|Home Center: Invest in a House|
1. How Much Can You Afford? The first step in finding a home is figuring out how much you can afford to spend. We'll look at six different factors to consider when making this decision, with three of them related to mortgages, and the other three focused on broader personal considerations, such as how long you plan to own the home. The Mortgage Taking out a mortgage is probably the biggest hassle facing prospective home owners. The bank will want to ask you all sorts of nosy questions about your income and savings (or lack thereof), and then might not even lend you as much as you need. The nerve! Of course, there is a reason for this. Put yourself in the bank's shoes: If you were going to lend people money, what would you want to know about them? Basically, you'd like to know 1) if they make enough money to pay you back, 2) if they've been trustworthy in the past, and 3) if they have something of value should they be unable to pay you back. Congratulations: In financial parlance, you've just been introduced to the concepts of income, credit worthiness, and collateral. Let's look at each one, and how they affect what you can afford. Do you make enough to pay the lender back? Your lender will want to know not only how much money you have, but how much you will likely make over the next 30 years. Also, what are your other debts? Do you owe money for college loans or credit card charges? Do you have any other assets? Things like stocks and mutual funds or personal property like a boat or a car are also considered in figuring out how much a bank will lend you. Ideally, you will want to come up with at least 20% of the value of your new home as a down payment, to avoid things like mortgage insurance payments. But, you probably qualify for plenty of financing arrangements that will get you into a new home for as little as 3% of the asking price. We'll talk more about mortgages and those special programs later. The lender will also plug your income numbers into a couple of formulas: the front-end ratio (having to do with your mortgage payments) and the back-end ratio (having to do with your debt). Let's say your gross income is $4,000 a month, and you have $400 a month in debt payments. The rule of thumb is that they'll allow you to pay 29% of your gross income toward your mortgage payment every month. This is known as the front-end ratio. In this example, 29% of $4,000 is just under $1,200 a month -- so, they'll reason, you can put $1,200 toward your mortgage payment. Your debt ratio, or back-end ratio, on the other hand, is $400/$4,000, or 10%. That's not bad. They don't want more than 41% of your gross income going to total debt -- mortgage, credit card interest, and other payments -- and in this case you're paying 39% towards that purpose. (These ratios can vary somewhat; the ones given here are just examples). Have you been trustworthy in the past? What is your credit rating? The three major credit reporting agencies are Experian, Equifax, and Trans Union. You can request credit reports individually from each agency -- or order from all three agencies in one easy step at TrueCredit.com. Your credit report -- a nifty little compilation of your personal financial history -- will reveal whether you have a track record of paying your bills on time. If not, there are ways to clean up your credit that will make you more attractive to lenders. Do you have any collateral? The house you buy will generally be considered collateral for your mortgage. As a result, in case you can't repay the loan, the bank can decide to do something really nasty: foreclose on the mortgage and repossess the house. You will find yourself out on the street -- with your dog, your La-Z-Boy, your collection of unpublished poetry, a couple of suitcases, and your toiletries kit. Your house now belongs to the bank, and it is unlikely that anyone will ever loan you money again. Hot tip: Avoid this scenario at all costs. Your Considerations How much you make, your creditworthiness, and how much collateral you have are all questions from the bank's point of view, because how much house you can afford is largely a question of how big a loan you can afford. Now, let's look at a few things from your point of view. Your Timeline To determine whether you should buy a new home, think about how long you're planning to stay in it. It generally doesn't make economic sense to buy if you are only planning to stay there for a couple of years. Why? Because you're going to be paying fees to buy and then to sell your house. It would have to appreciate in value very quickly between the time you buy it and the time you sell it to make it financially worthwhile. In other words, you'd have to get lucky. Your Comfort Zone Before you borrow $90,000, $200,000, or whatever you need for your mortgage, figure out whether you can really afford it. Just because the bank will loan it to you, doesn't mean that you will live your life in such a way as to be able to pay it back. Are you planning to have a big family? Would you rather replace your Chevy Cavalier with a new Mercedes? Your house payment is just one piece of your financial puzzle. What might you need to give up to make that house a reality and are you really willing to do it? As part of our collection of tools to help you in your home purchase, we've made a personal worksheet that you can use to get an accurate snapshot of your financial situation. This is for your own use; we've put together another one that will more closely mirror the information that a prospective lender will want. Should You Rent Instead? What if you're renting? Would you be better off in a home you own, from a month-to-month financial standpoint? As we'll see, there are tax advantages that make buying a home more affordable than you might imagine. 2. The Anatomy of a Mortgage. What exactly is a mortgage? Simply put, it's a loan from a financial institution to you. In return, you pay interest on the amount loaned. The lender also has first dibs on your house in case you neglect to pay back the loan. Francophiles and wordsmiths will recognize the root word "mort" in there. No, that's not your Uncle Mort; that's the French word for "dead." The idea is that you're going to kill off that loan, by paying back the money you borrowed. You amortize the loan, over time. Yes, it's a slow death, but it must be carried out. A loan has three facets: a. Size (how many dollars you need to borrow) b. Interest (the percentage rate you pay on the loan) c. Term (how long it will take to pay off the loan) The first one is self-explanatory (although there are choices you can make with regard to the down payment, which we'll investigate in a little while). The other two are more complicated. Let's look first at the interest rate. The Calculation of APR (Annual Percentage Rate) The annual percentage rate is a method developed under federal law to disclose to loan applicants the actual amount of interest that will be paid on a given loan, over the life of that loan. It makes it easy to compare one mortgage to another by making it an apples-to-apples comparison. You should, however, use the APR as just one tool in evaluating a loan, not as the sole factor in making your decision. To understand APR, you must first understand the concept of points. A point is 1% of the loan amount. If the loan is for $100,000, one point is $1,000. There are two types of points: origination and discount. Origination points are the fees normally charged by a lender, and sometimes by a mortgage broker, for originating, or starting up, your loan. Discount points are charged to lower your interest rate, and this lowers your payments. In other words, if you pay some more money up front, the bank will let you pay less over time. Both types of points should be considered interest that you pay up front. Therefore, you must figure points into the cost of your loan repayment. If you take out a loan for $120,000 at 9% interest for 30 years, and you pay one origination point and one discount point, you're paying a total of two points, or $2,400. Your payment will be $965.55 per month. To get the proper APR on your loan, then, you have to add that $2,400 to your starting balance, since (remember?) it is interest, albeit prepaid interest. This makes your total loan $122,400. Figure the new payment on that balance, which works out to $984.00. Now return to the original loan amount and (ready, mathematicians?) compute the polynomial backwards to reach the interest rate it would take to equal the payment on the total loan. It works out to roughly 9.23%. In paying points to lower your rate, a good rule of thumb is that it will take you about five years to make up the additional point(s) paid; then you will begin saving money over the remaining term of the loan. By federal law, lenders are required to send you a TIL (no, that's not something you get your hand caught in when you're stealing -- it stands for Truth in Lending) statement within three days of applying for a loan. The Term The most common term for a fixed-rate mortgage is 30 years, with 15 years the next most common. A 30-year vs. 15-year mortgage debate rages, but one thing is sure: You will pay much more interest over the term of the loan (in most cases double) on a 30-year mortgage. On the flip side, a 30-year mortgage will offer lower monthly payments. You'll be getting a tax write-off for the interest portion of your payments, which could be substantial. On the other hand, in the first 15 years of your loan, you will be unFoolishly lining someone else's pocket with interest, while not building up significant principal for yourself. Example: Let's say you buy a $150,000 home. You put down 20%, or $30,000, which leaves you $120,000 to finance. If you get a 30-year loan at 8.5%, your payments are $922.70. After five years of payments, your balance owed is $114,588. If, on the other hand, you obtain a 15-year mortgage at 8.00% (rates are lower with shorter-term loans), your payments are $1,146.00 ($224.00 more each month). After five years in this loan, however, your balance is only $94,000. That's quite a difference when it comes time to sell. In sum, a 30-year loan is good for long-term stability. If you can afford a 15-year mortgage, you will build principal faster. Another option would be to pay what would be equal to the 15-year payment on a 30-year loan, enabling you to pay it off in about 15 years (slightly longer due to the higher interest rate), while still having the cushion of the lower payment should money problems arise. Details... There's one other loan categorization that has to do with size. A conforming loan is less than the Federal National Mortgage Association's legislated mortgage amount limit, which is currently $300,700 for a single-family home. A jumbo loan, also known as a nonconforming loan, exceeds that amount. Since such jumbo loans cannot be funded by the agency, they usually carry a higher interest rate. 3. The Two Basic Types of Mortgage Once you know some of the basics about mortgages, you can more closely examine the different types. You should familiarize yourself with two basic kinds of mortgages before we get to some of the more exotic variations. Fixed-Rate Mortgage This is the plain-vanilla loan that most people think of when considering a mortgage. You will owe a certain percentage of the loan as interest to the lender. This amount never changes, and your monthly payment will remain the same over the life of your loan. Fixed-rate mortgages are usually for 15 or 30 years. ARM No, not the thing hanging from your shoulder. This is an "adjustable-rate mortgage." The interest rate changes to reflect changes in the credit market out in the great, wide world. The first-year rate (otherwise known as the teaser rate) is generally a couple of percentage points below the market rate. There are also upward limits, above which the interest rate isn't allowed to go -- this is called the cap. If your teaser rate is 4%, and you have a five-point cap, then the highest that your interest rate can go is 9%. What's more, the amount that the interest rate can rise each year is limited, usually to one or two percentage points per year. The frequency at which the rate adjusts might vary; make sure you know these features. If you're considering an ARM, think about the worst-case scenario. What if interest rates go up, and your ARM adjusts to its maximum? What will that maximum be, and when will it kick in? Will you be able to afford the payments? And that, folks, is it: the two major types of loans. 4. The Additional Types of Mortgages Within the broader mortgage categories of fixed and adjustable-rate, there are plenty of other variations, such as COFI, Hybrid, and Balloon loans, several of which combine aspects of the two main types. Let's take a look. COFI, Anyone? One type of ARM is a COFI loan. COFI stands for "cost of funds index." This loan doesn't have any caps, and adjusts monthly. It is, in a sense, the most adjustable ARM of all, since it isn't fixed for a certain time. But, the index to which it is tied is, in many ways, the most stable index of them all: It is tied to the rate that banks have to pay their depositors to keep their money (i.e., checking accounts, savings accounts, certificates of deposit). It tends to be a slow-moving index. The COFI loan has certain advantages in that you can vary the amount of your payments as you wish (paying off more or less each month). If this suits your temperament and your budget, inquire about it since it is often not brought up as an option. Hybrid Loan Just as in a candy store, why have two flavors when we can have a mix and make three? Sure, your hands might get sticky and your tongue can turn green, but we like freedom of choice. Typically a hybrid loan is fixed for 1, 3, 5, 7, or 10 years and then converts to an ARM. This means you get stability for a given amount of time, and then your fate is cast to the winds of the prevailing interest rates. If you imagine a fixed-rate mortgage as a motorboat, and an ARM as a sailboat, then you get to run the ship under its own engines for a time before you unfurl those sails and hope for favorable winds. Two-Step Loans These loans attempt to provide the best of both worlds: the stability of a fixed loan with the lower rates of an ARM. They appear in their most common forms as 5/25 or 7/23 loans. Math buffs among you will note that the numbers straddling those slashes add up to 30, as in a 30-year loan. This means that your interest rate will be fixed for the first five or seven years, then the loan adjusts in one of two ways: It will either become an ARM, adjusting annually, or a fixed-rate loan. The beginning interest rate for these loans is generally lower than that of a standard 30-year fixed loan. Balloon Loans These tend to be short-term loans. You borrow money for, say, three or seven years, and the loan is amortized as though it were a 30-year loan. At the end of the three- or seven-year period, you owe the bank all of the remaining principal, in one lump sum -- like a big balloon. Again, these loans tend to have lower interest rates than the standard 30-year mortgage. If you're not planning to stay too long in your house, you might be interested in such a loan. The reasoning goes like this: You pay less in interest over the course of the loan than you would with a 30-year fixed loan -- saving potentially thousands of dollars. So, you're less out-of-pocket when it comes time to sell. Keep in mind, though, that if for some reason your plans change and you want to stay in the house, you're going to have to pay off the loan in full -- by getting another loan, at the prevailing interest rates and with the attendant costs of getting that new loan. So, it isn't for the faint of heart or irresolute of mind. Regardless of what type of mortgage you're interested in, you also need to figure out where you'll get it from: a bank or a mortgage broker. 5. The Lender: Bank or Mortgage Broker? Mortgages are marketed (that is to say, offered to you) by several types of lenders. You can get a loan from mortgage brokers, mortgage bankers, banks, credit unions, and savings & loans. In most cases, the lender earns origination fees and, in the case of a mortgage broker, a broker's fee. The servicer is the company where you, the borrower, make your payment. What Is a Mortgage Broker? Mortgage brokers are much like independent insurance agents or, for that matter, your local supermarket. They have access to many lenders (roughly equivalent to suppliers, such as tomato companies) and many different programs (several brands of frozen, canned, or fresh tomatoes). In some cases, especially where your credit is not flawless, and nonconforming properties are involved, a mortgage broker can find funding for you. (They might also be able to find tomatoes for you, but that's extra.) They charge a fee, and are sometimes compensated by the lenders. They provide a great service for many consumers, and originate more than 50% of loans in the country. Mortgage brokers normally originate the loan, process it, and pass it along to a lender, who sells it to an investor. These investors range from state pension funds to government and quasi-government companies such as the Federal National Mortgage Association (FNMA), or "Fannie Mae"; the Federal Home Loan Mortgage Corporation (FHLMC), or "Freddie Mac"; and the Government National Mortgage Association (GNMA), or "Ginnie Mae." A mortgage broker can, in many cases, speed up your closing time, do all the processing, and get you a better interest rate. The mortgage broker is compensated on commission, and he is going to have higher closing fees. At a given mortgage brokerage house, for example, closing fees might be $700. But, some in the brokerage industry charge up to $1,200 -- which some of their colleagues (and, indeed, the real estate agents with whom they work), might regard as gouging. A broker is allowed to charge whatever he wants for loan processing or "doc prep" -- document processing. As is the general rule in shopping: ask. Ask what the broker's fee will be. You can then make an informed decision whether paying that fee will be worth it over time if you get a better deal on a loan. Banks and Mortgage Bankers The term "mortgage banker" can refer either to a loan officer who works at a bank or to the bank itself. A mortgage banker generally sells the underlying loan to an investor, but continues to service the loan. Banks generally have a corporate approach, in which the mortgage bankers are told, "These are the fees -- don't deviate from them." So, there is more stability in terms of what the person sitting across the desk from you is going to charge for his or her services. Which Should You Use? Whichever gives you the best deal. That's why you should shop around first and find out all you can. Some borrowers don't like the idea that the mortgage broker will find them the loan and then exit the picture, leaving the borrower to deal with a lender. On the other hand, the borrower will be dealing with a lender anyhow, and mortgage bankers might also end up selling the loan on the open market. 6. Loan For Sale One aspect of home mortgages that you should be aware of is that there is a market for them, just as there are markets for tomatoes, potatoes, running shoes, or designer suits. Your mortgage, once you get it, can be sold later to FNMA ("Fannie Mae"). FNMA buys mortgages and, in some cases, also takes on the servicing of these loans after they are originated by the individual lenders. These loans usually carry the lowest interest rates. Some lenders sell loans to funding sources other than FNMA, but usually these are types of loans that carry a higher rate of interest. Also, some banks and lenders hold their own loans (portfolio lending) and make their own credit and lending decisions. These interest rates vary widely. If your loan is sold, you still have the same term, and the same loan; you just make the check out to another institution. You will receive written instructions from both lenders notifying you when the loan will be transferred and other relevant payment information. 7. Shopping for a Loan There are thousands of mortgage lenders across the country, each with many different loan products. From lenders that will only sell to the most creditworthy borrowers (at the best interest rates), to lenders that will lend 50% of a property's value (at high interest rates), there's a mortgage product for just about everyone. Banks One place to check is your local bank. This can result in a reasonably good deal for the qualified customer. In many other cases, the bank will not have a program that fits your needs, or you may fall outside the guidelines of its lending ability. Once you have visited your bank, look in the real estate section of your local paper for the rates at other banks. It's a good idea to start the legwork on your own, before bringing in a mortgage broker, so that you'll 1) avoid the hard sell from the get-go, and 2) have a better idea of what you could find on your own. The Web The Web lets you comparison shop, right from the comfort of your own computer. Not only that, but you don't have to hunt down a hundred different banks -- certain aggregator sites have done that for you. In fact, you might check out the loan services provided by MortgageSelect.com (our Home Center sponsor). Both companies can help you shop for the lowest mortgage rates. By the way, there is no reason why you shouldn't take out a loan with a bank in California if you live in Virginia, or vice-versa. Real Estate Agents You might well find the cheapest rates in town (or in the country) on the Internet. If, however, you end up working with a real estate agent, you might feel more secure with a lender that has a relationship with your agent. The idea is this: The agent brings business to the lender, so the lender has some sense of responsibility toward honoring commitments with that agent's clients. There are, to be sure, legal protections for you, but a hassle is a hassle. This is not a reason to get a lousy deal, but, as Mr. Freud said, psychology counts. (OK, maybe he didn't say that, but he should have.) When should I shop for a mortgage? Ideally, you should find a lender and get "pre-qualified" for a mortgage before you ever start looking for a house. Not only will you feel more confident knowing that you'll have a certain amount of money (which can also narrow down your price range for potential houses), but you'll be a more serious candidate to sellers. What information should I get from the mortgage company? There are many questions to ask prospective lenders. You might find yourself feeling a little nervous. After all, you can feel like they have you by the... suspenders. But, don't think of it that way. You are going to pay them a lot of money for a very long time. They serve you, not the other way around. Don't let them take advantage of you or bully you into a deal that isn't to your advantage. 8. Finding Your Loan Online How does shopping for a mortgage online differ from getting one from a bank? Let us count the ways... Advantages Well, to begin with, you can comparison shop several loans at once, without a great deal of effort. This is similar to the services that a mortgage broker might offer you -- but you get to do it without leaving home. In addition, because it's on the Internet and laid out neatly, you can more easily compare apples to apples. This is more difficult when you're going from bank loan officer A to bank loan officer B. You can do it whenever you want, even in the dead of night (if you should be so inclined). Since you have a wide range to choose from, you're not limited by the mortgages from one particular bank. You may like the impersonal nature of the inquiry: You don't have to go and stare across the table at a loan officer. Disadvantages You don't get to go and stare across the table at a loan officer. That is, you may find it a bit impersonal for your taste. Similarly, if you're not comfortable using the Web, you probably won't be comfortable exploring mortgages by clicking hither and yon. If need be, though, we gently suggest you find someone who's Web-savvy to give you hand -- if only to arm yourself with information for the moment you go in to your local bank or mortgage broker's office. If you have special circumstances, either related to you personally or to the specific kind of loan you might need to have tailor-made, you're probably better off speaking to a real live human being. Keep in mind, though, that most online loan aggregators have personal representatives who will work with you over the phone. It's just that they may not be as experienced in more complicated loan situations. Things to Watch Out For These tools, as you might say to your five-year-old when she starts flicking the light switch on and off, "are not a toy." In fact, you don't want to comparison-shop just for fun. Each time you give an online lender your social security number, they may do a credit check. And if that happens repeatedly, you may be harming your credit rating. That's because lenders who see that a customer has been applying for a lot of loans may conclude that they're actually in dire straits -- and therefore are a bad credit risk. Is there a way for you to protect yourself? Yes. Credit scorers will disregard inquiries made within 30 days after you've been given a credit score. Perhaps more importantly, they regard inquiries within any 14-day period as a single inquiry. So, if you want to protect your credit, get your mortgage shopping done within a 14-day period. Even if you're not ready to apply for a loan right away, these mortgage aggregator websites can be quite useful as information-gathering tools. In most cases, you can get an idea of the rates that might apply to your situation before you enter any personal data. For a more exact quote, you'll have to provide some detailed personal information -- which means they will most likely make an inquiry into your credit rating. 9. Consider a Mortgage Pre-Approval You've spent a lot of time imagining your dream home. Now imagine this: You've found the perfect neighborhood, the cutest little house with the greatest backyard, and you think you can even afford it. It has everything you ever wanted. You've spent a couple hundred hours finding your little treasure, you've spent a couple hundred dollars on fees and property inspections, and you have scrunched up your courage to make an offer. Your heart is so set on it that you've even started telling your friends your new address. And then the bank calls. Your mortgage application has been denied. Arrrghhh! How could you have saved yourself from this heartache? With a pre-approval for a mortgage. In fact, we Fools heartily recommend you get one before you go any further in the home-finding process. What is pre-approval? It's basically a quick-and-dirty look from a lending institution at your creditworthiness. With a pre-approval or pre-qualification letter in your hand, you're immediately in a stronger negotiating position with any seller. There are two types of "pre" letters: Pre-qualification is an informal agreement between you and your lender. The bank gives its opinion on how much they think they will be able to lend to you based on information that you have provided to them. Your bank doesn't do any background checks at this point. It relies solely on you portraying an accurate picture of your circumstances. Because this is more like a friendly handshake, the lender can decide not to give you the loan if they find out later that you have been less than candid with them. There is no charge to do this and you are under no obligation to get a mortgage with this lender if you find a better deal later. Pre-approval is more serious. The bank will actually check your credit history, employment information, assets, and liabilities. The only thing they won't check is the property that you plan to buy, because, of course, you haven't found it yet! If you're concerned that you might not qualify for a mortgage, we highly recommend that you go for pre-approval. It will put your mind at ease while you search for your new home and make the entire experience much less worrisome. Some lenders charge for a pre-approval. If you decide to go with one who charges for this service, make sure you're really going to buy a house soon or you'll just be throwing money away. 10. 6 Strategies for Savings on Mortgage The key to saving money on your mortgage is to get the best possible mortgage for yourself. Sounds so obvious it's silly, right? But the point here is that you don't need to do it the way everyone else does. In fact, if you're willing to educate yourself in the ways of the mortgage world, you can save quite a bit of money by being a little different. Below we introduce you to some of the strategies that other Fools have used. But remember, the only person who knows if it's right for you is you. a. Seller Concession: The 6% Solution There is something called a seller concession that is worth considering. It works like this: suppose you agree on the price of the house at, say, $200,000. You then ask the seller for a 6% seller concession. What this means is that you add (up to) 6% to the price of the house. That's right, you're now going to pay $212,000 for that house -- but the seller is going to give you that $12,000 back when the sale takes place. You're going to use that money to cover all of your closing costs. If we pretend for a moment that those costs add up to precisely $12,000, then what you've done is folded those closing costs into the mortgage. Points, title search, recording fees -- all of these closing costs, most of which are not tax-deductible, and which we discuss in an article on making the deal -- have effectively been included in your mortgage. Since your mortgage interest is tax-deductible, these costs have effectively become tax write-offs. In addition, you don't have to come up with all that extra cash at settlement. Your down payment will be somewhat higher, (if you're putting down 20%, then in the current example your down payment would be $42,400, versus $40,000) and, of course, your mortgage payments will be higher, but it ends up saving you money. The seller has no reason to refuse this -- after all, the agreed-upon price is still the same. What's the catch? The catch is that the house has to appraise for the higher value. If the appraiser comes back and tells you that this house won't appraise for higher than $200,000, you can't do it. Let's look into this a little further. Say you buy the house for $200,000. Your $40,000 down payment leaves you needing a loan for $160,000. You get a 30-year loan at 8%. Your monthly payments for principal and interest are $1,174. Now say you decide to use the 6% seller concession strategy. You buy this house for the price of $212,000. You put down 20%, and this leaves you needing a loan of $169,600. Your monthly payments will be $1,244, or $70 more per month. Is it worth it? To begin with, many people aren't going to feel an enormous difference between paying the extra $70 per month -- not nearly as much as they would feel having to fork out an extra $12,000 all at once. But what about the fact that you have to now pay this extra money over the course of 30 years? Well, over the course of 30 years you're paying $25,200 more for that extra $12,000 ($70 more per month x 12 months in a year x 30 years = $25,200). However, remember that's $12,000 less out of your pocket at the time of closing. If you take $12,000 and invest it at 10% (less than the market average has returned over the past 35 years) then your money will grow to over $200,000 (before taxes) at the end of 30 years. So, in this scenario, it's well worth it. Naturally you'll want to run the numbers for your particular loan to see whether it would be worth it for you. Finally, there are certain rules under certain mortgages as to what the seller can actually pay for at closing. If you get $12,000 from the seller and all of your costs are $12,000, this does not necessarily mean that you won't have to pay anything. Be sure to ask your lender which costs the seller may cover. b. Assume an Existing Mortgage One option is to assume the mortgage on the house you are buying. (That's another way of saying you'll take over the existing mortgage on the house, rather than getting a new one.) This is beneficial if, for example, the existing mortgage has a lower interest rate. You can also avoid some of the administrative costs of taking out a new loan. In order to assume a mortgage, it must be transferable, and you must be able to pay enough cash (or get a second mortgage) to cover the difference between the purchase price and the outstanding debt. c. Seller Financing "Seller financing" means that you can pay the seller directly over a period of time, rather than borrow money and pay at once. With a seller mortgage, you can often negotiate a better interest rate and avoid the various administrative fees charged by lending institutions. Seller financing can be attractive if for some reason you can't qualify for a loan. More importantly, it enables you to avoid the dreaded mortgage insurance. One circumstance in which such financing is available occurs when the seller has had difficulty in selling the house. If that's the case, you'll naturally want to know why. Also, sellers are not in the lending business. They tend to want a short-term mortgage -- usually not longer than three years. After that time, you will have to get a mortgage from a regular lender and pay the seller in full. There are other reasons why a seller might want to provide financing. It gives him a steady stream of income and return without having to pay capital gains tax. The seller also has collateral -- the house. If the buyer defaults, then the seller can take the house back. d. Play With the Points, Play With the Time Yes! You see? Mortgages are just like basketball! Depending on the mortgage, the strength of your finances, and the interest rate environment, it might be to your advantage to pay off the interest or principal sooner than you might otherwise, in order to lower your overall interest payments. Check out our calculators to find out if you should pay points or take out a 15-year mortgage instead of one for 30 years. e. Pay Down the Principal For a very long time, most of the money that you will pay to your mortgage company is going to go to interest payments. That means that you may be in your house for over 20 years before you own more of it than the bank does. But there's a way to speed up the amount that you own. And why is that important (other than the obvious psychological benefits)? Because if you owe less to the bank, you will also owe them less interest. Click on over to our Foolish calculator to find out how paying down additional principal works and to see if it will work for you. f. Be Your Own Best Advocate Mortgage lenders must compete for your business. That means they will negotiate. Don't assume that their published interest rates are final. Collect information on available interest rates and mortgage features from lenders in your area. Decide which features meet your needs. Be prepared to ask for better terms -- a reduction of at least a quarter percent of the published interest rate is reasonable. You will be in a stronger negotiating position if your credit history is good. 11. The Down Payment For most first-time home buyers, saving enough money for a down payment is a major hurdle to owning a little piece of paradise. Traditionally, lenders have preferred a down payment of at least 20% of the home's purchase price. However, lenders will almost always accept less than that if the borrower takes out private mortgage insurance. In the last few years, innovative programs have made it possible to put down anywhere from 0% to 3% of the value of a home and still qualify for a mortgage. How Much Should You Put Down? If you've got the money, there are advantages to putting 20% down. For one thing, you immediately have substantial equity in your home. This may be important to you psychologically, and that counts. In addition, you'll avoid having to pay private mortgage insurance. If you haven't got the money, then you'll want to learn a little more about the private mortgage insurance mentioned above. Private Mortgage Insurance (PMI) Private mortgage insurance protects a lender in the event that you default on the loan. Lenders generally require mortgage insurance on loans with low down payments because experience shows that a borrower with less than 20% invested in a house is more likely to default on a mortgage. You're a Fool and you're not going to do this, we know. But they don't know it yet. Mortgage insurance also enables lenders to grant loans that would otherwise be considered too risky to be purchased by third-party investors like the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The ability to have a market for the mortgages means that lenders can loan more money to people like you. The good news about insurance is that you don't have to pay it forever. You can usually cancel it after you have at least 20% equity in the home. (Contact your loan servicer to find out the procedure for doing this.) Typically, you'll be required to get an appraisal on the property. This will cost money (a few hundred dollars), but could be worth it in the long run. Some lenders may have fancy ways to allow you to avoid PMI while still putting down less than 20%. For example, they might offer you a second-tier mortgage to make up the difference. The interest on the second loan will be higher, but it will be tax deductible, whereas PMI is not. As always, it pays to do your homework and explore as many options as you can with your lender. 12. Special Loans for Everyone Here's one instance where "your tax dollars at work" really will mean something to you. Thanks to several programs sponsored by Uncle Sam, it's possible for almost everyone to own a piece of the American Dream. The programs are so successful that almost 60% of all families in America now own their own homes. FHA Loans The Federal Housing Administration (FHA) is a federal agency within the U.S. Department of Housing and Urban Development (HUD). FHA's primary objective is to assist in providing housing opportunities for low- to moderate-income families. FHA has both single family (one to four units) and multifamily (five or more units) mortgage lending programs. The agency does not generally provide the funds for the mortgages, but rather insures home mortgage loans made by private industry lenders such as mortgage bankers, savings and loans, and banks. Homeowners with FHA loans usually only have to make a small down payment equal to about 3% of the value of the home. They also enjoy a lower interest rate, between 0.5% and 1% below the interest rates on other mortgages. The down side is that they do indeed have to purchase private mortgage insurance, or -- as it's called under these loans -- mortgage insurance premium (MIP). VA Loans The more you know about loan programs, the more you will realize how little red tape there is in getting a VA (Veterans Administration) loan. These loans are often made without any down payment at all, and frequently offer lower interest rates than ordinarily available. Aside from the veteran's certificate of eligibility and the VA-assigned appraisal, the application process is not much different from any other type of mortgage loan. What's more, if the lender is approved for automatic processing, as more and more lenders are, a buyer's loan can be processed and closed by the lender without waiting for the VA's approval of the credit application. Rural Home Buyers Special loans also exist for people choosing to locate in a rural area. These loans are given to encourage economic development in depressed regions. The specifics of the program are similar to the FHA loan program but may not be as stringent with the income qualifications. You'd be surprised, though, at what's considered a "depressed region." You can sometimes find these loans available in very nice areas that for one reason or another have managed to qualify. Be sure to ask if such a program exists in your area. No matter what kind of loan you end up getting, though, there will be tax implications -- generally positive ones. 13. The Tax Implications As you've figured out, owning a home is an expensive proposition. Lucky for us, though, there's a silver lining to our little black cloud. What is it? Elementary, my dear Watson! It isn't a Sherlock Holmesian deduction. It's a tax deduction. And it's major. When you file your federal and state income tax forms, you'll be able to deduct mortgage interest and property taxes (assuming that your loan is for $1 million or less). So how much is this really going to save you? Well, It works like this: Let's say that you're in the 28% tax bracket. Let's also say that, once you get your loan, you end up paying $1,000 a month. The interest portion of that $1,000 is tax-deductible -- and, in the early years of repaying the loan, almost all of it is interest. This means (assuming that you have other deductions at least equal to the standard deduction) that it will lower the amount of money on which you pay taxes. And this, of course, means that your tax bill will be significantly lower -- so you'll effectively end up having paid something like $720 a month for that loan. ($1,000 minus 28%, or $280.) This is not to say that the reason to buy a house is to save taxes, but it sure is a nice perk. And the place you live will belong to you, not some landlord who doesn't know your name, won't fix plumbing problems, doesn't like you knocking holes in the wall to hang paintings, and threatens to call the police when you try to sneak a waterbed up the back stairway. One caveat -- be sure to check with your accountant to make sure that you're going to be able to get the tax savings you expect. The likelihood is that you will, but you don't want to count on this kind of savings and then discover that for some reason you've miscalculated. So go ahead, slosh away. If the waterbed springs a leak, it's your problem. Welcome to the joys of home ownership!
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