Buying a home is the biggest financial investment most of us
will ever make. As with any large project or goal, it requires
dealing with a variety of complex issues. The best approach is to
divide the process into manageable tasks. The following deals with
the first steps of gathering your records, determining what you can
afford, and understanding mortgage options.
Put Your Own Financial House in Order
Before you go looking for a home, you should determine how much
home you can afford. Most lenders will prequalify you to borrow up
to a certain amount. Prequalification allows you to focus in on a
realistic price range and makes you a more attractive buyer.
Whether or not you want to prequalify, eventually you'll need to
complete a loan application and it may take some time to gather and
assemble the required information.
It's also a good idea to review your credit report. Contact
local lenders to determine which credit bureaus they use. Then
contact the credit bureaus and request a copy of your credit report
(in most states, credit bureaus are required to provide individuals
with a free copy of their report). Review your report to ensure
that all information is correct. If you have past credit problems,
don't lose hope. Be prepared to present a rationale for each
slipup, and demonstrate an improvement in your ability to pay bills
on time.
How Much Mortgage Can You Afford?
The Federal National Mortgage Association (Fannie Mae) is a
government-sponsored organization that purchases mortgages from
lenders and sells them to investors. Two income-to-debt ratios
established by Fannie Mae are standard requirements for
conventional mortgages. The first requirement is that monthly
mortgage principal and interest payments (P&I), plus insurance
and property taxes, cannot exceed 28% of the buyer's gross monthly
income (some exceptions may apply to increase this limit to 33%).
The second requirement limits total monthly debt payments (housing,
credit cards, car payments, etc.) to 36% of gross monthly income.
In addition to these requirements, you may have to pay 20% down on
the total purchase price to qualify for a conventional
mortgage.
Mortgage Rates and Minimum Incomes Needed
to Qualify |
Interest Rate |
Monthly Payment |
Minimum Annual Income |
3% |
$401 |
$19,225 |
4% |
$454 |
$21,770 |
5% |
$510 |
$24,479 |
6% |
$570 |
$27,340 |
7% |
$632 |
$30,338 |
8% |
$697 |
$33,460 |
9% |
$764 |
$36,691 |
10% |
$834 |
$40,017 |
11% |
$905 |
$43,426 |
Mortgage companies use ratios to analyze your
mortgage payment. The above example shows the monthly payments of
principal and interest, and income needed to qualify for a $95,000
mortgage at various interest rates, amortized on a 30-year
schedule, assuming a payment ratio of 25%.
Source: National Association of Home Builders, Economics
Division. |
Types of Mortgages
How much house you can buy also depends on the term and interest
rate of your mortgage. The term is the length of time (usually 15
or 30 years) over which payments will be paid. The rate can be
fixed (meaning it doesn't change over the loan's term) or
adjustable (it fluctuates with market conditions). Thirty-year
fixed-rate mortgages remain the most popular. The longer term
lowers the monthly payment, while the fixed rate provides stability
over the life of the loan. Given relatively low interest rates,
these mortgages are attractive to buyers planning to stay at least
six or seven years in their new home. The drawbacks are low
principal payments in the early years, and the risk that market
rates will decline over the term. However, if your credit history
is sound and you have sufficient income, you can usually refinance
your mortgage when rates decline.
A 15-year term lowers the interest rate, reduces total interest
payments, and increases principal payments. But it also increases
monthly payments. If you can't afford the higher payments now, you
might opt for a 30-year mortgage. If there are no prepayment
penalties, you can make additional principal payments as your
income increases. Making just one extra monthly payment a year will
pay off a 30-year mortgage in less than 22 years and can save tens
of thousands of dollars in interest costs. If you plan to stay in a
home no more than three years, you might want an adjustable-rate
mortgage (ARM). ARMs offer initial rates that are lower than fixed
mortgages. At some point, usually after the first year, rates are
tied to market conditions and are subject to potential rate
increases. Most ARMs include a cap on rate increases in any given
year, as well as over the life of the loan. Some ARMs offer initial
rates at least 2% below fixed rates and limit increases to 1%
annually and 5% to 6% over the life of the loan. Many home buyers
are attracted by the affordability of an ARM during the initial
period. However, you should be confident that your future income
will be sufficient if both interest rates and your monthly payments
increase.
Another popular mortgage involves a balloon payment. A balloon
is a lump-sum payment that pays off the loan in full after a fixed
period of time. Generally the rates on balloon mortgages are 1/4%
to 3/4% less than on 30-year fixed mortgages, but during an initial
period of between 3 and 15 years, payments are similar. After this
period, the remaining outstanding principal balance is either due
in full or subject to refinancing. This is a good option for home
buyers who plan to sell before the final payment is due. But
because property values fluctuate, you may not be able to sell when
you want. You may also face higher payments if you are forced to
refinance at a higher rate, and there is also a risk that you may
not be in a position to refinance when the balloon becomes due.
Three Steps to Finding the Right
Mortgage |
- Estimate how long you expect to live in the house. If the
answer is less than three to five years, consider an Adjustable
Rate Mortgage (ARM), which typically starts out with a lower rate.
If you plan to live in your new home longer than five years, a
fixed-rate mortgage offers protection against rising interest
rates.
- Shop around for mortgage rates. Banks, credit unions, and
mortgage companies all offer mortgages. Compare at least six
lenders in your area.
- Add up all the costs for each lender. Include fees, points,
closing costs, etc., to arrive at the total mortgage cost for each
lender.
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Interest Rate Points
Points are interest paid in advance to reduce the rate on a
loan. One point is equal to 1% of the mortgage amount. The general
rule is that 1 point is worth 1/8 of 1% off the loan rate. The
decision to pay points for a lower rate is based on how much the
seller is willing to contribute to points, how long you plan to
stay in the house, and how important lower payments are
vis-à-vis higher closing costs. You will need to calculate
the long-term value of points based on these factors, keeping in
mind that points are generally tax deductible in the year paid.
Other Alternatives
If you cannot afford a conventional mortgage, there are a
variety of alternatives. An anxious seller will sometimes offer
owner financing. Federal Housing Administration (FHA) loans offer
down payments as low as 3%, but may require the buyer to purchase
mortgage insurance. (The FHA is a government agency responsible for
insuring affordable housing mortgages.) The Veterans Administration
(VA) offers no-money-down mortgages to qualified veterans of the
U.S. military. Finally, there are local affordable housing
advocates that offer low-cost, low down-payment loan alternatives.
For further information, contact the FHA, VA, Fannie Mae, or your
local mortgage lender or real estate broker.