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Mortgage 101

This guide was created to provide you with accurate and clear information about the different types of mortgages and how to ensure that you choose and negotiate the right mortgage that meets your particular needs.

Getting a Pre-approval

Probably the most important step in the home buying process, why? Because in today's market lenders are being very strict and selective with their lending guidelines. In addition, by getting a pre-approval it helps you set your home hunting budget. Your lender will consider your credit history, income and payment history (as well as other factors) and then tell you how much of a mortgage they will be willing to approve you for.

Once you know how much you can qualify for, you might want to take the time to work out payments, and then decide if that works for you. If not, consider lowering your mortgage amounts until you get a payment amount you are comfortable with. Knowing the mortgage amount you can afford becomes your key information in house hunting.

Mortgage types

Mortgage types and interest rates have more variety than you can imagine. This is the challenging part when shopping for a mortgage. Here we will touch up briefly on the most commons mortgage types available in the market right now.

Fixed Rate

Fix rate mortgages are the most common mortgages for first time home buyers because they are stable. This mortgage guarantees a certain interest rate for a period of time. The most popular fixed rate mortgages are 15 and 30 years. The biggest selling feature of fixed mortgages is the 'guarantee' of the payment that you will be paying. They offer inflation protection if rates increase, your mortgage and mortgage payment won't be affected. It is great for long term planning, you know what your monthly payment will be for the rest of the loan and it will help you for other expenses and long term goals. Low risks, you always know what your payment will be. But know this; when interest rates go down your mortgage payment won'tgo down. Make sure you get the best possible fix rate and you will rest assure you got the best mortgage terms for years to come.

Adjustable rate mortgage (ARM)

Adjustable rate mortgages do what you'd expect - the rate adjusts. It works like this; with a fixed rate mortgage your monthly payments will be the same over the life of the mortgage. You'll always know what you'll have to pay. In contrast with an adjustable rate mortgage (sometimes called an ARM) your payments will change over time.

The mortgage payment will be'adjusted' when the interest rate is adjusted. You can expect the interest rate to be adjusted at regular intervals.

Usually, you start with a period of a year at a fixed rate. This rate is often quite low, as an incentive to get an adjustable rate mortgage. Then, after the initial fixed period the interest rate is usually adjusted yearly to reflect the current rates. If the rates go down so do your mortgage payments. But if the rates go up, your payments will go up.

Interest only mortgage

An "interest-only" mortgage is like a line of credit. You can pay only the interest on the mortgage. This can greatly reduce your payments in time of financial stress. However, it also means that the debt will never be paid off.

With an interest only mortgage, you pay only interest for the first five, 10, even 15 years of the loan. This can lower your monthly payment by quite a lot. And that seems to have increased the popularity of interest only mortgages in the past few years.

The interest only mortgage is an interesting balloon mortgage approach, which means the total loan principal becomes due at the end of your term.

When would you consider this kind of loan? The circumstances to consider this kind of loan would be unique. Usually, a family with a single wage earner should not be considering this type of mortgage. Your exposure to financial risk would be too high. However, investors might be interested. The advantage with an investment property, that you expect to go up in value, is that the interest you pay is tax deductible. Therefore, you can deduct the interest paid from your taxes, while you own the property. At the end of the period of the loan, you could then sell your property (hopefully at a profit) and take the returns to pay out the mortgage.

However, this is a gamble. There is no guarantee that the property appreciates in value. And there is no guarantee that you can sell it when you decide to. If you cannot sell the property, you would have to refinance (unless you have made enough from the property to pay out the balance of your mortgage) and refinancing could cause you some challenges.

The other advantage to this kind of mortgage is that you can save or invest the money that you would have paid in principal on the loan. Again, this situation will usually favor investors of one kind or another.

Jumbo Mortgages

Because jumbo mortgages aren't eligible investments for government-sponsored enterprises like Freddie Mac and Fannie Mae, lenders take on additional risk with this type of loan and consequently apply a more stringent credit standard. A further difference is the interest rate charged. Because it?s a non-conforming loan, the rate is usually one-quarter to one-half a percent above what the conventional rate would be.

Low interest rate mortgages

A low interest rate mortgage is the fondest desire of every potential homebuyer. How do you get a low interest rate mortgage? Well, while you can try to negotiate yourself with a commercial lender, you might also want to think about a mortgage broker.

A mortgage broker will do some of the footwork on your behalf. A mortgage broker may know about smaller lending institutions which are offering a much more competitive interest rate than a big bank or finance company. However, mortgage brokers will not necessarily work with all potential lenders. They are also not completely unbiased because they may prefer certain lenders who provide them with the best commission. So, you will always have to do some checking of your own. Having said that, a mortgage broker may find some great opportunities for you to get the lowest possible interest rate.

FHA mortgages

The Federal Housing Administration (FHA) is a special program under the jurisdiction of the Department of Housing and Urban Development (HUD). FHA was established in the 1930's to improve housing standards and conditions, as well as provide an adequate home financing system through insurance of mortgages. In other words, FHA was the original mortgage insurance for US families! With the mortgage insurance provided through FHA, families that would otherwise be excluded from the housing market were finally able to buy homes.

The FHA helps homeowners into the market in more than one way. With the FHA you can buy with as little as a 3.5 percent down payment. That can save you a lot of time spent saving up in order to get into the housing market. Most conventional mortgages require down payments of 10 percent or more of the purchase price of the home.

Another benefit of the FHA is that many closing costs can be financed. With most conventional loans, the borrower must pay closing costs (the many fees and charges associated with buying a home) equivalent to 2-3 percent of the price of the home. With an FHA loan, you can finance many of these closing costs, thus reducing the up-front cost to you of buying your home.

However, as good as the program is, FHA mortgage insurance is not free. You will pay an up-front insurance premium (which may be financed or rolled into your mortgage amount) at the time of purchase. In addition, you may have to pay monthly premiums that are not financed, but instead are added to the regular mortgage payment.

The FHA does protect you from some predatory lending practices. FHA rules impose limits on some of the fees that lenders may charge in making a loan. For example, the loan origination fee charged by the lender for the administrative cost of processing the loan may not exceed one percent of the amount of the mortgage.

While this program can be very useful, it is limited to certain people; you will have to qualify. To make sure that its programs serve low- and moderate-income people, FHA sets limits on the dollar value of the mortgage loan. These figures vary over time and by place, depending on the cost of living and other factors. Any person able to meet the cash investment, the mortgage payments, and credit requirements can apply for an FHA mortgage. Applications are made through an FHA-approved lending institution. If you want more information before applying, be sure to check out the HUD website.

VA mortgages

If you get a VA loan, there is zero down payment option when purchasing a home. With a VA loan, even if you have bad credit, you can get the same low interest rates for veteran home loans that are available to those with great credit, as long as you have been improving your credit history for the past year. Improving your credit history is as easy as making your current utility, rent, loan or credit payments on time. (Be sure that this change in your payment history is accurately reflected on your credit report.)

Even with a Loan-to-Value of 100%, there is no monthly Mortgage Insurance required for a VA home loan. This alone can save you considerable money every month. The VA mortgage loan is guaranteed with no money down for any loan up to $359,650. All you have to do is qualify for the size of mortgage that fits within your budget.

VA mortgage loans are often assumable. This means that you can transfer this mortgage to the new owner of the home when you sell. It can be a significant selling point, since VA loans have very competitive interest rates. VA has released a hybrid ARM product. Veterans now have a choice of a fixed rate or an Adjustable rate VA mortgage. So you have the choice of mortgage product that you want, even with a VA loan So, how do you get a VA loan? You will need a certificate of eligibility to qualify. Whether you are a first time user of the VA loan system or you have used your eligibility in the past, you must have your certificate. If you don't have a certificate, you'll have to get one first. Contact your local Veteran Affairs office if you need to get a copy of yours.

Assumable mortgage

You've put in an offer on a house. The real estate agent says that the seller of the property has a mortgage on the property that is 'assumable' and it's at a great interest rate. What do you do? Assumable mortgages are mortgages that can be passed from one owner to another. It can be an advantage to assume a mortgage if the interest rate is very good compared to negotiating a brand new mortgage.

Keep in mind that you cannot assume a mortgage unless you have a big enough down payment to cover the difference between the value of the house and the amount of the mortgage. Otherwise, you are in the situation of negotiating a second mortgage - which you should generally avoid. Second mortgages are often at much higher interest rates and any savings you get from assuming the first mortgage could be lost.

Reverse mortgage

A reverse mortgage isn't really a mortgage at all. A reverse mortgage allows you, the property owner, to access some of the value of your property without selling it. You remain the owner with all your current obligations. And you get a cash stream from your property. When the reverse mortgage agreement is over you or your heirs must repay all of your cash advances plus interest. Reputable lenders don't want your house; they want repayment.

Although there are different types of reverse mortgages all of them are similar in certain ways. For instance, you are still responsible for paying your own property taxes, homeowner insurance and repairs. So this doesn't change.

Private Mortgage Insurance (PMI or MIP)

Private mortgage insurance, is an insurance that actually protects the lender. Many lenders will require private mortgage insurance on a mortgage because the less money that a buyer has invested in a home, the greater the chances that buyer has on defaulting on the loan. Private mortgage insurance becomes a financial guaranty that protects lenders against loss in the event you default.

Without mortgage insurance lenders will typically require a down payment of at least 20 percent. So, if you don't want to have to keep saving while the cost of houses goes up private mortgage insurance might be a good solution for you.

By going with mortgage insurance, first time homebuyers can increase their buying power. For example, $10,000 constitutes a 20 percent down payment on a $50,000 home. However, with mortgage insurance, that same $10,000 can also provide enough financial leverage to help you buy a $200,000 home with only five percent down. This is the true value of private mortgage insurance. Don't confuse private mortgage insurance with mortgage life insurance. Private mortgage insurance puts people in homes; mortgage life insurance pays all or a portion of your mortgage in the event of your death.

Mortgage Interest deductions

Mortgage interest is a tax deduction! The mortgage interest deduction is one of the most well-known deductions available to US taxpayers. Created in its current form as a part of the Tax Reform Act of 1986, this legislation allows for mortgage interest to be deductible while almost all other forms of personal interest are not. Further, while there are limits to the amount of debt covered, there is no limit to the dollar amount of interest that you claim on your tax deductions. So, no matter if your interest rate on your mortgage goes up or down, you can claim all interest paid that is on an allowable debt.

What does that mean for you? It means that you get savings on your yearly tax return, while you build equity in a property at the same time. You are not at risk of losing your interest deductibility if interest rates go up. And, this benefit is only available to home owners. If you are a renter, you miss out on this.

However, there's always a catch. Many taxpayers don't understand that there are actually several limitations on their ability to deduct mortgage interest. The comprehensive rules are not nearly as simple as you might hope. Why? Based on the Internal Revenue Code (IRC), there are actually two different kinds of "mortgage interest" for tax purposes. Different rules, restrictions and deductibility limitations apply to each type. In addition, as more taxpayers find themselves affected by the alternative minimum tax (AMT), the picture gets even more complicated. See the home equity indebtedness pages for more clarification. As always, get professional advice on how you can best take advantage of the mortgage interest deduction rules.