The Mortgage Process
Securing an affordable home loan with fair terms requires understanding the types of loans available and then selecting the option that fits your budget and needs. It also requires determining how much house you can afford and getting your finances in order.
Often the cost of real estate financing is greater than the original purchase price of a home (after including interest and closing costs). Because financing is so important, buyers should have as much information as possible about mortgage options and costs. Your Illinois REALTOR? can provide you with mortgage information, discuss financing options and recommend loan sources ? and may be able to help you find financing that suits your needs.
Read on for five steps about the mortgage process to get you started.
A wide range of mortgage financing options can be obtained from mortgage bankers, mortgage brokers, mutual savings banks, commercial banks, credit unions and insurance companies. REALTORS can help you find responsible lenders that make fair and affordable loans.
In general, the mortgage you choose will be determined by:
Your down payment: Loans with low money down are available from some lenders. However, for down payments of less than 20%, lenders require mortgage insurance.
Your credit: The best rates and terms are available to those who have the best credit/credit scores. To qualify for the best loans, be sure to pay your credit cards, installment payments, rent and mortgage bills in full and on time.
?First-time? homebuyer status: First-time Illinois homebuyers (or those who have not owned a home in three years) may qualify for low-cost loans through the Partnership for HomeOwnership?s Rural Initiative, Quincy Initiative and HomePower Mortgage Assistance programs. Learn more about these affordable mortgage programs from your Illinois REALTOR.
? Illinois mortgage programs
Types of loans include the following:
A conventional loan is the most common type of mortgage. For down payments of less than 20%, a lender will require mortgage insurance on the loan. Mortgage insurance helps the lender recover some of the losses incurred in case you stop making payments on the loan. Private mortgage insurance adds a small cost to your financing, but it allows you to buy a house with a lower down payment. The lower the down payment is, the higher the mortgage insurance will be.
A fixed-rate mortgage maintains the same interest rate over the lifetime of the loan. Many consumers prefer this mortgage option for its stability in terms of budgeting and planning.
In addition to the typical 30 year mortgage, 25, 20 and 15 year mortgages also are available. The short-term loans call for higher payments, but with less interest than 30 year mortgages. Shorter loan terms will build equity more quickly which can be tapped for other financial needs. The 30 year fixed-rate mortgage is easiest to qualify for because the payments are lower. This should be considered in financial planning.
Adjustable-rate mortgages (ARMs)
ARMs work well for buyers planning to live in the home a short time, or whose income will continually rise and the interest deduction then becomes more important later. The ARM interest rate changes at pre-determined times throughout the life of the loan. As the interest rate changes, so does the mortgage payment. The interest rate could adjust every six months, once a year, or once every three, five or 10 years.
ARMs usually have two caps which restrict how much the interest rate index can fluctuate. One cap will limit how much the interest rate can increase from one adjustment period to the next, such as 2%. The second cap will limit the interest rate fluctuation for the duration of the loan. With a 6% lifetime rate cap, the highest interest rate can be no more than 6% above the original interest rate. Note: The FHA ARM has a 1% annual and a 5% lifetime cap, making it an attractive ARM.
Beware of ARM "payment caps" that limit how much the principal and interest payment can increase. Negative amortization can occur and the unpaid interest will be added to the loan balance.
ARMs may initially provide lower interest rates, therefore increasing the affordability of your desired home. But, before embarking on such a loan program, you must be certain you can manage sudden payment increases. Here are some questions to ask:
How long does the initial interest rate apply?
How frequently can the interest rate change?
How is the adjusted interest rate determined? (Generally, a specified amount ? known as the ?margin? ? is added to a current published rate ? known as the ?index.?)
How high can the interest go? (Remember, even small changes in your interest rate can affect your monthly payment significantly.)
Are there any limits on how much the interest rate can change each year?
Do the monthly payments still pay off the loan even if the interest rates increase? (With some loans, the amount you still owe ? your ?loan balance? ? can increase rather than decrease each month. This is called negative amortization.)
As conventional mortgage rates continue to fluctuate, some homebuyers turn to specialty mortgages to ?stretch? their income in order to qualify for a larger loan. Like ARMs, specialty mortgages begin with a low introductory interest rate ? a ?teaser? ? but the monthly mortgage payments are likely to increase a lot in the future. Common specialty mortgages include: interest-only, negative amortization, option payment ARM and 40-year mortgages.
It is in your best interest to learn the ins and outs of specialty loans which can pose greater risks to affording mortgage payments in the future. For more information, download Questions to Consider Before Choosing a Specialty Mortgage ? a free brochure from the National Association of REALTORS.
Federally insured mortgages
In addition to conventional mortgages, one of the safest and most affordable types of mortgages is the Federal Housing Administration (FHA)-insured mortgage. The FHA mortgage insures homebuyers with less-than-perfect credit and offers low down payment options, a loan at reasonable cost and help with mortgage payments if needed. The USDA Rural Development and the Veterans Administration (VA) also provide insurance for home mortgage.
In some cases, a seller may provide financing. The rate of interest may be lower than conventional financing. Often, other contract terms are beneficial to both the buyer and the seller. Seller financing frequently occurs for speculative acreage transactions and rural properties. If the seller has a large equity position in the property, often he or she is willing to accept a contract for deed, as the IRS considers that transaction an installment loan, and the profit can be spread over the term of the contract. When mortgage money becomes tight, interest rates rise or home values drop, homeowners are more willing to accept a contract for deed to complete a sale.
A reverse mortgage is a type of home equity loan that allows the owner to convert some of the equity in their home into cash while retaining home ownership. RMs work like traditional mortgages, only in reverse. Rather than make a payment to the lender, the lender pays the owner. Funds obtained from an RM may be used for any purpose, including expenses, such as taxes, insurance and maintenance.
To qualify, the borrower must own their home. The amount available will depend on the borrower?s age, the equity in the home and the interest rate the lender charges. There are three RM plans available today: FHA insured, lender-insured and uninsured.
To obtain a home mortgage, you must complete a written loan application and provide supporting documentation.
Acceptable income for a mortgage application is considered to include:
- Full-time employment, two years tenure
- Part-time employment if steady for two years and expected to continue
- Overtime and bonus income that has occurred for two years and which will probably continue. (Lender will average.)
- Raises guaranteed to occur within 60 days of loan closing.
Other possible income can include:
- Retirement income
- Military income
- Veteran's benefits
- Social Security
- Alimony/child support
- Notes receivable
- Interest and dividend/trust income
- Unemployment benefits
- Rental income
- Auto allowance
During the prequalification procedure, the loan officer will describe the type of paperwork required. Specific documents include recent pay stubs, rental checks and tax returns for the past two or three years if you are self-employed. Following is a checklist of documents most lenders require in order to process your mortgage application. Documents required may vary by lender so be sure to follow your lender?s instructions accurately. In addition, some fees associated with appraisals, credit reports and lenders may be required.
Buyers General Financial Information
W-2s, 1099s or 1040 tax returns for the past three years and recent pay stubs
Profit and Loss Statements (when self-employed) for current year and previous two years.
List of savings bonds, stocks or investments and their approximate market values. List of inheritances and their cash values.
List of account numbers, addresses, balances and past two months' statements of all open bank accounts.
List of account numbers, addresses, monthly payment and balances of all open and liability accounts (credit cards, personal and cosigned installment loans), and copies of the past two month's statements.
Copy of lease agreement(s) on rental property you own, mortgage held and notes due.
Verification of additional income (veteran's benefits, pension, social security, trust funds, disability, overtime bonus, commission, interest income, etc.)
Copies of alimony, child support and separate maintenance payments, with agreements, decrees and canceled checks.
Other Buyer Documentation
Copy of military orders, if applicable
Copies of titles to any motor vehicles or boats that are paid in full
Information about the Purchase
Signed copy of sales contract
Copy of canceled deposit check (earnest money) on house
Copy of gift letter, copy of gift check and copy of deposit slip for gift check (if money for downpayment is a gift from a relative)
The Annual Percentage Rate (APR) is the ratio of the total finance charge compared to the total amount financed. For example, If your loan has a 10% APR, you?ll pay $10 per $100 you borrow annually. The finance charge can include interest and various loan fees.
APR is one way to compare loans offered by different lenders. Although APR comparison is not completely accurate because lenders are not subject to clearly defined rules for calculating this number, it is a benchmark used by the U.S. Department of Housing and Urban Development to identify institutions that charge unreasonable fees.
APR calculations include a variety of fees, including:
Points - these are up-front fees where each point is equivalent to 1% of the loan amount.
Other fees ? such as a loan processing fee, document preparation fee, pre-paid interest (paid from the closing date to the end of the month), underwriting fee, appraisal fee, credit report fee, attorney fees, filing fees and private mortgage insurance.
Consumers should not use APRs to compare a 30 year loan to a 15 year loan. APR also should not be used to indicate the true cost of an adjustable rate loan as it does not indicate the interest rate adjustments or the period of time the rate is locked.
A good way to compare loans of the same type of program is to request a good-faith estimate from different lenders at the same interest rate. Then, subtract all fees that are unrelated to the loan ? such as attorney fees ? and add up all the loan fees. The lower the loan fees, the cheaper the loan.
Closing, or settlement, is the formal process of transferring the property title from the seller to the buyer. When you apply for a loan, the lender will give you an estimate of closing costs. Closing costs will vary by lender and by area and may include:
Application Fee: The fee you paid at the time of the loan application to cover your appraisal and credit report; will appear on your closing statement as a pre-paid fee.
Origination Fee: Your lender may charge a fee to cover the administrative cost of processing your loan. This fee is usually a small percentage of the loan amount.
Items Paid in Advance (Prepaid Escrows): Most lenders require you to pay in advance for some items that will be due one year after closing. These pre-paid items usually include first-year hazard insurance premium and two months of mortgage insurance and real estate taxes. However, you will get credit for last year's taxes up to closing.
Title Insurance Charges: Insurance policy that ensures against losses. This also includes protection against unrecorded easements or liens.
Recording and Transfer Fee: A record of your home purchase will be on file with your local government, and there will be a fee to record the various forms.
Attorney's Fee: This fee is to pay your attorney for preparing and reviewing all of the documents needed to close your loan.
Document Preparation Fee: This fee covers the cost of the bank to prepare and close your loan.
You can expect to pay closing costs from 3% to 4% of the amount of your mortgage loan.
Most closing costs are either tax deductible or should be capitalized and added to the purchase price of your home when you are ready to sell.
Deductible costs for buyers include:
Points (interest collected in advance by the lender)
Interest paid from the closing date to the first payment
Credits to the buyer for taxes already paid
Mortgage interest for the selling year
Deductible costs for sellers include:
Termite inspection fees
Capitalized fees include:
For more information, consult your tax advisor.
When you make a mortgage payment, exactly what are you paying? You are probably familiar with principal and interest, which are the major parts of your mortgage payment. Here is a breakdown of all the costs included in your mortgage payment.
Principal - The amount of money you borrowed. Each month when you make your mortgage payment, you are paying back a small portion of principal. The longer you make payments, the more of your payment goes to reduce the principal you owe. Over time, interest will become a smaller part of your monthly payment.
Interest - The cost of borrowing money, usually expressed as an annual percentage of the loan amount, for example 7.5%, 8%, etc. Your lender will give you an "end of the year" summary showing the interest you paid. That interest is a straight deduction from your income prior to calculating the payment of your Federal taxes.
Property Taxes - Taxes paid to local governments, usually charged as a percentage of the property value. Your lender collects the taxes through your monthly payments. The amount of tax will vary depending on where you live. Your real estate taxes are deductible on your Federal income tax return.
Hazard Insurance - An insurance policy that protects you from any financial losses on your property that might result because of fire, flood or other "hazards." Before you buy, compare companies and policies. Often, new construction has lower premiums. Initially, "safety" devices can also reduce the premium.
Mortgage Insurance - An insurance policy that helps mortgage lenders recover some of the losses incurred if a borrower fails to fully repay a loan. Mortgage insurance makes it possible to buy a home with a low down payment. This amount is reduced with higher down payment.
Lenders often refer to principal, interest, taxes and insurance as the acronym PITI. Generally, the PITI is the amount you will pay each month for your mortgage.