Understanding mortgage loan basics can help first-time borrowers get the right loan. This blog describes several loan features that you can vary and the pros and cons of doing so.
Typical Mortgage Loan Scenario
A typical home purchase scenario involves a 20% down payment and a 30-year fixed-rate mortgage for the remaining 80% of the price. You’ll also need between 2%-3% of the purchase price for closing costs.
Let’s go through the two parts of this scenario (down payment size and mortgage loan) and see the pros and cons of varying them.
A. Down payment size
The first part is the down payment size. You can make a smaller down payment than the typical 20%, say 10% of the purchase price. Your mortgage loan from a commercial bank or credit union would be for the other 90% of the purchase price.
The lender, however, will charge private mortgage insurance (PMI) because you don’t have at least 20% equity in the home. You’ll pay the PMI monthly charge until the loan to value of the home drops to 78%. This can occur as you pay off the mortgage or the value of the home increases.
Private mortgage insurance generally ranges from 0.5% to 1.0% of the loan amount. If you put 10% down, you’ll pay PMI for at least five to seven years depending upon the rate. This payment is a wasted charge.
It is often better to wait accumulate a bigger down payment or to use one of the loans described below when you have less than a 20% down payment.
The first way uses a Federal Housing Administration (FHA) loan. An FHA mortgage is a government-backed home loan with more flexible lending requirements than those for the commercial loans describe above.
The flexibility comes in the form of less stringent down-payment requirements, as low as 3.5%. It also comes with lower credit score requirements (as low as 580) compared to at least 680 for conventional mortgages.
Because of this flexibility, interest rates for FHA mortgages are higher than a commercial loan. You also are likely to pay monthly mortgage insurance premiums.
A second way to lower your down payment from the traditional 20% is to use two loans: an 80% first mortgage and 10% home equity line of credit. The other 10% is your down payment.
A home equity line of credit (HELOC) is a form of revolving credit in which your home serves as collateral. As you repay the HELOC, you can borrow back up to the original value of the loan during the “draw period.” The draw period is usually 10 years.
During the draw period you are required to pay only the interest on the outstanding amount. After the draw period ends, you’ll be required to repay interest and principal generally over a 10 year period. The HELCO’s interest rate is generally variable and higher than the rate on the 30-year fixed loan.
This structure avoids the mortgage insurance, but you have a higher variable interest rate on the HELOC. The HELOC’s rate is often tied to the Prime Rate and is quoted as “Prime + 0.5%.” As of this writing, the Prime Rate is 4.0%, so the interest rate would be 4.5%. As the Prime Rate changes, so does your interest rate.
This structure is ideal if you have 10% for a down payment and good cash flow to prepay the HELOC quickly. You can pay more to the HELOC to eliminate that loan. Once it is repaid, your monthly mortgage payments will be lower. But you still can borrow back up to the original amount during the draw period should you need them for renovations or other expenses.
B. Type of Loan Product
The standard mortgage loan is a fixed-rate 30-year mortgage. Your monthly payments are fixed for the term of the loan – 30 years. The lender applies more of the monthly payment towards interest during early years of the term and more toward principal toward the end of the term. It takes nearly 13 years in a 30-year mortgage at 4% to have more of your monthly payment applied toward the principal and not the interest charge.
Thirty-year fixed mortgages make sense for borrowers who plan to stay in their homes. They also make sense for borrowers who don’t know what the future holds.
An adjustable rate mortgage (ARM) may be more attractive than a fixed rate loan if you are not planning on staying in your home for a long time (e.g., a 3-year assignment in a new city). A 5/1 ARM means that for the first five years of the loan your payment will be fixed. After five years, the interest rate will vary based on market conditions and your payment will adjust annually. You take your chances here depending upon the level of interest rates after the end of the five-year period.
Adjustable rate mortgages also make sense for those with sporadic big payments (e.g., bonus money or large commission checks). You can make one or two big payments and then refinance a smaller amount at a later date but before the interest rates begins to adjust annually.
Always have an exit strategy ready if you use an ARM to buy your home.
Avoid using an ARM if it will be a stretch to make the monthly payment. Wait to get a better deal by saving more for the down payment or improving your credit score.
Two types of mortgage loans: Conforming and Jumbo
Conforming loans have lower interest rates. Lower rates mean lower monthly payments. The “conforming” means the loan meets the standards set out by the two mortgage loan buyers established by the federal government to help home ownership – Fannie Mae and Freddie Mac. These two entities are the government sponsored entities that buy mortgages, package them, and sell them to sophisticated investors. The conforming loan limit is $424,100 in most areas although certain high cost areas have higher conforming loan limits.
Jumbo loans, those with a higher balance than a conforming loan, have higher rates because the bank cannot as easily sell the loan to another buyer.
I have seen many borrowers use a variation of the 80 / 10 / 10 structure above to get their first mortgage at the conforming loan level and then use a HELOC and down payment for the rest of the purchase price. By doing so, they get the benefit of the lower interest rate conventional mortgage.
Getting a Low-Cost Loan
The two main costs of a mortgage loan are its interest rate and its fees. The interest rate is the charge you will pay to borrow the money. Loans have nominal interest rates of say 3.75%.
The APR (annual percentage rate) is a proxy of the cost of the loan including fees. A low-cost loan has an APR just slightly larger than the nominal interest rate. For example, an APR of 3.75% for a 3.75% interest loan is good because there are no fees attached to the loan. A loan APR of 4.414% on a 4.375% loan, however, is more expensive.
Loan fees include “points” and origination charges. Points represent prepaid interest. One point equals one percent of the loan. You will pay the “point” at the closing. Loans with points often have lower interest rates than ones without points. So if you are struggling to get a 10% down payment, avoid paying points.
Origination charges are just pure lender profit. This charge is BS. You can avoid it by shopping for a low-cost lender.
Shop among lenders for your mortgage loan. Three are enough. Use a local bank and try two online lenders. Online lenders are great for the typical 30-year loan conventional loan with 20% down and good credit.
Within 24 hours of applying for a loan, you’ll get a standardized loan estimate form. The estimate allows you to compare the offers from different lenders on an “apples-to-apples” basis. Use the estimates to get the best deal.
Once you decide on a lender, you’ll schedule a closing. Seventy-two hours ahead of time you’ll receive the closing disclosure. It shouldn’t vary from the loan estimate disclosure. If it does, use the 72-hour period to get to the bottom of the issue. This link gives a good overview of the required disclosures to help you make the best mortgage loan decision.
In sum, by understanding mortgage loan basics you’ll be in a good place to get the right mortgage loan.