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Home Buying and Financing Tutorial

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Living the American Dream – Buying a home and then financing it

Buying a home is one of the largest financial investments that one will make in his / her lifetime.  The entire process if fairly complex and can be confusing at times.  As with all large projects, it is best to divide the project into tasks and follow a checklist for each of the subtasks.  We have divided this mortgage tutorial into 5 easy steps that will take you through the process of buying a home and evaluating your mortgage options. You can choose to go through the entire tutorial or check out the steps in the order that are most useful to you.

Before you Start
  • Review your household budget to determine how much you can spend on a mortgage each month.
    • See our list of helpful tips in determining the amount of mortgage that you should take on
  • Request free copies of your credit report (you are entitled to receive a free one annually from each of the nation's main credit reporting agencies).
    • See our list of contact information for each of the main reporting agencies
    • See our FAQs regarding credit reports
  • Getting a good understanding of the commonly used terms and the general principles associated with getting a mortgage
    • Use this tutorial to get familiar or view our tools & calculators section to find different calculators, lender comparison tools and a glossary.

Evaluating your Current Financial Situation

Prior to finding a home of your dreams, one  should consider how much of a home can one afford.  (See our "How much home can I afford?" calculator).  Most lenders use a 28/36 ratio to determine how much of a loan you may qualify for.  This ratio is often referred to as debt-to-income ratio or DTI.  The number 28 refers to the housing ratio and number 36 refers to the debt ratio.

The housing ratio of 28% refers to the commonly accepted guidelines that recommend that a person should spend 28% or less of their monthly income for housing payments.  Calculations of housing payments include payments on the loan, mortgage insurance, property taxes, homeowner's association dues and fire/hazard insurance.  This is commonly known as PITI, which stands for principal, interest, taxes and insurance.  Although Fannie Mae guidelines are 28%, typically acceptable housing ratios for Conventional Loans are 28-33% and for FHA loans 29-31%.

The debt ratio, which includes mortgage monthly payments plus all other monthly debt obligations, should not exceed 36% of the monthly income.  Lenders often include credit card payments, child support, car loans, and other non-short-term obligations in their calculations of the other monthly debt obligations.  If the debt ratio is greater than 36%, then lenders are forced to get creative on the loan and start considering additional factors such as credit, assets and available savings.  There are other debt ratios that lenders use such as (33/38 or 45/45); however, these loans usually require higher down payments and contain various restrictions.

To calculate the housing payments percentage for the housing ratio, one should take their monthly gross income and multiply by 28%.  For example, if a person is earning $60,000 gross per year, that equates to $5,000 gross income per month.  $5,000 x 0.28 = $1,400; therefore, this person should only spend $1,400 per month on housing payments (PITI).  Once the housing ratio has been calculated, the debt ratio should be calculated in order to come up with the full debt-to-income ratio.  To calculate the debt ratio, one should take their monthly gross income and multiply by 36%.  Taking that same person, their debt ratio would be $1,800, which means that they can have only $400 dollars worth of monthly recurring debt in order to qualify for most conventional loans.  (Use our Debt-to-Income Calculator to calculate your Debt-to-Income ratio).

Most lenders also offer a prequalification program.  In this prequalification program, you would be able to fill out basic information about yourself and your financial stability to determine how much loan money you may qualify for under their programs.    The prequalification application is significantly less document intensive than a full loan application and it may help to put you in a more competitive position when it comes to getting the home you want.

At this time you may also want to review your credit reports (see "Before you start:" for helpful tips on how to get your credit reports for free).  As well as, figure out how much down payment you can afford.  If the money for your down payment is currently earning interest in CDs, stocks, bonds, etc, make sure to pay attention to the small font disclosing the potential penalties for early withdrawals – as all of this may impact your timing for buying a home.  Also, if your down payment is going to be less than 20%, make sure to familiarize yourself with the concept of Private Mortgage Insurance (PMI) and your potential options regarding PMI.  (See our section on PMI – Benefits, New Requirements and Understanding your options for a detailed overview of PMI)

Finding your Dream House

Let's face it, we have all seen the movies, where they walk into what seems like the first place they see, they look at each other, say "this is the one" and the next scene is that of them moving into their "dream" house.  However, in reality things are not that simple.  The experience of buying a home is different for a majority of the population.  Factors like, where you live, how well you make decisions, how quickly you make decisions, how competitive the real estate market is, how experienced your real estate agent is, is this your first home, how much of a home you can afford – all play a significant role in your overall home buying experience.

When you decide that it is time to buy a home – be it your first home or your 5th replacement home or your vacation home – you should do some research prior to getting involved with a real estate agent.  If you are strapped for time or prefer not to do the initial research yourself, then signing up with a real estate agent, with whom you feel comfortable with, should be your first move. (See our tips on Finding a Real Estate Agent).

If you are doing the research yourself, you can use our Buying a Home checklist to ensure that you are covering the basics during your research.  While the checklist gives you specific details to consider, some of the main topics are:

  • Put together a list of cities / zip codes in which you would be interested in living in.
  • Rank the following in the order of most to least important: location, schools, commuting, accessibility, age of the house, property condition, and neighborhood.
  • Review the current competitiveness of the real estate market.
  • Determine the length of time that you plan to spend in this property, as this will impact both your property decision as well as your loan options.

Once you have done your initial research and have signed up a real estate agent, you are off to a world of open houses, seeing 3+ houses a day, and an overall overwhelming experience.  When you are viewing these houses make sure to do the following:

  • Take notes (both on positives and negatives) on each house – after seeing many houses it may be difficult to keep them straight in your mind.  With notes you will be able to narrow your search list and remove those that do not have a potential.
  • Wear comfortable clothing – the last thing you want is a pair of uncomfortable shoes impacting your home purchasing decision.
  • Communicate your observations to your real estate agent – most people are not mind-readers, but you do not want to be stuck looking at the types of houses that you are not interested in purchasing
  • Don't judge a book by its cover – you are buying a house, a frame for your imagination and for your ability to create the home of your dreams, therefore, you should not let the current wall colors or house décor dissuade your purchasing decision.

When you have found the house of your dreams, don't rush into making a mistake.  Make sure that you have a full understanding of what it is that you are buying.  Pay attention to the inspections and recommendations of your real estate agent and make sure that you understand the risks/rewards that are outlined in your purchase agreement.

Getting the Right Mortgage for You

Mortgages are offered by a variety of companies; however, the three most common lender types are mortgage companies, banks and credit unions.  Mortgage brokers work with a variety of lenders; thus, by working with a mortgage broker you may be able to compare rates/offers from the three common lender types.  Brokers are often also more flexible with loan guidelines and rates.  Most lenders offer a variety of loan programs tailored towards different consumer needs.  Therefore, in order to get the right loan for you, you should have a full understanding of the pros and cons of all of the different loan programs.

There are many types of mortgages used worldwide; however, each mortgage type has similar key characteristics, which are interest, term of the loan, payment amount and frequency of payment, as well as prepayment clause.

  • Interest may be fixed, variable or a hybrid for the life of the loan.  It also has the ability to change (higher or lower) during certain per-set times.
  • Term of the loan is usually the maximum number of years after which an amortized loan should be repaid.  However, some mortgage loans may require payment in full at a certain date, have no amortization or even have negative amortization.  The two most common loan terms are 15 years and 30 years
  • Payment amount and frequency of payment refers to the amount that is paid per interval and the frequency of those intervals.  The most common frequency of payment is monthly, while the payment may be either fixed or flexible depending on the conditions of the loan.  Some loans provide the borrower with an option to increase or decrease the amount paid on monthly basis.
  • Prepayment clause provides a limit, restriction or a payment of penalty due to the lender if the borrower decides to prepay the loan.

The two basic types of loans, from which all of the other hybrids are derived, are fixed rate mortgage (FRM) and adjustable rate mortgage (ARM).

In a fixed rate mortgage (FRM), the interest rate and the payment amount (since the amount is usually a combination of interest and principal) remain constant for the term of the loan; however, additional fees, such as property taxes and insurance, usually change.

In an adjustable rate mortgage (ARM), it is common for the interest rate to remain fixed for a period of time and after which the interest rate adjusts periodically, either monthly or annually, to coincide with some market index.  Some of the commonly used indices for ARM rate adjustments include the Prime Rate, the Treasury Index (T-Bill), and the London Interbank Offered Rate (LIBOR).  With this periodic rate adjustments, lenders are able to transfer part of the interest rate risk from themselves to the borrower.  As a result of this risk transfer, the initial interest rates on a loan may be 0.5%-2.0% lower than the average interest rate on a fixed rate loan at that given time.

Based on these two basic types of loans and in combination with various additional features and structures, lenders are able to offer over 20 different loan products to consumers.  Each of these loan products have different benefits and restrictions and are not targeted at 100% of the population.  See our Loan Matrix below for a comparison.

Other loan types:

  • Assumed mortgage
  • Balloon mortgage
  • Blanket loan
  • Bridge loan
  • Budget loan
  • Buydown mortgage
  • Commercial loan
  • Equity loan
  • Foreign National mortgage
  • Graduated payment mortgage loan
  • Hard money loan
  • Jumbo mortgages
  • Package loan
  • Participation mortgage
  • Reverse mortgage
  • Repayment mortgage
  • Seasoned mortgage
  • Term loan or Interest-only loan
  • Wraparound mortgage
  • Negative amortization loan
  • Non-conforming mortgage

Understanding Interest Rates and Points

Mortgage rates are based on the prime lending rate plus a percentage point, which is dependent on the lender's preference.  Keep in mind that a quote from a lender given over a telephone is not guaranteed and is not final until you actually lock-down your rate.

Points are used to reduce the interest rate on a loan and are usually paid in advance.  The general rule is that 1 point is worth 1/8th of 1% off the loan rate.

Alternatives

There are a variety of alternative options when it comes to getting a mortgage loan.  There are two government agencies that offer mortgage loans for the public.  The FHA is a government agency that offers limited loan amounts to consumers.  These loans are based on a person's current financial situation, the area in which they live and their general usage for the property.  Veterans Administration (VA) also offers various loan packages to qualified veterans of the US military.

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