The Mortgage Maze
Navigation tips for first-time homebuyers
Buying a home, and thereby securing a first mortgage, is still a rite of passage to the American Dream. But many fail to understand that buying a house is nothing like signing a simple rental agreement and moving into an apartment. Making the leap to home ownership is a significant step and one that should not be taken without much thought and planning.
Experts say to start with the basics. What is a mortgage anyway? It is a loan — a very big loan. The median home price in the Columbia market is $160,000, according to data from the S.C. Association of Realtors. Most prospective homebuyers will not have enough cash on hand to buy a house that may cost well above that amount. That is where a mortgage comes in. Prospective homebuyers borrow the money they need to be paid back over time in monthly installments, generally in 15 to 30 years, with interest.
But even before they apply for the mortgage, prospective borrowers are likely to get confused by a dizzying array of industry terms and acronyms: preapproval, prequalification, FRM, ARM, escrow, and PMI, not to mention VA, FHA, Fannie Mae, and Freddie Mac.
As the first step in getting a mortgage, experts say prospective homeowners should do their homework; that includes knowing how much house they can afford, checking out lenders, and getting prequalified for a mortgage. Before applying for a loan, any prospective borrowers need to have cash for the down payment (usually 20 percent of the home’s value) and closing costs, which is usually several thousand dollars, as well as an adequate working knowledge of their personal finances, including their credit score. Armed with this information, a prospective homebuyer will know how large a monthly mortgage payment is realistic. Lenders advise that a mortgage payment should not exceed 30 percent of the borrower’s take home pay.
Borrowers need to be certain that they don’t overlook this fact: a mortgage payment is only part of the cost of owning a home. A borrower’s budget needs to include such factors as utility costs and home maintenance. As any homeowner knows, the unexpected always happens and is almost always expensive.
Getting prequalified and preapproved — not the same — can help a prospective borrower know how much house they can afford and ease the home-buying process. To get prequalified, the prospective borrower must provide their mortgage banker with some financial information that is used to determine how much home a person can afford, and thus how much the bank is willing to lend. Preapproval requires providing additional financial information so that a lender can check the borrower’s credit and financial status. Preapproval tells a seller that a buyer can get the money needed to purchase the home.
One of the best steps a prospective homeowner can take before shopping for a mortgage is to learn the lingo. With a mortgage, a homeowner pays principal, interest, taxes, and insurance, called PITI. Principal is the original amount borrowed; interest is the cost of borrowing the money, often expressed as annual percentage rate or APR; and property taxes go toward supporting city, county, and school district infrastructure and can be paid along with the mortgage. Insurance to protect a house against fire, theft, or other disasters can be paid as part of the mortgage — held in an escrow account by a third party — or paid separately. Yet, lenders often will require high-risk borrowers to have private mortgage insurance, called PMI. A lender will also charge “points,” which are fees the borrower pays at the time the loan is closed or executed.
Mortgages come in several different types. The 30-year fixed mortgage is the most popular form. The borrower pays a “fixed” amount on the loan’s interest and principal for 30 years. While fluctuations in escrow payments for taxes or insurance can change the total monthly payment from year to year, the borrower gets the confidence of having a stable monthly payment toward their loan. The 15-year fixed mortgage carries a lower interest rate and only takes 15 years to pay off, but the monthly payment is higher. The interest rate on an adjustable rate mortgage, or ARM, is adjusted periodically. With an ARM, the initial interest rate may be lower than on a fixed-rate mortgage, but the rate will change over the term of the loan, which provides the borrower less stability in the amount of the monthly payment.
With an ARM, experts suggest that potential borrowers ask their lender what the monthly payment would be if interest rates rise by 1, 3, or 5 percentage points.
Who Makes Mortgages Available?
Mortgages generally come from three sources: traditional brick-and-mortar banks and other lenders, online lenders, and mortgage brokers, who have access to both large banks and other lenders. All three have advantages and disadvantages.
Potential borrowers may already have a financial relationship with an institution that provides mortgages, or their real estate agent may suggest a local mortgage banker. A reputable mortgage banker can walk a prospective borrower through the process, answer any questions, and customize the mortgage to fit the borrower’s needs. Every mortgage is different, one size does not fit all. The savvy borrower needs to be sure to compare.
Applying for a mortgage online is becoming increasingly popular as companies — both online lenders like Quicken Loans and traditional providers like Bank of America — do more on the web. Financial advisor service ConsumersAdvocate.org points out the pros of online mortgages, which can include lower interest rates and fees, faster application, and ease of approval. The cons can include filling out a myriad of financial forms and documents, the potential for scams, and customer service issues.
A third method for finding a mortgage is to use a mortgage broker. A broker acts as a middleman and can shop dozens of lenders for a potential borrower. However, using a broker has pros and cons just like with any other kind of financial process. While brokers can potentially save borrowers time and money when applying for a mortgage, financial experts say borrowers need to know the loan process and be certain to ask questions. Some mortgage brokers may attempt to increase profits by writing hidden costs into the loan.
As part of the process, here is a checklist for borrowers:
• Determine how much house you can afford.
• Check your credit score and credit report.
• Assemble the financial documents and your down payment.
• Consider whether you need a broker.
• Look for a lender with a reputation for good customer service and timely mortgage closings.
• Choose the right mortgage for you.
• Get preapproved.
• Ask for an estimate of closing costs.
• Consider what you’ll do if you get rejected.
Reasons Abound for Refinancing
Getting a mortgage is usually not a one-time event. Depending on family needs and other factors, such as job relocations, homeowners may buy several houses over their lifetime, each move requiring a new mortgage. But even homeowners who stay put may find it advantageous or necessary to get a new mortgage, doing what is commonly known as refinancing.
Refinancing simply means paying off the existing mortgage loan and replacing it with another mortgage. Reasons to finance might include:
• lowering the monthly mortgage payment;
• switching to a short-term mortgage, 15 versus 30 years, which might result in a large monthly payment but could also mean considerable savings over the life of the loan;
• changing from a fixed-rate to an adjustable rate or vice versa, which could lower payments or save money;
• taking cash out of the home’s value to pay for expenses like home improvements, higher education costs, paying off debt, or making large purchases such as an automobile or down payment on a vacation home.
And, because refinancing can cost 3 to 6 percent of the loan’s principal and, just like taking out an original mortgage, has costs like appraisals, title searches, and application fees, borrowers need to be sure that refinancing will offer a significant benefit.
Consider refinancing when the borrower’s credit score has improved. Even if rates have not decreased overall, a borrower might be able to qualify for a lower rate if their credit score has gone up.
How much do rates need to have dropped before a homeowner should consider refinancing? A “rule of thumb” is often quoted and can vary between 0.5 percent and 2 percent, depending on who is quoted. For that reason, professionals suggest that a better approach is to do the math.
Determine how much interest will be saved each month. Figure how much the tax savings would be. The federal tax reform legislation enacted into law earlier this year has significant implications for mortgage holders. The mortgage interest deduction cap fell to $750,000 and the property cap tax reduction drops to $10,000. The changes may not impact homeowners as much in South Carolina, except for owners of very expensive houses.
How does one determine the total cost of refinancing?
Divide the total cost of the refinance by the monthly after-tax savings. This will show the number of months it will take to reach the break-even point. If the mortgage holder plans to stay in the home longer than the break-even point, then refinancing may make sense.
Whether it is a first-time mortgage or third-time refinance, experts agree that the best steps a prospective borrower can take are to educate themselves, do their research, and compare their options.