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Things you should know about Loans |
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Conventional Loan
This is the most cost-effective loan available. If possible, you would
choose Conventional before FHA and non-conforming loans. If you have
good credit scores and are not looking to push your borrowing capabilities
to the max, then conventional financing probably is for you. There is
a full range of products available:
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5% Down Payment from your own savings.
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0% Down Payment. Available for borrowers with excellent
credit.
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3% Down Payment. Available for borrowers with excellent
credit with limitations.
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No PMI (Private Mortgage Insurance)
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30 year and 15 year fixed term are most common
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ARMs (Adjustable Rate Mortgages) and balloon payments.
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FHA
A government-insured mortgage. Appropriate for borrowers who:
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Have credit issues (typically a FICO score below 620)
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Want to borrow more money than a conventional lender
will allow. FHA loans have more generous lending criteria.
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Want a low down payment.
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Does not have a down payment coming from their own
savings. Gift money can count as a down payment.
If you cannot qualify for a conventional mortgage, then an FHA mortgage
may be for you. If you qualify for a conventional mortgage you may
want to avoid FHA since it is more expensive. The extra costs of an
FHA loan come from:
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Up-front MIP (Mortgage Insurance Premium) = 1.50%
of the mortgage
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Appraisals that may add additional requirements
to the transaction, which can complicate matters.
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Additional time to close due to government requirements.
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VA
If you are a veteran you may qualify for a VA loan. If you want to close
with the least amount of cash as possible and not pay a premium, then
VA is the way to go. Not only is VA zero-money down, but you can also
have the Seller pay for almost all of your closing expenses. If your agent
structures the transaction correctly, you should be able to come to closing
with no money required. It's not unheard of to even receive a check at
closing.
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Fixed Rate Mortgage
There are generally two types:
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A 30-year fixed mortgage has the same interest rate
for the entire 30 year period and is amortized over 30-years (paid
in full at the end of the 30th year). You can usually pre-pay and/or
refinance whenever you want. This is a conservative loan and has less
risk. Consequently the rate is usually higher than an adjustable rate
mortgage.
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A 15-year mortgage has a fixed rate but is paid off
in 15 years. The monthly payment will be higher but the interest rate
will be lower by about 3/8%. If you can afford the higher payment
and you like the idea of the mortgage being paid off quicker then
this may be appropriate for you. The bank gets less of your money
with this option.
Tip: sending in extra principal payments
can pay off a loan quicker. Typically if you pay 13 payments a year
instead of 12 it can reduce the period from around 30 years to around
22 years on a 30year mortgage. Payments made earlier in the life of
the loan benefit the borrower more than additional payments made later
in the life of the loan.
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Adjustable Rate Mortgages (ARM)
These loans are fixed for given periods of time, and then adjust based
on a formula. Typically the rate during the initial period prior to adjusting
will be less than a more conservative 30-year fixed-rate mortgage. They
are most appropriate for borrowers who want to match up the term with
how long they think they may own the house: Very short-term ARMs are loans
that are fixed for 1 to 3 years then adjust. They are usually referred
to as 1 years ARMs, 3/1 ARMs, and 3/3 ARMs. Mid-term adjustable rate mortgages
are fixed from five to seven years then adjust. They are usually referred
to as 5/1, 5/5 and 7/1 ARMs. Longer ARMs terms are fixed 10 years prior
to adjusting. 10/1. How do they adjust?
The most common adjustment is every year after the initial fixed period.
For example, a three-year ARM would adjust in year four and every year
thereafter. The typical limit (referred to as a cap) on how much it can
adjust is typically 2% each adjustment with a lifetime cap of 6% over
the initial rate. It can go up or down depending upon what rates do.
Tip: When shopping rates for ARMs you should
also ask about the lifetime interest cap and the maximum cap for each
adjustment period. A lender may offer a very low teaser rate (the rate
you are quoted) but if the rate can go up 3% each year instead of 2% you
may find your savings being quickly erased.
There are some ARMs that only adjust once. These are fixed for the initial
term then convert to the 30-year rate at the adjustment period. A three-year
product would stay fixed for three years, then convert in year four to
whatever the 30-year fixed is at that time.
The last kind stay fixed for a given period, then adjust, but the next
adjustment period is for the same time frame. It is fixed for three years,
adjusts, then fixed for another three years (referred to as a 3/3). Then
it adjusts again for another three years.
The amount they adjust by is written into the note. It will normally be
based on a United States Treasury rate of like duration with a margin.
For example: A one year ARM will adjust by looking at the one year treasury
note and adding a margin of perhaps 2.75%. These two numbers added together
will determine your rate. Your Agent should be aware of this because the
margin is not the same at all banks. If a particular lender has a low
initial rate to capture your business but during the adjustment period
uses a higher margin than everyone else, then your rate will be more expensive
over time. Your Agent should be shopping the margin as well as the rate.
What kind of borrower should be interested in an ARM?
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If you know that you will only live in the house for
3 to 5 years, then why pay for the security of a 30-year fixed rate
loan? You should see what the rates are for 3 and 5 year ARMs. You
can use ARMs to match the term of the loan with the length of time
you intend to live in the house.
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The lower initial rate may help you qualify for a
larger mortgage. This is appropriate for buyers who otherwise would
not be able to afford the house they want to purchase.
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If you believe rates will be going down in the next
few years. Remember that it is difficult to predict the behavior of
rates, especially one to three years into the future.
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You have expectations of an increasing income. If
you are confident that your income will increase enough to cover the
potential of increases in your mortgage when it adjusts, then you
are minimizing your exposure to risk. It is also appropriate if you
have debts or payments that are going to be going away.
Tip: Sometimes the markets can price short
term vs. long-term rates so that one has a clear advantage over the
other. There are times when 10- and even 7-year adjustable loans are
the same as 30-year fixed. In those cases you would never go with
the adjustable. If the difference (spread) on a 5-year ARM is only
a 1/8% then you may not go with it. But if it is 1/2% or greater then
you may consider the difference worthwhile. Then you can determine
the costs of the security that is right for you.
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Hybrid Products
These are specialized products. They are literally too numerous to mention
all of them. The following examples will give you a good idea of available
options:
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3% to 0% Down Payment. The better your credit score
the cheaper the mortgage available. If you have credit issues these
may not be available or be too expensive.
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First and second mortgages combined. These are sometimes
called 80/10/10 or 80/15/5 mortgages. The 80/10/10 is a first mortgage
of 80%, a second mortgage of 10% and equity of 10%. The 80/15/5 just
changes the proportions. With an 80% first mortgage there is no PMI
(Private Mortgage Insurance), which can be expensive and is not tax
deductible. The second mortgage is fully deductible, which will generate
a larger tax deduction. The second may also be designed as a line
of credit, which allows the borrower to pay it off quickly or pay
interest only.
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No PMI loans. Some lenders will self-insure the mortgage
and not charge you PMI. They add a premium to the mortgage rate. The
advantage is that the payment may be less and it will be fully deductible.
The disadvantage is the rate premium stays with the mortgage until
it is paid off or refinanced.
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Marginal credit borrowers have many opportunities
with B and C loans. They will pay a premium but they can also refinance
when their credit improves and then take advantage of cheaper conventional
rates. Usually requires a larger down payment.
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Buy Down Mortgages. The most common form of a buy
down is a 2-1 Buy Down. The first year's rate will be 2% below your
note rate. The second year's rate will be 1% below your note rate.
Starting the third year the rate will be the note rate. Buy Downs
are appropriate for people who want to purchase a more expensive house
than they would usually qualify for. (The lender will use the lower
initial rate). Don't think you are getting a great deal for free.
The lower initial rates are possible because you are borrowing more
money up front and the lender is using the excess funds to make up
the difference in the mortgage payment during the first two years.
For example: If the market rate on a 30 year fixed mortgage is 8%
then the 2-1 Buy Down in year three might be 8.25%. That would make
the first year’s rate 6.25% and the second year rate 7.25%.
Tip: Some rates will seem incredibly good
...until you look further into them. Be sure to see if the lender
is adding origination fees, discount points, and high closing costs.
The low rate could be the result of up-front charges you may not initially
be aware of.
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Things You Should Know About Loans
POINTS
A point is 1% of the loan amount charged to the borrower at the time
of closing. For a $100,000 loan one point is $1,000. Points are used
to lower the interest rate since they are simply a pre-payment of interest.
A typical yield for one point will be to lower the interest rate by
1/4%. Not all loans require points and you should carefully analyze
if it is appropriate for you, since it can be a large up-front expense.
Points are pre-paid interest, even if paid by the Seller, and are tax-deductible.
However not all borrowers will be able to take advantage of the deduction,
depending on the individual Buyer's scenario.
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JUNK FEES or LENDER'S FEES
The amount of fees that the lender charges to process the loan. These
can vary greatly from lender to lender and should be shopped for to
get the best deal (see below).
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CLOSING COSTS
This is a widely used term that can mean different things to different
people. The broadest meaning would include all funds needed for closing,
except the Down Payment. But this can be broken down further as follows:
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Lender's Fees or Junk Fees. These are costs that the
lender charges to process the loan. They would include terms like:
processing, credit report, underwriting, tax prep, doc prep fee and
tax service fee.
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Origination Fees. Some lenders charge an up-front
fee for the right to loan you money. This should be shopped carefully.
In some markets people are paying it and if they had shopped more
carefully they could have found the same loan with no origination
fee. A typical amount can be 1% of the loan amount, which makes this
a significant expense to watch.
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Appraisal. To obtain a loan the home must pass an
independent appraisal ordered by the bank. The fee will depend upon
the going rate in your market.
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Title charges. The lender has no control over these
and they depend on custom and the market in your area. Expenses may
include a fee for processing the closing, a title policy to cover
the lender and a title policy to cover the purchaser.
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Pre-paid items and escrows. The lender will require
a few months reserves be deposited by the buyer to cover insurance,
taxes, and possibly the PMI. Technically these items are not closing
costs however.
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Taxes. The local jurisdiction will charge taxes for
transferring title. The amount depends on your locality.
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Pre-paid Interest. At closing you will pay interest
for the rest of the month. If there are five days left in the month
then you will only pay for five days. If there are 28 days then you
will bring a larger check to cover 28 days. If you are cash sensitive
then you may want to close at the end of the month.
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Survey. The lender will require a survey of the property
for the title insurance coverage.
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Miscellaneous expenses. These will depend on your
particular deal. They would include items like: repairs, warranties,
wood destroying insect reports and treatments, delivery fees, etc.
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PRIVATE MORTGAGE INSURANCE (PMI)
When you put less than 20% down on a house you will have to pay PMI.
It is an insurance policy that protects the lender and pays part of
the principal balance upon default. The lower the down payment the higher
the PMI rates, since there is a greater risk of default. For a $150,000
house with 5% down the PMI can run $80 per month and since it is not
interest, it is not tax deductible. Some lenders will not require PMI
with 15% down and no premium in rates.
How to avoid PMI:
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Some lenders will self-insure and not require PMI.
They cover the risk by increasing the interest rate. With a competitive
lender the higher payment may still be less than the lower rate payment
plus PMI. It also has the advantage of being tax deductible. The disadvantage
is the rate premium is added for the life of the loan. These loans
are very appropriate for low Down Payment borrowers who will be in
the house 4 to 6 years, hence not likely to achieve 20% equity anyway.
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80/10/10 loans. First mortgage of 80%, second mortgage
of 10% and equity of 10%. Instead of PMI you have the second mortgage
which is fully deductible.
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Put down 20% equity.
How to get rid of PMI:
When your loan to value equals at least 20% (some lenders may require
as high as 25%) you can petition to have the PMI removed. You will have
to pay for an appraisal to verify the value. You can achieve this benchmark
by putting more equity into the house and by having the home appreciate
in value. You also need to make all of your payments on time. Making
certain home improvements may also increase your equity.
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RATE LOCKS
When you receive rate quotes most lenders will honor that rate if you
close within the next 30 to 45 days. If you want to lock in a rate for
longer than 45 days you will likely pay a premium. The longer the rate
lock the higher the premium.
If you are in contract and have a rate lock some lenders will drop your
rate if market rates drop prior to closing.
When building a house the advantage of using the Builder's financing
is they will give long-term rate locks without the large premiums. If
you are custom building a home many Lenders will give a construction
loan that converts to a permanent loan with the rate locked in at the
beginning.
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PRE-APPROVED vs PRE-QUALIFIED
A lender or real estate Agent can pre-qualify you. All it means is that
someone has looked at your income, your debts and your credit and determined
the amount and type of mortgage you could qualify for.
When a lender pre-approves you it means you have made a formal loan
application and taken the next step past pre-qualification. The approval
may be contingent on verification of your income, Down Payment, appraisal
and other misc. items. Being pre-approved may give you added strength
when negotiating because the Seller will feel more secure about your
ability to close. Being pre-approved does not prohibit you from shopping
for rates when you are in contract and switching Lenders if you can
find a better deal later.
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MISC GOVERNMENT PROGRAMS
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Down Payment Assistance Grants. These are grants that
the state or local government gives to borrowers for their Down Payment.
They are available on a periodic basis and you must qualify based
on income, purchase price, and/or number of people in your household.
The income limit changes for each county and the availability is hard
to predict. You would be well advised to check with a qualified Lender
to see if you qualify and if the funds are available. You can not
reserve them in advance. Once you are in contract then you can apply.
Be patient. It is a government program so approval can take around
45 days.
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First Time Home Buyer: This "bond" money
is intended for first time home buyers only. It is used to lower your
interest rate to a below market rate. You must qualify by not exceeding
the income limit for your county. The income level for bond money
is higher than Down Payment Assistance Grants.
Remember that you will need to give more time in a contract to close
as each of these processes takes additional time to complete.
Ask me for a list of lenders or refer to your
local Yellow Pages.
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Financing Your Production Home
Builders will often market the home based on a low initial payment.
Be cautious of the financing benefits because you may be taking on more
financing risk than is appropriate. Some important points include:
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Financing incentives are buried in the price: Many
production Builders add on 3-5% to the price of the home for the great
financing. On a $200,000 house, that means you just paid $6,000-$10,000
to the Builder to give you that great rate, buy-down, or low introductory
rate. The real value of the house is 3-5% lower.
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Why is the payment so low for a new build? The large
print giveth and the small print taketh away. Never shop for a home
based on the payment. If the house costs $150,000 and the payment
for the Builder's 30-year fixed mortgage is lower than if you bought
an existing home at $150,000, it is most likely because you are paying
extra for the financing.
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Risk of adding expenses to the mortgage if you are
a short term Buyer: If the Builder added in 3% for financing to the
price of the home, the benefits of the lower payment will be justified
after 4-7 years. If you have to sell the house quickly, you may lose
money because the true value of your home on resale may not cover
the over-payment you made for financing incentives.
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Benefit of long-term rate lock: This is one of the
best benefits of Builder financing. They will lock in the interest
rate during the entire construction process, which is usually around
270 days. If you are nervous about rising rates, then this feature
will be hard to beat. Most lenders can lock in the rate but they will
charge a premium for long-term locks.
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Shop to see if it's truly a benefit. Get a good-faith
estimate from the Builder's lender. Ask how much they would drop the
price of the home if you got financing on your own. Ask other lenders
if they can compete if they are also using the same financing premium.
Only then will you truly know if you are getting a good deal.
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Short-term mortgages are used to decrease the initial
payment. The low payment you see in the paper may change at the end
of the year and adjust every year thereafter. If you are going to
live in the house for a short time then a short-term adjustable mortgage
may be appropriate. Short-term mortgages can be risky, so make sure
you get the mortgage that is appropriate for you because the payments
can adjust upwards.
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