No. 22
Why Read?
Part III of a three part series on buying your first home
Learn about different types of mortgages
Understand the potential pitfalls of interest rates and loan duration
Because I told you so
So, you’ve done the analysis on Buy v. Rent and you’ve determined what you can afford to Buy Your First Place. Now comes shopping for a mortgage. Believe it or not 77% of buyers only speak with one lender or broker when seeking a mortgage. This is a big mistake since you can save thousands of dollars by shopping around and researching first time home buyer programs in your state.
Pretty much every state offers a series of grants, special loans and down payment assistance programs to buyers looking to purchase their first home. As a first step, spend a few minutes on your state government’s website to see what is being offered.
Interest rate and mortgage length are the two biggest factors that can affect your monthly mortgage payment. (Tip: Get the lowest rate possible without having to pay points or additional fees and closing costs). One way to accomplish this is to work with a reputable broker who can shop for the best rate and best terms (low fees, no points, minimal closing costs). This doesn’t preclude you from doing your own homework on the Internet or visiting a couple of local banks and speaking with a loan officer. Just remember that a bank loan officer is limited to offering what their bank has and will not shop for the lowest rate or best deal.
Should you care about who the lender is?
Not really since mortgages are originated at one place and then sold off to another financial institution. The only thing that changes for you is who you send a check to each month.
Isn’t debt a bad thing?
Not necessarily. If you have done your homework and determined what you should be able to afford a mortgage can help you build wealth. Let’s look examine the table below that shows the ten-year financial outcome for a home purchased with a mortgage and one without a mortgage.
In the case of the all cash purchase, the buyer purchases a home for $500,000 and pays all cash. Ten years later the home is sold for $750,000 - a profit of $250,000 a 0.5x return on an investment of $500,000.
In the second scenario the buyer puts down 20% or $100,000 and gets a 30-year fixed mortgage at 5% interest for the remaining $400,000. Ten years later the home is sold for $750,000. The owner pays off the remaining $325,367 and retains $424,633. However, the owner did pay interest expense over the ten years of $183,007 which when deducted from the proceeds yields a net gain of $241,626. Therefore, the owner made 2.4 times their investment of $100,000.
Debt can work to your advantage provided that: a) you can make your monthly mortgage payments on time; and b) the price of your home appreciates over time. On the flip side if your home does not appreciate, or even depreciates in value at the time of sale you can lose money on the transaction. Also, if you struggle to make payments you can lose your house and down payment. If that doesn’t convince you to research and negotiate before buying nothing will.
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Types of Mortgages
Mortgages are not one size fits all, which is why you should shop. If you have exceptionally good credit, you should easily qualify for a lower interest rate and be able to negotiate fees as well.
Then there are fixed-rate and variable-rate mortgages. Fixed rate, as the name implies, means that your interest rate and your monthly payment will not change over the life of the loan. Variable rate, more commonly known as Adjustable-Rate Mortgages or ARMs, feature rates that adjust every year. Depending upon what is happening with interest rates in general, your rate might jump significantly from one year to the next. Typically, there is a cap that limits the amount that your rate can climb, but even a modest jump can put pressure on your ability to make monthly payments.
Some ARMs can be fixed for five or seven years and then adjust. These “teaser” rates can be good if you don’t plan to stay in your home for more than the fixed period. However, as we saw during the financial crisis in 2008, if you have one of these loans and the value of your home drops at the time that the rate adjusts you could easily find yourself upside down on your mortgage and in deep financial straits.
An ARM might make sense if you know, for certain, that you aren’t going to be in the home for more than five or seven years. However, if you aren’t sure then an ARM is probably not the way to go for the average person.
The good news is that if you are currently a first-time buyer, these types of loans aren’t as readily available to you as they once were. You’ll have to wait until you have a much higher net worth before you’ll be able to make foolish financial choices.
Back to fixed rate mortgages. Typically, buyers choose a 30-year fixed rate mortgage over a 15-year fixed rate mortgage. This is because the monthly payment is less, however, you will pay more interest with a 30-year versus a 15-year even though the interest rate on a 15-year is usually lower. (See chart below)
Why should I put down 20%?
As you can see from the chart, with a 15-year mortgage at 5.5% you pay $652.69 more per month. However, you save $206,289 in interest with a 15-year mortgage. If the additional monthly cost seems a bit too high for you, here is another idea. Get a 30-year fixed mortgage and make 1 extra payment per year. You can achieve this either by rounding up each month or perhaps using a tax refund to make the extra payment. Using the above example, if you made 1 additional payment each year, you would pay down the principle 65 months earlier saving $73,662.55 in interest payments.If you don’t put down 20% you will likely have to pay private mortgage insurance (PMI), which is for lender protection. If you put down less than 20% your interest rate will likely be higher to defray the cost of PMI. Once the equity in your home reaches 20% you can request to stop paying for PMI, but it is best to try an avoid this all together.
What is Amortization?
An amortization schedule shows what your monthly payment will be and further breaks it down to show how much goes to paying down principle and how much goes to interest. Like most loans you will pay mostly interest for several years. This means that it can take many years to build equity (ownership) in a home. Using the example above for a 30-year fixed mortgage, it takes approximately twenty years to pay down half the loan and the remaining amount gets paid down over the remaining ten years.
What are points?
Paying “discount points” upfront can lower the interest rate that you will pay for the term of the loan. For instance, in our example above you might pay 1 percentage point of your loan at closing ($3,000 on a $300,000 loan). This discount only works if you are going to remain in the home long enough so that the savings in your monthly payments equal the $3,000 that you pre-paid. Generally, it doesn’t make sense to pay points if you are going to stay in the home for approximately less than five years.
What are loan origination fees?
Origination fees are processing and underwriting fees that the mortgage company charges to recoup their internal and administrative costs. The amount is typically $1000 - $2000. Sometimes these fees are negotiable and sometimes they are not.
Other Expected Fees
There are more fees associated with getting a mortgage than there are teeth in the front row of a Lynyrd Skynyrd concert – credit report fees, documentation fees, notary fees, application fees, flood and wind certification, mail, copies, and of course lawyers’ fees. Be sure to ask up front for a good faith estimate of all fees.
What is the purpose of an appraisal?
Once you sign a Purchase & Sale Agreement (P&S), your lender will request an appraisal. This is done to ensure that you aren’t overpaying for the home. If the appraisal is significantly less than the price that you agreed to pay, the lender might refuse to give you a loan, ask you to go back and renegotiate a better price, or ask you to put down large down payment. Oh, and the appraisal is another $300-$500 that you pay.
What is Title Insurance?
There are two types of Title Insurance. The first is Lender Title Insurance. The lender will want to make certain that the home is free of an encumbrance that could appear after closing. The lenders coverage works to protect the mortgage amount or loan.
The second type of Title Insurance is owners’ insurance. This is optional but is designed to protect the owners’ equity in the property. It remains with the owner for as long as you own the property. This insurance is sold be the attorney that you are using for the closing.
Daunting? Yes, but done well buying a home can be a good way to wealth creation and security if you don’t overpay at the beginning, or over invest while living in the home. Just remember that the mortgage is only part of your additional monthly cost. You’ll have maintenance, utilities, property taxes, and insurance to name a few so plan accordingly.
I know that at current mortgage rates many of you feel as though you will never be able to own a home. As I have said in previous posts, I believe in reversion to the mean. Eventually rising energy costs and rising rates will bring down the price of housing and the dance between rates and housing starts and purchases will reach equilibrium. Just be ready to move when it happens.
Got questions? My friend, mortgage banker John H., is happy to answer questions that you post in the comments.