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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
- Fixed-rate
mortgages
- Adjustable-rate
mortgages
- Government
loans and programs
- Balloon
loans
- Other
affordable housing loans.
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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