The Basics of Home Financing: A Mortgage Loan Guide

Let this mortgage loan guide help you as you work on your home financing options.

Dealing with the real estate market has felt like a roller coaster ride lately. From the housing bubble that burst to the government takeover of Fannie Mae and Freddie Mac, something unpredictable is always going on. In this confusing market, it helps to understand the basics of home financing.

Start Out With Mortgage Loan Basics

Knowledge is power. Before you apply for a loan, it’s a great idea to gather some key information that will be needed for the financing process:

1. Find out your current credit rating, otherwise known as your FICO score, because lenders certainly will. A poor credit history usually means higher interest rates, or the possibility that you may not even qualify for a loan. If your credit isn’t stellar, then take time to improve your credit score or shop around for a reputable lender specializing in difficult credit situations. Here’s how to check your credit score.

2. Figure out how much you can afford to borrow. Develop a home buying budget. A mortgage payment should not exceed one-third of your monthly income because you have to pay for utilities, homeowners insurance, taxes, home repairs and other everyday expenses. Many online lenders and financial sites have loan calculators to help you figure out what you can borrow.

3. Determine the cost of borrowing money. Be aware of the current Annual Percentage Rate (APR) to get the most competitive rates. Carefully review terms, fees and rates before committing to the loan.

The Pros and Cons of Different Mortgage Loans

Fixed Rate Mortgages (FRM)

Do you dislike surprises? If you prefer a predictable monthly budget, a fixed rate mortgage is the perfect loan. You pay the same interest rate for the term of the loan: the loan interest and principal never changes. With a FRM, you never have to worry about your monthly payment fluctuating along with market changes.

Tip: If you want to pay off your loan more quickly, you can take out a 15 year FRM. For lower monthly payments with the same predictability, take out a 30 year FRM.

Adjustable Rate Mortgages (ARM)

An adjustable rate mortgage lures you with a lower preliminary interest rate for a period of 1, 2 or 3 years. After that time, the interest rate on the ARM fluctuates in accordance with the current market APR. Budgeting is more difficult because your monthly payments are unpredictable. If you plan on selling your home within three years, you can take advantage of ARM low interest rates before the loan rates start to fluctuate.

Tip: For those with credit problems, it’s easier to get an ARM which you can refinance to a FRM when you credit improves.

Balloon Payment Mortgages

Balloon payment mortgages have a balance that’s due at the time of maturity. Typically, balloon mortgages charge lower interest rates and last for a term of 5 to 7 years. At that time, the remainder of the loan becomes due. Borrowers may be left in a position where they do not have the money to cover the balance. At this point, a borrower may attempt to refinance the remaining amount of the mortgage, which is often called a two-step mortgage. If the borrower is unable to refinance, they may have to sell their home to cover the balance of the loan. If you are expecting a windfall or inheritance, a balloon mortgage may be the best deal. On the other hand, balloon mortgages can be a risky proposition if you can’t cover the balance at the end of the term.

Jumbo Loans

Jumbo loans are also called non-conforming loans: they exceed the limit guidelines established by Fannie Mae and Freddie Mac. The current conforming loan limit for a single family home is $417,000 while in Alaska and Hawaii, the limit is $625,000. Jumbo loans are associated with higher risk and often have accompanying higher interest rates than conforming loans do. You can finance up to 97 percent of your home with a jumbo mortgage, which you’ll find in the guise of a FRM, ARM or FHA loan. If you can’t come up with a down payment or you want the best possible house for your money, a jumbo loan can be a good option. Note, however, that jumbo loans can be a stretch to pay off if your income does not keep up with your loan obligations.

Government Mortgages

FHA, VA and RHS loans are government mortgages. Some basics:

• FHA loans are easier to get than conventional loans and require lower down payments. You can check out FHA eligibility requirements to see if you qualify for such a loan. My neighbor used an FHA loan to purchase her home with a 3 percent down payment. While she couldn’t afford a conventional loan, the FHA made it possible for her to still become a homeowner.
• VA loans are guaranteed by the US Department of Veterans Affairs, and are easier to qualify for, often requiring no down payment. These loans are for service people and veterans; we were able to buy our home through this route — with no money down — because my husband is a disabled veteran.
• The Rural Housing Service (RHS), part of the US Department of Agriculture, guarantees rural loans with no down payment and no minimum closing costs. If you long to live in a town with 20,000 or fewer people, this could be the dream loan for you. Without coming up with any cash, you can enjoy a rural lifestyle or start your own farm.

Graduated Payment Mortgages (GPMs)

A graduated payment mortgage is a loan that requires initial lower payments that increase over time. The structure of the loan enables you to qualify for a larger loan amount. During the later years, monthly payments increase while more of your payments applies towards your principal. If you believe that you’ll earn more money over time, this loan may work out for you pretty well. Doctors, lawyers and other professionals can use a GPM to set up a home office in a good community then build their business to cover the loan. On the flip side, if you aren’t able to earn as much as you anticipate, you may have difficulty covering future payments.

Interest Only Mortgages

For the first 5 or 10 years, you only pay interest on interest only mortgages with an option to pay down the principal. After 5 or 10 years, your monthly payment increases to include principal. If you have a bright future and anticipate pay increases, you can buy more house with an interest only mortgage. This type of mortgage can also help you maintain your home during difficult times until you get on your feet. Unfortunately, you are not building equity when you are just paying off interest.

What Mortgage Should You Get?

Your mortgage should be affordable, attainable and a good fit for your situation. Are the interest rates competitive? Can you borrow enough to get a decent home? What are your financial goals? If you prefer stability, stay with conventional loans such as an FRM. For those who can manage their risks well, balloon mortgages and ARMs may offer unique advantages — but be very careful! Be wary of the risks inherent in these loans. After all, we ended up with the real estate bust and a mortgage loan crisis to boot, due to poor home financing decisions made by both lenders and homeowners alike!