Mortgages Part 1

This is the first installment in a multi-part series on mortgages (it’s been on my mind). First we’ll look at key terms. We’ll get into specific advice later.

Key Terms

Rate – The percentage of interest that you will pay on the loan. The higher it is, the more you’re paying, so low is good. Thankfully with mortgages interest is not generally compounding and rates tend to be much lower than on things like auto loans and credit cards. This is the key term that people generally talk about when shopping for or selling a mortgage. Rates change daily and vary widely from lender to lender and year to year.

Principle – This is the amount actually owed on the loan. A portion of your payment each month will go toward paying the principle off – and when it’s all gone, you actually own the home and can stop paying. In the early years, the bulk of what you pay each month goes toward paying the interest on the loan, but with each passing month the amount applied toward the principle gets slightly larger. With most loans you can make additional payments that are applied directly to the principle. If you can afford to make additional payments this is a good way to shorten the amount of time you have to pay on your loan and the amount of interest you’ll pay over the life of the loan.

Interest – The cost of having someone else buy something for you that you then pay them back for. As stated above, each month a portion (thankfully a declining portion) of your payment goes to pay interest on the loan. The good news is that under the current IRS tax code you can deduct the amount of home mortgage interest you pay each year from your taxes (this is one of the advantages of home ownership over renting) – and this is only guaranteed for your first mortgage, some home equity and second mortgages will not be deductible. On most 30-year fixed rate loans you’ll pay as much or more in interest over the life of the loan than the original purchase price. This can be depressing and is a good incentive to pay it off early. If your rate is extremely low and/or your loan amount is relatively small compared to your purchase price you might manage to pay less in interest over the life of the loan than the purchase price was, but probably just barely (and this is tough to pull off).

Term – Number of years to pay off the loan. These range from 10 to 50 years. Thirty years is fairly standard today. I don’t recommend going longer than that. While the house will likely last longer than 30 years (assuming it was built well to begin with and is fairly new), but you need the payoff window to be realistically within your lifetime and preferably within your working lifetime so that if you stay in the home and pay it all the way out you’ll do so before you retire (hence reducing your expenses in retirement).

Points – Points are things you can buy in order to reduce your Rate. If you’re going to stay in the home for a long time (10+ years generally) and you have the cash on hand to do it, buying a point may pay off. Ask the lender to show you a payout comparison to see if it makes sense. Buying “a point” means you’ll pay 1% of the loan amount at closing to reduce your interest rate (and thus your monthly payment) usually by about .25% (sometimes a little more or a little less). That 1% you’re paying doesn’t go toward the principle amount of the loan, you’re essentially pre-paying interest in exchange for a reduction in the interest over the life of the loan. On a $100,000 loan one point will cost $1000. If that point reduces your interest rate by .25% (on a $100,000 loan with interest rates generally between 6% and 8%) you’ll pay about $20/month less. The equation to determine if this makes sense is to see how many months of paying that $20 less it will take to make up for the amount you put up initially (in this case $1000 up front would take 50 months or just over 4 years). After that you’re actually saving money each month. Points can be bought in fractions as well as wholes.

Closing Costs – There are significant costs to purchase a home – beyond the price of the home. How loosely or narrowly a lender defines closing costs will have a lot to do with the quality of the GFE (see next paragraph) they give you and how much they claim their closing costs are. Many of the costs included in closing costs are set by a third party and aren’t really negotiable (appraisal fee, closing fee, survey, etc.). The ones to watch for are the ones that the bank is charging you for writing the loan. These can range from about $400 up to about $1000. Each lender lists closing costs a little differently, so it can be a challenge to compare one GFE to another, ask for help or make the prospective lender do it for you. Look for total closing costs to be between $1500 and $2500 depending on the size and cost of the home, the lender, type of loan, etc. This doesn’t include the “pre-paids” (see below).

GFE – Good Faith Estimate. This is a document a lender will send you showing the terms of the loan in short form and the estimated costs associated with it. The GFE makes it easier to compare one lender’s offer to another – particularly as it pertains to closing costs and the validity of their pre-paid estimates. Don’t be afraid to show the GFE of one lender to another – sometimes they’ll ask to see it – this may help in getting them to shoot straight with you. A lender who will look at the GFE of a competitor and tell you to go with that lender because he or she can’t touch it is probably worth calling the next time you’re in the market, because they’ve just proven they’re honest (or at least given evidence of it). I’ve got a couple I can recommend based on that.

Pre-Paids – In purchasing a home with a mortgage you have to pre-pay for taxes, interest and insurance to make sure those requirements will be met. The time of month and year you close (see next paragraph) will have a significant impact on the amount of pre-paids you’re dealing with. Generally, if you’re setting up an escrow account you’ll have to pre-pay a full year of homeowners insurance, a reserve amount of insurance payment (3 months is common), as well as the portion of the property taxes and that should have accrued by the point in the year you are closing on the home (this is so that there will be enough in the escrow account when they come due to pay them). In addition, you have to pay interest on the loan for the days from closing until the end of that calendar month (so closing on the 15th will result in about 15-16 days of interest to pay at closing). This is something to watch carefully in the GFEs you get, because some lenders will plug in a standard set of numbers that may not reflect your actual costs. The result will be that you’ll either have to pay more at closing when the real numbers surface or you’ll get an unwelcome letter in a few months when your escrow account is terribly underfunded and the taxes/insurance are due. If you’re short on cash, it would be best to close at the end of a month and just after property taxes in your area are due, this will reduce your pre-paids significantly. FYI in Jasper County, Mo. Property taxes are due in November.

Closing – This is the date you actually take “ownership” of the home. This is when the buyer and seller (along with their entourage of lenders and agents) go to a pre-arranged meeting with very specific, large amounts of money from specific sources in specific forms to sign papers agreeing to buy or sell and all that comes with it. Until you close, you don’t own it. Once you close, you definitely own it and there’s probably no going back.

Cash To Close – Total amount of cash (generally a cashier’s check from your bank) you are required to produce at closing. This will include any down payment you are making, the closing costs, and pre-paid amounts.

Lock Period – Mortgage offers come with a specific amount of time that the rate quoted will be honored from the time it is locked-in until the closing date. The typical is 30 days. So if you have a contract to buy a house and the closing date is going to be more than 30 days from the signing of the contract you’ll either need to get a lock period that is long enough to include your closing date (they can be 45, 60, or 90 as well as 30 – all in days) or wait until your closing date is within 30 days to lock in your rate. Talk to your lender about this to see how a longer lock period will affect your rate. It may make sense to select a lender, sign the papers, but hold off on locking in the rate. The purchase contract on the home will generally give you a fixed period of time to secure financing (generally about 14 days). If you are closing say 35 days from contract signing you can just wait a few days and then lock your rate once the closing date is within the 30 day window. But if you are closing 60 days after contract signing you won’t have that option and still be able to meet the contract requirement to show evidence of financing within 14 days. My advice if you have a longer time period until you close is to shop around and figure out which lender is going to give you the best deal when you’re ready to lock it in, apply for the loan, but wait to lock until you’re within 30 days of closing. When you get a longer lock period the rate will not be as good because that is a longer time period of uncertainty for the lender. Unless there is a good reason to think rates will go up between contract signing and when you are within 30 days of closing it’s generally not in your best interest to lock in a rate more than 30 days out (with a longer lock period).

Escrow – I mentioned this above. This is an account the bank keeps on your behalf to set aside money to pay your homeowners insurance and taxes that come due usually once a year. It is not required that you have an escrow account – and most lenders charge a small fee for doing this for you. But this helps you budget for these larger expenses and avoids having to have cash available at a specific time to pay for all of them at once. If you choose to escrow your taxes and insurance then a portion of your payment each month (which is sent to your lender) will go toward those items (essentially they’ll divide the estimated yearly amount for insurance and taxes by 12 and you’ll pay that each month). Pay attention to this amount when looking at the payment on the mortgage you’re considering. If you’re just looking at the P&I (Principle and Interest) amount you may be surprised when you get your payment slips and they are $150/month higher as a result of the insurance and taxes being included. Most GFE’s will show you the payment amount including the escrow, just make sure you are looking at the right number.

Fixed v. Adjustable – Loans can have a fixed interest rate that won’t change over the life of the loan. Or they can be an Adjustable Rate Mortgage (ARM), which will have an initial rate that begins to change at some point. All things being equal, if you’re planning to own the house very long (more than 5 years) go with a fixed rate, that way you’re not subject to the fluctuations in interest rates. This is especially true at a time when rates are low compared to historical averages (i.e. it’s more likely that in 5 years they’ll be higher than they are now and very unlikely that they’ll be a great deal lower). There are times when an ARM can be a good choice. If you know, for instance that you will own a home less than the fixed period on a specific ARM loan then it might make sense to take the lower initial interest rate (anywhere from .5% to 1.0%). In general would not advise anything with a fixed period of less than 5 years (usually called a 5/1 ARM – meaning the rate is fixed for 5 years and then can adjust each year after that). ARMs with a longer fixed period won’t have a significant rate advantage and ones with shorter fixed periods are going to reset so soon that unless you know for sure you’re selling inside that window it can be a risky venture.