How To Shop For A Mortgage

With dozens of competing lenders and mortgages to choose from, you may think that today's home loan market is terribly confusing. It really isn't, if you know the basic facts about financing a house. That's what this article is designed to give you. Let's start with the questions that are probably uppermost in your mind.

How Large A Mortgage Can I Get?

That depends upon your income and the cost of your new house. Lenders use certain guidelines to determine the mortgage amount they will lend any one home buyer. The two guidelines used are housing expenses and long term debt. Lenders generally say that housing expenses (including mortgage payments, insurance, taxes and special assessments) should not exceed 25 percent to 28 percent of the homeowner's gross monthly income. For Federal Housing Administration (FHA) loans, this figure is not to exceed 29 percent of the home buyer's gross monthly income. With loan guaranteed by the Department of Veteran's Affairs (VA), lenders measure prospective home buyers with "Residual Income," or the monthly income minus expenses. The remainder is then measured against geographical and family size data to qualify the borrower.

• FHA Loans

  • Housing expenses = 29% of gross monthly income

  • Housing Expenses Plus Long-Term Debt = 41% of gross monthly income

• VA Loans

  • Housing Expenses Plus Long-Term Debt = 41% of gross monthly income

  • Residual Income = Varies by location and family size

• Conventional Loans

  • Housing Expenses = 25% - 28% of gross monthly income

  • Housing Expenses Plus Long-Term Debt = 33% - 36% of gross monthly income

Lenders usually define long-term debt as monthly expenses extending more than 10 months into the future. These expenses should not exceed 33 percent to 36 percent of the homeowner's gross monthly income.Your lender will compute these figures for you when you discuss the mortgage you want.

What Types Of Loans Are Available

Although you may see many different types advertised, they all belong to two families: mortgages that carry fixed interest rates, and those whose rates change during the course of the loan, on a periodic schedule mutually agreed upon by you and your lender. This article does, however, discuss some new loans who are really "cousins" to each family - convertible mortgages.

Fixed Rate Mortgages

You are probably familiar with a fixed-rate mortgage. Your parents more than likely had one, as did their parent before them. The major advantage of fixed rate mortgages is that they present predictable housing costs for the life of the loan. Some fixed-rate mortgages you will probably hear about are:

• 30-year fixed-rate mortgages

• 15-year fixed-rate mortgages

• "Convertible" mortgages

When people thought of a mortgage 10 to 50 years ago, they thought of a 30-year fixed-rate mortgage. This traditional favorite is not the only choice nowadays because volatile financial times created a whole new range of selections. However, the 30-year fixed-rate mortgage may still be the best mortgage for your circumstances. It offers the lowest monthly payments of fixed-rate loans, while providing for a never- changing monthly payment schedule. Some lenders offer 20,25, and even 40-year term mortgages as well. Remember, the longer the term of the loan, the more total interest you will pay.

The 15-year fixed-rate mortgage allows homeowners to own their homes free and clear in half the time and for less than half the total interest costs of the traditional 30-year loan. The loan's term is shortened by the 10 percent to 15 percent higher monthly payments. Some home buyers prefer this mortgage because it allows them to own their home before their children start college. Others prefer it because they will own their home free and clear before retirement and probable declines in income.

Mortgages That Change

Some newer mortgages afford home buyers some the best qualities of the fixed-rate and adjustable rate mortgages. One new type of loan, often called a Two-Step or Premier Mortgage, gives homeowners the predictability of a fixed- rate and adjustable rate mortgage for a certain time, most often seven or 10 years, and then the interest rate is adjusted to fit market conditions at that time. The main advantage associated with this type of loan is that home buyers often get a slightly lower than market rate to begin with. The main disadvantage is that they may see their interest rate go up by as much as six percentage points at the end of the seven-year period. The lender may also reserve the option to call the loan due with 30 days notice at that time, making this loan similar to a balloon mortgage in some cases.

Lenders offer this type of loan in part because research indicates that many home buyers remain in the home for seven to 10 years before moving. For this type of home buyer, the Two-Step loan presents an excellent way of getting a fixed-rate loan at a better than market price for a fixed period of time.

Another type of mortgage that is becoming popular is a Lender Buydown, where the home buyer gets an initially discounted rate and gradually increases to an agreed-upon fixed rate over a matter of three years. For example: When the market rate is 10 percent, the fixed rate for the mortgage is set at about 10.5 percent, but the home buyer makes monthly payments based on a first year rate of 8.5 percent. The second year the rate goes up to 9.5 percent, and for the third year through the remaining life of the loan, the rate is calculated at 10.5 percent. A second type of lender buy-down, called a Compressed Buydown, works the same way, but with the interest rate changing every six months instead of on a yearly basis.

The Lender Buydown gives consumers the advantage of lower initial monthly payments for the first two years of the loan when extra money may be needed for furnishings and, secondly, the advantage of knowing that, although the interest rate does change during the first three years of the loan, the interest is fixed from the third year on.

Convertible mortgages offer today's home buyer the option to change the loan's interest rate after some period of time or some specified movement in interest rates.

Convertible fixed-rate mortgages are often referred to as the Reduction Option Loan (ROLE) or, in some locations, the Reducing Interest Loan (RIL), or Mortgage (RIM). This type of loan offers homeowners the option of getting a loan, under the right conditions, can be adjusted to a lower interest rate with a payment of $100 or $200 or so and a small loan amount-based fee, sometimes as little as one-fourth of a percentage point. These conditions usually are a prescribed movement in rates-typically two percent below the initial- during a set time limit-between months 13 and 59, for example.

On a 30-year fixed-rate mortgage with a reduction option, the home buyer pays an extra one-fourth to three-eighths of a percentage point in the interest rate on the mortgage plus a quarter to three-eighths of 1 percent of the loan amount (points) at the time of closing. This allows the homeowners to adjust the interest rate on the loan without having to go through a refinancing, which could cost up to 5 percent or 6 percent of the loan amount, if the rates are right during the prescribed time limit.

On an $80,000 loan, this means that you could reduce the interest rate on your loan from, say, 10.5 percent to 8.5 percent, and take advantage of the low rates for the rest of the loan term for $150 instead of up to $4,800 , if the rates dropped to that point during your "window of opportunity" - months 13 through 59. Some homeowners may find the ROL a good "insurance policy" against the high costs of refinancing. Others may want the flexibility that refinancing offers - namely the ability to draw on built-up equity- that is not available with ROLs. The decision is up to you.

Convertible Adjustable Rate Mortgages (CARMs) are another loan product on today's market. It works like any other ARM, but it offers homeowners a distinct advantage-it allows them to turn their ARM into a fixed-rate mortgage after a set period (usually during the second through fifth years of the loan).

Adjustable Rate Mortgages

Adjustable Rate Mortgages (ARMs) have become one of the most popular and effective tools for helping some prospective home buyers achieve their dream of home ownership. Developed during a time of high interest rates that kept many people out of the housing market, the ARM offers lower initial rates by sharing the future risk of higher rates between borrower and lender.

There are several things to compare when looking at different ARM products. If you are thinking about getting an adjustable rate mortgage, make sure you inform yourself on how they adjust and what it is based on.

One of the best things to use for a good comparison is the start rate. A low start rate is always nice to have. Just make sure you are looking at the whole picture because that nice low rate won’t stay there for very long. They usually adjust every 6 months or every year.

ARMs can be an excellent choice of financing under certain conditions, such as rising income expectations, high interest rates, and short-term home ownership. Because payments and interest rates can increase, either steadily or irregularly, home buyers considering this kind of mortgage need their income to keep up with all possible rate and/or payment changes. Each ARM has four basic components:

• Initial interest rate, which is typically one to three percentage points lower than that of most fixed-rate mortgages. Lower interest rates also make ARMs somewhat easier to qualify for. The initial interest rate is tied to certain economic indicators that dictate in part what the monthly payments will be.

• Adjustment interval, the time between changes in the interest rate and/or monthly payment will be.

• Index, against which lenders measure the difference between what they are making on their investment in the mortgage and what they could be making on other types of investments. The most popular index is based on the rate of return on a one- year Treasury bill (also called T-bill).

• Margin, the additional amount the lender adds to the index to establish the adjusted interest rate on an ARM. The margin is usually 1.5 percent to 2.5 percent.

It is the index plus the margin that will determine what the interest rate will eventually be.

The Index

An ARM’s interest rate goes up and down according to a nationally published index. The lender has no control over the index and cannot arbitrarily adjust your rate. Your rate is determined by the index.

The index is what the lender uses as a reference for what it might cost to take in money that it can then lend. Take the CD Index as an example. If a lender is currently paying 5% to depositors for Certificates of Deposit it must then make up that cost when it takes those funds and lends them out.

The index on an adjustable rate mortgage will change during the time that you have the loan. So whatever the index is at when you initially get your loan you can be sure that it will change during the time you have your loan. An index can go up or down depending on the current market conditions. There are several different indexes and they are tied to different market indicators that will change differently.

Treasury Bills

This ARM index is officially called "The weekly average yield on U.S. Treasury securities adjusted to a constant maturity of 1 year." It is based on the interest rate that the government pays on some of its debt. This index is used on the majority of ARM loans. The Treasury Bill index tends to be fast moving, which means that when market conditions in interest rates change, they will react to that change very quickly. This can be a good thing if rates are going down, and not so good if rates are going up.