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Mortgage Basics
The key in choosing a loan that best fits your needs is to evaluate your finances and choose the best type of loan that fits your budget and your long- or short-term investment strategy. A mistake that many consumers make is to choose the type of loan that will allow them to buy the house they want without fully understanding the terms associated with lower-interest rate loans. This section is to inform readers about the most common loan types available and to map out the pros and cons. There are two basic categories of mortgages: the fixed-rate and the adjustable-rate mortgage (ARM). Within these categories, there are many variations. However, in nearly all mortgages, two factors are usually at odds: how predictable the payments are and how low, or affordable, they are at least initially. Borrowers choose fixed-rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. But in so doing, they give up a lower initial mortgage payment. Borrowers choose adjustable-rate mortgages because the mortgage payments are initially lower. A lower initial payment makes the home more affordable at first, but the borrower must also be willing to accept the risk of — and be confident in their ability to afford — an increased mortgage payment, sometimes significantly higher. In some cases, there's even the possibility of an increasing loan balance or negative amortization. To recap, getting a loan with adjustable payments results in lower payments at first but exposes you to some risk of high payments later. On the other hand, locking in steady predictable payments gives you a higher initial payment than the ARM, but you know exactly what you owe in principal and interest at any given time. Qualifying for a Mortgage
To some potential buyers, particularly first-time buyers, the prospect of meeting a mortgage lender may seem a little scary. Lenders ask a lot of questions because they want to help you get a mortgage. If you work with a lender before you decide on a home, you will know whether you’ll qualify for a mortgage large enough to finance the home you want. It may seem that your lender needs to know everything about you for the application, but actually all the lender needs to know about is employment, finances and information about the home you’re buying (but you can be pre-approved before you choose a home). You will, however, need to provide quite a few details about these topics. The goal is to arrive at a monthly payment you can afford without creating financial hardships. Here's an idea of what lenders consider when they are qualifying you for a loan: Your household income and expensesLenders look at your income in ways other than the total amount; how you earn it is also important. For example, income from bonuses, commissions and overtime can vary from year to year. If these sources make up a large percentage of your income, your lender will want to know how reliable they are. Your lender will also consider the relationship between your income and expenses. Generally, your fixed housing expenses (mortgage payment, insurance and property taxes, but not repairs or maintenance) should not be more than 28 percent of your gross monthly income, although this is not an absolute rule. Your lender will also consider other long-term debts, such as car loans or college loans. It is a good idea to bring the following when you meet with your lender: Income• Employment, salary and bonuses, and any other source of income for the past two years (bring your most recent pay stub, previous year’s W-2 forms and tax returns if possible) • The most recent account statement showing the amount of any dividend and interest income you received during the past two years • Official documentation to support the amount of any other regular income you may receive (alimony, child support, etc.) Employment historyJob stability is a factor that a mortgage lender will look for, and two years at your current job helps, but this also is not an absolute requirement. If you change jobs but stay in the same line of work, you should not have a problem — especially if the job change is an advancement or increase in income. Credit scoreYour credit score also helps to predict how likely you are to repay the mortgage debt. Personal assets• Current balances and recent statements for any bank accounts, including checking and savings• Most recent account statement showing current market value of any investments you may have, such as stocks, bonds or certificates of deposit • Documentation showing interest in retirement funds • Face amount and cash value of life insurance policies • Value of significant pieces of personal property, including automobiles • Debt Information • The balances and account numbers of your current loans and debts, including car loans, credit card balances and any other loans you may have Underwriting The lender does the best possible job of ensuring that a borrower qualifies for a loan. The final decision, however, rests with the lender's underwriter, who measures the total risk that the specific investor, who backs up the loan, is taking. Each investor (or investment company) has its own underwriting guidelines (often using statistical models), so while the underwriters evaluate many of the same factors as the lenders, they may look more closely at some areas than others, depending on the guidelines. For example, while the lender may have pre-approved you before you chose a home, by the time you get to underwriting, you will have chosen the property you want to buy, and the underwriter will review the property details closely. However, most of the information used is the same as that used by the lender, but it may be evaluated differently. The underwriter will evaluate the borrower's ability to pay (income), willingness to pay (credit history), and the collateral (property). As underwriters analyze each of these risks (although this is not a complete list), here are some possible guidelines they may use: Income • Is the income sufficient to repay the loan? Ratio guidelines of 28 percent payment-to-income and 36 percent total debt-to-income are standard, but some programs allow for higher ratios. • Is the income stable from month to month and year to year? • Has the borrower been on his/her current job and in the same industry for a sufficient amount of time? A minimum of two years is the standard guideline, but exceptions can be made. • Can the income be verified? Credit • Does the borrower have a good credit score (typically, 680 or higher is considered good)? • Does the borrower have late payments, collections, or a bankruptcy? If so, is there an explanation that can be provided for the late payments/collections/bankruptcy? • Does the borrower have excessive monthly debts to repay? • Is the borrower maxed out on credit cards? Collateral Is the property worth what the borrower is paying for it? If not, the lender will not loan an amount in excess of the value. If the appraisal comes back less than the offer on the house, sometimes you can renegotiate the terms of the purchase contract with the seller and his/her real estate agent. Some borrowers agree to purchase the home at the price they originally offer and pay the difference between the loan and the sales price. You need to have disposable cash to do this, and you should assess whether the property is likely to hold its value. You also need to consider the type of loan for which you have qualified. If you need to move suddenly and have a large loan relative to the original value, and the property has not held its value, you could face a difficult cash shortfall when you go to pay off your loan. Is the property an acceptable type of property, and does it meet coding requirements and zoning restrictions? Is the property comparable to other properties in the area? Surveys are common and are used to get an accurate measurement of the land that goes with the property you are purchasing. The person who prepares the survey should be a licensed land surveyor. The survey shows the location of the land, dimensions of the land and any improvements. Encroachments are improvements to property that illegally violate another's property or their right to use the property, such as building a fence that is actually on your neighbor's property instead of yours, or constructing a building that crosses from your property to another’s property without their permission. Evidence of encroachments can slow the final approval process. The downpayment A downpayment is a percentage of your home's value. The type of mortgage you choose determines the downpayment you will need. It can range from zero to 20 percent, or more if you wish. A number of loans are available that do not require high downpayments, particularly for first-time home buyers. FHA loans, for example, may requie less than 5 percent down, and veterans or those on active duty in the military can obtain loans with no downpayment at all. In addition to downpayment assistance, these programs may have less strict guidelines for loan approval, such as allowing a higher ratio of payment to income or debt to income. They also may accept alternative forms of credit history if you have not established credit through traditional means — credit cards and car loans. For example, a lender could look at the history of utility payments and rent payments to determine credit worthiness.
What's in a Mortgage Payment?
A monthly mortgage payment includes at least two parts: an amount that goes toward the principal of the loan (the money you've borrowed) and a second amount that goes toward interest (the cost of borrowing the money).For most homeowners, however, there is also a third part of the mortgage payment: an amount that is paid into an escrow account that the lender maintains for you to pay for things like homeowners hazard insurance, property taxes, condominium and association fees and mortgage insurance (if applicable). This is the element of the monthly payment that can go up or down even in a fixed-rate mortgage. Together, these elements are called PITI: • P — Principal • I — Interest • T — Taxes • I — Insurance Your tax and insurance costsHomeowners must pay property taxes and they must have some type of homeowners insurance. Depending on state laws and other variables, most lenders require homeowners to pay into what is called an "escrow account." In this account, the lender or mortgage servicer keeps enough money to cover your property taxes and homeowners insurance. You pay into this account each month as part of your mortgage payment. When your taxes are due, the lender/servicer pays them for you. The same is true for your insurance. The lender/servicer sends you a periodic statement showing how much is in this account. You can compare the statement with your property tax bill and your homeowners policy to ensure that the right amount is being held to cover the payments. The Real Estate Settlement Procedures Act (RESPA), which is enforced by the U.S. Department of Housing and Urban Development (HUD), is the major law covering escrow accounts It is important to maintain the required property insurance on your home. If you don't, your lender/servicer can buy insurance on your behalf. This type of policy is known as "force placed insurance"; it usually is more expensive than typical insurance, and it provides less coverage. If you're buying a house, most sellers disclose the amount of the annual property taxes on the house when it is listed for sale. If they don't, you can easily get this information from your local property tax assessor. A local insurance agent can give you an idea of the annual insurance cost. Divide each of these numbers by 12 and add them to the principal and interest to get the estimated total monthly payment. What is private mortgage insurance? If a buyer puts down less than 20 percent of the selling price on the mortgage, lenders may require the buyer to buy another type of insurance called private mortgage insurance (PMI). This provides insurance to the lender in case the buyer is not able to repay the loan and the lender is not able to recover costs after foreclosing the loan and selling the property. The annual cost of PMI can vary but usually is between .19 percent and 1 percent of the total loan value, depending on the loan terms and loan type. PMI can be paid up front but most buyers prefer that it be included in their mortgage payment. The cost can vary based on several factors that include: loan amount, loan-to-value ratio, occupancy (primary home, second home, investment property), documentation provided at loan origination, and probably most of all credit score. Once the principal of the loan reaches 80 percent (the owner has 20 percent equity in the home), the PMI is usually no longer required and can be canceled, although you may have to prove your equity by having a new appraisal done to show that the house is worth at least 20 percent more than you owe on it. (Note: Some lenders may require that PMI be paid for a fixed period even if the principal reaches 80 percent.) The cancellation request must come from the servicer (the company you send your mortgage payment to) of the mortgage to the PMI company that issued the insurance. Note: PMI may be waived or avoided through some types of government or other loans. Check with your lender to determine your situation. A PITI Payment with PMI Maria and George have found a home that costs $150,000. They are able to make a downpayment of 5 percent, or $7,500. The annual property taxes are $1,650 and the annual homeowners insurance is $780. These payments are made in monthly installments in their mortgage and are held in an escrow account. When their taxes and insurance are due, the lender (or mortgage servicer) makes the payments for them. Because their downpayment is less than 20 percent, Maria and George will pay PMI as part of the mortgage payment. With a 30-year fixed mortgage and an interest rate of 6 percent, the PITI with PMI is as follows: • Principal and Interest (P and I): $854.36 • Monthly Property Taxes (T): $137.50 • Monthly Property Insurance (I): $65.00 • Private Mortgage Insurance (PMI): $85.50 • Total payment: $1,142.36 Making bi-weekly paymentsPaying half your mortgage every two weeks instead of a full payment once a month can be done with most any type of loan but is most common with a 30-year fixed-rate loan. Doing so pays your mortgage more quickly because you pay the equivalent of 13 months of payments each year. For people who can budget to make a half-payment every two weeks, this offers more rapid building of equity. You can choose to do this on your own. Many people have it automatically deducted from their checking accounts. Because your payments are applied to the loan every 14 days, the principal amount decreases faster, saving you more in interest costs. Your loan term shortens to 22 or 23 years, providing a substantial decrease in total interest costs. For example: Monthly mortgage payment (12 months/12 payments): $997 Interest paid over the life of the loan: $209,263 Paid off in 30 years Half payment (13 months/26 payments): $498 ($997 / 2) Interest paid over the life of the loan: $155,938 Paid off in 22-23 years Interest savings over the life of the loan are $53,325 – paid off in 22-23 years instead of 30 years! Paying additional principal Another option — if you can afford a slightly higher monthly payment — is to achieve the same savings with monthly payments. To do this, you would need to pay an extra amount of principal to your total mortgage each month. Using the above example, with a mortgage payment of $997, you would add $83 a month ($997 divided by 12) toward the principal (You will need to specify the extra amount for "principal only" on your payment.), making your payment $1,080. The interest savings would be the same and the loan would be paid off about seven years early, but you wouldn’t have to commit to making payments every two weeks.
Mortgage Types
Basically, there are two categories of mortgages: the fixed-rate and the adjustable-rate mortgage (ARM). Within these categories, there are some variations. However, in nearly all mortgages two factors are usually at odds: how predictable the payments are and how low, or affordable, they are at least initially. The 30-year fixed-rate mortgage Not long ago, there was only one kind of mortgage: 30-year fixed rate (the borrower has 30 years to pay back the mortgage at a fixed interest rate and the payments are the same over the life of the loan). It is still the most common home loan. Borrowers choose fixed-rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. The payments are the same over the life of the mortgage, regardless of interest rate changes. Initially, both the rate and mortgage payment are higher than those of an adjustable-rate mortgage, but the payment is lower than that of a 15-year fixed-rate mortgage (see below). People who choose a fixed-rate mortgage usually are planning to keep their home and mortgage for several years. The 15-year fixed-rate mortgage This type of mortgage enables you to own your home in half the usual time, meaning you could possibly own it before your children start college or you reach retirement. Because the loan is shorter, you pay substantially less in the total interest over the life of the loan, often less than half the total interest of a 30-year fixed-rate loan. However, because the term is shorter, the monthly payments are higher than those of a 30-year mortgage. For people who can afford the higher monthly payments, this is an excellent choice, with lower total costs and a shorter term. Qualification for this type of loan may be more difficult because the income requirement may be higher. Fixed-rate balloon mortgage This is a special kind of fixed-rate mortgage that offers relatively low, fixed payments as though it were a standard 30-year fixed-rate mortgage. After a few years—usually five to seven years—the mortgage term ends with a single large payment (the “balloon”) for all the remaining principal. Borrowers generally have the option to refinance their balloon mortgage to a fixed-rate loan at the end of the term. The balloon is considered a short-term loan that offers rates and steady payments that are usually lower than those of conventional fixed-rate mortgages. Because the term is quite short, the total interest paid is significantly less than a conventional mortgage if the house is sold before the balloon payment comes due. People who choose this type of mortgage usually don't plan to stay in the home for very long and expect it to appreciate in value quickly. They expect to sell it before the maturity date when the balloon payment is due, but if they do not sell, they must refinance because all remaining principal is due. If they do refinance, they take the risk that interest rates may be much higher than when they got the balloon loan. If the house doesn't appreciate as expected, the owners may end up owing all remaining principal plus additional settlement costs if they sell after the balance is due. As noted below, this type of loan may not be available when the housing market slows down. The adjustable-rate mortgage (ARM) In general, adjustable-rate mortgages can offer lower interest rates and mortgage payments at first because the borrower assumes the risk of changes in interest rates. Usually borrowers choose ARMs because the lower initial payment makes the home more affordable at first, but the borrower must be willing to accept the risk of an increased mortgage payment, which can sometimes be significantly higher. After a specified period of time, the interest rate and payments on an ARM are adjusted based on changes to a specific interest rate index (such as the U.S. treasury bill rate). These adjustments occur at times specified in the ARM disclosure you receive from the lender and can result in payment increases. There is always a floor cap, payment cap, and life cap on the rate. It's important to understand all the aspects of ARMs before you make your decision. People who choose an ARM usually are intending to sell or refinance before the rate adjusts upward. They also may expect income to increase over time. These borrowers must be confident they could afford the post-adjustment higher payments if they cannot refinance or sell. NOTE: Fluctuations in the economy often determine whether certain types of the loans listed below are available. During times of slow housing markets and high foreclosure rates, some types of ARM loans listed below may not be available. This is because ARMs are riskier to the borrower and lender, and when the economy is slow, they become even more risky. Just like borrowers, lenders do not want to risk handling foreclosures. Hybrid ARM There are two types of hybrid loans: those that begin as a fixed-rate loan and convert to an ARM and those that begin as an ARM and convert to a fixed rate. The first type of hybrid ARM offers the predictability of a fixed-rate mortgage at a lower rate for an initial specified period, such as two, three, five, seven or 10 years. This ARM starts as a fixed-rate mortgage, then converts to a one-year adjustable ARM at the prevailing interest rate, plus an additional amount or margin. The adjustment from the fixed-rate period to the ARM and subsequent adjustments can result in significant mortgage payment increases at each stage. The rate is capped at specified amount, so mortgage payments will stop increasing when the rate cap is reached. People who choose this type of hybrid ARM usually want a predictable payment for a period of time and plan to refinance or move before the rate adjustment. Borrowers must be confident that if they stay in the home, they can afford higher monthly payments after the fixed-rate period ends. Two-step mortgage This type of mortgage is a hybrid ARM that offers a fixed rate for a set time and adjusts only once—usually at five or seven years. After that the interest rate is adjusted to market conditions at the time. Convertible ARM A convertible ARM is a hybrid ARM that allows you to start with a lower-rate ARM and convert to a 30-year fixed loan at a specified conversion rate. In other words, at a specified time, the rate stops adjusting and remains the same for the rest of the loan. However, if the interest rate is at a higher level when it’s time to convert, you may not want to do it. In that case, the loan would become a regular ARM, which would continue to adjust. A convertible mortgage enables you to have initially lower payments with the option to make it a fixed-rate mortgage at the time of conversion, when payments could go up. Borrowers must be confident that if they stay in the home, they can afford higher monthly payments after the lower-rate period ends. There is usually a fee to be paid when the loan converts, and the rate can be slightly higher than the going rate for fixed-rate loans. Payment-option ARM This type of loan offers flexibility and choices but can be costly if the buyer does not fully understand all the options. For a period of years — this period is spelled out in the mortgage — borrowers can choose the type of payment made each month. Typically, there are four options: • a minimum payment that does not cover interest — this option increases the total loan balance • an interest-only payment that doesn’t reduce the total loan balance • a payment of interest and principal that pays off the mortgage in 30 years • a payment of interest and principal that pays off the mortgage in 15 years After the option period, mortgage payments increase. In some cases, payments may increase before the option period ends. This happens when borrowers choose to make only the minimum payments that do not cover the interest on the loan; the unpaid interest is added to the balance of the loan so the loan balance actually goes up instead of down; this is known as "negative amortization." When the loan balance reaches a certain specified amount, the payments will go up regardless of when the option period ends. Borrowers then must begin making significantly higher payments to lower the loan balance. Paying only minimum payments can increase the amount that is owed to the point where the borrower owes more than the home is worth. People who choose a payment-option ARM usually want flexibility in making payments and may have an income that is uneven over the year. Common examples are commissioned salespeople who may receive their income in a few large and unpredictable disbursements over the course of a year, as opposed to a steady monthly or bi-weekly paycheck. These borrowers must have sufficient income to cover adjustments, and they often plan to refinance or move before any uncomfortable adjustment occurs. The 2/28 adjustable-rate mortgage A 2/28 (3/27, etc.) ARM is a type of hybrid adjustable-rate mortgage in which the rate is fixed at a higher rate than the fully indexed rate for the first two years, then adjusts for each of the next 28 years, unless refinanced, to the value of a rate index at that time, plus a margin . These margins can be high, so the payment almost always goes up even if market rates are the same or lower. For example, the rate is 8 percent for two years and the index is currently 4 percent, but the margin at the end of two years is 6 percent. Even if the index remains at 4 percent after two years, the loan rate will jump to 10 percent. These loans often are offered to borrowers with lower credit scores who may not qualify for a conventional loan. The idea is to give these borrowers two years to rebuild their credit and become eligible to refinance at a better rate. These borrowers may avoid PMI (see What's in a Mortgage Payment ?) because often the two-year ARM is for 80 percent of the sales price and is combined with a loan on the other 20 percent that usually has a fixed rate with a balloon payment. This enables borrowers to finance 100 percent of the loan (but not the closing costs.) Those who get a 2/28 usually plan to refinance in two years, but it is important to make sure the prepayment penalty does not run past the two-year mark. Mortgages allowing interest-only payments An interest-only option can be a feature of any type of loan; however, it is typically available only for a limited time, after which payments go up sharply. Paying only the interest enables you to make lower payments without increasing your loan balance. At the same time, however, the balance does not decrease and you do not build equity unless the home goes up in value. If the house value doesn’t go up, you may owe money if you sell. In most cases, you can make principal payments at any time during the interest-only period. People who choose a mortgage allowing interest-only payments usually are those who plan to move (or less often, refinance) before the interest-only period ends; expect their income to increase sharply; receive large bonuses at certain times of the year; or reasonably expect the value of the house to rise sharply. They must budget wisely and be willing to make lump-sum payments, steering clear of using that money for other purposes. These borrowers must be confident that if they do remain in the home or cannot refinance, they could afford the higher monthly payments. At the end of the fixed period, you must refinance, pay a lump sum or start paying on the principal. Low- or no-documentation loan This type of loan is only for those who have trouble verifying all of their income. These usually include self-employed borrowers, commissioned professionals, or service-industry professionals (bartenders, waitresses, hair stylists, etc.) who rely on tips for a substantial part of their income. The lender does not require proof of income and assets. No ratios (debt-to-income or housing-to-income) are considered. The interest rate can be significantly higher because the lender is assuming a higher risk of default. A larger downpayment also may be required, the and credit score usually must be very high. Loans with pre-payment penalties A pre-payment penalty can be part of any type of loan, so you should check with the lender to find out whether the loan you want carries this type of penalty. However, loans with these penalties may offer initially lower payments in exchange for a promise to pay a specified lump sum if the borrower refinances the date specified in the mortgage agreement. Buydown mortgage This type of mortgage enables you to get a lower interest rate by paying a lump-sum fee or by paying a fee that is financed over the life of the loan. Buydowns are similar to paying "points" (see All About Interest Rates ), but they usually are paid by the seller or the builder as an incentive to make a sale by creating lower monthly payments. Be aware that the cost of those points may be included in the selling price, and you could end up paying more for a house than its appraised value. There are two types of buydowns: temporary and permanent. A temporary buydown lowers the interest rate and the monthly payments for the first few years of the loan. The most common type of temporary buydown is the “3-2-1” buydown. For example, an 8-percent loan with a 3-2-1 buydown would have a 5-percent interest rate the first year, a 6-percent interest rate the second year, a 7-percent interest rate the third year, and an 8-percent interest rate beginning the fourth year through the life of the loan. This type of buydown will generally cost three to four points – that’s $6,000 to $8,000 on a $100,000 loan. A permanent buydown lowers the interest rate for the life of the loan. Again, this type of buydown will generally cost six to eight points and may reduce the interest rate by only 1 percent for the life of the loan. a guide to mortgages
Like everything on this site, The Simple Facts guide is meant to Help make the home buying process easier to understand. With it, you can make better decisions about the biggest purchase of your life. The Simple Facts can also be downloaded and printed, so you can use it when you speak to bankers about which mortgage you should consider. You'll get descriptions of common types of mortgages, reasons people choose or don't choose a type of mortgage, a basic discussion of risk and a list of questions you should always ask. Don't leave one of your biggest investment decisions up to others; educate yourself on the facts of different loan types and evaluate what is best for you. While mortgage bankers are experts in the real estate finance field, you are the one who has to live with the loan—not the real estate agent, the broker or the mortgage banker. Use The Simple Facts to research the loan that fits your budget and your future plans the best. Armed with the facts, talk with a lender about your options. About Interest Rates
Lenders provide a great deal of guidance, but you make the final decision about whether you’re getting the best loan you can get. Part of taking that responsibility involves comparing interest rates. Mortgage interest rates change daily based on a number of national and international economic factors. The current national rate is posted at left on this page. You’ll note that last week’s and this week’s rates are included, indicating whether rates are moving up or down for the week. You can find longer-range forecasts in business newspapers and on Web sites. Use our calculators to see how easily you can check the effect of different rates. You can see what monthly payments may look like on different loan sizes at different rates. However, the total cost of a mortgage involves more than just the basic interest rate. Origination fees, discount points, other miscellaneous costs, and other terms and conditions may affect the ultimate cost of your mortgage. When you are comparing different mortgages, do your best to be sure that you’re taking into account all the factors that can influence your final costs. The lowest mortgage rate may not necessarily be the best choice. Ask lenders these questions: • What are costs for origination fees? • What are the costs for discount and origination points? • What fees does your rate quote include? • What is the annual percentage rate (APR) of the loan? The APR is computed based on all the major costs of your loan, not just the loan amount. It usually includes points, origination fees, and other costs associated with the processing of your loan. Be sure to ask lenders which fees are included in their APRs, and try to compare APRs that include the same fees. This will help you determine the most accurate rate you would actually pay. Simple vs. compound interest Virtually all mortgage loan repayment schedules are computed based on a compound interest formula. In the beginning of your repayment period, you are paying little on the principal, so if your annual interest rate, say 6 percent, is added to your balance every month, your principal balance doesn't go down very much. So if your balance is $100,000 and interest is compounded monthly, it's like adding $6000 to 100,000, then adding 6 percent of $106,000 ($6,360) to the 106,000 (112,366) , then adding 6 percent of $112,366 to the 112,366, and so on every month. This example is oversimplified (because you usually do pay a little on the principal at the beginning), but it gives you an idea why it takes so long to pay off a mortgage loan and why you end up paying a lot of interest over a 30- or 15-year period. The moral of the story is it's not just the interest rate you pay that matters but how often it is compounded. (Sometimes these two factors together are called the "effective interest rate.") You should get this information from the lender. If your interest is compounded frequently, such as weekly, you may want to shop around and see how often interest on loans from other lenders is compounded. Discount points By paying a lump sum of money to the lender at the time you close on loan, you can lower the interest rate. That sum is measured in "points." One "point" is equal to one percent of the principal amount of the mortgage. (One point on a $100,000 loan would be $1,000.) You should know how points and other terms and conditions affect the total cost. On most types of loans, lenders offer mortgages with several combinations of points and interest rates. Generally, the lower the interest rate, the more points you will pay at settlement. Interest rates affect your monthly mortgage payment, while the points affect the amount of cash you must have at the closing. For example, if a loan with the current market interest rate has two points, a loan with an interest rate that’s one-half percent higher than the market rate may have no points. Your choice among the various interest rate/points options will depend on how much cash you have available for the closing and settlement. When is your rate set? As you discuss your options among different mortgages, be sure you ask how and when the final interest rate you pay is determined — or when your rate is "locked." Most lenders will quote a rate and fees at the time you apply for a loan, and then guarantee—or lock—the quote for a specific time. While this lock protects you from paying more for your mortgage if interest rates rise before you close on the loan, it also means you will pay the quoted rate even if interest rates fall. Lock periods usually run from 10 to 60 days. Longer periods are sometimes available for an additional fee. You generally will want your lock period to be long enough to get you through closing and settlement. Some lenders, however, will give you the option of letting the interest rate for your mortgage "float," so the rate can change between the time you apply and the time you close (although the rate is usually set after some specific period before the actual closing). Allowing the rate to float enables you to benefit from reduced interest rates if interest rates fall between the time of your application and closing. But before you choose a float, make certain that you have the resources to cover a higher monthly payment if interest rates should go up. Otherwise, you could be denied your mortgage. "No-cost" options A “no-cost" mortgage is one in which you are allowed to pay some or all of the discount points and other closing costs over time instead of paying them in cash at closing. The lender may refer to this as financing the finance charges. As with all financial transactions, you need to understand how this option will address your particular needs over the long and short term. No mortgage is truly without costs. By choosing a "no-cost" mortgage, you pay a higher interest rate on your loan in exchange for reducing the amount of money you will need at closing. Generally, the interest rate on a “no-cost” mortgage ranges from half a point to a full point above the market rate. Fees commonly financed and paid by the lender in a no-cost loan include points and processing fees and fees for credit reports and appraisals. (A “point” is 1 percent of the outstanding principal balance of a loan.) A “no-cost” mortgage makes the most sense when you are likely to move or refinance within a relatively short period. The following example shows why. You want to refinance your $150,000 mortgage with a 30-year fixed rate loan, and you have two options. Under loan A, you would receive a mortgage at 7 percent with fees of $2,500. Under loan B, you would have a “no-cost” mortgage at 7.5 percent. (This example assumes the costs for each loan are identical, but that might not be the case in real life as lender programs may differ.) You will pay $998 per month on loan A. You will pay $1,050 per month on loan B, or $52 more per month. After four years (at 49 months), the total of the extra amount ($2,548) you've paid on loan B will exceed what you saved at closing ($2,500). Unless you sell your home and pay off loan B or refinance loan B to obtain a lower rate mortgage, you will pay considerably more for loan B over the life of the loan. If, however, you sell or refinance at a lower rate after three years, you may save money by having avoided the out-of-pocket costs at closing UNLESS your mortgage carries a prepayment penaltyIf cash is very tight at the time of closing and you are confident that you can make the higher monthly payment and that the home will increase in value over time, the higher payment of a no-cost mortgage may still be okay for you, even if you can’t refinance at a lower rate after the fourth year. However, if you have the cash available, it may make sense to opt for the lower interest rate mortgage and pay the discount points and fees in cash at closing. Other points to consider: • You need to check whether a “no-cost” loan carries a prepayment penalty to discourage you from refinancing as soon as you can find a lower-rate mortgage. Prepayment penalties may require you to pay six months of interest or a percentage of the outstanding principal balance of the loan. • Check exactly what fees may be waived on a “no-cost” mortgage. Chances are you will still need to pay escrows for hazard insurance and property taxes, local transfer taxes, daily interest from the closing date to the first day of the next month, and perhaps other items at closing. • Don’t confuse “no-cost” mortgages with “no-cash” mortgages. With “no-cash” mortgages, the closing costs are added to the outstanding principal balance of the mortgage, not to the interest rate. This means that you are borrowing more money than you would under a no-cost or regular mortgage and paying interest on it over time. A note about loans with pre-payment penalties. Pre-payment penalties can be part of most types of loans, so be sure to ask your lender whether your loan carries one. Generally, loans with pre-payment penalties offer lower initial payments in exchange for a promise to pay the additional lump sum if the borrower refinances prior to a date specified in the mortgage. The amount of that lump sum is also specified in the mortgage. If you think you will refinance, you may not want a pre-payment penalty on the loan. For instance, a 2 percent prepayment penalty could be a significant amount of money — for every $100,000 left on your loan balance, you would have to pay $2,000. The best way to make a decision on whether or not to pay the penalty is to compare the cost of the penalty to the difference in your payment now and what the payment will be after you refinance. For example, if the refinance transaction costs $3,000, and it would save you $300 a month, it would take you 10 months to recover the cost of the transaction. Generally, if you can recover your costs within a year, or if you are reducing the interest rate on your mortgage by 2 percent or more, refinancing is a good option even with the pre-payment penalty. Any time you refinance, it is important to look at the savings on your monthly payment vs. the cost of doing the refinance. (In this case, it would involve the cost of the pre-payment penalty plus closing costs on the refinance transaction.) After that, you need to determine how long it will take you to get back what you paid to do the transaction. Make sure you understand You should understand all the terms of the mortgage you choose, so you won’t be surprised down the road. That’s why it’s so important to choose a lender who makes you feel comfortable and welcomes your questions. Mortgages are complicated financial transactions, but lenders are experienced in explaining ins and outs to home buyers.
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