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Housing Finance Basics: Finding the Right Home Mortgage
Brenda Procter, M.S., State Specialist & Instructor Personal Financial Planning, University of Missouri Extension
If you are like most of us, you cannot pay for a
house all at once. You will need a mortgage loan from a
bank, savings and loan, credit union, or home mortgage
lender. As of 2000, the U.S. population owed over 5.178
trillion dollars in mortgage debt, or about $18,427 for
every man, woman and child.
You will be able to choose from hundreds of
variations on different types of mortgages. Types of
mortgages include fixed rate, adjustable or variable
rate, balloon, graduated payment, shared equity, growing
equity and reverse annuity. Learning a few basics will
help you make sense of the variations available.
- Fixed Rate Mortgage
A fixed rate mortgage has an interest rate that remains constant throughout the life of the contract. Its interest rate is almost always a little higher than an ARM's but you will have a constant, predictable payment for the life of the loan.
- Adjustable Rate Mortgage (ARM) or Variable
Rate Mortgage
An adjustable rate mortgage (ARM) or variable mortgage carries an interest rate that rises and falls as the money market changes. The initial interest rate is lower on an ARM than on a fixed mortgage. An ARM's rate is usually pegged to an index specified in the mortgage. Common indices are the Short-term Treasury Securities Rate, the Federal Reserve District Cost of Funds, the National Average Contract Rate (published by the Federal Home Loan Bank) and the Prime Rate as it appears in the Wall Street Journal.
The interest rate on your loan will be calculated each
year (or more, if specified) as the index on your loan
plus a predetermined additional amount--often another 3
percentage points. For example, if your index is defined
as the Prime Rate and the Prime is at 3%, then your
ARM's interest rate would be 6%.
Some lenders offer "teaser rates" initially on an ARM
that are artificially low (less than the usual 3
percentage points above the index your loan is pegged to
in the above example). Your payments may rise
substantially after the first year and thereafter.
If you are certain that your index rate will fall during
the first few years of your loan, an ARM will cost you
less because the mortgage interest rate can fall along
with it. If rates actually rise, a cap on the ARM's
interest rate can protect you.
Annual caps are often about 2%, which means that no
matter what happens to your index rate, the lender can
raise your mortgage interest rate no more than 2
percentage points in any one year.
If possible, also get a lifetime cap--commonly about 5%.
This means that your rate could never rise more than 5
points during the life of the loan. The lifetime cap
serves as your "worst case scenario" if you go with an
ARM.
- Balloon Mortgage
A balloon mortgage works like a standard mortgage, with one big difference. There is a due date that is 3, 5, 7 or 10 years out when you will have to pay off the entire balance of your loan. At the due date, you can either refinance the balloon mortgage or pay it off in cash.
Balloon mortgages may not be a good idea for everyone,
but they can be a good option for those who plan to sell
their home before the balloon due date. Why? Balloon
mortgage interest rates may be lower than the same loan
without the balloon.
- Graduated-Payment Mortgage
A graduated-payment mortgage can be dangerous, particularly for young people. With a graduated-payment loan, you do not pay all the interest that you owe each month. The unpaid part of the interest gets added to the unpaid balance of your loan.
You are not paying off any principal--just building up
more debt. A graduated-payment mortgage can lead to
negative amortization, which means that your loan amount
is actually going up as you make payments, not down.
Typically, negative amortization is limited to 125% of
the original mortgage balance.
- Shared Equity Mortgage
A shared equity mortgage is one that gives the lender title to a portion of the property. For example, if a home costs $100,000, you can buy it for $80,000 if you let the lender buy $20,000 worth. Then if the home appreciates in value, the lender gets the same percentage share (20% in this example) of the proceeds at sale. The borrower typically pays all costs of insurance, property taxes, and maintenance.
- Growing Equity Mortgage
A growing equity mortgage (GEM) is similar to the graduated-payment mortgage (GPM), except for one thing--no negative amortization is allowed, reducing the principal at a faster rate.
Whatever mortgage you are considering, lenders will be
looking at several things when they consider your loan
application. They will want you to have a good credit
record. They will get a copy of your credit report to
check your record. If you have a habit of making late
payments or have failed to repay past loans, you will
have a very difficult finding a lender who will approve
your loan.
Your ability to come up with cash upfront also will
be considered by a lender. You will probably have to
come up with a minimum of 3% of the home's value (with
20% you can avoid private mortgage insurance). You also
will have to come up with various closing costs of 1-4%
of the home's price. Some lenders will want you to have
2-3 months of payments in reserve as well. Many lenders
will let you use a gift from relatives or friends as
upfront cash as well, but they will want written proof
that it was not a loan.
Your lender also will consider your income and debt
load. The lender's general rule says that you can afford
a house that costs two and one-half times your annual
income. Lenders commonly will allow you as a borrower to
spend 30-35% of your monthly gross income on total
monthly debt payments. They also will want to see a
history of stable employment.
There are sources of help for those who have trouble
qualifying for a home mortgage. The Missouri Housing
Development Commission's mission is to provide quality,
safe, affordable housing for low and moderate-income
citizens of Missouri. Their website (http://mhdc.org) provides a wealth of
information about special loan and downpayment
assistance programs for low and moderate-income buyers,
even those without a perfect credit history.
Sources :
Israelsen, C. Consumer and Family Economics 183,
Personal and Family Finance, Winter 2003 Class Lectures,
University of Missouri, Columbia, Missouri.
Israelsen, C. & Weagley, R. Personal and Family Finance
Workbook, 3rd ed., 2002, Kendall/Hunt Publishing Co.,
Dubuque, Iowa.
Kobliner, B. Get a Financial Life: personal finance in
your twenties and thirties, A Fireside Book, New York,
NY, 2000.
Weagley, R. Today's Mortgage Menu, GH3346, MU Extension,
University of Missouri-Columbia, 1999.
(discontinued)
If you'd like to learn more about this and other personal finance topics, the University of Missouri offers 'Personal & Family Finance' a correspondence course, through the Center for Distance and Independent Study (800-609-3727). Information about this course is available at http://cdis.missouri.edu/CourseInfo/DetailCourseInfo.asp?1985.
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Last update: Thursday, March 20, 2008
