There are two basic types of mortgages you will come across: - Conventional fixed-rate
- Adjustable rate
Let's take a closer look at each.
Fixed Rate
The more traditional of the two, fixed rate mortgages are a very popular option. Here is how it works:
- The interest rate is determined by the general level of mortgage interest rates at the time you take out the loan.
- Your payments remain level for the life of the loan, with the vast majority of each payment going toward interest in the early years.
- As you continue to make payments over the years, a larger proportion of each payment goes toward principal, gradually reducing your loan balance.
Adjustable Rate
Adjustable rate mortgages were created by banks in the 1970s when inflation was high and interest rates even higher. To give home buyers an incentive to assume some of the risks associated with interest rate fluctuations, banks started offering adjustable rate mortgages, or ARMs. Here is how it works:
- Mortgages are granted with lower initial rates
- Interest rates on those loans could be adjusted to reflect changes in market rates.
Keep in mind that although potentially a great deal, if you have taken out an adjustable rate mortgage, you could be assuming considerable risk: If interest rates go up, your costs will increase. These higher costs may take the form of higher monthly payments or, where the lender has agreed to put a cap on the monthly payments in order keep them affordable, the principal amount of your loan could increase. However, many remain fixed for five to seven years and then adjust upwards, which enables you to refinance before the loan balloons to fixed-market levels.
Pledged Asset Mortgages
For those people in a high tax bracket who have most of their funds locked up in investments, there is another alternative called a pledged asset mortgage. With a pledged asset mortgage, you can use stocks, bonds, mutual funds, and CDs as collateral for the down payment on your house as long as the securities are not held in a retirement account.
Anatomy of a mortgage
Think of a mortgage as having three basic parts.
- Down payment
- Monthly payments
- Fees
Let's take a closer look at each.
Down Payment
The down payment is the up-front cash you will pay toward the purchase of your home, reducing the amount of the loan amount that needs to be financed. Depending on the particulars of your financing arrangement, your down payment can be anywhere from three percent to twenty percent of the total cost of the home. As we have said, saving early, and as much as you can, is key. Remember, too, that the more you put down up front, the lower your mortgage will likely be - that can mean lower monthly payments and a shorter loan term altogether.
If you expect to make a down payment of less than twenty percent of the purchase price, know that most lenders require that you buy PMI (private mortgage insurance), a policy that promises to pay your mortgage if you default.
HerTip: If you can put down more than twenty percent, the lender may be willing to approve a larger loan.
Monthly payments
Part of determining how much house you can afford, in addition to knowing how much down payment you will need, is figuring out what the monthly payments will be and whether or not you can afford them. As a general guideline, lenders want your monthly mortgage payment to be no more than twenty-eight percent of your gross monthly income, with total monthly debt limited to thirty-six percent of your gross monthly income.
Fees
There is no uniformity in the fees that banks and financing companies charge for closing costs on your mortgages, so it is wise to comparison shop and see the range of options. If ever you see a fee that seems questionable - question it. These are negotiable by nature. Additionally, a buyer can also ask for a good-faith estimate of all fees in writing from the mortgage broker or lender when she applies for a loan. Federal law requires lenders to provide such an estimate within three days of the loan application.
You should expect to pay for title insurance, an appraisal on the property, an inspection, mortgage insurance, and taxes. However, you should closely examine all other service charges you are presented with. Most fall under what are known as "closing costs." We will cover the common ones in some detail in the last section of class.
HerTip: Mortgage rates can and do change quickly. Even a small move can cost - or save - you real money over time. If you are confident that you have received a terrific rate on your mortgage, try to "lock it in" for as long as it will take you to close the deal. Many lenders will allow you to do so for a period of thirty days at no extra charge.
The following sites can help you track down the latest rates and lenders as well as information about mortgages and calculators to determine how much you can really afford to finance.
- HSH Associates (www.hsh.com) -- You will find average mortgage rates by city, state, and much more.
- Homepath (www.homepath.com) -- This is Fannie Mae's site that can provide you with a list of mortgage lenders in your area and guide you in the mortgage shopping arena.
- Bankrate monitor (www.bankrate.com) -- Lists the top mortgage rates in the country.
- Ratenet (www.ratenet.com) - Tracks over 11,000 lenders and can locate the top ten rates offered in your location.
Continue to: Part IV: Mortgage Brokers
Qualifying for a mortgage