CHAPTER 4
Getting a Good Mortgage
Shopping around for a mortgage is just as important—though not as fun—as shopping around for a house. In fact, it’s more of a quest, an odyssey. It’s that important. Yes, quests and odysseys take some time, but you are going to have this loan for some time, too. At least three years—maybe 30. It doesn’t make any sense to pour all this time into finding the right house at the right price and then get the wrong loan. The wrong loan will cost you money.
People in the industry call home loans mortgage products, and you should think of them that way, too. As I argue in my little rant at the beginning of Part III, the credit section, credit is a product with a price. A mortgage is the biggest kind of credit you can buy, so it pays to pay attention. Literally. I’ll tell you how to choose the right one and SAVE BIG.
In this chapter, learn to SAVE BIG by:
• Understanding different mortgage types and choosing the right one for you.
• Applying for an FHA mortgage that only requires 3.5 percent down.
• Paying points only when it’s beneficial.
• Locking in your interest rate at the right time.
• Rejecting prepayment penalties.
Picking the Right Mortgage Product
There are lots of different types of mortgages and there is no one right choice for everybody. It all depends on your circumstances. The trick is to choose the ideal mortgage that helps you cut costs. In this section, I describe each mortgage type and then tell you in what situations that type of mortgage is a good idea.
Fixed-Rate Mortgage
The fixed-rate mortgage is your father’s loan, the most traditional, safe type of mortgage available. There was a time when it was the only type of mortgage available. With this product, your principal and interest payments remain the same for the life of the loan. That can be comforting. It’s nice when your income goes up over the years but your mortgage remains the same. On the other hand, with a fixed- rate mortgage, if interest rates drop significantly, there is no way for you to benefit except by refinancing into another loan.
You Can Get an Energy-Efficient Mortgage
These mortgages are part of a federally recognized program that gives you a larger loan if you purchase an energy efficient house or agree to make energy-efficient upgrades. It’s not that lenders have gone green, necessarily. Rather, they figure that the less money you have to spend on energy, the more green you will have available to send them for your mortgage. The federal government estimates that if you would normally qualify for a $133,000 mortgage, you could qualify for a $142,000 energy-efficient mortgage!
Fixed- rate mortgages come in 10-, 15-, 20-, 30-, and 40-year terms. Don’t even consider a 40-year mortgage. It stretches out the interest payments far too long, costing you tens of thousands of dollars. A 30-year fixed is by far the most common and it is perfectly respectable. But if you can afford a 10-, 15-, or 20-year loan instead, you will SAVE BIG because they typically come with lower interest rates and you won’t be paying that interest for as long since the loan term is years shorter.
To give you an idea of the BIG SAVINGS, let’s shop for 15-and 30-year fixed-rate mortgages on a $200,000 loan. As I write this, the 30-year mortgage is available at 6 percent interest, while we can get the 15-year mortgage at 5.85 percent interest. Here’s how the lower interest rate and shorter loan term help us SAVE BIG:
Benefit of 15-Year Mortgage| Length of Mortgage | Interest over Life of Loan |
|---|
| 30 years | $ 231,676 |
| 15 years | 100,879 |
| BIG SAVINGS = | $ 130,797 |
Nice! We’d all love to save nearly $131,000 in interest over the life of our mortgage. Of course, you have to weigh whether you can afford the substantially higher monthly payment that you have to make in order to pay for the 15-year mortgage. The monthly payment on the 30-year loan is $1,199, but the payment on the 15-year is $1,672—$473 dollars more per month. That’s pretty hefty.
Let’s see if the monthly payment is more manageable on a 20-year fixed- rate mortgage. The interest rates are the same, 6 percent for the 30-year and 5.85 percent for the 20-year, so we’re not sacrificing anything if we choose to go with the 20-year mortgage instead of the 15-year. Here’s how the savings play out:
Benefit of 20-Year Mortgage| Length of Mortgage | Interest over Life of Loan |
|---|
| 30 years | $231,676 |
| 20 years | 139,746 |
| BIG SAVINGS = | $ 91,930 |
Well, $91,930 is still big savings. And the monthly payment on the 20-year mortgage is $1,416, only $217 more than the monthly payment for the 30-year mortgage, which is $1,199.
I believe in being aggressive, but the 20-year deal might be more manageable for some folks, and that’s fine. The point is to explore your options. Ask lenders to run these different scenarios for you or do it yourself using an online mortgage calculator. I like the mortgage payment calculator at
www.Bankrate.com and I’ll link you right to it from my website,
www.ElisabethLeamy.com.
When to Choose a Fixed-Rate Mortgage Get a fixed-rate mortgage if you plan to stay in the home more than five years and interest rates are low. A fixed-rate mortgage is also the way to go if you are simply unsure of your plans and interest rates are low. Since the year 2000, we have been enjoying relatively low interest rates—historically low at times—so fixed-rate mortgages have been a great deal overall. Of course, that could change, so monitor those rates frequently.
Rural Area Living
If you live in a rural area—or want to—there’s a program to help you buy a home. The mortgages are called Section 502 loans or Rural Housing Guaranteed Loans. They are intended for people with low to modest incomes. The program allows you to get a competitive mortgage with no down payment. To learn more, visit the U.S. Department of Agriculture’s website at
www.rurdev.usda.gov.
Adjustable-Rate Mortgage
The other mortgage product mainstay is the adjustable-rate mortgage (ARM). ARMs start at one interest rate and then adjust to another interest rate after a set period of time, usually changing every year thereafter. When you see an adjustable-rate mortgage described as a “3/1 ARM,” the first number means the interest rate is initially fixed for three years and the second number means that it adjusts every year after that.
The most common ARMs are the 3/1 ARM, 5/1 ARM, 7/1 ARM, and 10/1 ARM. Technically, these are hybrid ARMs because they are fixed for a while and then adjust. ARMs can sound scary since your future interest rate is unknown. However, the initial interest rate is lower than a fixed-rate mortgage, and that can help you SAVE BIG.
How do ARMs help you save? It all depends on your circumstances. Take Lee Z. of Maine, a successful career woman. Her company just rotated her to a new city, and she knows she will be transferred again in five years. In her case, a five-year ARM is ideal because she will be selling right as it adjusts. Let’s put this to the test.
I just checked a mortgage website and saw that the interest rate on a 30-year fixed is 6.5 percent, but the initial interest rate on a 5/1 ARM is 5.5 percent, a full point lower. Here’s how that lower interest rate will save Lee on a $200,000 mortgage during the five years she owns the home:
Adjustable-Rate versus Fixed-Rate Mortgage| Loan Type | Interest Owed over Five Years |
|---|
| 30-year fixed | $75,840 |
| 5/1 ARM | 68,160 |
| BIG SAVINGS = | $ 7,680 |
As you can see, Lee will stockpile a nice $7,680 savings over five years if she chooses the 5/1 ARM over the 30-year fixed-rate mortgage.
When to Choose an Adjustable-Rate Mortgage Most experts advise that you choose an adjustable rate mortgage only if your goal is to get out of it before it adjusts. I will add that I would not enter into any adjustable rate mortgage with an initial term of less than three years. To me, that defeats all its benefits. Having said that, there are multiple reasons to choose an adjustable- rate mortgage.
As you saw, an ARM is a great choice if you know you will be selling the house before the interest rate adjusts. Another shrewd move is to choose an adjustable- rate mortgage if you are planning to pay the loan off before the rate changes. A 10/1 ARM might be best for this, giving you 10 years to pay off your house at the lower opening interest rate you enjoy with an ARM.
A third tactic is to take out an ARM when interest rates are high, in hopes that you will be able to refinance when rates go down. If this is your plan, make sure not to pay a lot of points or fees up front for your ARM, because it’s hard to recoup these costs if you refinance quickly. Also study the interest rate caps in the loan contract to make sure your loan won’t adjust to a monthly payment you can’t afford in the event that you get stuck with it for a while before refinancing.
Banks Are Notorious for Miscalculating Adjustable-Rate Mortgage Interest Rates
When it’s time for your ARM to adjust, be sure to look up the index it is pegged to and calculate it yourself. I know, you’d rather eat dirt. But you may be paying too much for your little
piece of dirt! Don’t worry. Thanks to the Internet, you don’t have to actually do any math. Just go to
www.Bankrate.com and click on the adjustable-rate mortgage calculator.
Interest-Only Mortgage
My name is Elisabeth, and I have an interest-only mortgage.
No, I don’t need a 12-step program, because interest-only loans are not always the irresponsible, addictive products they’ve been made out to be. Interest-only mortgages are loans in which you are only required to pay the interest—no principal—at the beginning. After either 5 or 10 years you start paying the principal, too, and you have to pay a lot more of it per month because you’re cramming it into less time. Plus, many interest-only loans are ARMs, so you get a new interest rate at the 5- or 10-year mark. If you actually paid the loan the way it is written, that would be irresponsible.
You and Your Credit Are a Commodity
When you apply for a mortgage, the lender pulls your credit report at the big three credit bureaus. No surprise there. But here’s the shocker: The credit bureaus then sell the fact that you’re shopping for a mortgage to other mortgage lenders. If you start receiving random calls from brokers and bankers, that’s why.
When to Choose an Interest-Only Mortgage You should only get an interest-only mortgage if you intend to pay more than just the interest only. Make sense? You must know yourself and your finances and be certain that you have the means—and the willpower—to regularly pay extra toward principal. Just remember that, like an ARM, an interest-only loan changes at the 5- or 10-year mark. So if you won’t be able to afford the new, higher payment, you need to have a plan to pay down the loan, refinance, or sell the property before that happens.
If you can pull this off, an interest-only loan has real benefits. For example, if your income fluctuates from month to month, perhaps because your salary is commission-based, you have the freedom to pay just the interest in a slow month and then send in a large principal check in a strong month. When you send in that chunky check, the loan reamortizes, which is a fancy industry way of saying it’s recalculated. Your future monthly payments immediately drop. With traditional mortgages, paying extra doesn’t change your monthly payment.
FHA Loans
As you know, I’d like to see you save 20 percent for your down payment, but I will let you in on a little secret: There is a legitimate way to buy a house with as little as 3.5 percent down. It’s not some sleazy back-alley deal, either. You do it by getting your good ol’ Uncle Sam to be your cosigner. The Federal Housing Administration (FHA) was founded in 1934 with a single-minded mission: to advance home ownership. The idea is that owning a home makes people care more and strengthens communities.
If you can’t otherwise qualify for a mortgage, you may be able to with the help of the FHA. When you take out an FHA loan, the Federal Housing Administration provides mortgage insurance to your lender. In other words, the FHA guarantees that if you don’t pay your mortgage, it will. You pay for this mortgage insurance—about 2 percent of the home’s purchase price—when you close on the home. The interest rates on FHA loans are excellent.
FHA Criteria
FHA loans are limited to homes that the buyer intends to live in, not investment properties. These government-backed loans can only be used for relatively affordable houses. The limits change with time, but as I write this, you can get an FHA-insured loan for up to $271,050 in inexpensive areas and for up to $625,500 in pricier places. You can even roll your closing costs into the loan.
Has Your Mortgage Really Been Sold or Is It a Scam?
After you go through all the trouble of choosing the ideal loan and lender, that company could turn around and sell your loan to some other bank. Some consumers have run into problems where the new bank fails to credit their payments in a timely manner—if at all. Worse yet, other mortgage holders have received a letter stating their mortgage has been sold and instructing them to send their payment to a new location, only to discover the letter was a scam and crooks are cashing their checks. When your bank sells your mortgage, you should get two letters, one from your old bank at least 15 days before the transfer and another from the new bank within 15 days after. Call your old bank’s customer service center, using the number on your statement, to confirm the switch is legitimate.
There is no minimum income requirement for FHA loans. You do have to demonstrate that you’ve had a steady income for at least three years, although that income can be from a wide variety of sources, even child support and unemployment compensation. The FHA allows you to go slightly over the 28/36 debt-to- income ratio we discussed earlier. Housing costs can be 29 percent of your gross income and housing plus other long-term debts can be up to 41 percent. In other words, FHA’s ratio is 29/41. I’m not saying I agree with it, but there you have it.
Additionally, you don’t have to have perfect credit to qualify for an FHA loan, although there are some credit requirements. The Federal Housing Administration will consider approving your loan if you carry a bit of credit card debt, although I don’t recommend it. The FHA gives young people without much of a credit history other ways of proving their trustworthiness. You can even have a bankruptcy in your past, as long as the bankruptcy process was completed more than two years ago. The government really believes in the positive power of home ownership, huh? If you qualify, you might as well take advantage of it.
I repeat, FHA loans only require a 3.5 percent down payment. Very generous. Nelson J. of Wisconsin was surprised and pleased to learn that there is even one program within FHA that allows you to count sweat equity as part of your down payment. In other words, if you are handy—like Nelson is—and plan to work hard to fix up the place, the value of that work is counted toward your down payment. Nelson knew he could add value to his home and hatched elaborate plans to finish the basement, add a back deck, and remodel the kitchen.
You Can Make up for Weak Credit with a Bigger Down Payment
Some people have an interesting problem: a high income but a low credit score. If that’s you, you won’t qualify for an FHA loan—not because of your poor credit but because your income is too high. But you may be able to qualify for a conventional loan if you put down a larger-than-conventional down payment. This also works for people who have weak credit but inherit money with which they can make a sizable down payment.
Moving Parts of a Mortgage
No matter which mortgage you choose, there are a few moving parts common to all of them that can make a huge difference in how much your loan ultimately costs. Should you buy down the interest rate by paying points? When should you lock in the rate? And how do you make sure there’s no prepayment penalty, so you will be able to pay your mortgage down early and SAVE BIG? Those are the questions. Here are the answers.
Paying Points
First let’s talk about what points actually are. As a word nerd, I’m a bit flustered by the fact that the term points is used for several totally different concepts. At its most basic, a point is just 1 percent of the loan amount. Get it? A percentage point. The trouble comes in how the term is used and abused from there.
Basically, any fee that is a percentage of the loan amount is referred to as a point these days. This can be the typical 1 percent loan origination fee, which pays for the lender’s up-front profit. It can be a mortgage broker’s fee, the money paid to the broker for getting you the loan. And it can be the amount the seller will pay toward your closing costs—a point or more.
But the true, original meaning of point is the loan discount point, a fee you pay to obtain a lower interest rate. Yes, a loan discount. For whatever reason, that fee is calculated as a percentage of the loan amount. Another way of explaining it is that loan discount points are interest you pay in advance in exchange for paying a little less interest later. That’s why they’re tax deductible, just as mortgage interest is tax deductible.
Historically, each point the buyer paid lowered the interest rate a quarter of a percent. So if you paid one point, you could lower your rate from, say, 6 percent to 5.75 percent. Lenders sometimes give bigger or smaller discounts, depending on the economy, but that is the most common rule of thumb. So, should you do it? There are a bunch of ifs in my answer.
If interest rates are high.
If you plan to keep the loan a long time.
And if you have the money.
With the historically low interest rates we have right now—and have had for several years—I see no point in paying points. Interest rates in the 4 to 7 percent range are just so affordable that you might want to invest your money elsewhere instead of paying discount points. If interest rates get up into the double digits again someday, points will once again be major players.
For points to be worth it, you have to keep your loan long enough to earn back the fee you paid up front for the point. This is the true trick. Many first-time homebuyers just don’t stay in their homes long enough.
Take 20-something sisters Bonnie and Laura M. of California. They are considering buying a house together, but they know it won’t last forever because eventually they will start their own families. Bonnie and Laura are looking to take out a $200,000 mortgage. A point would be $2,000. If they pay a point to lower their rate from 6 percent to 5.75 percent, here’s how the math would look:
Paying a Point, Short Term| Interest Rate | Monthly Payment |
|---|
| 6% | $ 1,199 |
| 5.75% | 1,167 |
| Monthly Savings = | $ 32 |
As you can see, that $2,000 would only get them $32 worth of savings each month. That means it would take them 62 months—more than five years—to earn back the $2,000 they paid for the point. Not a compelling deal considering that they don’t want to live in that home for very long.
However, if neither young woman ever met the man of her dreams (unlikely, as they are both smart, pretty, and fun) and Bonnie and Laura stayed in the house much longer than five years, then the savings would become worthwhile. Let’s say they manage to live in the house together the entire 30 years of the loan without killing each other! Here’s how their savings would look then:
Paying a Point, Long Term| Interest Rate | Interest Paid over 30 Years |
|---|
| 6% | $431,640 |
| 5.75% | 420,120 |
| BIG SAVINGS = | $ 11,520 |
If they become spinsters, Bonnie and Laura will be able to save $11,520 over 30 years by paying one point. That is the argument loan officers will make when trying to sell you points. But don’t count on staying put long enough for it to be worthwhile, because to pull it off you have to be complacent enough to stay in one house for that long and psychic enough to know you’re going to be that complacent!
Most first-time homebuyers are neither. Besides, many first-time homebuyers don’t have the money to pay discount points. They are relieved just to manage a nice down payment and closing costs. Bottom line: Paying points is not high on my list of recommendations.
Fake Discount Points Paying fake points is even worse. Some shady brokers and bankers charge people discount points and then don’t give them a discount. Uh-huh. A discount point is supposed to give you a discount off of the going market rate that you qualify for, right? But how are you to know what rate you really qualify for? It’s easy for sneaky mortgage professionals to quote you an inflated rate, then sell you a discount point that brings your rate down but doesn’t bring it below market rate as it should.
Shopping around will help you get a feel for what interest rate you qualify for, but you can do more. Ask the lender what the par rate is for your loan. That’s the base market rate that you qualify for and, by law, the lender should tell you. If you are paying discount points, your rate should be below that par rate. If the rate you’ve been quoted is the same as or higher than the par rate, the loan officer is cheating you.
Locking and Floating
In addition to choosing your loan and your lender, there’s one more decision to make: when to lock in your rate. You can either lock in a rate as soon as you sign up with a lender, or you can float if you think interest rates are likely to go down. My question is, how in the heck are you supposed to have any idea if interest rates will go down? Are you an economist or something? I’m not, so what I suggest you do is lock in your rate right away so that at least it can’t go any higher.
Then, if rates do happen to go lower before you close your loan, you can always ask for the lower rate. Some banks advertise “one-way commitments,” which are interest rate floats that go down but not up. That sounds pretty snazzy, but the truth is, the lender needs to make you happy or you can take your business elsewhere. Getting a relock should not be a big deal and the bank certainly shouldn’t charge you for the privilege. Some ballsy banks have started charging people a few hundred bucks for a float down option—whether you use it or not. That’s a rip-off.
When you lock in your rate, get the commitment in writing and hang on to it. This lock in document should state the interest rate and any points you will be paying. It’s critically important because getting the right rate can mean tens of thousands of dollars over the life of the loan.
Beware of Rate Lock Gambling
Mortgage brokers and loan officers have been known to gamble with people’s rate locks, either because they genuinely want to get their customers a lower rate, or because they genuinely want to get themselves a fatter commission. It works out all right when rates go down, but when rates go up instead, sleazy operators may try to slip the higher interest rate into your loan without you noticing.
Prepayment Penalties
There’s one more moving part you should look out for: the prepayment penalty, a punitive fee for canceling the loan before the term is up. Often there is no prepayment penalty if you sell the house, but a hefty one if you refinance it. You do not want to accept a prepayment penalty of any kind under any circumstances. Why? Because under my Four Walls of Home Ownership you are going to pay your mortgage down early to SAVE BIG. A prepayment penalty would cut into your profits.
Don’t take the lender’s word for it as to whether there is a prepayment penalty. Look it up yourself. It’s easy. When you request Good Faith Estimates from lenders, they are also supposed to provide you with a Truth in Lending form. Ask for it. It’s a one-page federal form required by law. On this form, a couple of inches from the bottom, is a line item called “Prepayment.” If the box is checked that says you “will not” have to pay a penalty, then, you guessed it, there is no prepayment penalty. But, in true government-ese, if the box is checked that says you “may” have to pay a penalty, it means you will have to pay one. If the “may” box is checked, go back to the lender and tell them you “may” just have to take your business elsewhere unless they remove the prepayment penalty!
BIG TIPS
• Spring for a 10-, 15-, or 20-year mortgage if you can afford it.
• Choose the right loan for your situation.
• Ask about FHA loans that only require 3.5 percent down.
• Don’t pay points unless you plan to stay put.
• Get your rate lock in writing.
• Never take out a loan with a prepayment penalty.
