Mortgages

Applying for a mortgage is a little like trying to say the words “Mortgage Smorgasbord” three times fast while eating peanut butter on a cracker and whistling the Happy Birthday song standing on your head. But if you learn some of the buzzwords and rules of the game up front, you’ll come to the table better prepared.

The 28/36 Rule

Lenders typically use the “28/36 Rule” to determine the maximum amount a borrower can qualify for in a home mortgage (assuming the borrower is otherwise qualified).
Under the 28/36 Rule:
- The monthly total of Principal, Interest, Taxes, and Insurance (“PITI”) plus any homeowners’ association (“HOA”) fees (such as in a condo), cannot exceed 28% of the borrower’s monthly gross income.
  - Stated another way: your monthly housing costs (PITI plus HOA fees) divided by your monthly gross income cannot exceed 28%.
- The monthly total of PITI plus HOA fees plus all other monthly debt (credit-card debt, auto loans, student loans, other consumer loans, alimony and child support payments, etc.) cannot exceed 36% of the borrower’s monthly gross income.
  - Stated another way: your monthly housing costs (PITI plus HOA fees) plus all other monthly debt, all divided by your monthly gross income, cannot exceed 36%.

Pre-qualification vs. pre-approval vs. mortgage commitmentPre-qualification:

Pre-qualification is an informal and quick process by which a lender can estimate how much a potential borrower may be approved for when applying for a mortgage. The pre-qualification may involve a soft-pull of credit (not a full credit report, which has no impact on your credit score).

Pre-approval:

Pre-approval is a more detailed, formal process which typically involves a borrower filling out an application and submitting documentation. Additionally, the lender will use a “hard-pull” of the credit report (which does have an impact on credit score but is more thorough) as well as other information and data.

A pre-approval letter tells the potential borrower the amount that s/he would qualify for. It may also indicate the rate, subject to certain conditions such as verification of employment, income, and assets as well as other contingencies.

A written pre-approval can make a buyer more attractive to a seller by showing that the borrower is serious about buying a home and is able to obtain the necessary financing. This can be very helpful in a seller’s market if there are multiple offers.

Even if you’ve been pre-approved for a certain mortgage amount, you need to determine on your own how much you can realistically afford.
- - Lenders may pre-approve you for a mortgage that’s much higher than what will comfortably work for your budget.
- - You need to figure out how much breathing room you want for other expenses.
- Do your own calculation of what size mortgage you want so that you don’t end up “house poor.”

Mortgage Commitment:

Because the process of purchasing real estate can take time (up to a few months), sellers typically request a “Mortgage Commitment” or “Commitment Letter” from the lender (after agreeing on a price with the potential buyer) so that the seller doesn’t waste time with a buyer who will not be able to obtain financing.

The mortgage commitment is a written statement from the lender that typically states that the borrower has been pre-approved for a mortgage of X amount for a particular property. It would also indicate that the lender commits to provide the borrower with a mortgage of X amount for that property as long as certain conditions are met. These may include:
- - clear title
- - proof of insurance
- - proof of sale of any property required to be sold for down payment
- - satisfactory appraisal
- - verification of employment and other facts
- no material changes in financial condition

Before providing a mortgage commitment, the lender wants to make sure that the property has been appraised for at least the amount of the purchase price. This can involve an in-home appraisal by the bank’s appraiser, a “drive-by” appraisal, or an appraisal based on “comps” (recent sale prices on comparable homes in the neighborhood).

Other Differences Between Pre-approval and Mortgage Commitment

Pre-approval:
- - A pre-approval is not specific to a particular property and just indicates the mortgage amount for which the borrower has been conditionally approved.
- The borrower can use the information in the pre-approval to look for a home in that price range.

- Mortgage Commitment:
  - A mortgage commitment covers a specific property address and is typically provided after the buyer and seller have signed a contract.
- The timing, terms, and details covered in pre-approval and mortgage commitment letters can vary among lenders and in different areas of the country. You need to read the fine print carefully and make sure that you understand the conditions that apply and the timing and terms involved in your particular case.

The names of these various documents can also vary (conditional approval, conditional commitment, pre-approval, verified pre-approval, etc.). You need to read the letters and documents carefully and make sure you understand the terms and conditions that apply.

Down payment

Many lenders want the borrower to put down 20% of the price of the property as a down payment.

Some lenders will allow a borrower to get a mortgage with less than 20% down, but the borrower may have to purchase private mortgage insurance (known as “PMI”).

Points

Points (also called discount points) are pre-paid interest paid at the time of closing. Paying points up front is a way to reduce the interest rate paid over the life of the mortgage.
- The more points you pay up front, the lower the interest rate.

Lenders typically offer mortgage options with between 0 and 3 points.

A mortgage with 0 points (a no-point mortgage) will have a higher interest rate than a mortgage with points (from the same lender).

Points are calculated as a percentage of the total mortgage amount: 1 point on a mortgage = 1% of the total mortgage amount.
- For example:
  - - 1 point on a $200,000 mortgage means the borrower pays $2,000 of pre-paid interest (points) up front at closing.
  - 2.5 points on a $500,000 mortgage mean the borrower pays $12,500 of pre-paid interest (points) up front at closing.

- If you itemize deductions on your tax return (and fewer taxpayers will be itemizing under the new law), you may be able to deduct the points (discount points) in the year you pay them if certain conditions are met. There is also a limit on the amount of points you can deduct, based upon the size of the acquisition debt.
  - See IRS Topic No. 504: Home Mortgage Points and consult with your tax preparer or other tax advisor for advice specific to your particular facts.

Unlike discount points, origination points are just fees paid to originate the loan.
- Origination points are not tax-deductible.

Fixed-Rate vs. Adjustable-Rate Mortgage

Fixed-Rate Mortgages:
- The interest rate never changes during the life of the loan.
  - Advantage: A fixed-rate mortgage provides you with predictable and constant housing costs.
  - Disadvantage: If rates drop enough during the term of your mortgage, you either refinance—which has a high transaction cost—or you continue to pay more than you could be paying.
  - Many generally prefer fixed-rate mortgages over ARMs, just for the security of knowing that your rate and payment can never change. You don’t want to hold your breath when the news of your new rate and payment amount arrives in the mail. That said, some borrowers have gotten lucky with variable rates when the rates are dropping. The decision is, of course, yours, based upon your tolerance for risk vs. your desire for stability and predictability.
Adjustable-Rate Mortgages (ARMs):
- The interest rate in an adjustable-rate mortgage is fixed for an initial period and then can vary according to changes in an economic benchmark (plus a spread).
  - Advantage: An ARM provides you with a lower rate for the initial period and allows you to benefit from lower rates if interest rates decrease over the term of the mortgage.
  - Disadvantage: Your monthly payments after the initial term are subject to change and can increase materially over the life of the loan in a rising interest-rate environment.
- Interest rates on ARMs are tied to an index plus a fixed margin.
  - For example, if the index at a certain date is 2.5% and the pre-set margin is 2%, the interest rate on the ARM would adjust to 4.5% at the adjustment date (subject to any rate caps—see below).
  - Common indexes include the yield on 1-year Treasury bills and the one-month LIBOR rate (London Interbank Offered Rate).
  - ARMs typically include different kinds of rate caps (initial, subsequent, or lifetime caps) to put an upper limit on rate adjustments.
    - It’s a good idea to compare rate caps (in addition to other terms) if you are shopping around for an adjustable-rate mortgage.
- ARMs are expressed by two numbers, indicating the length in years of the initial fixed term and (usually) the number of years between adjustments.
  - For example:
    - a 5/1 ARM (or 5-1 ARM) means there is a fixed rate for the first 5 years and then the rate adjusts every 1 year after that.
    - a 10/1 ARM (or 10-1 ARM) means there is a fixed rate for the first 10 years and then the rate adjusts every 1 year after that.

Mortgage term

The most common mortgage terms are 30-year and 15-year (in that order), but other terms like 20-year and 10-year are also sometimes available. Consider the pros and cons of different terms, and figure out which term would make the most sense for you.
30-year:
- Pros:
  - 30-year mortgages have lower monthly payments because the debt is spread out over a longer time period.
  - Lower monthly payments make it easier for first-time buyers to qualify for a mortgage.
  - You can save a lot of money if you make extra payments (for example, 13 payments per year instead of 12 or paying 1/2 the monthly amount every two weeks). However, this assumes that your mortgage has no prepayment penalty (a penalty for paying the loan off early) and allows you to make extra payments of principal only. Doing this would save you a lot of interest over the life of the loan.
- Cons:
  - 30-year mortgages result in higher total interest amount paid over the life of the loan, compared to mortgages with shorter terms.
  - Interest rates are usually higher than on a 15-year mortgage.
  - Due to the longer amortization schedule on the balloon mortgage, less principal is paid off during the early years.
  - Takes longer to pay off the mortgage and own your house free and clear.
15-year:
- Pros:
  - Amount of interest paid over the life of the loan is less than on a 30-year mortgage.
  - Interest rates are usually lower for a 15-year mortgage compared to rates on a 30-year mortgage.
  - Principal is paid off more quickly in the early years (which would give you more equity in the home if you sell before the mortgage term is up).
  - A loan is paid off more quickly.
  - If you can afford the payments on a 15-year mortgage, this is something you might want to consider. You’ll pay off your mortgage more quickly and save large amounts of interest over the full term.
- Cons:
  - Higher monthly payments due to the reduced time period to fully amortize the loan.
  - Higher payments make it harder for buyers to qualify.
20-year:
- Some people think the 20-year mortgage (which is much less common) is a good compromise between 30-year and 15-year, because:
  - there is less total interest paid over the life of the loan (compared to the 30-year option)
  - the loan is fully paid off sooner (compared to the 30-year option)
  - there are lower monthly payments (compared to the 15-year option).