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Mortgage Guide

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

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.

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$ 252,700.00).

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.

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.




Centre Square Funding Associates is an Equal Opportunity Housing Lender.