You can ask the simple question “How much house can I afford?” But you can’t get a simple answer. The price that you can afford is determined by the size of the mortgage that you can get.
This sounds straightforward enough, but computing the mortgage is another matter, which will depend on a number of factors. Your income is a central one, but most lenders also want to know how you spend your money, and what other debts you have that could affect your ability to pay a mortgage. They want to know about your car loans, credit-card debt, student loans, property taxes where you want to buy a house, the amount of down payment that you can make, the amount of equity you have in the house you own now (if you own one), and your credit rating as reported to the three national credit reporting bureaus. Lenders are also interested in any extenuating circumstances in your life that could affect your credit rating and your assets such as a recent divorce, a job layoff of several months that occurred two years ago, or a medical emergency that gored your credit.
Include the optional upgrades or options when you calculate how much production-built house you can afford. The house offered at the base price will be very basic, and you will likely want to get some options, unless you are looking at the high end. For example, if you qualify for a $160,000 mortgage with a 5 percent down payment, the total price you can afford would be $168,000 (a midpoint to lower end in most markets). But if you want to get some options, the base-price range that you should be looking at is not the full $168,000; it should probably be $155,000 to $160,000, which gives you room to add the upgrades.
After all this data is sorted out, and a lender goes through all the calculations, he will come up with a dollar figure that he’s willing to lend you. Since every person’s financial profile is a little different and every lender interprets all this data a little differently, three lenders could come up with three slightly different answers. The bottom line here, however, is that a mortgage figure plus the amount of money that you put down as a down payment will determine what price of house you can afford.
lendersandloans
Before you get very far in your search for a new house, you need to meet with several mortgage lenders and discuss your prospects. You may be under- or over-estimating what you can afford. When you meet with each lender, explain that you are just starting out and gathering information. Any lender should be happy to talk with you.
You will discover that every lender offers a slightly different interest rate on their mortgage loans. Interest rates are calculated to an eighth of a point. If the going rate is “around 8 percent” you could hear quotes of 8.125, 8.25, 8.327, and 8.5 percent. The lenders also offer a startling array of loans. The standard thirty-year fixed mortgage that your parents may have had still exists, but lenders also offer fifteen-year fixed mortgages, ARMs (adjustable-rate mortgages with interest rates and payments that change over the life of the loan), intermediate ARMs, balloons, and buydowns. The terms of these various types of loans can make a difference in how large a mortgage you can qualify for, and, depending on your situation, which is the right choice for you. Since each lender may offer a slightly different version of each type of loan, make sure that you ask about a standard thirty-year fixed loan so that you can make an apple-to-apple comparison between lenders.
There are numerous websites that have mortgage calculators and detailed mortgage information. In fact, it is possible to do the entire mortgage transaction over the Internet. But just as you need to go out and look at the new houses in your market to get a sense of what’s out there, you also need to meet with two or three mortgage lenders to get a sense of how lenders think and interpret financial data before you surf the web. The lending formulas make the lending seem hard and fast, but a lender’s decisions are also nuanced and take into account personal information that won’t show up on a credit report such as late payments due to a divorce, being out of work, or horrific medical expenses.
There are a number of factors besides the loan terms that may make one lender look better than another, such as closing costs. These are the fees that a lender charges to make the loan and are an important source of a lender’s income. The list of closing costs can be long, and the charges can be as little as 1 percent to as much as 5 percent of the total mortgage amount. If you are borrowing $160,000, this would mean you might be paying $1,600 to $8,000 in closing costs.
check your credit
Before you start to meet with lenders, you should check your credit rating with the three national credit reporting bureaus. You certainly know if you generally pay your bills on time, but there can be errors in the records. Since your credit rating and credit score will greatly affect how a lender will assess your credit worthiness, you need to make sure that the records are in order (for information on how to contact the credit report bureaus, see Resources).
Besides all the usual ins and outs of getting a mortgage, you will have additional factors to consider if you are building a brand-new house. If you are working with a production builder, the builder himself will offer financing. It is often very competitive with conventional lenders such as full-service banks or mortgage banks, but not always. You still need to shop around and compare what builders are offering to what other lenders are offering. If you’re building a custom-built house, you will have to get both a construction loan to cover the cost of building the house and a permanent mortgage after the house is done.
Before you meet with several lenders, as a very first step, you might go to a bookstore and get one or two books on the subject, especially if the mortgage process already sounds intimidating. (See Resources for some of the many helpful books that have been written on this subject, as well as how to check your credit.)
howmuchhousecanyouafford?
If you have cash in hand—a lot of cash from, say, an inheritance—you can just plunk down the money and buy the house. But if you have to borrow money, the answer is not so straightforward. How much money a lender is willing to lend you depends on how much debt he thinks you can carry and still repay the loan, and his calculations can be a cumbersome process.
When a lender considers your income, he’s not just looking at the gross annual figure. Twenty-five years ago, a lender’s rule of thumb was that a household’s mortgage debt burden should be about 2 to 2.5 times its annual income—that is, a lender was willing to lend you 2 to 2.5 times your annual income. In response to the vastly different levels of consumer indebtedness, however, today’s mortgage lenders focus on your gross monthly income and your other debt. Their rule of thumb is that your monthly mortgage payment should not exceed 28 percent of your gross monthly income. Also, that your monthly indebtedness for everything, including your mortgage as well as car payments, credit cards, property tax, and home owner’s insurance should not exceed 36 to 40 percent of your gross monthly income.
For example, if Household A’s annual household income is $50,000, its gross monthly income before taxes is $4,167, and 36 to 40 percent of this would be $1,500 to $1,667 for total monthly debt. The 28 percent for the house would be $1,166, and the money left for other debts would be $334 to $501.
If Household B’s annual household income is $75,000, its gross monthly income before taxes is $6,250, and 36 to 40 percent of this is $2,250 to $2,500 for total monthly debt. The 28 percent for the house is $1,750, leaving $500 to $750 to pay other debts.
As you can see, this formula doesn’t leave a lot of room for high credit-card balances, big car-loan payments, or student loans. You may think this is not very realistic, given the way that people live and spend their income—or how you live and spend your income. Nonetheless, this is how a lender sees it.
The next step in calculating how much house a household can buy is going from the monthly mortgage payment a lender thinks you could make—$1,166 and $1,750 in our two examples—to how large a total mortgage amount he will offer that results in these levels of monthly payments. This will depend on mortgage interest rates, which are always fluctuating. For Household A, if the current interest rate is 8 percent and they want a thirty-year fixed rate, the monthly payment would be $1,174 and the amount they could borrow would be $160,000. If the interest rate on the loan becomes 9 percent, they could borrow only $150,000.
A further consideration that you will face in getting a mortgage for your brand new house is that you have to get a loan approved at the time you sign a sales contract with the builder, but you don’t sign all the papers and assume a mortgage until the house is built. This could be anywhere from four to nine months later. It may only take four months to build the house, but the builder might not start for five months or he could be delayed by weather. If the interest rates go up in the interim, your monthly payments do, too. For example, on a $160,000 mortgage, if the interest rate goes from 8 to 9 percent, your monthly payment would increase 6 percent on a 30-year fixed. If the lender determines that you can’t meet this with your income and current debt load, you could lose your financing for that loan and not be able to buy the house. Furthermore, the builder to whom you paid a deposit will almost certainly state in his sales contract that in this event he will not be obliged to return your deposit (see Chapters 11–13 on purchasing and contracts).
Since rising interest rates are always a possibility, when you make your initial calculations and apply for a mortgage, you should not put yourself too close to the edge of your limit. At the time you get the loan approval, the lender will guarantee the interest rate for thirty to sixty days. However, your house won’t be finished for ninety to one hundred twenty days or even longer. You can either let your rate “float” and lock in on a rate much closer to the date that you will close, or you can pay to lock in your rate at the time you get the loan approved. With many lenders, you can pay to get a lock-in on an interest rate for as long as a year. But the longer you want to secure the lock, the more you will have to pay. For example, for a twelve-month lock you usually have to pay a full point (1 point is 1 percent of the loan amount, or $1,600 for the $160,000 loan).
For Household B’s $1,750 monthly mortgage payment, when the interest rate is 8 percent they could borrow $240,000 with a thirty-year fixed loan. If the interest rate was 9 percent for the same thirty-year fixed rate terms, they could borrow only $220,000.
If you have a superb credit rating, however, you may qualify for a mortgage amount that is a higher percentage of your monthly income.
These amounts, however, are the total amounts that you can borrow. When you buy a house, you will have to make a down payment. The amount varies with the terms of the loan, but let us say it’s 5 percent down and you want a mortgage for the other 95 percent. If $160,000 is the maximum you can borrow, this is 95 percent of $168,000; so that is the price range you should be looking in. If $150,000 is the maximum you can borrow, the house price would be $157,500. If you can borrow $240,000, the house price would be $256,000.
However, this is the total price for everything. With a production-built house, the basic house may be pretty basic, and you may want some upgrades. So for Household A, a base price of $155,000 to $160,000 would leave them with $13,000 to $8,000 for upgrades. On the other hand, they might decide that they want space above all upgrades, so they will buy the biggest house they can get with their $168,500.
other factors: property taxes and equity
Before you can make your final calculation, you also have to add in the property taxes that you will have to pay on your new house. In some jurisdictions, these can be very high, which would leave you with less money per month to pay off a mortgage (the 36 to 40 percent of your gross monthly income that is used to calculate your mortgage also includes property taxes).
On the other hand, you may own a house now and have equity in it (the difference between what you paid for it and what it’s worth today if you sold it), which you want to apply to your new-home purchase. This also affects the lender’s assessment of your mortgage qualifications—you can afford more. If both of these households had $50,000 of equity in a house that they already own, this would, of course, affect their mortgage prospects. They could either put down a much bigger down payment and pay a smaller mortgage or buy a higher priced house.
down payment
If you have extraordinarily good credit, you may be able to get a conventional mortgage with no down payment. You will still have to contribute 3 percent of the mortgage amount toward the closing costs, but this can be a grant or a gift from relatives. Otherwise, the minimum down payment that you can make for a conventional loan is 3 percent, but you may qualify to buy a house with no down payment by getting a Federal Housing Authority (FHA) loan or a Veterans Administration (VA) loan. Some states also have special loan programs to help first-time home buyers. If you make a down payment of less than 20 percent for a conventional loan, however, you will have to pay for private mortgage insurance (PMI), and this will be included in the calculation of how much debt burden you can carry. The amount of PMI a lender will require depends on the type of loan you get and the size of your down payment. For a thirty-year fixed-rate $160,000 mortgage, with a 5 percent down payment, it would be about $105 a month in addition to the $1,167 that you are already paying. If you were making a 19 percent down payment on the same thirty-year fixed mortgage, the PMI would only be about $55 a month. In either case, once you have paid down the principal to 80 percent—that is, you owe only $128,000 because you’ve paid off the first $32,000 of the loan—you will not be required to pay the PMI.
loan application
If you bought a house ten years ago, you will already have some familiarity with the mortgage-seeking process. But you will be pleasantly surprised to discover that the procedures have been streamlined to a remarkable degree. You no longer need to bring in a shoe box of documents including twelve months of bank statements and canceled checks. You may still have to fill out long and detailed forms, but the lending decision can be made within minutes because today most mortgage lenders use an automated underwriting system to evaluate your application and credit. The required documentation is mercifully short—many lenders only want a W-2 form, an income tax return, a bank account statement, and your most recent pay stub. Bring these items with you when meeting with a loan officer, and, after all the data has been entered into the automated underwriting system, you may get a loan approved in less than ten minutes.
yourcredit
When you meet with a lender, he will want to know your income. But he will be even more interested in your credit record, because he wants assurance that if he lends you money, you will repay him. This is a critical factor because your ability to get a mortgage depends on your financial history. Whether you can get a mortgage loan or not, the amount that you can borrow, and the terms and rates under which the funds will be lent will depend in large part on your track record in repaying past loans, including auto loans and credit-card payments.
credit scores
Your repayment track record can be quantified into one number called a credit score. When a lender calls up your credit records from each of the three national credit reporting bureaus—Equifax, Experian, and Trans Union—he will order a credit score from each one. The scoring is calculated using a statistical model designed by Fair Isaac & Company in San Rafael, California, and everyone in the mortgage business refers to the credit scores as “FICO scores.”
Each of the three credit reporting bureaus applies Fair Isaac’s statistical model differently, so each gives a different FICO score. Lenders generally request two or three scores and use either the lower of two numbers or the middle of three, and lenders also interpret these scores differently.
FICO credit scoring does not focus on income or assets but on your recent credit history and your track record of paying loans and credit card bills on time. In other words, paying these bills promptly or even early will help your score; late payments will hurt it. The FICO scoring model also includes how much credit you have available and how much you have used. Maxing out on the allowable amount you can charge to a credit card and maxing out on the number of credit lines you may get can lower your score.
When the FICO score was first used by mortgage lenders, the sheer number of credit inquiries into your credit record would have affected the score itself. Your friends and relatives who have gone through the mortgage process may caution you from talking with many lenders for this reason. For instance, if you were a careful consumer who shopped ten different car dealers looking for the best price, each one would check your credit. By the time you reached the tenth dealer, your score could have been sufficiently lowered that you couldn’t get a loan. Likewise with mortgage lenders; the more diligent you were in checking out lenders and rates, the worse off you were, FICO score–wise.
The FICO model was then modified for car-loan and mortgage inquiries so that within a thirty-day period all such inquiries will show up in your record as a single inquiry.
“a paper,” “a+ paper,” and “b paper”
FICO scores range from 300 to 900, but scores at the extreme ends of this range are very rare, said Craig Watts, FICO consumer affairs manager. Most people score in the 600s and 700s; the magic cut-off number is 620. Generally, if you score 620 or above, you can qualify for “A paper,” meaning a loan at the best terms; some lenders, however, require a FICO score that is close to 700 to get the lowest interest rate and the lowest down-payment requirement. When you talk with lenders, ask each one what FICO score is required for “A paper.”
If your FICO score is really high, a lender might consider it an “A+ paper” score. In this case, he might decide that you qualify for a higher mortgage amount than he would ordinarily give to someone with your income and debt load. Before you borrow to the max, however, you should consider how comfortable you will be with the higher payment and how it will impact your lifestyle.
With a lower FICO score, you can still qualify for a mortgage, but you will have higher down-payment requirements and you will have to pay a higher interest rate. For example, if your FICO score is 600, a lender might consider you “B paper”—that is, you could still qualify for a mortgage, but not on the best terms. Instead of getting the 8 percent “A paper” rate on a thirty-year fixed mortgage, you might get a 10 percent rate. With a $50,000 annual income and $1,166 monthly ceiling for a mortgage payment, you could borrow only $130,000. You would also have to come up with a much higher down payment—possibly as much as 20 percent, or $31,000 to buy a $155,000 house.
After thorough analysis of statistical models, Freddie Mac and Fannie Mae, two quasi-federal government mortgage investing corporations, determined that the lender’s risk—that is, the probability the person borrowing the money will repay it—is significantly better if the FICO number is 620 or above. Their analysis also showed that when FICO scores are below 600, the chances of default increase dramatically. Although only 15 percent of consumers have scores below 600, they account for 50 percent of all consumer defaults.
Mortgage lenders are quick to say, however, that the FICO score is not the sole determinant in making a mortgage decision. The FICO score does not take into account other pertinent information such as the length of your present employment, your monthly income, your marital status and age, and your occupation. Your score may also be low because of errors in the report, or because you were laid off for two months, or you incurred an enormous medical expense and were late in some of your payments. If there is a good explanation that you can document for why your scores were low, a loan officer will take this into account. But if your scores are low because you have been irresponsible in paying your debts, this will work against you.
The FICO scores may sound onerous, but they have actually made mortgage-lending decisions much less subjective. Many people who couldn’t have qualified in the past are now getting mortgages.
Rather than pay such high interest rates, you may be better off cleaning up your credit before applying for a mortgage. But this cannot be done in two weeks—it may take you a year or more before you can qualify for “A paper.”
disclosing your fico scores
In the past you were not told your FICO scores unless you were turned down for a loan. The Fair Isaac’s (the firm that developed the FICO scoring model) rationale for this was that interpretation of the scores can be very confusing. But many consumer advocates complained about the Kafkaesque secrecy of credit scoring—getting a loan depended on a score that wasn’t divulged to you. Both the U.S. Congress and some state legislatures proposed legislation to require that the scoring be disclosed. As of July 1, 2001, California law requires that lenders must disclose your scores to you, and this will soon become the norm everywhere.
In response to consumer advocates, FICO itself now allows consumers to pull their scores directly off the Internet. Working with Equifax, one of the three national credit reporting bureaus, FICO will give you a credit report and a FICO credit score along with an explanation of your score. However, you can only get the FICO score as calculated by Equifax. The other two credit reporting bureaus, Trans Union and Experian, use the Fair Isaac model differently. Their FICO scores can differ from Experian’s by ten to sixty points (for information on how to get your scores, see Resources).
The FICO scores may also become less of an issue for borrowers in the future because Fannie Mae has removed them from their automated underwriting system and replaced them with actual data taken directly from the borrowers’ credit report. Whatever method is used, however, the intent will be the same—a lender wants to evaluate your ability and willingness to pay off loans.
what if your fico score is 0?
Frugal consumers who have never used a credit card or borrowed money won’t have any credit score. Should you fall into this category, you need to apply for a credit card, use it sparingly, and pay bills on time or early, so that you create a credit track record and a credit score. This might seem unfair—why shouldn’t you be rewarded for your frugality? Unfortunately, the credit-rating system is set up to reflect the spending habits of the occasionally extravagant majority rather than the frugal minority.
typesoflenders
There are numerous institutions that lend money for home mortgages, including credit unions and savings-and-loan associations, but the three most common ones are banks, mortgage banks, and mortgage brokers. Both banks and mortgage banks have their own funds to lend. A mortgage bank lends funds only for real-estate mortgages, whereas a full-service bank makes all types of loans and offers other services as well, such as checking and savings accounts. Mortgage brokers do not have their own funds to lend; they sell or broker mortgages for other lenders. Mortgage brokers make their money on the “retail markup”—that is, they offer you the same rates and terms as a bank or mortgage bank, but the lender who is actually lending you the money is charging a slightly lower interest rate. The broker makes money on the difference. In effect, a mortgage broker buys wholesale and sells retail.
Another important difference between the banks or mortgage banks and the mortgage brokers are the barriers to entry. The banks and mortgage banks are highly regulated, but mortgage brokers do not generally receive the same degree of oversight. In some states a mortgage broker is not even required to be licensed, or license requirements are minimal.
Nevertheless, there are many excellent mortgage brokers with years of experience. Many of them have worked for banks or mortgage banks and have contacts throughout the industry. The really aggressive mortgage brokers may represent fifty or more lenders from all over the country, and they are well positioned to get you an extremely competitive rate. But watch out for the less-qualified and less-scrupulous ones who may over-promise and under-deliver. They may promise a great rate and a low estimate of closing costs, but then jack up the closing costs and the loan rate just as you are preparing for closing, when it’s too late to find another lender. If you do not close when the seller or builder says your house is ready for occupancy, you can forfeit your deposit and lose your house. Even worse, a bad mortgage broker may not be able to get the mortgage funds lined up for you on the promised date and therefore just not show up at the closing.
When you meet with a mortgage broker, ask how long he or she has been in business and for a list of the lenders represented, as you would ask a builder or anyone else for references. If the broker looks promising after your initial interview, randomly call two or three of these references. With every mortgage lender of any type that you meet, you should ask for a list of recent customers and randomly call three or four. Should the lender refuse to give you any references or names of former customers, cross him or her off your list.
How do you get the names of several lenders to go and talk with? Ask your friends and relatives which lender they dealt with, or look in the Yellow Pages. You will find that mortgage brokers generally do not identify themselves as such, for example, if you look in the Yellow Pages. When you call to inquire about a company, you have to ask if the firm is a mortgage broker or a mortgage banker.
When you visit a new subdivision and ask the residents about their experiences with the builder, also ask which lender they used and if they would use the same one again.
The mortgage-lending business is ferociously competitive. But an interest rate that sounds too good to be true probably isn’t true—the lender may charge more points or add more junk fees (see below). If you call a lender for a quote and it differs from what you read in the newspaper, however, it does not mean that you are being stiffed. Mortgage rates fluctuate from day to day and even within one day. By the time a rate comes out in the newspaper, it is already two or three days old and may be out of date.
closingcosts
In addition to coming up with the down payment and securing a mortgage, you will also have to pay closing costs: the fees charged by lenders to process your loan, secure the funds, and attend to all required legalities, such as affixing document tax stamps to the warranty deed and getting it properly recorded at your local county courthouse in their property-records department. The closing costs will be due at the closing, the time when you sign all the papers and assume both the mortgage and ownership of the house.
After you and a loan officer have discussed your mortgage prospects, a realistic price range for a new house, and down-payment requirements, ask him or her about their closing costs. These can be substantial, and can range anywhere from 1 to as much as 5 percent of the total mortgage amount. Your down-payment money, which is also due at the closing, is in addition to the closing costs.
Some of the closing costs are fees that are legally required, such as the document tax stamp, but some are “junk fees” the lender tacks on to make more money on the loan. When mortgage interest rates are low, the lender will make less money on the loan and will be more inclined to pad his fees. When the interest rates are higher, the lender makes more money so he has less reason to pad the closing costs. As a general rule, the higher the mortgage rate, the lower the closing costs should be, and vice versa.
There is no set amount or formula that lenders use to calculate the closing costs. Each lender calculates this differently and charges a different amount for closing, so this is an important point of comparison between lenders. Standard closing costs generally include:
♦ an appraiser fee (an independent third party inspects the property to make sure it is worth what you are paying and they are lending)
♦ required taxes (many jurisdictions have a document stamp tax, for example)
♦ a charge for a credit report
♦ flood certification
♦ title insurance fees
♦ discount points
♦ tax service fees
Typical junk fees are:
♦ “administrative fee”
♦ “processing fee”
♦ “closing review fee”
♦ “document preparation fee”
♦ “application fee” (this is not a standard charge, and many in the mortgage industry consider it to be a junk fee)
Some lenders claim to omit fees that they simply call something else. For example, they advertise “no origination fee” but instead charge a “funding fee” or a higher interest rate. Mortgage brokers may also charge their version of junk fees. A mortgage broker makes money by selling mortgages for other lenders, and the broker’s profit will be folded into the cost of your mortgage. Some tack on additional fees that can be called “loan brokerage,” “loan origination,” or “one-time add-on fee.”
making the apples to apples comparison
To make a comparison of mortgages between lenders and not get lost in the details of all the different loan packages that each offers, ask each loan officer for the interest rate on a conventional thirty-year mortgage with zero points. He or she will immediately follow this with quotes that include a rate plus points, for example, “8 percent plus 2 points.” A point is 1 percent of the mortgage amount. A lender uses points to raise its yield on a loan without raising the interest. To get the rate quoted, you will also have to pay 2 (2 percent of the total) points; nearly all lenders charge points. For example, if you are borrowing $160,000, 2 points would be $3,200 and it would be due at closing. (If you are borrowing $240,000, two points would be $4,800.) Many lenders also charge an origination fee of 1 percent, which would be another $1,600 (or $2,400). You can see how the closing costs begin to add up. As with the mortgage interest rates, points will be quoted to an eighth of a point, so a lender could say 2.125 points, or 2.375 points, and so forth.
Some lenders lump the origination fee in with the points when they give you a quote, but many do not, so you have to ask when getting a quote whether it includes both. You can avoid paying the points, which would lower your closing costs and reduce the amount of cash that you have to bring to closing, by folding them into your mortgage. But you will have to pay a slightly higher mortgage rate and a higher monthly payment than was originally quoted.
Many buyers have the income to qualify for a mortgage but they don’t have a lot of cash to bring to the closing table. These buyers get a “zero discount” or “premium pricing” mortgage with no points. Even if you do have the cash available to pay the points at closing, there can still be advantages to going the zero-discount route, especially if you plan to live in the house less than seven years.
Suppose that a lender tells you that to get the 8 percent interest rate on the thirty-year fixed $160,000 loan you must pay 1.125 points, or $2,000, at closing. If you elect to pay zero points, this amount is folded into your mortgage and you pay an added $41 a month. It will take you about five years to pay off this added amount to your mortgage. If you plan to move in less than five years, you are better off paying zero points because you will be selling your house before repaying all the extra that you borrowed.
Even if you plan to stay in the house indefinitely, there are still advantages to the zero point option. The $41 extra that you are paying is tax deductible, along with the rest of the interest you are paying. With the extra cash in hand you can buy some of the furnishings that your builder does not supply, such as window treatments. Or you can invest it or put it in a CD and make money on it while you pay off the points. In addition to the points, all the other closing costs can be folded into the mortgage, but this will increase your monthly payment.
good-faith estimate
Within three days of formally applying for a loan, a lender is required by law to give you a “good faith estimate” that lists the specific dollar amounts for all the closing charges. Bear in mind, however, that this is an estimate only, and these can be higher when you actually close.
While you are still shopping around for a lender, however, you should ask for an itemized list of their closing-cost charges with the percentage amount where applicable (for example, the document stamp is .01 percent of the sale price of the house), plus an estimate of the total closing costs based on the amount of money that you want to borrow. If the lender will not give you a list of his closing charges or an estimate of what they might be until you plunk down a three hundred dollar application fee, move on.
When the lender gives you this list, ask for an explanation of each one and ask which charges are legally required and which are “customary charges.” This difference should become clear as you compare closing costs at different lenders. The legally required charges will be on every list, but the customary charges will differ.
The legally required closing fees must be paid, but all the others are negotiable. After you have assessed the loan package that each lender is offering, go back and ask which fees each is willing to waive or reduce to get your business. When business is hot and many people are looking for loans, he may not budge on anything. When business is slow, however, he may talk. Even if you don’t get any break on your mortgage, making such an inquiry sends a signal that you are a knowledgeable consumer who knows what you are doing.
Another question to raise is whether the lender is willing to guarantee in writing that it will not charge any more closing fees than the ones listed at the time you make a loan application. This will protect you from arriving at closing and discovering that fees have been added that were not previously disclosed. The required good-faith estimate is just that, and is not binding on the lender.
builder-lenders
When you buy a brand-new house from a production builder, the builder will invariably offer financing—that is, a mortgage if you qualify, just as any other mortgage-lending institution would. The builder will do this through his own mortgage banking company, his own mortgage broker, or a designated lender; the interest rates and terms are usually competitive. To induce you to use his financing, the builder may also offer you sizable monetary incentives—usually several thousand dollars.
The largest national home-building firms—including Pulte Homes, Ryland Homes, US Home, Kaufman and Broad, and Centex Homes—own subsidiaries that are full-service mortgage banks with their own funds to lend. Smaller, regional home-building firms are more likely to have a lending subsidiary that is a mortgage broker, not a bank. The smallest building firms may also have their own mortgage broker, but they are more likely to have simply a relationship with a local bank. Whatever the arrangement, the builder-lenders offer buyers the same enormous variety of loan programs that other lenders offer.
You should certainly shop the competition and check out other lenders before you sign on with the builder’s lender, however. The builder’s on-site sales agent may assert that the builder-lender’s rates are “competitive,” but you should check for yourself. The sales agent may also assert that buyers must deal with the builder’s lender, but in fact you are free to get a loan from any lender. The only constraint is that in doing so you forgo the builder’s contribution toward closing costs.
Some builder-lenders have programs and coaches to help first-time buyers save up enough money for a down payment, which is often the biggest hurdle to home ownership for first-timers. Some builder-lenders even have counselors who work with buyers to clean up their credit.
Another plus with builder-lenders is that they’re very attuned to two situations that frequently occur in the financing of new houses: delays in construction that affect the closing (and hence the timing of a lock-in on mortgage rates); and a buyer’s desire to add ten thousand dollars worth of options after the initial loan amount has been approved.
builder-lenders and rate locks
A builder-lender will be in frequent communication with a builder’s sales agent, often learning of delays before the buyer does and adjusting the lock-in and closing dates accordingly. If you use a different lender, you will have to monitor this yourself and make sure that the lender is kept informed of any construction delays that could affect the timing of the lock-in. Otherwise, your lender may lock you prematurely into a rate that may expire before the house is finished.
Even a builder’s lender is not infallible, however, and he can lock in the mortgage rate too soon. When this happens, some builder-lenders will extend the lock because they have a vested interest in selling you the house. When you meet the builder’s lender, ask what they do when this happens.
Even when construction proceeds in timely fashion, months will pass between signing the sales contract and the builder finishing the house. Since there is always the possibility that interest rates can go up in the interim, some builder-lenders will approve a loan at the highest rate for which you can qualify, so that if the rates do go up, you can still get a mortgage.
With most mortgage lenders, you can lock in your mortgage rate at the time your loan is approved without charge for thirty to sixty days. Some builder-lenders, however, offer a rate lock-in period that is as long as eighty-nine days, so be sure to ask.
builder-lenders and adding options
As your house goes up and you finally see what it looks like, you may decide to add things. Rather than seek approval for a bigger loan at this later stage, many builder-lenders will get approval for a higher mortgage initially. “They ask for $300,000, we get $310,000 or $320,000,” said Deborah Still of Pulte Mortgage. The loan adjustment is easily managed because the builder’s sales agent simply calls the builder-lender. If you use another lender, you must inform him that you want to borrow more money and then check up to make sure that you are qualified to do this and that your lender has adjusted the mortgage and the good-faith estimate of closing costs accordingly.
Some production builders, however, require that you pay cash for any upgrades you wish to add after your loan has been approved and construction has begun. When you discuss terms with the builder’s lender, ask about their policy on change orders. If you don’t use the builder’s lender, ask the sales agent about the builder’s policy on change orders with other lenders.
Buyers can benefit from the quality of service that the builders’ mortgage lenders have a strong incentive to provide. Since a home builder can supply many customers to a lender, it’s in the lender’s interest to have everything go smoothly. As Donna Veronick, a vice president and area manager for US Home Mortgage, described the situation, “We have two customers to keep happy: We must please both the buyers and the builders. And the builder is not happy if the buyers are not happy.”
switching lenders
If you initially decide to use a lender other than the builder’s, and later change your mind, your builder-lender will usually welcome you back with open arms—even if it’s two days before closing. Moreover, you may still get the builder’s incentives that were initially offered.
The opposite can also be true. You can start with the builder-lender, but find it’s advantageous to switch as your house nears completion because another lender offers a better deal. When your house is about thirty to sixty days from completion, plan on a second round of comparison mortgage shopping. In some areas, builder-lenders may inflate their loan rates above the prevailing market rates as your house nears completion. This means that you will be paying for the builder’s financial incentives such as the $1,000-title insurance policy yourself, explains Dallas mortgage banker Lonny Coffey. “The perception is that you get value with the builder’s incentives, but if he inflates the rate you’re not getting value, you’re paying for it.”
Although the builder is obliged to give you the closing-cost incentives as stated in his sales contract if you use his lender, he is not obliged to give you a competitive interest rate on the loan, nor is he obliged to state that the rate he offers may not be competitive, Coffey adds.
When you get quotes from other lenders on your second round of mortgage shopping, ask for the market rate with zero points and the market rate with the same number of points your builder lender is charging, as you did when you first looked for a mortgage. To make an apples to apples comparison, make sure that you are comparing the same type of loan and loan program that your builder-lender is offering. Then, because mortgage interest rates are always negotiable, go back to your builder and ask for the better rate or you will walk. In many cases, the builder will oblige because he will see that you are an educated buyer and he doesn’t want to lose you, Coffey says.
If he won’t, make the switch. Loan approval and the preparation and assembly of all required loan documents can be done in less than four days (though most lenders prefer to have about thirty days). Starting your second round of mortgage shopping when you are about sixty days out gives you enough time to get everything in place without unduly stressing yourself or your lender.
Some builders may write into their sales contract that once you sign on with their lender, you can’t switch to another one to get a better rate. This point is negotiable. To give yourself the opportunity to shop around and possibly switch as your house nears completion, add a clause to your sales contract that states: “The buyer will use the builder’s lender if he can match the competitive rate the buyer can get elsewhere at the time of closing.” If you also add that your alternative financing will be “at no added cost or risk to the builder,” the builder will be more amenable.
Because the builder knows that inexperienced buyers can end up with unscrupulous lenders who can derail a closing, he may insist that you seek this second round of alternative financing from a lender that he knows is reliable. In that case, a builder usually gives three or four choices, and these must be listed on the sales contract.
Whether you stay with the builder’s lender or switch, when you get the lock-in rate, you should ask for it in writing, along with a written itemized list of all the closing costs. This is simply a good business practice.
While some builders inflate their loan rates to cover their incentives, there are some who will still extend their financial incentives if you find a lender who offers a better deal and want to switch, as long as the other lender is one who they know to be reliable so that your switching will not delay closing.
As you work your way through the mortgage maze, keep in mind that the builder’s financial incentives to use his lender are very market-driven. When the market is slow and buyers are scarce, some builders are willing to let you apply their financing incentives to a mortgage obtained from another lender. But you have to negotiate this at the time you sign the sales contract, not when you approach closing and find that you can get a better deal somewhere else.
“Portability” with a builder’s financial incentives can be especially advantageous when the builder-lender’s closing costs are not competitive. For example, if the builder-lender charges $1,000 more in closing costs for a $200,000 loan than other lenders, you’re only saving $500 when you use his $1,500 incentive. If the builder’s $1,500 financing incentive is portable and you can use it with a different lender whose closing costs are $1,000 less, you could save $2,500 ($1,000 because the other lender’s closing costs are less, plus the $1,500 from the builder that you can apply to the other lender’s closing costs).
Should the builder refuse to let you apply his financing incentives elsewhere under any circumstance, and you know when you negotiate the sales contract that you will not be using his lender, try to apply the dollar amount of his financing incentives toward an upgrade or option (such as an outdoor deck) when you negotiate the sales contract.
financingacustom-builthouse
When you buy a production-built house, the builder takes out a construction loan and pays interest on it while your house goes up. You only have to apply for a permanent mortgage, which you assume when your new house is finished. If you are building a custom house, however, you will have to apply for a construction loan as well as a permanent mortgage.
The construction loan requirements dictated by lenders may prevent you from acting as your own general contractor to save the builder’s markup and to construct a bigger house. Unless you have all the money in hand and don’t need any financing, you won’t get a construction loan. In financing a custom-built house, almost all lenders will insist that you hire a licensed, experienced builder to supervise construction. Moreover, lenders will not lend you money if you want to work with just any builder. If you want to engage one whom the lender has not worked with before, the bank will check him out—some banks more thoroughly than others. For example, Bank of America Mortgage, the fourth largest mortgage lender in the United States, not only reviews a builder’s work experience, his credit, his own banker’s reference, and how well he pays subs and suppliers. This lender also reviews his current inventory to ensure that he can handle your job along with the others on his docket. “If the builder’s credit profile indicates an inability to pay debts, subs, and suppliers in a timely fashion, we will not make the loan,” said Corina Zamora, manager of construction lending for Bank of America Mortgage.
As many custom builders have a few spec houses for sale on the side, the number and status of these unsold houses in a builder’s inventory is a particular concern, added Vicky Olsen, division risk manager for Bank of America Mortgage. “If I saw a builder with five houses unsold, I would ask why. If there’s no financial liability and there’s a good explanation and the builder’s paying his bills on time, I might go forward. But usually five unsold houses means there’s a problem. You will see late pays to creditors and other red flags.”
loan terms
The construction loan and the permanent mortgage are commonly combined so that you have only one closing and one set of closing costs. When the house is completed, the construction loan is rolled over into the permanent loan. But the construction portion of the loan has a higher interest rate than the permanent portion, usually one or two points above the prime interest rate. During the construction period, you do not have to pay the principal, only the interest; but the dollar amount of interest payments increases as the construction proceeds. For example, for a $450,000 construction loan at the rate of 11.5 percent (assumed for this example to be 2 points above prime), your initial monthly interest payments (when the bank has paid out only 20 percent of the loan amount to the builder) would be $862.50. But as you get closer to completion and the bank has paid out the 80 percent of the loan amount, you would be paying $3,450.00 per month. Construction delays early on are irritating, but as you get closer to completion, they can really cost you.
down payment
The down-payment requirements for a construction loan for a custom-built house follow the same parameters as a permanent mortgage. The amount required varies with the loan type, but as the total cost of the project increases, so does the down payment. Sometimes you can borrow as much as $400 thousand with only 5 percent down, but most lenders require a higher down payment at the $300 thousand mark. Above that, the down payment generally rises to 10 percent, and at $500 thousand it goes up to 20 percent. Above $750 thousand, the down payment usually tops off at 30 percent, but most lenders have an upper limit to what they will lend—Bank of America, for example, draws the line at $1.5 million. Above that you have to pay cash.
The total cost of a custom-home building project includes the lot cost as well as the construction. If you are buying the lot at the same time that you are building on it, the construction loan would include both. If you have owned the lot for six months to a year, depending on the lender’s specific requirements, you can apply any equity that has accrued toward your down payment. It is unlikely that the lot value would have appreciated much in such a short time. But if you have owned it for ten years, its value may have appreciated significantly, and you may have enough equity to cover your entire down payment. That is, if your total project cost is $440,000 and you have $44,000 of equity in your lot (10 percent of $440,000), you won’t have to put down any additional cash for the down payment; you can then apply the entire $400,000 loan to the construction of your house. If, on the other hand, you are buying the lot at the same time as you are building the house, you would have to come up with the down payment in cash. More important, this could affect your construction budget. If you can spend a total of $440,000 but the lot costs $75,000, you would only have $365,000 to spend on the construction. In addition, $44,000 in cash for a down payment would be required.
Your existing house, if it has appreciated significantly, can be another source of down-payment money. To use it, however, you will have to take out a home-equity loan, because most lenders require that you bring cold cash to the closing table.
Should you sell your existing house during construction, you can apply the funds that you net from the sale to the principal of your permanent mortgage when your loan rolls over from the construction phase. If you net $100 thousand, for example, you can reduce the principal on your permanent mortgage by this amount (reduce the amount you are borrowing from $400 thousand to $300 thousand). You can then greatly reduce the repayment period, or greatly lower your monthly payments over the same period. But you will have to address this when you are negotiating the loan. You may find that it is beneficial to have two closings—one for the construction portion of the loan and a second for the permanent mortgage. At the second closing, you would add the funds from the sale of your old house to your down payment. This will reduce the amount that you are borrowing, and hence the size of your monthly payment. Since the closing costs of lenders vary, you may find that the total closing costs for two loans and two closings with one lender are less than the closing costs charged for one closing and two loans with another lender.
When construction is completed, the finished house will be worth more than the total cost of the sticks and bricks required to build it. (For example, your $440 thousand house could appraise at $500 thousand.) When you move in, you will already have a hefty chunk of equity in your new house.
cost overruns and construction delays
The lender will base your loan amount on its appraiser’s assessment of your proposal—your lot value, plans, and specifications. If you hit bedrock while excavating the basement or decide later that you really did want to add the forty-five-thousand-dollar bonus room over the garage, you will have to come up with the cash yourself. To avoid any unpleasant surprises once you start excavating, some lenders, such as CTX Mortgage (a national mortgage company based in Dallas), require a soil report before approving the loan.
Cost overruns are always a possibility on a custom home-building project, so most lenders will insist that you have a sterling credit record and other assets that you can draw on to cover them.
A six-month time frame to build your house may be reasonable, but with nationwide shortages of skilled construction labor and materials, nine to twelve months may be more realistic in some places. Since it’s easier to finish early than ask for an extension on your construction loan, apply for a longer loan period than you think you will need.
draw schedule
Rather than give you all the construction-loan funds at once, the lender will pay out a portion at the completion of each phase of the job. The construction loan is usually broken down into five payments, or draws, but it can be as many as ten or as few as three, depending on the lender and the builder. And before the lender writes any check, it will send out an inspector to verify that the work has been done.
During your initial meeting with all lenders that you are approaching about financing for your custom-built house, you should ask who is doing the actual inspection. You need to have a professional inspector or a retired builder to do this, not an “internal” inspection that could be a clerk who does a drive-by. If the clerk doesn’t verify that the work has been done or is clueless about what he is looking at, the builder could be paid for work that hasn’t been performed. If the builder then skips town and blows the money in Vegas, you are out of luck. Of course, this would not happen with a reputable builder. Still, it is prudent to protect yourself by insisting that a professional verify that the work has been performed before any checks are issued.
Though a builder-owned mortgage company sounds as if the builders have their hands in both pockets—they sell you the house and then loan you the money to buy it—a major reason that builders have their own mortgage company or a preferred lender is “to control the deal.” In explaining why his firm set up its own mortgage company, here’s how Tom Bozzuto, chairman of Bozzuto Homes (a medium-size home-building firm in the Washington, D.C., market), described the situation: “Every time we sold a house, a mortgage company made money for something we could do just as well. We’re making the same money that a third party would, but we didn’t do it just to make money. Just as important to us was keeping control of the process. Our customers would go through the mortgage process with no difficulty, then they got to the closing table and needed more money to close and take possession of the house. Or two days before closing, it turned out that their credit was not okay, or they had a relative ‘who does mortgages, I want her to do mine,’ and it delayed things.”
Home builder Allan Washak of Columbia, Maryland, further elaborated: “The product I build, I own until you settle and move in. I’m trying to protect my financial interest in that house. I also want to protect our customers—their interest is just as important. I want to make sure that our buyers have a sound mortgage from a reputable lender. My concern is the buyer who looks up on the Internet, gets baited and switched and taken advantage of by a lender that promises teaser low rates but adds on thousands of dollars in closing fees and prepays.”
And then there are the no-shows—the lenders who don’t show up at the closing. One builder who now has his own mortgage company said, “I’ve had unsuspecting buyers sign up with flaky lenders who offered great rates but didn’t show up for closing. We had to deal with a moving van on the street full of furniture, crying children, distraught parents, and we had to scramble to find alternative financing.”
Another reason that builders cited for having a single designated lender was logistics and overhead. A medium to large builder may close on fifty houses a month, and all of them will be in the last few days of that month. If the builder has to deal with fifty different lenders and make sure that all the loan documents are in order, it can be a logistical nightmare that requires several full-time employees to coordinate. Even the small builder who builds only thirty houses a year prefers to deal with only one lender instead of thirty.
While builders clearly benefit from having their own mortgage company, so do buyers, because the priority of the builder’s mortgage company is to sell houses and secondarily to sell loans. As Bozzuto said, “We are principally in the home-building business. It is not unusual for our mortgage company to say we will take a little less money on this buyer to make sure that the sale did happen.” And not just one house. “We want to sell their first house, their last active adult-community house, and their two houses in between,” said Deborah Still, executive vice president and chief operating officer for Pulte Mortgage.
Besides generally offering favorable rates in an industry that is ferociously competitive, the builder-lenders may have lower closing costs than conventional lenders. They do not usually charge a loan application fee, which can often be several hundred dollars, and charge only their cost—about twenty dollars—to obtain credit reports from the three major credit reporting bureaus (many lenders charge fifty to seventy-five dollars for this). As with other lenders, however, all the fees applied to closing costs that are not legally required by law are negotiable, so you should ask.