How to Obtain and Understand Your Mortgage

One of the biggest financial decisions people make in their lifetime is to buy a home. Why do so many people make such a large financial commitment when renting is cheaper and is a much shorter, more flexible obligation?

One reason is that homeownership allows individuals to build equity and to deduct mortgage interest from their taxes, which makes it the single biggest tax break available. There is also the advantage of investing in a home that will hopefully increase in value over time. There are also intangible benefits such as having greater control over renovations.

When an individual buys a home, their monthly payouts increase, but owning your home can be rewarding if the right decisions are made from the start.

Proper preparation is half the battle to qualify for a mortgage. The first thing a potential borrower must do is obtain a copy of their credit report to determine their FICO score and their creditworthiness. In 2018, the Federal Housing Administration, or FHA, required a credit score of at least 500 for an FHA loan; however, many lenders require a score of 620 to 640. If your score is low, you should attempt to improve it by keeping balances low on credit cards, paying bills on time, and paying down your high-interest debt. Don't close out unused credit cards, because doing so can negatively affect your FICO score and your credit utilization ratio (for more on this ratio read "Credit Utilization Ratio"). Just keep the balance low. Also, check for any mistakes or discrepancies with your creditors' reporting and have them corrected.

At the same time, you should save as much money as possible for your down payment. However, paying off high-interest rate debt is more important. Any credit card rates that have an interest rate greater than two times the prime rate are too high. For example, if the current prime rate is 6%, you should try to pay off all your credit cards with an interest rate of 12% or greater, or look for another lender with a better rate to which to transfer your debt.

Once your credit score is where you want it, you should shop for a lender. Assuming you are a good prospect, let three or four lenders compete for your business. Do not give each lender approval to access your credit report. Obtain a preliminary copy of the "good faith estimate" (HUD-1 form) and analyze every charge. Only when you have selected a lender should you allow them to check your credit.

Lenders' fees to the borrower are highly creative and variable. Fees such as loan origination, processing fees. and underwriting fees can often be negotiated down by at least 50% or even waived by the lender if they want your business. Avoid points if you can. When you pay points, you pay interest (1 point = 1 percent) in a lump sum upfront to get a lower rate on your fixed-rate mortgage, which basically increases the amount of your down payment. Points are unnecessary additional charges by the lender. Refuse to pay these fees, or take your business elsewhere.

In some cases, it may be worth it to hire a real-estate attorney who can identify unnecessary costs. A knowledgeable real estate agent can also guide you as to which costs are customary and which could potentially be eliminated. For example, title costs in the state of Florida are the responsibility of the buyer (unless the seller agrees to pick up the costs), so you need to know that these costs should appear on your good faith estimate. If your lender is an out-of-state lender, they may have different fees (which usually exceed $1,000) and may show up as a surprise cost on your HUD-1 settlement statement prior to closing.

Lenders can prey on first-time homebuyers. Most lenders charge private mortgage insurance (PMI) if you fail to make an initial down payment of 20% or more on your home. This insurance protects the lender, not you, in case of default on your loan. Generally, a lender will consider a loan financed at more than 80% of the home's value a greater default risk and require the PMI payment. Just how much is this payment for PMI? If you're applying for a $200,000 loan with 10 percent down payment, you can expect to pay at least $100 per month for the PMI payment. It's not unusual to see PMI payments in the range of $150 to $200 a month.

If you already have a mortgage with a PMI payment, when you reach a certain equity percentage in your home (usually 20%) you can cancel the PMI. Over 30 years, a $150 monthly PMI payment can add up to over $54,000! Since the lenders will not remind you that you can cancel the additional payment, many homeowners never take the time to cancel the PMI payment themselves, and the lenders are more than happy to keep receiving your money.

What can you do if you cannot afford the 20% down payment on your home loan? If you are looking at a $200,000 home and you have $10,000 for the down payment, most lenders will require a PMI payment if you do not put at least $40,000 down on the home (lending/loan fees have been excluded from our loan calculation). For most first-time homebuyers, a $40,000 down payment is out of the question.

However, you can try to "piggy-back" your loans so two lenders take part in the loan. This could resemble an 80-15-5 type plan: you finance 80% on a primary mortgage, 15% on a second mortgage or home-equity loan, and 5% as your down payment. By using the home-equity loan plus your down payment, you can leverage that amount against the purchase price of your home and cover the 20% down requirement, thus avoiding PMI. The home-equity or second loan will most likely have a variable rate or a rate higher than your primary mortgage, so you'll need to keep an eye on this loan and try to pay it off first. The interest from the home-equity loan is also deductible interest on U.S. federal taxes (home-equity debt is subject to a $100,000 ceiling for deductibility).

The 30-year fixed-rate loans are the most common mortgage loan because the interest rate does not change over the life of the loan. Most homeowners prefer this type of loan because their monthly payments will remain steady over the years. A 15-year fixed loan is becoming more popular because it reduces the time horizon of the loan, which decreases the amount of interest paid over the life of the loan. These shorter-term loans typically have a higher interest rate because the lender is giving up the opportunity to make money, particularly if the interest rate is rising.

Adjustable-rate mortgages (ARMs) offer a low-interest rate for a period of time. The interest rate can be adjusted annually or they may be listed as "3-1," "5-1," "7-1," or something similar. Under a "7-1" adjustable rate loan, the amount of the loan will be fixed for the first seven years and then it will be adjusted in the eighth year based on current market conditions, which are usually based on the one-year Treasury index. Initially, the interest rates on ARMs can be anywhere from one to three percentage points below the conventional fixed mortgage and then typically adjusted annually after the fixed term expires. Whether an ARM is right for you often depends on how long you plan to stay in the home. In the case of the "7-1," if you only plan to stay in the home for seven years, this may be the perfect loan for you. However, if you plan to stay in the home for longer and interest rates start to rise; your monthly payments can rise significantly.

It's worth the extra effort to review your HUD-1 settlement statement before the closing date of your new home; the figures listed there should match those that were provided to you on the good faith estimate. If the figures are inflated, or you see new charges, contact the lender and ask them to explain or correct the mistakes. Purchasing a home is a long-term commitment, so make sure that you fully understand all the terms of your loan and do not overlook any hidden charges that you may later regret.