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Loan Officers vs. Brokers
A mortgage can be obtained through a loan officer or a broker. Loan officers are those who are employees of large banks or financial institutions (lenders). They actually lend you the money. Brokers are not employees of large banks or financial institutions. Brokers do not lend you the money. They are middle-people who shop for rates and terms from a wider source.
Large banks or lenders may not offer the most competitive rates and terms. Their rates and terms are usually set and cannot be changed by the loan officers. However, they may have reputations and customer service that you may not find in independent brokers. Their loan officers tend to have more experience, and most have local branches with people you can talk to.
On the other hand, brokers provide more options for mortgage products. The rates and terms are usually more competitive. However, some of them are independent and may work part-time, and some lack the experience and expertise loan officers at large banks or financial institutions may have. Also, reputation and good customer service may be an issue. Some brokers are not local, making them hard to work with.
Local vs. Virtual
Does it matter if your lenders or brokers are local or virtual? In theory, it doesn't. In reality, it does. "Local" means in your neighborhood, close enough that you can drive to and speak to that person in person. "Virtual" means not in person, far enough that phone, email and mail are your main communication vehicles.
There are advantages to working with local lenders and brokers. They are knowledgeable about the local market, lending practices, and regulations. If there are problems, you can come to see them in person. In general, people are more responsive and provide better customer service in person. A local loan officer can also come to the closing and will help straighten out any issues or provide missing information. The option, unfortunately, is not straight forward. Few Internet-based loan brokers have local offices. This helps them keep costs down and allows them offer more competitive rates.
If you find a loan on the Internet that offers a competitive rate and term, see if they have a local office. Make an appointment to see the loan officer or broker you will be working with. Build a relationship with that person. It is in your best interest to keep in touch with the loan officer or broker during the entire loan process. When meeting with the loan officer or broker, ask questions about his or her experience, assess his or her professionalism and integrity, and check for his or her knowledge about different types of loans. More importantly, make sure he or she takes the time to explain the loan process to you and answer questions you may have.
Types of Mortgages
Although there are different types of mortgages, as discussed below, searching for the right type of mortgage requires you to ask some basic questions:
- Is the mortgage fixed or adjustable?
- What is the term of the mortgage?
- What is the rate? Is the rate good for the term of the mortgage or is it a "teaser" rate? (A rate that is only good for a short amount of time before another rate kicks in.)
- Is it an interest-only loan or does payment goes to both the principle and interest?
- Is there a pre-payment penalty? (Penalty for paying off early or refinancing.)
- Is the loan assumable? (Another person can assume the loan with the same rate and term.)
- If it is an ARM, can I convert to a fixed rate mortgage before the term ends? If so, when can I convert?
Click here for a Loan Comparison Worksheet.
Fixed
As the term implies, a "fixed mortgage" is fixed for the life of the loan. The most common terms are 30 years and 15 years. The longer the term, the higher the rate. Your monthly payment is not lower, however, if you have a shorter fixed mortgage, say 15 years, with a lower rate. The loan will be amortized over a short period; thus your monthly payments will be higher, but the loan will cost you less in the long run.
Adjustable Rate Mortgages (ARMs)
Adjustable mortgages are not fixed. Their rates are adjusted to the market's rates monthly or yearly, depending on the term of the loans. Hybrid ARMs have become popular, as they give borrowers a period with fixed interest rates, then an adjustable term after the fixed term ends. For example, a 3/1 ARM rate is fixed for 3 years, and then will be adjusted once a year. Other terms such as 5/1 and 7/1 are also popular with borrowers. ARMs have lower interest rates than the fixed mortgages of 30 years or 15 years, thus giving homebuyers more borrowing power.
An ARM consists of a margin and an index. The margin is the cost charged by lenders to cover their overhead costs and is fixed when you sign the loan. It ranges from 2.25% to 2.75% or even 3%. The index is the published interest rate. While the margin is fixed, the index fluctuates with the market performance. The three most commonly used indexes are the one-year Treasury Bill Maturities (issued by U.S. Treasury), the 11th District Cost of Funds Index (COFI) (paid by western U.S. banks on deposits they hold), and the London Interbank Offer Rate (LIBOR) (charged by international banks on large loans). While margins are fixed, indexes are what drive your ARM rate up or down. Lenders consider the movement or volatility of the indexes in pricing the ARM rates, so there is really no "best" index.
While you cannot control the fluctuation of the index linked to your ARM, you can control your margin cost up front. Since margins are simply lender costs, you can compare the same ARM product and rate among various lenders. If an ARM is tied to the same index but has different margins, one is 2.25 and the other is 2.75, you are paying 0.5% higher for the second loan. Over the time, this could cost you thousands of dollars in interest. Beware that some lenders may offer you a lower rate as a "teaser" for a short amount of time and then increase the rate. Make sure you know whether this is your real rate, which index is used (so you can track the market performance), and how much you are charged for the margin (so that you can choose the loan that costs you the least).
After you know the term and the rate of the ARM, you should ask yourself how much the lender can adjust each time and how high they can go. "Caps" protect you from paying too much. There are three common "caps": the initial change rate cap, the periodic rate cap, and the lifetime cap. The initial change rate cap limits how much the lender can charge you after the fixed period. The periodic rate cap limits how much the lender can adjust (either up or down) at any one time. The lifetime cap limits the maximum rate the lender can charge you regardless of the market rates. For example, imagine you have a hybrid 7/1 ARM at 5.0 with 5-2-5 caps (initial rate change, periodic rate and lifetime cap respectively). This means you have a hybrid ARM at the rate of 5.0% fixed for 7 years, adjustable once per year after year 7. The initial rate change will not exceed your base rate of 5.0% plus 5% (therefore, 10.0%). Your interest rate adjusted once per year will not exceed 2% either direction from the previous year. (If you are paying 7% in year 8, the rate in year 9 will not exceed 9% or go below 5%. Remember that rates can go either up or down.) The life time cap of the loan will not exceed 10.0% (base rate 5.0% + lifetime cap of 5%).
Another thing you need to know about ARMs is negative amortization. Negative amortization is the payment added to your mortgage balance if your rate does not cover the market rate. It is "negative" because instead of reducing your balance over time with normal amortization, it does not reduce your balance according to the normal amortization schedule. For example, imagine you have an ARM at 5.0% with a cap of 5%, for a maximum rate of 10.0%. If the market rate is 11%, the lender will add the difference, 1% in this case, to your mortgage balance. In this case, the caps do not protect you, they just postpone your payment and then add it to your balance. Not all lenders charge negative amortization. You need to confirm this or select a lender that does not add a negative amortization clause to your contract.
Like fixed mortgages, ARMs also have interest-only loans. Make sure you ask what kind of ARM you have.
It may seem that Adjustable Rate Mortgages cause too many hassles. While ARMs are more difficult to understand, they have several benefits compared to fixed mortgages.
| |
FIXED |
ADJUSTABLE |
| Benefits |
- The same payments from year to year
-
No "surprise" of payment changes from year to year |
- Lower interest rate allowing higher borrowing and purchasing power
- Lower payment if homebuyers do not plan to stay more than a couple of years
- When rates go down, borrowers can benefit without refinancing and paying out of pocket closing costs
|
| Drawbacks |
- May need to refinance when rates go down costing thousands of dollars in closing costs
-
May cost more in the long term |
- Harder to understand and select the right loan
- Uncertainty in rate and payment changes
-
Possible negative amortization |
Other factors that you need to consider in selecting a fixed or adjustable mortgage are the time you plan to stay in your home and your comfort level with a fluctuating interest rate. If you are a first time homebuyer, chances are you will not stay in your first house forever. You may move someday because you make more money, get married, have kids, or relocate for a career opportunity. Whatever it is, chances are you will move into another home. Americans today are more mobile than their parents and grandparents decades ago. Why pay for a 30-year rate when you can pay for a lower rate for a shorter term that suits your need?
Interest-Only Loans
Interest-only loans have gained popularity among lenders and borrowers. As the term implies, this type of loan requires you to pay only the interest and not the principle. Before you decide to go for an interest-only loan, understand its risks and benefits.
Risks:
Interest-only loans are usually adjustable, although fixed interest-only loans are also available. The terms are shorter, usually 5-10 years. After the term ends, you must either pay off the loan or refinance it. With an adjustable rate, be prepared to pay more when interest rates rise. Make sure you have financial flexibility should that happen. Because you only pay the interest of the loan, the amount of principle stays the same, and you earn no equity. If the market price of your house drops (yes, it does happen), when you sell, you may end up owing more than what your house is worth. Many people believe that the money they do not pay toward the principle can be used in the stock market. Be careful, though, because there is no guarantee that you will make money in the stock market.
Benefits:
Interest-only loans require you to pay only the interest, therefore, the monthly payment amount is smaller compared to regular loans where you have to pay both the interest and principle. A smaller monthly payment allows you to borrow more, helping you afford a larger house. Another advantage of interest-only loans is that the interest is tax deductible. As you pay more interest, you are able to take more tax deduction. However, the IRS rules that "itemized deductions are limited if your adjusted gross income is more than $139,950" for tax year 2003. Also, your tax deduction may not be as big as you think if you are in a low tax bracket.
Shopping Around for a Lender
After you understand different loan products and their pros and cons, you will want to shop around for a lender that provides the best rate and terms of a loan product that meets your needs. Besides rates, terms and the services provided by the lenders, make sure you understand the closing costs that associate with each loan product offered by each lender. There will be various costs associated with the closing process. Basically, there will be three types of fees: lender fees (points, administrative, processing, credit reports, and underwriting fees), third party fees (appraisal, survey, title, and attorneys’ fees) and government fees (recording fees and local taxes). Click on closing costs and for more information on closing related costs and worksheet.
Should You Pay Points?
Paying points costs you more money up front but is not necessarily a bad thing. Many people stay away from points without further analysis of their situation, but paying points may save you money in the long term. There are two types of points: loan origination points and "discount" points. Loan origination points are simply the cost to originate your loan. Not every lender charges loan origination points. When the lender says the loan does not have any points, make sure it carries absolutely no points. Sometimes, lenders don't mention loan origination points, and buyers often do not notice. A "discount" point is prepaid interest to buy down the interest rate of your loan.
So what is a "point"? A point is a 1% of the amount of the loan. For example, if the loan amount is $200,000, one point is 1% of $200,000 or $2,000. As mentioned above, "discount" points require you to pay more money up front in order to lower the rate of the loan. However, paying more points does not always mean lower costs. Consider this scenario: the loan amount is $100,000 amortizing over 30 years at fixed rates, (1) the rate is 6.0% with 0 point, (2) 5.5 with 1 point and (3) 5.25 with 2 points.
| Interest Rate |
Points/$ |
Monthly Payment |
Amount saved over 0 point |
Break Even (months) |
| 6.0 |
0/$0 |
$599.55 |
$0 |
0 |
| 5.5 |
1/$1,000 |
$567.79 |
$31.76 |
31 months (= 1000/31.76) |
| 5.25 |
2/$2,000 |
$552.20 |
$48.35 |
41 months (= 2000/48.35) |
In this scenario, if you plan to stay in the house for more than 31 months, paying 1 point will save you money over the long term and is less costly than paying 2 points. It takes you 31 months to break even for the $1,000 in point you paid up front. After 31 months, that $31.76 a month is free for your own use. So before you balk from paying points, if you have money to pay more up front, do some quick calculations to see whether they will save you money.
After you apply and get approved for a loan, do not change your financial status until after you close on a house. Leasing or buying a new car, for example, can skew your debt ratios and affect your loan qualification. The lender may refuse to lend you the money they previously committed. Don't attempt to move money from one account to another either. Lenders dislike any unusual activities.
Click here for a Loan Comparison Worksheet.
Get Pre-approved from the Lender
Many lenders' web sites offer instant pre-qualification. However, in this tight market, pre-qualification is not good enough. Pre-qualification is a ballpark estimate of the amount you may be able to borrow. It does not require verification of the information you provided the lender. It is only offered "for your information" and is not a commitment to lend you the amount of money for which you are pre-qualified.
To strengthen your position with the seller, you will need a pre-approval, which is a lender's actual commitment to lend the money to you. The lender will check your credit scores and collect your pay stubs, your bank and investment statements, tax returns with W-2 forms, and debt information. After verifying your financial information, the lender will be able to commit to a loan amount. Having a pre-approval letter in hand is like buying with cash, as you already have the money committed to you. It also provides the seller peace of mind knowing that you are a serious buyer and are financially ready to settle once the contract is signed.
Once you are pre-approved, ask if you can lock in the rate (i.e., guaranteeing the rate today even if it goes up by the time you make your purchase) and whether there is any associated charge. Most lenders allow a 30-day lock-in with no additional charge. Time it with your house hunting process, or you will have to pay additional money to extend the lock-in period.
What if you don't have 20% down?
Second Mortgage
A second mortgage is also called piggy-backed loan. If your loan to value (LTV) is higher than 80%, the lender will require you to pay Private Mortgage Insurance (PMI) to protect them in the event you default on the loan. A second mortgage fills in the gap of that 20%. Some second mortgage programs will lend you 20% of the loan but may have some requirements that you have to satisfy. Others will lend you the difference between the 20% and your down payment. For example, your loan package can be structured as 80-10-10 -- 80% from the first mortgage, 10% from the second mortgage, and 10% from your own money. Or it can be structured as 80-15-5 -- 80% from the first mortgage, 15% from the second mortgage, and 5% from your own money. Just like first mortgages, there are different types of second mortgages: fixed, adjustable, or interest only. A second mortgage will help you avoid mortgage insurance. Interest paid on the second mortgage is tax deductible while PMI premiums are not.
PMI is more than a loss of tax advantage
By law, you can request lenders to cancel your mortgage insurance if your LTV drops below 80% of the purchase price. You must have good payment history and the value of your property must not have declined. For loans owned by Fannie Mea, PMI can be cancelled when the LTV drops below 75% of the current market price. A good payment history and an appraisal are required, and the loan must be at least two years old. Since PMI premiums are not tax deductible and cancellation is a hassle, why take the chance? | |
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