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Mortgage 101: Paying for Your Home

Moving into a new home

Do the words “loan-to-value ratio”, “debt-to-income ratio” or “adjustable-rate mortgage” make you scratch your head? Don’t worry, you’re not alone! If you’re reading this article you are probably in the market for buying a home, and although you may have heard of these terms, do you really understand them completely?

This article introduces the fundamental concepts of a mortgage and provides a framework for understanding so you can make your own informed decisions about the mortgage process.

Let’s start with some basics:

What is a Mortgage?

The word mortgage comes from the French words mort, meaning “dead”, and gage, meaning “pledge”. Thus, a mortgage can be translated as a “death pledge”, which refers to how the mortgage is dead or void after the pledge or debt is fulfilled.

In contemporary terms, a mortgage is an agreement to lend money in exchange for a property that is voided when the loan is repaid in full.

Are there different types of Mortgages?

Yes! There are 4 main “types” of mortgages, which should not be confused with different “amortization types”. The 4 main mortgage types are Conventional, Federal Housing Administration (FHA), Department of Veterans Affairs (VA), and USDA/Rural Housing Service. The main difference is Conventional mortgages are backed by banks or private lenders, and the other three (FHA, VA, and USDA) are all backed by the government. Conventional mortgage qualifications are more stringent and generally require some percentage of upfront down payment, whereas as the government loan options can be more flexible (lower credit scores acceptable, no down payment).

What about fixed and adjustable-rate (ARM) mortgages?

These terms refer to the “amortization type” of the mortgage, which is a separate and independent description of a loan. For example, you might have a conventional adjustable-rate mortgage, or a conventional fixed rate loan. Fixed and variable refer to how the interest rate changes during the course of the mortgage.

Fixed rate mortgages have a constant interest rate over the course of the agreed upon time (e.g. 30 years or 15 years), while adjustable-rate mortgages have interest rates that are constant for a shorter term and then “adjusts” to the the variable market rate. Importantly, all ARMs are 30-years loans, and they are named by the length of time the initial rate remains constant followed by the time interval at which they vary thereafter. So for example, a 7/1 ARM means a constant interest rate for 7 years, followed by an adjustment to the market rate that will vary every 1 year for the following 23 years.

With all these options where do I start??

Although there are many options available, truthfully the criteria for many of the different types of mortgages will help you eliminate some immediately. For example, VA loans are strictly for veterans and the USDA loans may only be used for certain rural areas defined by the USDA. The FHA mortgages often have the most lenient criteria, but also carry mortgage insurance premiums that can be costly. These options are best discussed with your lender and should be tailored to your individual financial situation, which leads right into our next question.

What qualities should I look for in a lender?

External shot of a bank

When I started to look for a lender, I initially focused only on comparing interest rates. This was no easy task in itself since interest rates vary based on the market (see below). In my case, the market was quite volatile, so when I called one lender one day and asked another lender the next day, I got two very different interest rates, but there was no way for me to tell if this was simply due to market variation. Finally, I learned to ask different lenders to quote me an interest rate for the same exact mortgage type on the same day. While this did help weed out the major outliers, many lenders had identical interest rates, so how do you choose between them?If you have the same interest rate on the same type of mortgage, the real difference in cost comes down one important key difference, the origination fee. This is the fee that lenders charge upfront for giving you the loan. While a small percentage of your loan overall, the difference can be significant. For example, one lender had origination fees nearly 3 times another lender.

Origination fees are not the only factor to consider however. If you are a first time borrower, it’s also important to find someone who is available and willing to answer all your questions. In other words, someone who is willing to work to earn your trust and your business. I was immediately turned off by some mortgage brokers who I contacted and never promptly replied or returned my calls. If they are unreliable in this regard, how can you trust them to work effectively when it’s time to close, or when you need a pre-approval letter on an urgent basis?

What are interest rates based on?

As I mentioned above, interest rates are tied to general market fluctuations. As a rule of thumb, the interest rate on a fixed rate mortgage is directly related to the 10-year Treasury Note yield or rate. Whereas for variable or adjustable-rate mortgages, interest rates are determined by the LIBOR (London Interbank Offered Rate) index.

What criteria are needed to qualify for a mortgage?

After speaking with multiple brokers, lenders at banks and also a friend who is a loan officer at a major direct lending service, I’ve learned quite a bit about how lenders determine if you qualify for a loan.

There are 3 main criteria that are examined when you apply for a mortgage. The first and foremost is your credit score. This number gives an overall sense of your trustworthiness when it comes to repaying your debts. There are several good articles describing strategies for maintaining an excellent credit score.

The second criteria is the debt-to-income (DTI) ratio. This ratio is used to weigh your routine expenses with your income sources. Common debt examples include car payments, other loan repayments, monthly credit card payments (the minimum amount stated). Other payments, such as cable bills, cell phone bills, health insurance costs are not included. Examples of income sources include, wages, salaries, pension, social security, bonuses/tips. If you are an employee, you will be asked to provide your W-2 statements to prove your income. As the process continues the lender may also verify employment and salary with your HR department.

Finally, the last value which lenders analyze is the Loan-to-Value (LTV). The lower the LTV, the less risky the loan, and thus the more likely the lender will qualify you for the mortgage. This affects how much money you put down, with a larger down payment lowering your loan, and thus decreasing the LTV.

Summary Points

  1. There are four major different types of mortgages (conventional, FHA, VA, and USDA) and two different amortization types (fixed or adjustable-rate).
  2. Choose a lender wisely by considering their interest rates and origination fees, but also their quality of customer service.
  3. Knowing the criteria that lenders look for ahead of time can better prepare you as you seek to take out a loan for your new home.
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