Down Payment and Mortgage

Down Payments

Twenty percent is the general rule.  If you are looking for the best interest rates and the best mortgage loan products then you will want to put at least 20% down.  A 20% down payment avoids Private Mortgage Insurance, or PMI.  PMI is insurance, which is required by lenders as a sort of foreclosure insurance for borrowers who put less than 20% down on their home.  You pay PMI until the equity in your home becomes at least 80%, and the money you pay to PMI does not go towards the principal balance on your mortgage loan.  Why do lenders insist upon PMI?

Statistics show that the larger the down payment made on the purchase of a home, the less likely the borrower is to wind up in foreclosure.  It is almost as if borrowers who make larger down payments simply have more invested in the home and is therefore more vigilant in making their payments each and every month.  So when you are talking to a mortgage consultant and they quote you certain terms and interest rates they are more than likely assuming that you intend to make a 20% down payment.  If you are going to put less than 20% down then you should let your consultant know this; they may have different products for borrowers who are not making a 20% down payment.  These different products aren't always less desirable than the other products because many lenders understand that people can't always scrape together a 20% down payment in every case.    

There are ways to get around the twenty percent down payment.  There are all sorts of loan products, which are designed to avoid Private Mortgage Insurance.  If your lender starts tossing around terms like 80/10/10 or 80/15/5 or even 80/20 then what they are referring to are loan structures which include second mortgages attached to the first mortgage in order to avoid a situation which would result in less than a 20% down payment and thus the need for PMI.  When the lender says 80/10/10 what they are saying is that you will finance eighty percent of the mortgage loan in a first, or primary, mortgage.  You will then open an equity loan, also called a second mortgage, in the amount of 10% of the loan.  The other ten percent is what you bring to the table in the form of a down payment. 

The other structures are similar: an 80/15/5 is 80% first mortgage can either pay the PMI monthly and think about how that money doesn't go towards the principal balance at all, or you can use one of the creative structures and pay tow payments each month (the first and the second mortgage) but at least know that the money is going towards the principal balance of the loan.  You should know that lenders may charge extra fees for loans structured this way, and that these sorts of loans are often not eligible for the lowest interest rates offered by lenders.  If the idea of making two payments monthly for your mortgage makes you uncomfortable then these sorts of loans are not for you.  They can be, however, an effective and somewhat sneaky way of getting around the twenty percent down payment rule.  

"No money down" doesn't mean you don't have to pay anything.  If you use one of the aforementioned split mortgages to avoid Private Mortgage Insurance, or if you use something like a Veteran's Administration loan to secure a "No Money Down" loan you may have a vision in your mind of picking out a house, signing the papers, and then walking away with the keys and no money out of your pocket.  Unless you can negotiate with the sellers to pay your closing costs, though, this simply won't be the case.  Closing costs are a necessary evil.  There is no avoiding them.  Someone must pay them, and whether it is you as the buyer or the seller can't avoid closing costs. 

In some cases you can ask the lender to roll the closing costs into the mortgage loan, and that means that you are able to avoid paying the closing costs at closing, but this is only for the time being.  Rolling the closing costs into the loan will usually mean that you start out your mortgage owing more money than the home is worth, and this is never a good situation to be in.  You should also be aware that if you do indeed use a Veteran's Administration loan there are even more fees involved.  The VA charges a funding fee of 2% of the loan for your first VA loan and .5% for each subsequent VA loan.  You can roll this into the mortgage loan or pay it out of pocket, but just remember that rolling more costs into the mortgage makes for an even higher ratio of debt compared to the value of the home.   

There are some resources out there to help first-time homebuyers.  Many states have programs for first-time homebuyers, which furnish some sort of help with a down payment.  These programs vary from state to state and not all areas have these sorts of programs.  Some occupations, such as teachers or fire fighters may also be able to receive down payment assistance from their professional organizations.  Do a little detective work to see if there is any first-time homebuyers grant programs in your area, which you might qualify for.  It can't hurt to ask.

Is someone gifting the down payment to you?  In some cases people have the good fortune of having someone give them the money for a down payment on a home.  Sometimes parents do this for their sons and daughters to give them a jump-start on an adult life.  You should know, though, that most lenders will want to know the source of your down payment and if the money is being supplied by someone else as a gift the person giving the gift will have to sign an affidavit stating that the money will never need to be paid back.  Lenders want to see this because they do not want money for the down payment to produce even more debt.  If the person gifting the money to you is not comfortable getting involved in this sort of situation then it would be best to have them gift you the money at least six months ahead of time from when you intend on applying for the loan; this way the money has been sitting in your savings account for some time and will not be an issue with the mortgage loan officer.

Fixed Rate Loans

You'll always know what your payment will be.  Payments on a fixed rate loan are predicable because the interest rate does not fluctuate for the life of the loan.  You will find that fixed loans have a bit of a higher interest rate than any other type of loan because lenders know these sorts of loans aren't the moneymakers that something like an adjustable rate mortgage can be.  Most financial experts agree, however, that if you can't pay cash for a house then going with a fixed rate loan is the best choice.  There will be no big surprises with your monthly payment and the only changes you should encounter are if your property taxes increase or decrease and if the annual cost of your homeowners insurance changes. 

If you pay taxes and insurance on your own then it is a safe bet to assume that your mortgage payment will remain the same for the entire life of the loan.  Whether interest rates hit rock bottom or skyrocket up to the moon your interest rate remains stable when you have a fixed rate loan.  If the thought of interest rates going down after you have signed all the papers makes you nervous then rest assured you can always refinance down the road if new interest rates make it worth the hassle.  

An interest rate fluctuation won't put you in the poorhouse.  You may wonder what the big fuss is about with adjustable rate mortgages…how much can interest rates fluctuate, really? Back a few years ago when the interest rates hit record lows many people scrambled to snatch up some of the adjustable rate mortgages, both for new purchases and for refinancing.  Borrowers were practically salivating at the prospect of having a really low interest rate and didn't think towards the future.  After all, when interest rates are at a record low common sense tells us that they can only go one place: back up.  So people who were enjoying their 3% rate on an adjustable rate mortgage noticed that every year the rate was crawling up…and up…and up!

Unless they have since refinanced these same people have stupendously higher interest rates than what they originally had, and as the rates continue to climb they need to figure out ways to pay more on their mortgage payment each year.  If an increase of a few interest rate points does not worry you then consider this: at 3% interest the monthly payment on a $200,000 mortgage is around $845 for principal and interest.  Bump up the interest rate only a few points to 6% and you're looking at a monthly principal and interest payment of around $1200.  That's a difference of $355 per month, or $4260 a year.  For most people, having to come up with this sort of additional money can cause real financial problems.  It is best to simply go with a fixed rate loan and know what you are getting yourself into.

Look out for balloon payments.  You may find a great interest rate for a fixed rate mortgage and wonder what the gimmick is.  If the lender or mortgage broker casually mentions the term "balloon payments" and then attempts to gloss over it without much of an explanation then you need to slam on the breaks and find a different mortgage product.  A balloon payment is an interesting type of loan, which can turn out to spell disaster if a borrower doesn't fully understand the terms of the loan.  Here is how a balloon payment works: a loan will be amortized for a full term, such as a thirty-year period.  This means that the borrower will pay the mortgage payments monthly, just as if it were a full thirty-year term.  At a certain point, typically around ten years into the loan, the entire balance of the loan is suddenly due.  This is the balloon. 

So who in their right mind would accept a loan like this? Some people take on these sorts of loans when they know they will only be in a home for a certain amount of time and do not expect to ever encounter the balloon payment.  Others take on these sorts of loans because it is the only product offered by the lender for certain circumstances, such as for investment properties.  Unfortunately there are also some borrowers who simply don't understand the terms fully and accept a balloon payment yet do not know that they are in for a rude awakening in ten or so years.  It is best to simply stay away from a balloon payment, especially if this is your first time buying a home.   

Know when to lock in your interest rate.  Most lenders do not lock in your interest rate when you apply, but instead you need to tell them when you're ready to lock in the rate.  Don't make this decision hastily; you should research the recent interest rate trends to see which way rates are heading before locking in.  Sine you don't have a crystal ball, which magically tells you if current trends will hold constant, then you just need to use your best judgment.  You shouldn't get too caught up on tiny percentages either…if you hold out for a lowering of an interest rate which isn't even going to make much of a difference at all in your monthly payment then you should just go ahead and snatch up the interest rate which is being offered lest the rate shoot up before you can lock in.

Adjustable Rate Loans

What's an ARM loan?  Some mortgage consultants get so used to dealing with mortgage terms that they simply forget to explain what each acronym stands for.  This can lead to great confusion on the part of the borrower.  ARM stands for Adjustable Rate Mortgage.  This is a type of mortgage, which starts out with a set interest rate for a predetermined number of years and then becomes adjustable according to whatever method the lender uses to determine interest rates.  Most lenders use the federal Prime rate, so whenever this rate goes up or down the lenders will adjust their interest rates up or down accordingly. 

So if a mortgage loan consultant tries to talk you into what they call a 5/1 ARM then what they are trying to sell you is a mortgage which has a fixed rate for five years.  After the five years is up the interest rate has the potential to go up or down each and every year for the remainder of the loan, which is usually amortized over a thirty year period.  Other terms exist, but each one works in pretty much the same way: a 3/1 is fixed for three years; a 7/1 is fixed for seven years, and so on.  Generally, the lower the first number the lower the interest rate.    

ARMS can be tricky.  Different lenders have different rules and regulations when it comes to their ARM loans.  Some lenders have caps on how high the interest rate can go, which means that they can tell you right off the bat what the very highest amount you will ever pay for your ARM might be.  Some lenders also have annual caps, such as never allowing an interest rate jump to go beyond one interest rate point each year.  Make sure that you understand the terms that your lender uses so that you aren't surprised by a huge interest rate jump later in the life of the loan.  

Lenders love financing ARMs.  Mortgage consultants are trained to make ARMs sound like the best idea for everyone because these sorts of loans guarantee lenders that the mortgage will follow current interest rate trends.  ARM loans are generally more profitable when they start out low and then the interest rates climbs higher.  This is great for the lender, but bad for the borrower.  For this reason you need to be aware that your mortgage consultant may glaze over fixed rate loans and keep steering you towards the idea of an adjustable rate mortgage.  Be prepared to fight for a fixed rate if that is what you want.  If you decide on an adjustable rate mortgage just make sure it's because that's what you have decided makes sense for your particular situation, and not because the mortgage consultant made it sound so cool. 

When does an ARM make sense?  Many conservative financial advisors will caution people against taking an ARM loan under any circumstances because there is simply too great a risk that the monthly payments will go higher.  Other financial experts, however, may endorse an ARM loan under certain circumstances.  If a borrower knows exactly how long they will be in a new home they might tailor their ARM accordingly.  For example, a person who knows they will be in a home for four years might select a 5/1 ARM because in theory they will never see the interest rate fluctuate.  This sort of thinking can be flawed, however, since people never really know for sure what cards they will be dealt by fate.  What if they decide they love the house and want to stay forever? What if they have a hard time selling the house in a soft real estate market? There are no guarantees when it comes to homes, and people need to make their financial decisions based on this fact.

Length of Term

Thirty-year terms are quite common.  Most mortgage loans, whether fixed rate or adjustable rate mortgages, are amortized over a thirty-year period.  This seems to be an industry standard as thirty years is a nice long period for someone to pay off a big amount of money, but not such a long term that the loan seems like it will never be paid off.  Thirty year terms work well for many people because the monthly payments are less than if the term was for fewer years, and unless your lender has some sort of pre-payment penalty fees then you can pay the loan off as if it were amortized for a smaller amount of years while still having the option of occasionally paying the set amount if you need the extra money one month for an unexpected expense.  Thirty years can seem impossibly long to some buyers, though, and for many people the thought of signing away thirty years of payments can simply make their stomach turn.  

Fifteen-year terms are gaining popularity.  Not everyone likes the idea of a thirty-year term, and fifteen-year terms are very popular for fixed rate loans.  This sort of amortization forces the buyer to pay off the loan in half the time it would have taken them if they had gone with a traditional thirty-year loan.  The payments on a fifteen year loan will be higher than with a thirty year loan, but surprisingly they will not be that much higher.  When you are applying for a mortgage loan you can have the mortgage consultant run the figures for both terms - either thirty or fifteen - and see which one is doable. 

There are other terms available.  Lenders are answering the cry of borrowers who feel that thirty years is too long yet fifteen years is too short by offering a twenty-year amortization.  This can be a happy medium for borrowers who cannot quite afford a fifteen-year term yet whom are also put off by the idea of paying for a mortgage for thirty years.  Some lenders have other amortization terms such as a ten year loan, but it is important to remember that as long as your lender does not charge a prepayment penalty you can always pay extra towards the principal balance each month and pay the loan off in as many years as you want.  Use one of the many calculators available online or have a mortgage consultant run the numbers to see how much extra you would need to pay to have the loan paid off in fewer years than your loan is amortized.  You may be surprised at how little extra money it will take. 

Have you ever heard of a prepayment penalty?  You would think that lenders would really appreciate people making their payments ahead of schedule, but in fact the opposite is true.  Every time you pay some extra money towards the principal payment it reduces the amount of time you will have your loan, no matter how little.  The less time you have the loan the less interest you will have to pay, and therefore this is why some lenders discourage people from paying their loans off earlier than scheduled.  You need to make sure that the lending company you go with does not have any sort of prepayment penalty because you may find that at the end of your mortgage, if you have made any extra payments, you will be faced with the decision to either wait it out until the end of the scheduled terms or rather to pay what can sometimes be a hefty penalty to pay off the loan sooner than expected. 

To add insult to injury, some lenders consider a refinance of a mortgage loan to be a prepayment, so if interest rates drop considerably and you would like to refinance your loan at a lower rate the company is going to hit you with the prepayment penalty fee.  The best way to avoid this is to simply refuse to finance with a company that uses these sorts of tactics.  The more reputable lending companies do not generally have these sorts of fees, but you should still ask.  If they tell you they do indeed have a prepayment penalty then it is time to find a different lender.  It doesn't matter if you can't envision yourself ever paying the mortgage loan off early.  Circumstances change and you don't want to get caught in a bad situation.  Besides, it just seems silly that you might have to pay someone extra money simply to pay them off early.  Avoid this sort of thing as best you can.

On the next page we cover Other Mortgage Products and Important Savings Advice.