy points” in order to lower their interest rate.
This calculator demonstrates how long it would take to break even with buying points. If you plan to be in the house for a long time it might be useful to buy points for a lower overall interest rate but it will increase your initial costs.
Rates – the interest rate is extremely important but if you want to compare mortgages between two companies you need to compare the Annual Percentage Rate (APR). The APR is the interest rate plus all the other fees included over the life of the loan (closing costs, fees, points, etc.) to show your actual cost of borrowing.
Since fees can vary dramatically between lenders, it is important to compare the APR and not just the interest rate. Loan companies have to disclose both the interest rate and the APR to you when you apply for a loan for easier comparisons between loan offerings.
Term is the duration of the loan. Most loans terms are 15, 20 or 30 years. The shorter the loan duration the lower the interest rate should be but the monthly payment will be higher because you are paying off the principal in a shorter time frame.
For a $100,000 loan, the monthly payment (principal and interest only) would be $739.69 at 15 years with a 4% interest rate and a total interest paid of $33,143.05 over the duration of the loan.
The same $100,000 loan at 30 years and 5% would have a monthly payment (principal and interest only) of $536.82 with a total interest paid of $93,255.78. For only $202.87 more a month you could save $60,112.73 in interest and 15 years of mortgage payments.
Types Of Mortgages
Most loans are either fixed-rate or adjustable-rate mortgages, and can be either government guaranteed or privately issued.
A fixed-rate mortgage means the interest rate remains the same for the entire duration of the mortgage. This provides a very stable and predictable monthly payment and in today’s low rate environment, can help lock in a historically low interest rate for a mortgage.
With a fixed-rate mortgage, the only reason the monthly payments would change is if the escrow amount increased due to increased property taxes or insurance. The current interest rate today on a 30 year fixed mortgage is 4.125% and a 15 year fixed mortgage is 3.25%
An adjustable-rate mortgage (ARM) means the interest rate is subject to change based on specific dates (after 3 or 5 years for example) or terms of the loan agreement. An example of an adjustable-rate mortgage is a 30 year 5/1 arm. This means that for the first 5 years the interest rate is set. At the end of 5 years the rate is reset and then each year the monthly payment is recalculated.
The new rate is based on a specific index (commonly the 12 month Treasury rate or Prime rate) plus a margin (a fixed percentage rate charged by the bank). There are interest rate caps which limit how much the interest rate can change each year and how much they can change over the life of the loan.
For example, the loan could have an annual 2% cap and a 6% cap over the life of the loan. If your initial rate was 4%, the highest possible rate you would have is 10%. ARMs will provide a lower rate in the beginning of the loan but the payment will change over time so you need to be financially prepared for these changes.
Always read the fine print in these types of mortgages so you understand the terms and what index it is tied to. The 5/1 ARM example could be a great choice if you plan on staying in the home for less than 5 years since you lock in the lower rate during the introductory period. The current interest rate today on a 5/1 ARM 30 year mortgage is 2.75%
Private issued loans are loans that are not backed by government guarantees. These loans can be from big national banks or local city banks. They can be from your cousin Vinnie or from a private investment company.
These loans are generally kept by the lender for the duration of the loan but if they meet federal loan standards, they may be sold off to other companies as part of a larger loan package.
Government guaranteed loans are loans designed to help homeowners with income restrictions (FHA loans), military service (VA loans) and rural homeowners (USDA loans). These loans are backed by the US Government as protection for the loan company against default. The government assures the loan company that even if the borrower defaults the loan company will get paid.
These loans have lower down payment requirements and fewer financial qualifying guidelines but they do have very specific criteria. Government guaranteed loans can only be used for a primary residence, but if you are interested in rental properties you can use a government guaranteed loan for a small multifamily (up to 4 units) as long as you live in one of the units. All government guaranteed loans can be fixed-rate or adjustable-rate.
Federal Housing Authority (FHA) Loans
One of the most popular ways for low and middle income households to purchase a home is through a FHA insured loan. FHA loans are popular because they only require a 3.5% down payment. FHA loans do have maximum purchase prices based on the median sale price for your area.
In order for the government to offset some of the risk of the loan, it charges two additional fees to the home buyer: a 1-2% one-time fee at the time of closing, which can get wrapped into the total mortgage amount, and a monthly Mortgage Insurance Premium (MIP) fee.
Both fees are based on a percentage of the purchase price which typically ends up being around $100 per month for each $100,000 financed. Unlike a traditional mortgage in which the PMI drops off as soon as you reach 78% loan-to-value ratio,you will never get rid of your monthly MIP fee with an FHA loan unless you refinance your loan after you achieve a 78% loan-to-value ratio.
The benefit of a FHA loan is that it allows low or middle income families to get into a house that they might not be able to afford otherwise. For a $70,000 home they would only need to have $2,450 plus closing costs to buy the home with an FHA loan vs $14,000 plus closing costs with a traditional 20% down mortgage.
FHA 203K Loans
The 203k loan is a subset of the FHA loan so all of the above applies. But the 203k is special because it is a two part loan that includes funds to both purchase and rehab your home. Often people using an FHA loan don’t have the money to also improve their home which is what makes this 203k loan so powerful.
This would allow you to shop for homes that other homebuyers may skip because they don’t have money for a renovation. FHA 203k loans require use of an FHA approved contractor if the rehab will cost over $15,000 and all work needs to be completed within six months of closing.
Not all mortgage companies will be familiar with the 203k loan so if you are interested in this type of loan you should find a company in your area that has done 203k loans before. Rehabs are not an easy process so make sure this is something you can handle yourself or that you can manage contractors. Be sure to budget for contingencies!
Veterans Affairs (VA) Loan
The VA loan is only for US military service members, veterans and surviving spouses. VA loans are very similar to the FHA loan but with a few notable differences: VA loans can be funded with 0% down, they have no PMI/MIP, and the VA loan allows the seller to pay 100% of the buyer’s closing costs.
This means the VA loan can truly be a no money down loan. There are one-time funding fees ranging from 1.25% to 2.15% of the purchase price, depending on the down payment, that can be wrapped into the loan amount.
The USDA loan is a nice combination of the FHA and VA loan products. Like the VA loan, USDA loans can be funded with 0% down and have no PMI. Like the FHA loan, repairs and upgrades can be financed into the loan. And unlike the others there is no maximum purchase price.
The main difference is the USDA loan is only for rural homes. To see if your location qualifies (and quite a lot of America does) check out the map on the USDA website.
Now that you have determined which loan type is best for your situation, it’s time to speak with lenders and get pre-qualified. This will require you to submit various financial documents to the loan company to determine if it wants to lend to you.
Required initial paperwork includes the last two years of tax returns, last two pay stubs and the last two months of bank statements from which the down payment will originate.
The loan company will pull a credit score and it will be a major determiner of the interest rate you are offered. A loan application with your employment information is also required, as well as a list of your monthly income and expenses, declarations that you are not in default on any loans, have not defaulted on a loan in the past 7 years, that you are not part of a lawsuit, and if the home will be a primary residence or investment property.
It takes time to gather these documents, but the process of doing so will prepare you for the coming paperwork onslaught, and help to organize your finances in support of your mortgage planning.
Once you submit all the information to the lender, it will give you a “good faith estimate” which is an estimate of all the closing costs and loan terms if you are fully approved for the loan. This is when you will get the APR for the loan which allows you to compare loan offers equally.
The following five examples give you an idea of the closing costs and monthly payments for various loan types. For all my examples I am not including property tax or insurance in the monthly mortgage payments.
My favorite online mortgage calculator can calculate your monthly payments and allows you to see the effect of extra monthly payments or extra one time payments on your overall mortgage balance.
1. Chris is getting a 30 year fixed mortgage at 4.125% with a 20% down payment. The purchase price is $100,000 and closing costs are 4%. He pays $24,000 at closing and his monthly mortgage payment is $387.72. Over the life of the loan he will pay $59,579.12 in interest.
2. Heather is getting a 15 year fixed mortgage at 3.25% with a 20% down payment. The purchase price is $100,000 and closing costs are 4%. She pays $24,000 at closing and her monthly mortgage payment is $562.14. Over the life of the loan she will pay $21,184.30 in interest.
3. Elaine is getting a 30 year FHA mortgage at 4% with 3.5% down. The purchase price is $100,000, closing costs are 4% and her FHA funding fee is 1.75% wrapped into the loan amount. She pays $7,500 at closing and her monthly payment is $569.06 (including $100 for MIP) Over the life of the loan she will pay $70,611.79 in interest
4. Jon is getting a 30 year VA mortgage at 3.75% with 0% down. The purchase price is $100,000, closing costs were paid by the seller and his VA funding fee is 2.15% wrapped into the loan amount. He pays $0 at closing and his monthly payment is $473.07. Over the life of the loan he will pay $68,156.13 in interest.
5. Andrew is getting a 30 year 5/1 ARM mortgage with a 20% down payment. It starts at 3% and after 5 years can increase by 1% every year up to a max of 10%. The purchase price is $100,000 and closing costs are 4%. He pays $24,000 at closing and his initial monthly payment is $337.28.
The max his monthly payment could increase to is $615.45 at year 12 if the interest increased the max 1% every year after the initial 5 year introductory rate. Over the life of the loan the max he could pay is $114,733 in interest if the worst case scenario occurred and the rate climbed to 10% by year 12 and stayed at 10% for years 13-30.
The actual amount he will pay is unknown but he should plan for the worst. Here is a useful ARM calculator.
There are many ways to purchase a home using a mortgage. Hopefully you now have a better understanding of the components of your monthly payment and of some of the financing options available to you. There are reasons to put 20% down and reasons to put 0% down.
There are reasons to pick a 15 year term or a 30 year term, fixed-rate or adjustable-rate. There is no one right answer. You need to look at your short and long term plans, how long you plan on being in the home, what else you could invest your money in, and what the current rates are before you decide what is the right loan for you.
Featured Image Photo Credit: “The old Man and the Sea” by Thomas Leuthard on Flickr