Mortgage Basics

As you consider purchasing a home you should become familiar with the types of mortgages that are available. While a lender can assist you with the specifics later in the process, it’s a good idea for you to do a little research on your own. 
The best mortgage for your particular needs can depend on several factors. Are you a first time home buyer? Do you plan on living in the home for many years or will you be moving in two or three? How much down payment can you afford? What are the current interest rates? You have a wide choice of financing options available to you. Some choices are yours to make and others are based on your specific circumstances.

  • Fixed-rate 30 year mortgage - This is probably the most common and easiest to qualify for because it keeps the payments fairly low. The closer you get to retirement though, the more you may want to consider a 15 year fixed-rate mortgage.
  • Adjustable-rate mortgage - Also referred to as an "ARM," the adjustable rate can be attractive to people who don't plan to keep the house very long or are confident their income will increase in the coming years. Your lender can adjust the interest rate on the mortgage once or twice a year although there is a cap restricting how much it can be raised at one time.
  • Low down payments - Historically, the standard down payment for mortgages has been 20%. Today many lenders realize how difficult it can be to come up with such a large amount of cash, and will help buyers with special loan programs.
    • FHA - The Federal Housing Administration insures this mortgage. The required down payment is usually 5% and can go as low as 3.5%. FHA offers all types of loan programs, such as a fixed rate, adjustable rate, or a buy down mortgage. In addition, FHA allows all of your down payment to be a gift from a family member, relative, or non-profit organization.
    • VA - This mortgage is guaranteed by the Department of Veterans' Affairs and is available only to veterans. Aside from the veteran's certificate of eligibility and the VA-assigned appraisal, the application process is not much different than any other type of mortgage loan.

Getting the best interest rate - One way to get a better interest rate is to pay what are known as "points." A point (short for discount points) is prepaid interest assessed at the time of closing by the lender. Each point is equal to 1% of the loan amount and a portion is tax-deductible that year.

Lock in - While you're in the process of shopping for a home and mortgage, interest rates can change. Ask your mortgage lender if you can "lock in" to the current rate being offered. It's good to lock in when rates are rising, but not when they're dropping. The lock in lasts for a specified period and will expire if you haven't closed before then.

What are ratios?

When you apply for a mortgage, the lender will look at your entire financial picture to determine how much money they will let you borrow. Lenders use income and debt ratios to determine how much you will be able to borrow. Ratios are nothing more than comparing your income against the amount of debt you owe.

They'll use several guidelines including one called the Debt-to-Income Ratio. This ratio compares your total debt to your total gross income (including your spouse's) and is important when determining someone's ability to repay a loan. Total debt includes your mortgage plus any auto loans, credit cards, and loans of any other kind.
For example, if 20% of your total gross income already goes to pay your current debt, 16% of your gross income is the maximum most institutions will lend you to buy a house. Again, this is a guideline and actual percentages may vary a little depending on a home buyer's circumstances.
Another ratio lenders look at is the Loan-to-Value Ratio (LTV). This ratio is calculated based on the value of the home compared with the mortgage amount. The down payment you have will impact the LTV ratio.
How Much Downpayment Do I Need?

An important component in determining how much you can afford to pay for a house is the down payment, which usually comprises 20% of the total cost. Purchasing a home that is selling for $98,000, for example, would require a down payment of $19,600. If you don't have 20% down, don't give up. There are many ways to accomplish your goal.
Today many lenders realize how difficult it can be to come up with such a large sum of cash, and will help some buyers take advantage of special loan programs. If you qualify, VA loans are often made with no down payment, and FHA loans can require a down payment as low as 3.5% of the purchase price.
If you don't qualify for a VA or FHA loan and you are unable to pay 20% up front, one alternative is Private Mortgage Insurance (PMI) which can reduce your down payment dramatically. PMI protects the lender in the event the buyer defaults on the loan. The cost of this insurance will be added to closing costs and your monthly payment. Because mortgage insurance adds to your overall monthly payments, it reduces your Debt-to-Income Ratio and effectively reduces the amount you will be able to borrow.

To avoid paying PMI, many young people purchasing their first house get help from their family for the down payment in the form of a monetary gift. This is acceptable, however you must produce a letter from your benefactor stating that the money is a gift and no repayment is required. But if this isn't an option, you still won't have to pay PMI forever. Once you've sent in enough payments that the principal paid and down payment together reach 20% equity, you should no longer be required to pay for Private Mortgage Insurance. So it's to your advantage to pay as much as you can, as often as you can, above and beyond your minimum payment.