Feature Articles: Housing
Finding the right home mortgage
Brenda Procter, state specialist and instructor, Personal Financial Planning, University of Missouri Extension
Most of us cannot pay for a house all at once. We need a mortgage loan from a bank, savings and loan, credit union, or home mortgage lender. Before shopping for a mortgage, ask yourself, “How much house can I afford?” The amount you can afford to spend on housing depends on many things. As a general rule, a lender says that you can afford a house that costs two and a half times your annual income.
Some lenders use debt ratios to determine how much house you can afford. They commonly will allow a borrower to spend 30 to 35 percent of your monthly gross income on total monthly debt payments. That means the more you already owe on nonhousing debts, the less house you can afford.
Avoid the temptation to push your monthly payment to more than 35 percent of your gross monthly income. If you can, keep it lower. You want to be able to make your monthly mortgage payment for years to come. General rules are only guidelines and they provide a ballpark idea of where to start.
You can choose from many different types of mortgages, including fixed rate, adjustable (or variable) rate, balloon, graduated payment, shared equity, growing equity and reverse annuity. Learning a few basics will help you make sense of the options available.
A fixed rate mortgage has an interest rate that never changes throughout the life of the mortgage contract. Its interest rate is almost always a little higher than an adjustable rate, but you have a constant, predictable payment for the life of the loan.
- Adjustable or variable
An adjustable rate mortgage (ARM) or variable rate mortgage has an interest rate that rises and falls as the money market changes. The first-year interest rate is lower on an ARM than on a fixed mortgage. An ARM’s rate is usually figured by adding a certain percentage to an index specified in the mortgage. Common indices are the short-term Treasury securities rate, the Federal Reserve district cost of funds, the national average contract rate and the prime rate as it appears in the Wall Street Journal.
The interest rate on your loan usually gets recalculated each year as the index on your loan plus an agreed-upon additional amount — often another 3 percentage points. For example, if your index is defined as the prime rate and the prime is at 3 percent, then your ARM’s interest rate would be 6 percent. If the prime rate goes up to 5 percent, then your interest rate will go up to 8 percent. If the prime rate goes down to 2 percent, your interest rate would be 5 percent.
Some lenders offer artificially low teaser rates the first year on an ARM that is less than the usual 3 percentage points above the index your loan is based on in the above example. But watch out — your payments can rise substantially after the first year and in future years.
If you are certain that your index rate will fall during the first few years of your loan, an ARM will cost you less because the interest rate can fall along with it. If rates rise, a maximum cap on the ARM’s interest rate can protect you. Annual caps are often about 2 percent, which means that no matter what happens to your index rate, the lender can’t raise your mortgage interest rate more than 2 percentage points in that year.
If possible, also get a lifetime cap — commonly about 5 percent. This means that your rate could never rise more than 5 percentage points during the life of the loan. The lifetime cap limits how high your rate can go with an ARM.
A balloon mortgage is like a standard mortgage but with one big difference. There is a due date that is three, five, seven or 10 years out when you will have to pay off the entire balance of your loan. At the due date, you can either refinance the balloon mortgage or pay it off in cash.
Balloon mortgages may not be a good idea for everyone, but they can be a good option for those who plan to sell their home before the balloon due date comes up. Why? Balloon mortgage rates may be lower than the same loan without the balloon. Just be sure your house will sell before the balloon comes due.
- Graduated payment
A graduated payment mortgage can be dangerous, particularly for young people. With a graduated payment loan, you do not pay all the interest that you owe each month. The unpaid part of the interest gets added to the unpaid balance of your loan.
You are not paying off any principal — just building up more debt. A graduated payment mortgage can lead to negative amortization, which means that your loan amount is actually going up as you make payments, not down. Typically, negative amortization is limited to 125 percent of the original mortgage balance.
- Growing equity
A growing equity mortgage is similar to the graduated payment mortgage, except for one thing — no negative amortization is allowed, reducing the principal at a faster rate.
- Shared equity
A shared equity mortgage is one that gives the lender title to a portion of the property. For example, if a home costs $100,000, you can buy it for $80,000 if you let the lender buy $20,000 worth. Then if the home appreciates in value, the lender gets the same percentage share (20 percent in this example) of what it sells for. The borrower typically pays all costs of insurance, property taxes and maintenance but gives up a share of the increase in the house’s value when it sells.
Whatever mortgage you are considering, lenders look at several things when they consider your loan application. They will want you to have a good credit record. They will get a copy of your credit report to check your record. If you have a habit of making late payments or have failed to repay past loans, you will have a very difficult time finding a lender who will approve your loan.
Your ability to come up with cash upfront for a down payment and closing costs also will be considered by a lender. You will probably have to come up with a minimum of 3 percent of the home’s value (with 20 percent you can avoid private mortgage insurance). You will also have to come up with various closing costs of 1 to 4 percent of the home’s price. Some lenders will want you to have two to three months of payments in reserve. Many lenders let you use a gift from relatives or friends as upfront cash, but they will want written proof that it was not a loan.
A lender will want to see a history of stable employment. Your lender will also consider your income and debt load. If a lender does not consider your income and debt load, you should consider it yourself and check with other lenders. Remember, the general rule says that you can afford a house that costs two and a half times your annual income or that requires a monthly payment small enough that you only spend 30 to 35 percent of your monthly gross income on total monthly debt payments. You may want a bigger monthly cushion, so do not let lenders push you into paying more than you want to pay.
There are sources of help if you have trouble qualifying for a home mortgage. The Missouri Housing Development Commission’s mission is to provide quality, safe, affordable housing for low- to moderate-income citizens of Missouri. Their Web site, http://www.mhdc.com/, provides a wealth of information about special loan and down payment assistance programs for low- to moderate-income buyers, even those without a perfect credit history.
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Israelsen, C. and Weagley, R. 2002. Personal and family finance workbook. 3rd ed. Dubuque, Iowa: Kendall/Hunt Publishing Co.
Kobliner, B. 2000. Get a financial life: Personal finance in your twenties and thirties. 2nd ed. New York: Fireside.
Weagley, R. 1999. Today’s Mortgage Menu. MU Extension guide GH3346. Columbia, MO: University of Missouri. (discontinued)
Last update: Wednesday, March 10, 2010