Getting a mortgage is a big financial decision. If you understand the basics, you can more effectively communicate with your lender.
Do you feel as though you mortgage lender is speaking a different language? Are you nodding your head to indicate your understanding when you really don’t have a clue what she just said?
If you’ve never had a mortgage—or even if you have--it’s easy to feel a little intimidated. Understanding a few common terms will give you the confidence to ask the right questions and understand the options presented to you. Don’t rely on your lender to make decisions for you. It’s your loan. You’ll be making the payments. A few basics go a long way to understanding your financing options.
Types of Loans
Mortgage loans are either fixed rate mortgages (FRM), adjustable rate mortgages (ARM) or some combination (hybrid) of the two.
A fixed rate mortgage has an interest rate that is fixed for the life of the loan. Rates may go up or down but once the rate on a fixed rate mortgage is locked in, it remains that rate for the term of the loan. Payments will stay the same each month.
The most common mortgage has a term of 30 or 15 years, but loans for 10, 20, or 25 years are possible as well.
In general, a short-term loan will have a lower interest rate with higher payments whereas a long-term loan will have a higher interest rate with lower payments. A 15-year mortgage may have less than half the interest costs of a 30-year mortgage.
An adjustable rate mortgage is one in which the interest rate periodically changes by adding a margin to an index specified by the mortgage. (A one-year ARM adjusts annually.) Payments fluctuate along with the interest adjustment. There are limits on the amount of interest adjustment that can be made in a given period and across the life of the loan.
A hybrid loan uses a combination of fixed and adjustable interest rates and is designed to meet a wider variety of needs. Qualifying for a hybrid loan tends to be somewhat more liberal than traditional loans.
Another type of loan is a balloon mortgage. A balloon mortgage is a short-term, non-amortizing loan that typically has lower monthly payments and can be easier to qualify for than a traditional 30-year fixed loan plan. With balloon mortgages, borrowers make regular payments for a specific amount of time and then pay off the balance as one large installment (a “balloon payment”) at the end of the term.
For example, if a buyer obtains a “30-due-in-7” balloon mortgage, he has seven years of equal monthly payments at a fixed interest rate. The rate is often lower than what the buyer would otherwise be able to get under a traditional mortgage loan. At the end of the seven years, the balloon payment of the remainder of the balance of the loan is due, and the borrower must either pay it in full, refinance with the same or a different lender, or sell the home.
There are advantages and disadvantages to all types of mortgages so it is wise to understand all the details before making a final decision.
Government Loans
Mortgage loans can also be categorized as government loans (also called government insured loans) or conventional loans.
Mortgage lenders usually require a down payment of 20% of the purchase price of the home. In California where home prices are high, many families have a difficult time coming up with a 20% down payment. If the down payment is less than 20%, the lender requires the borrower to buy private mortgage insurance (PMI). Then, if a homeowner defaults on the loan, the mortgage insurance company makes sure the lender is paid in full. Private mortgage insurance is paid monthly along with mortgage payment.
Families whose income is too low or whose credit rating is not good enough to qualify for private mortgage insurance may still be able to get approval for a home loan through a government program where the government acts as the insurance company. Government loans are FHA (Federal Housing Administration), VA (Veterans Administration), and RHS (Rural Housing Services under the Department of Agriculture). The government does not make these loans but rather insures them and agrees to pay if the homeowner stops making payments. This insurance protects the lender from loss.
FHA Loans
FHA loans are intended to aid families with low-to-moderate incomes who do not qualify for conventional loans. Currently, the minimum down payment on an FHA loan is just 3 ½ percent. FHA mortgage insurance costs more than private mortgage insurance, but some of the cost can be financed (included in the loan amount) so not as much cash is needed at closing. One other note: Not all properties accept FHA financing. Before you fall in love with that condo you’ve had your eye on, ask if it’s FHA-approved. If not and you are financing with an FHA loan, you’ll have to look elsewhere.
VA Loans
VA loans are guaranteed by the U.S. Department of Veteran Affairs. Lenders make the loans to eligible veterans for purchase or construction of a home or for energy-saving home improvements. With a VA loan, no down payment is required! Also, there is no mortgage insurance cost. There is a funding fee of 2 percent of the loan amount for loans with no down payment, but the fee may be financed (included in the loan amount). If a buyer makes a down payment, the funding fee may be reduced.
RHS Loans
RHS loans are guaranteed by Rural Housing Services under the U.S. Department of Agriculture (USDA). Like other government loans, they have easier terms such as no down payment and low closing costs. These loans are specifically for rural residents with low-to-moderate incomes that are unable to obtain credit elsewhere. RHS loans can be used for construction or repair of new or existing homes.
Conventional Loans
Conventional loans are classified as conforming or non-conforming.
Conforming Loans
A conforming loan is a loan that adheres to GSE (government–sponsored enterprise) guidelines. Guidelines include the borrower’s loan-to-value ratio (i.e. the size of the down payment), debt-to-income ratio, credit score and history, documentation requirements, and the most well-known guideline: the size of the loan. For example, in Los Angeles County in 2014, the conforming loan limit is $625,500. (In other parts of the country where homes are less expensive, the limit is $417,000.)
Fannie Mae and Freddie Mac are private corporations backed by the Federal government.
Fannie Mae and Freddie Mac purchase mortgages from the banks so that banks have the money to loan to other home buyers. Fannie and Freddie then bundle the loans (called “securitization”) into bonds and sell these investments to investors. Fannie and Freddie also guarantee the packaged bonds.
Loans that meet the specific guidelines and that will be sold to either Fannie Mae or Freddie Mac are known as conventional loans. Generally, any loan that is not an FHA, VA, or RHS loan is a conventional loan.
Non-Conforming Loans
A loan which does not meet guidelines for funding is known as a non-conforming loan. Non-conforming loans can be either A-paper or subprime loans.
A jumbo mortgage is a non-conforming loan that may have high credit quality but the amount of the loan exceeds the lending limit. There is no mortgage insurance with a jumbo mortgage so the down payments are larger, the required credit score is higher, and jumbo borrowers need six or more months’ worth of reserves in their bank accounts after closing.
Now You Know!
Don’t worry if you still don’t understand everything. Lenders are used to explaining their products. If you have questions, ask for an explanation or further clarification. You can only make a good decision if you understand your options and how they may or may not benefit you.
In the meantime, read articles in the newspaper or online about mortgage rates and trends in the market. The more you hear these terms (and perhaps even refer back to this article), the better you will understand.
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