For people who are considering buying their first home, or even their 3rd home, it is easy to get over-whelmed by the variety of home financing options available. Thankfully, by taking the time to research those options, buyers can save a substantial amount of time and money. Also by having some knowledge about the market, for instance, where the property is located can result in added “perks” for the buyers. Buyers also need to review their own finances to make certain they are getting the best mortgage for their situation.
There are three main types of mortgage loans.
The first type of loan is a conventional loan. First time homebuyers can also use Conventional loan financing which is a fixed-rate mortgage that is not insured or guaranteed by the federal government. Due to the criteria needed to qualify for this type of loan, they are the hardest to get. A homebuyer must have items such as a down payment, good credit score, and above average income. Certain costs, such as private mortgage insurance (PMI) maybe lower than with other guaranteed mortgages. Conventional mortgages can either be conforming or non-conforming. Conforming means that they comply with guidelines set forth by Fannie Mae or Freddie Mac. They are regulated by stockholder-owned companies that set guidelines like loan limits. They do this so they can package these loans and sell securities on them in a secondary market.
The Federal Housing Administration (FHA) of the U.S. Department of Housing and Urban Development also provide various mortgage loan programs. FHA requires a lower down payment and is easier to qualify for than a conventional loan. First time home buyers are excellent candidates for this type of loan due to lower loan costs and roomier credit requirements, in fact they allow as low of a down payment as 3.5%.
For veterans and people serving in the military, the U.S. Department of Veterans Affairs guarantees mortgages made by qualified lenders. By doing this, Veterans and service people can obtain home loans with beneficial terms. Most times there is not a down payment requirement and they are easier to qualify for then a conventional loan. To get this type of loan you must first request eligibility from the VA. Then, once approved, the VA will issue a certificate of eligibility to be used when you are applying for a VA loan.
Cost of Loans
The price of loans is determined by the lender in 2 ways. Together determining the borrowers credit worthiness. First the lenders will check the borrowers FICO score, which they obtain from the three major credit bureaus. Lenders then determine two ratios. The loan to value ratio (LTV) and the debt-service coverage ratio (DSCR).
A loan to value ratio is determined by the equity that is available in the property being borrowed against. This is done by dividing the amount being borrowed by the purchase price of the home. The higher the ratio the more expensive the loan will be because this will make the lender believe that it is at a higher risk of being defaulted on. The assumption is the more money the borrower is willing to put at risk lessens the possibility of defaulting on the loan.
LTV also can cause loan costs to be more by requiring the borrower to purchase private mortgage insurance (PMI). The purpose of PMI takes some of the risk from the lender and puts it on the insurer. This is required generally when the LVI is greater than 80%, meaning that the borrower would have less than 20% equity in the home. The cost of the PMI is determined by the loan amount and the type of loan.
The cost of PMI is usually added in with the mortgage premium, tax, and home owners’ insurance. PMI is usually automatically removed after the loan has been paid down enough to where the LVI is equal to or less than 78% or after a certain time has passed, for instance the borrower has been paying on the loan for 2 years. PMI can be avoiding in a couple of ways. One is to not borrow more than 80% of the property value, the other is to consider getting a second mortgage or use equity financing for the portion of the loan that is above the 80% LVI. This is commonly known as an 80-10-10 mortgage. The 80 being the LVI, the first 10 is the amount of the second mortgage and the second 10 is the amount the borrower is putting down. The essential point is, the buyer should try to avoid having to pay for PMI and saving money. Another huge benefit is borrowers can pay off their loans early because they can increase the payment on the second mortgage and get rid of that portion of the debt quickly.
The debt service coverage ratio (DSCR) shows the borrower’s ability to pay the mortgage. This is figured by taking the borrower’s monthly net income, after the borrower’s other monthly financial obligations, divided by the mortgage costs. Lenders then determine the probability of default. Lenders want to see this number greater than one, the higher the number the lower the rate. Borrowers should try to find any type of qualifying income they can when looking for a mortgage. Even getting an extra part-time job can make the difference between qualifying and not qualifying.
Fixed. Floating. Interest Only
Lastly, you need to consider whether to get a fixed-rate or a floating-rate mortgage. Fixed-rate means that the rate does not change for the entire period of the loan. The benefit of this type of loan is the borrower knows what the mortgage costs are going to be for the entire period of the loan. A floating-rate mortgage is designed to help first-time home buyers or buyers that expect their incomes to raise dramatically over the loan period. Another name for these types of loans are interest-only mortgage or adjustable-rate mortgage.
Floating-rate loans usually are set up to allow borrowers to get a lower rate during the first few years of the loan. Thus allowing them to qualify for a larger loan then if they would have if they would have applied for a fixed rate loan. Even though the benefit can be substantial, there is risk for borrowers whose incomes do not increase at the same rate that the interest rate does. There also is not set times that the rate may change due to being tied to some market rate that is determined in the future.
Adjustable-rate mortgages are most often one, five or seven year terms. It is fixed for a period and then resets periodically. This can happen as often as every month. Once it resets, it adjusts to the market rate.
Interest-only loans are when the borrower pays only the interest and not the principle on the mortgage for an introductory period and then later reverts to a fixed loan, which then is paying on the principle of the loan. By the borrower only having to pay the interest on the loan results in them having much smaller monthly costs and qualify for a much larger loan. The other side of the coin however is that the balance of the loan does not change until the borrower starts to pay on the principle. Because of the risk of the borrowers’ disposable income not rising with the increasing mortgage costs, an interest-only loan might become a trap hard to get out of.
Ultimately if you are shopping for a home loan for the first time, sit down and figure out what you want and how much you can afford and then shop for your loan accordingly. A good mortgage broker or mortgage banker can help steer you in the right direction of all the different programs and options out there. Still, you will be better off in the long run if you know what you want and what you can afford.
Call RL Real Estate Group at 605-212-8431 for more information on how to purchase a home!