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Qualifying For a Loan

     There are two major factors that qualify you for home financing:  your ability to pay a loan and your willingness to pay a loan.  

     Your ability is determined by verifying your current employment and analyzing your total income.   Employers usually like to see that you have been employed by the same company for two years.  There can, of course, be exceptions to this.

     Other factors that are taken into consideration include the amount of cash you have in your bank account, including savings, retirement accounts and investments.  

     Your willingness to pay the loan is determined by what is on your credit report.  If you have been consistent in paying bills, credit card payments and repaying loans this will demonstrate that you can be counted on to pay any loans in the future. 

 

A Standard Banking Ratio

     Typically, a bank will allow you to borrow up to a certain percentage of your combined gross monthly income.  This is often calculated using a 28/36 ratio.   The first number (28%) is a measure of your income against your monthly housing cost.   The second, (36%) a measure of your income against your total monthly payments, including car payments, credit card payments or any other long-term debt, as well as your housing cost.

    With an example of a gross monthly income of  $5000, the ratio is calculated as follows:

.28 x $5000 = $1400

     The $1400 represents the total allowable monthly housing costs, including taxes and interest.

     Next, the second number (36%) is multiplied by your gross monthly income.

.36 x $5000 = $1800

    This second number reflects the total allowable amount for your monthly obligations, including monthly housing costs.   From the $1800 figure you should subtract all of your monthly long-term debts.   For example, if you have a car payment of $300 a month and a credit card bill of $50 a month you would subtract $350 from $1800 leaving $1450 available for your housing expense.

     Using this ratio, the bank is requiring that your monthly mortgage payment be less than 28% of your gross monthly income and your total debts less than 36% of your gross monthly income. 

     If you and your spouse or partner are jointly purchasing a home, the bank will look at your total combined income against your combined expenses.  

     The ratio outlined here is only one of  the ways a bank can assess your eligibility for a loan.   Some lenders use more liberal or conservative ratios and have a number of programs that you may qualify for even if you do not fit into the 28/36 ratio.   

 

 

Checking Your Credit     

   To avoid any surprises, it's best to get a copy of your credit report before applying  for a home loan.  According to  Massachusetts law, the credit bureaus are required to provide you with one free copy of your credit report each year.  You can get a free report by calling Experian at 1-888-397-3742 or go online at www.Experian.com/freestate; call Equifax at 1-800-685-1111 or online at www.Equifax.com;  or call TransUnion Credit at 1-800-888-4213 or visit their website at www.TransUnion.com.

     Even if you are convinced that your credit is unblemished, it's wise to check your reports from time to time.  Credit bureaus can make mistakes and their files may contain inaccurate information.  Make sure that credit cards you think you have canceled show up as closed. 

     If you find inaccuracies in your credit report, notify the credit bureau.  Do it in writing and keep a copy.  Once the agency is notified of an error, it has thirty days to make the correction. 

    You have the right to provide credit bureaus with a one hundred-word statement explaining any circumstances that pertain to specific information in your report.  This includes information about late payments, divorce-related problems or a dispute with a company.  The credit bureau must then include these statements in your credit report.

 

What is a FICO Score?

     Most credit bureau scores in the U.S. are produced from software developed by Fair Isaac Corporation (FICO). The scores are used to evaluate how much of a credit risk a potential borrower is.  FICO scores are provided to the three main credit bureaus: Equifax, Experian and TransUnion. 

     These scores are considered to be a fair and impartial judgment of whom should be granted credit and what the limits should be.  FICO cannot tell if you are a single woman, a minority race or of any  particular religion.  It looks only to your borrowing habits measured against the patterns of hundreds of thousands of past credit reports. 

     FICO scores range from 300 to 850 and, though your scores among the three major credit bureaus will not be far apart, they are never identical to each other.  Each agency has its own method of  analyzing and reporting the data in your files.  It is  wise to get a copy of each score since that is exactly what some of the lenders do.  

     It's important to note that FICO only looks at information in your credit report, while lenders look at a number of variables when making their lending decisions, including your income and how long you have worked at your current job.   Your score considers both positive and negative information in your report.   Late payments will lower your score and a history of making payments on time will make your score higher.

     Your FICO score is based on five categories:

1.  Payment History -  This makes up 35% of your score.  One of the most important factors in a FICO score is whether or not you have paid past accounts on time.  However, it is just one piece of the picture.  

2.  Amounts Owed - Approximately 30% of your score is based on this factor.  Having high balances on credit card accounts may show that you are overextended and less likely to make future payments on time.  If you pay off your credit cards every month this indicates that you are a good credit risk.  

3.  Length of Credit History - Approximately 15% of your score is based on this.   Having had accounts for a longer period of time is viewed as more favorable than being a new credit customer.  FICO looks at how long accounts have been established and how long it has been since you have used certain accounts.

4.  New Credit - This accounts for approximately 10% of your score.  People who have not had credit for very long should not open too many new accounts in a short amount of time.  The scores are also affected by having a large number of requests for credit, although FICO distinguishes between a search for a single loan (such as a mortgage) and searches for many new credit accounts.  They do this, in part, by the length of time over which the inquiries occur.

5.  Types of Credit in Use - Approximately 10% of your score is based on this factor.   If you do not have a lot of other information on which to base your score, opening a vast array of retail accounts, loans, and credit cards will not necessarily be viewed favorably.  The score considers whether the loans and accounts are a healthy mix.  It is better to start off with a few accounts and establish a good payment record with them than to open many that you do not need.

     You can find out more information and purchase your FICO scores at www.myfico.com.  

     

Getting Pre-Approved

    After checking on your credit and working out some preliminary numbers, sit down with a banker or mortgage broker to go through the process of filling out a loan application.   

    Preliminary screening of mortgage companies can be done online or over the phone.  Currently, many banks and mortgage companies are competing for your business.   Go online to check their rates or call direct.  Most of them will give you a great deal of information on their products and current programs.  Take advantage of this information to help you to become a more informed consumer.  

    Just a note of caution.  As with everything else in life, if something sounds too good to be true, investigate further.  Sometimes an online mortgage company will lure buyers in with extremely low rates.  You may find out later that there are points or hidden fees built into the closing costs.   Get the full picture and also make sure that the company is a valid lending institution or a mortgage broker who has been in business for awhile.     

 

Get pre-approved for your home purchase

    All viable mortgage companies offer letters of pre-qualification that can be obtained over the phone and fax.  A pre-qualification involves a series of questions about your income, outstanding debts and monthly payments. The lender will also conduct a soft credit check.  The pre-qualification states that according to the information you have given, they anticipate being able to loan you a certain amount of money. This falls short of an actual pre-approval. 

     The pre-approval is usually the result of a face-to-face meeting (although, some of these are being accomplished through websites or telephone contact) with a solid credit check and an actual loan application.  This is a home loan, ready and waiting for an actual property.  In order to put a solid offer on a house a pre-approval is a necessity. (See Exhibit B)

 

    ________________________________________________________________________

Exhibit B

Pre-Approval Letter

 

ABC Banking

 

November 1, 2003

RE:  Loan Approval - property address - to be determined

Dear Mr. & Mrs. Smith:

Congratulations.  ABC bank is pleased to inform you that your application has been approved.  Your approval is based on a review of the information and the documents that you have provided, as well as a full credit report.  This means your credit history, income, and assets, as reported to us, meet the guidelines of the loan program for which you have applied.  

A final approval will be issued upon satisfactory compliance of the following conditions:

   -  Fully executed sales contract.

   -  Satisfactory appraisal supporting the sales price.

Thank you for choosing ABC Bank.

Sincerely,

 

Joan Bankcard

Loan Officer

     ________________________________________________________________

 

 

 Items Necessary for a Home Loan Application

 

     Some lenders may not require all of these items, but, just to be safe, you should have the following information ready:

  - Your social security number;

  - Employment history:  employment for two years; dates and addresses; salary; current pay stubs or  W-2 forms.

  -  Checking and Savings Accounts and Certificates of Deposits:   location  of bank accounts, account numbers and balances; address of bank if out of town and be prepared to provide the last 3 months' statements.

  -  Stocks, bonds, and investment accounts:  broker's name and address, description of stocks, bonds, etc. and the last 3 months statements or copies of stock certificates.

  -  Life Insurance Policy;

  -  Retirement Plan:  approximate vested interest value, copy of latest statement.

  -  Automobiles:  make and model of automobiles, their resale value, if possible;

  -  Other Assets:  market value of personal and household property.

  -  Liabilities and other non-mortgage debt:  creditor's names, addresses, account numbers, monthly payments and balances.

 

 

 

    

     Conventional Loan Programs

     For every home buyer there is a loan program.  You can determine which type of loan you fit into by your income, expenses and home ownership goals.  If you plan on spending many years in your new home, you are probably best suited for a fixed-rate loan.  By getting into a low interest fixed-rate,  you will have the security of knowing what your monthly payment will be over the long term and you can make the rate even lower by paying points up front.   If, however,  there is a good chance that you will be moving in five years or less, an adjustable-rate mortgage may be a better answer for you, and, if your income will be rising in the future,  an ARM  will give you more purchasing power now.

Fixed-Rate Mortgages

     The most easily understood loan is the fixed-rate loan.  It allows the borrower to repay the principal and interest over a fixed period.  During this time, the interest and payment amounts stay the same.  There are currently fixed-rate programs available for 30 years, 20 years, 15 years and 10 years.  The most popular terms are 30 and 15 years.

     With the 30 year loan your payments will be lower since the loan amount is extended over a long period of time.   However, if you can afford a higher payment, the 15 year loan will pay off  your mortgage in half of the time and the loan will be at a lower interest rate.

     The payments on fixed-rate fully amortizing loans are scheduled so at the end of the term your mortgage is paid in full.  The advantage to this type of loan is in knowing what your payment will be for the life of the loan.   In a period of low interest rates, the fixed-rate loan is a popular way to buy a home.

      

Adjustable-Rate Mortgages (ARMS)

     With adjustable-rate mortgages, your interest rate will fluctuate with the economy.  Depending on your financial situation, these types of loans may allow you to have more purchasing power now than a fixed-rate loan. This is due to the fact that lenders offer introductory interest rates on ARMs that are substantially lower than on fixed-rate loans.   ARMs carry risks in periods of rising interest rates, but, if interest rates drop, they can become less expensive.

     The rise and fall of ARM interest rates are tied to their relationship to an index.  The type of index varies and could include Treasury securities or the national average cost of funds to savings and loan associations.  If the index rate moves up, your payment does as well.   On the other hand, if the index rate goes down, so will your monthly payment.

     To get a better understanding of ARMs, you should become familiar with the following terms:

The Adjustment Period

     With ARMs, the interest rate and monthly payment change every year, every three years or every five years, depending on which program you are in.  The period between one rate change and the next is called the "adjustment period."  For example, in a 1-year ARM the adjustment period, i.e. when the interest rate can change,  is 1 year.  

The Margin

     To determine the interest rate they will charge on a loan, lenders add a few percentage points to the index rate.  This is called the "margin."  Margins tend to vary from one lender to another.  For example, both lenders may use t

reasury securities as an index, but one uses a 2% margin and the second uses a 3% margin.  The larger margin will make your monthly payment higher.

Discounts

     To make a loan program attractive and, sometimes, to get you approved, a lender may use a lower initial rate than what is standard for them.  These rates are referred to as discounted rates.   Often these loans are accompanied by large initial loan fees or "points."  

      The discount provides you with a lower monthly payment and also qualifies you for more than you would otherwise be approved of.   Just be aware that, after the discount period expires, which is often at the end of the first year, the savings from this period may be made up during the life of the mortgage by a rise in your mortgage payment.

Interest-Rate Caps

      Caps were put into effect to protect borrowers from extreme increases in their monthly payments.  A cap does this by placing a limit on how much your interest rate can increase.  A periodic cap limits the rate increase from one adjustment period to another; while, overall caps limit the rate increase over the life of the loan.

      For example:  you have an ARM with a periodic cap of 2%.  At the first adjustment, the index rate goes up 3%.  Because of your 2% cap, your interest rate will only go up 2%.

      Be aware that a drop in interest rates does not necessarily lead to a drop in your monthly payment.  Some ARMS have a carryover feature.  If your 2% cap has kept your interest rate to 2% during a 3% increase in the index, the additional 1% can carry over to the next adjustment period. This would raise your interest rate an extra 1% in that period even if the index rate has not had an  increase.  

      For an overall cap example,  you have an overall cap of 5%.  The index rate increases 1% in each of the next nine years.  Your payment will not go up 9 percentage points, but will only go up 5%.

     By law, virtually all ARMs must have an overall cap. 

Payment Caps   

     Some ARM programs have payment caps.  A payment cap will limit your monthly payment increase at each adjustment, usually to  a percentage of the previous payment.  

     With payment caps you need to know about the possibility of negative amortization.  This can happen when your monthly payment amounts are not large enough to pay all of the interest due on your mortgage.  Since payment caps deal only with payment increases and not with interest-rate increases, there could be a time when your payment does not cover all of the interest due on the loan.  This shortage is added to your debt and may have additional interest charged on the amount.

     Since real estate values are usually appreciating, the extra charges in the loan may be covered by an increase in your property value, but this is a possibility that you should carefully consider when looking at any adjustable rate programs.

    

 

1-Year Adjustable Rate Mortgage

     With this 30-year loan the interest rate changes every 12 months.  The amount of the adjustment is determined by an index, as previously discussed.  Whether it is the Treasury Bill Rates, Treasury Note Rates, Federal Reserve Discount Rates or the Cost of Funds Index, these indices are all published and readily available to the consumer.  Your lender has no control over the rate of increases or decreases.

     One reason to consider a 1-year ARM is that the introductory interest rate will be significantly below the rate on a fixed-rate loan which may help you to qualify for the largest possible loan on your current salary.  Your part in this arrangement is that you will be taking a risk in that your payment may change from year to year.  If interest rates rise dramatically, you could end up paying much more for a 1-year ARM than for a 30-year fixed rate mortgage. 

     This loan usually comes with a 2% periodic cap and a 6% overall cap.

 

3-Year Adjustable Rate Mortgage

    The interest rate on this 30-year loan changes every 3 years.  Like the previous loan, the rate is tied to a predetermined index.  

     While you are still taking a risk, it is not as much since the rate will not adjust as often.  Once again, you will be offered an introductory rate that is lower than a fixed rate loan.  Some view the 3-year adjustable as a moderate risk compared to the 1-year adjustable.  

      If you expect to move or refinance in three years, this could be a good solution for you.  It is also an opportunity to qualify for a larger loan than you would under a fixed rate.  In any event, you should have some expectation of an increase in your income to be able to cover any possible future adjustments.

 

5-Year Adjustable Rate Mortgage

     This is a 30-year loan in which the interest rate changes every 5 years.  

     You will still be offered a lower rate than the rates on fixed-rate mortgages.  In exchange, you are willing to accept a small amount of risk that your rate will go up.  

      This would be a good option if you expect to stay in the home for at least 5 years.  Once again, you should be confident that you income will go up to be able to cover the possible increase in your payment.  

 

 

 

 Understanding Closing Costs

     One of the most confusing aspects of  home financing is determining what is fair or competitive with regard to closing costs.  These costs are not fixed and can vary greatly depending on the lender, the lending program and the amount of your loan.  

     When shopping for a loan, get estimated closing costs from lenders.  Ask for them to be in writing.  This will help in your comparison shopping.  Once you have applied for your loan, The Real Estate Settlement Procedures Act requires your lender to provide you with a Good Faith Estimate of closing costs within three business days of your application.  Also, you must be provided with a disclosure estimating all of the costs associated with your loan, including your total finance charge and Annual Percentage Rate.

     Although the categories of lending costs are standard, the amounts charged for the fees are not.  Below is an explanation of each of the possible fees as they appear on the HUD (Department of Urban Housing and Development) statement. 

 

Loan Fees

Loan Origination:  A charge for the lender's work in evaluating and preparing your mortgage loan, often expressed as a percentage of the loan.  Cost: varies from lender to lender.

Loan Discount:  Also referred to as "points".  A point is a one-time charge imposed by the lender to lower the interest rate the lender would otherwise charge.  Each point is equal to one percent of the mortgage amount.  Cost:  varies with mortgage amount.

Appraisal Fee:   This covers the cost of an independent appraisal of the home you are purchasing.  The lender requires this evaluation of the property since it will serve as collateral for the loan.    Cost:   $200 - $400.

Credit Report Fee: Covers the cost of a credit report to evaluate your credit history.  Cost:  $50 - $100.  

Mortgage Insurance Application Fee:  If you are putting less than 20% down on your home you will be required to take out mortgage insurance (PMI)  This covers the lender's risk in the event you should fail to make loan payments.  Cost:  Varies from lender to lender.

Mortgage Broker Fee:  Any fees paid to the mortgage broker would be listed here.  Cost:  Approximately $500.

Items to be paid in advance

Interest:  Lenders usually require borrowers to pay the interest that accrues from the date of the settlement to the first monthly payment.  For example, if you closed on June 20  you would owe ten days of interest payments to the end of the month.  

Mortgage Insurance Premium:  The lender may require you to pay the first year's mortgage insurance premium in advance.

Flood Insurance:  If the property you are purchasing is in a flood zone, you would have to carry flood insurance.   

Reserves Deposited With Lender

Hazard Insurance Premium:   You will be paying at least three months of prepaid home insurance at the closing.  Cost:  Based on your home's value.

Property Taxes:  You are required to pay three months of property taxes which will be held in escrow with the hazard insurance by the lender.    Cost:  Based on your home's value.

Title Charges

Settlement or Closing Fee:  This is a fee paid to the settlement agent or closing attorney.  Cost:  Approximately  $600.

Abstract of Title Search, Title Examination, Title Insurance Binder:  The title search is done to prove to the lender that the seller owns the property you are purchasing.  The search involves reviewing public records, recorders of deeds, county courts, tax assessors and surveyors.  Also, records of deaths, divorces, court judgments, liens and contests over wills are examined.   Cost:  Approximately $250.  

Document Preparation:  This is a separate fee that some lenders charge to cover their costs of preparation of legal papers and the deed.  Cost:  $50-$200.

Notary Fee:  This is the cost of having a notary public sign the documents and swear to the fact that the persons named are the ones who signed them.  Cost:  $50-$100.

Attorney's Fees:  You may be required to pay for legal services provided to the lender such as examination of the title binder.   Cost:  Approximately  $600. 

Title Insurance:  The total cost of your title insurance as well as the lender's.  Title insurance protects you from an error in the title search.  Such an error could mean that you are buying a house from someone who did not own it in the first place.   Cost:  Based on your home's value.

Government Fees 

Government Recording and Transfer Charges:  These fees are for recording the new deed and mortgage.   Cost:  Approximately $300.

Recording Fee:  This fee is paid to the title company and involves recording the transfer of title with the county clerk's office.   Cost:  $125.

Additional Settlement Charges  

Survey Fee:   A survey, or an Improvement Local Certificate, is done by a licensed surveyor and determines that your lot has not been encroached upon.  At a minimum, the lender will require evidence that no additional structures have been added to the lot since the last survey was conducted on the property.   Cost:  Approximately $200.

Administrative Fee, Document Preparation Fee, Courier Fee and Certified Copies:  Costs vary.   

 

    

  

Private Mortgage Insurance (PMI) 

Will You Need It?

    The determining factor as to whether or not you need to purchase private mortgage insurance is your down payment amount.  The bank is concerned with the loan-to-value or LTV.  If you are putting down only 10%, your LTV is 90 percent.   Since most lenders will only insure 80% of the loan, you will have an exposure of 10% that must be covered.  This is done with private mortgage insurance.

What Does PMI Cost?

     According to the Mortgage Bankers Association of America, PMI costs are typically one-half of one percent of the loan.*  

     For example:  You put down 10% on a loan of $200,000.  $200,000 minus $20,000 (10%) is $180,000.   This is the  amount to be financed.  The lender multiplies $180,000 by .005.  The result is $900.  Divide $900 by 12 for your monthly PMI payment of $75.00.

*PMI costs may vary from lender to lender.

 

Avoiding PMI

     Some lenders have  programs in which you can avoid PMI by paying more interest. The usual rate increase amounts to  .75 % to 1% depending on the lender and the amount of the loan.  One advantage to this method is that mortgage interest is tax deductible.  

     Another method is called an "80-10-10" loan.  This involves getting two loans and putting 10% down on the property.  The program is structured with a first mortgage equal to 80% of the sale price and a second mortgage for the remaining 10%.  The second mortgage will usually have a higher interest rate than the first but since it only applies to a small portion of the total price, the monthly payment for both loans will usually come out to less than paying a PMI premium.  

     If you do end up with PMI payments in the structure of  your loan, keep track of your payments on the principal of the mortgage.  When you reach a point where your loan to value is 80%  there are provisions which mandate that you be notified.   According to the Homeowner Protection Act of 1998, Federal Public Law 105-216, the following rules apply:

Mandatory Initial Disclosure - At the time of the closing the lender must provide a written notice of when PMI may be cancelled or that the lender will notify the customer when the cancellation date is reached.

Borrower-Initiated Cancellation - When the balance of the mortgage reaches 80 percent of the original value of the property the borrower may request in writing that the PMI be cancelled.

Automatic Termination - When the balance of the mortgage reaches 78 percent of the original value of the property the lender must automatically terminate PMI, provided that payment is current.

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