Comparing the loan terms among various lenders can be a confusing process unless you approach it systematically. Make sure you get all the information you need to compare the policies and terms of different lenders. Keep your written notes handy as you call loan officers. Compare terms at various banks and institutions. You will begin to understand the differences in mortgage terms available, and become familiar with the buzz-words and categories that pertain to the mortgage market. Here are a few important concepts to know before you get started.
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Fixed-rate and adjustable rate
For some home buyers, an important decision is whether to get a fixed-rate or adjustable rate mortgage (ARM). As we discussed here, fixed-rate mortgages may be preferable to ARMs because your monthly principle and interest payment are fixed for the life of the loan (though your tax and insurance payments may change over time). However, ARMs usually offer a lower initial interest rate, which means lower initial monthly principle and interest payments, as well as the possibility of qualifying for a larger mortgage amount. If you're confident that your income will increase steadily over the years, you may have no qualms about an ARM. Again, you will have to consider your own circumstances.
Begin your interview by telling the loan officer what type of loan you are interested in, for example, a 95-percent, 30-year fixed-rate mortgage. (If you plan to make a down payment of 5-percent of the purchase price, lenders call this a "95-percent loan.") If you're shopping for an adjustable-rate mortgage, you will want to ask about a one-year, three-year, or five year ARM. (The number of years indicates how often the interest rate is adjusted).
Also, if you are interested in one or more of the mortgage products designed for low- and moderate-income families, or in FHA or VA financing, ask whether the lender handles these types of loans. You will want to be sure that you are comparing terms among various lenders for exactly the same type of loan, so be specific.
Did you know?
Lenders adjust their quoted rates by assessing points to the loan. Typically, the more points (a one-time cost) to the loan officer, the lower the interest rate (a recurring cost) will be over the life of the loan.
Origination fees (Points)
Lenders typically charge an origination fee in the form of points. Each point is equal to 1-percent of the loan amount. For example, one point on a $50,000 mortgage would be $500. Points are usually paid as a one-time expense at closing.
Paying additional points can lower your interest rate, known as discount points. Some borrowers may wish to pay additional fees to the lender in order to lower the long-term interest rate. That is why you will see offers of both a rate and point combinations of, for example, 8-percent and two points or 8.25-percent and 0 points. The more points you are willing to pay at closing, the lower your interest rate should be. Please feel free to consult with us about the relationship between the interest rate and points.
Annual percentage rate (APR)
To easily compare the various combinations of interest rates that lenders quote, ask for the APR of a particular mortgage. This is the actual interest rate, taking into account the points and other costs of financing. Lenders change their rates often, even daily. In addition, the same lender will quote different rates for each specific type of loan it offers. Your interest rate will determine both the size of the mortgage you qualify for, as well as the size of your monthly payment. Each quarter of a percent difference in the interest rate represents a significant amount of money over the complete term of a 30-year loan.
Find out how long is the maturity, or repayment period. Most home loans are repaid over 15 to 30 years. With a shorter repayment term, you will pay far less interest over the life of the loan, but your monthly payments will be higher. First-time home buyers typically take the longest term offered in order to get the lowest possible monthly payments.
Generally, the lender will include the cost of property taxes and insurance in your monthly payment. Ask the lender how much will be escrowed each month and whether you will earn interest on the amount held by the lender.
Keep in mind
If the lender does not require pre-payment, you may have to pay the first year's premium of your homeowner's insurance at closing, as well as the first year's FEMA flood insurance (if required). If the lender does require pre-payment, they will typically collect the first 2 months premiums at closing.
The lender may also require you to pay the first 2-3 months of property taxes at closing.
How long does this lender normally take to process a loan application? Traditionally, loan approvals have taken 30 to 60 days or more. Some lenders now promise very short approval times (some within 24 hours), which may be an advantage to you, especially if interest rates are rising, or if you are particularly anxious to complete the purchase.
Many of the closing costs associated with the purchase of a home are fees imposed by the lender, which may vary considerably from one lender to the next. Ask specifically about the following: the application fee, origination fee, credit report fee, appraisal fee, survey (is one required?), fees for the lender's attorney, cost of title search and title insurance, and the document preparation fee. If you plan to assume an existing mortgage, what is the "assumption" fee? (Many if not all of these fees can be negotiated with lenders, so be sure you understand what each fee is and, if it seems high, ask your lender to explain why.)
Private mortgage insurance (PMI)
If mortgage insurance is required, how much will it cost? Ask about the upfront costs (those payable at closing) as well as the monthly premiums. All private mortgage insurance companies now offer programs that require no up-front payment at closing, but the monthly premium may be slightly higher. FHA loans also require an up-front mortgage insurance payment, which is known as the Mortgage Insurance Premium (MIP).
Canceling mortgage insurance
If you are required to take on private mortgage insurance to qualify for the loan, make sure you have the option to cancel the insurance later as conditions change. Once a borrower has built up sufficient equity in the home, most borrowers can cancel the mortgage insurance premium, thereby lowering their monthly payment. Canceling mortgage insurance has become much easier than in the past. Under federal law, PMI on most loans originated on or after July 29, 1999, may terminate automatically once the mortgage has amortized to 78-percent of the original purchase price, provided that the borrower is current on all mortgage payments. The lender must tell the borrower at closing when the mortgage will hit the 78-percent mark.
This may help
The Federal Reserve Bank has published an informative brochure regarding the cancellation of private mortgage insurance.
PMI - Federal Reserve PDF
The process is slightly different for FHA loans made after January 1, 2001, where the MIP will automatically cancel once the unpaid principle balance, excluding the upfront MIP, reaches 78-percent of the initial sales price or the appraised value, whichever is lower. There are exceptions to these rules, so ask your lender at which point in the future you will be able to cancel your mortgage insurance.
Credit insurance: A word of warning
Credit insurance protects homebuyers under certain circumstances if they default on the loan. It is up to the consumer to decide whether they wish to buy such a policy.
However, paying for the whole policy up-front as a part of closing has drawbacks. Basically, you are buying a 30-year non-refundable insurance policy, and paying the insurance company all 30 years of payments in advance by borrowing the money as part of their mortgage (which you will pay interest on). If your lender tells you that credit insurance will be required, ask to have this requirement in writing and please feel free to contact us for clarification of your rights.
When a lender quotes you an interest rate, the quote may be the rate that is in effect today, but may not be the rate available to you on the day of closing. Since a higher interest rate may reduce the size of the mortgage for which you qualify, it's important for you to know whether a lender will agree to hold the quoted rate for you until closing. This is called a rate "lock-in." A rate lock-in may save you thousands of dollars in interest over the life of the loan.
As interest rates change daily, you should be very clear about how the lock-in works. Some of the questions you should ask are these:
- If the lender will lock-in a rate, when will it do so, at the time of application or only on approval?
- Will the lender lock-in both the interest rate and points? Can you get a written lock-in agreement?
- How long does the lock-in remain in effect?
- Is there a charge for locking in a rate?
- If the rate drops before closing, can you lock-in at a lower rate?
Some lenders charge borrowers pre-payment penalties if they pay the loan off early. Unless you expect to own the home for the entire term of the loan (the majority of loans are repaid within seven years), and you don't think you will wish to refinance your mortgage loan should rates drop, you should look for a loan with no pre-payment penalty.
Normally borrowers make one payment a month, or 12 payments a year. With a bi-weekly payment plan, you make payments every other week, or 26 payments a year. If you get paid twice a month, rather than once a month, you may want to consider a payment schedule that matches your pay period. It will save you a surprising amount of interest over the life of the loan.
Adjustable-rate mortgage (ARM)
If you are shopping for an adjustable-rate mortgage, you will want an ARM that offers you the best protection in the event of skyrocketing interest rates. The most important thing to find out is the maximum amount that your payments might increase. Would you be able to make these payments? The following information will help you compare ARMs offered by various lenders.
Initial interest rate
Watch out for "introductory discount" or other teaser rates, in which a lender offers very low initial rates that may appear to be a bargain, but in which the low rates last only until the first adjustment. After that, you will be charged the "full rate," at which time your payments may become unmanageable. Some loans may cost more than a standard ARM in the long run.
You need to find out how often the interest rate will be adjusted. Annually? Every three years? Every five years? A loan with an adjustment period of one year is called a "one-year ARM," and the interest rate and monthly payment change once every year.
Financial index in margin
What financial index is used to determine the interest rate? Many ARMs are pegged to Treasury Notes, which are widely published in newspapers, making them easy to track. How much has this index changed in the past five years? Does your interest rate drop if the financial index falls? The margin is the rate added to the financial index to calculate your mortgage interest rate at each adjustment. What margin is the lender charging?
Keep in mind
If you agree to a mortgage with a payment cap, be sure you discuss the possible consequences with the lender.
If your mortgage limits the amount of negative amortization that can build up, you might eventually owe the lender more than the original amount you borrowed, despite having made all monthly payments.
Rate caps limit how much the interest rate on an ARM can increase or decrease. Periodic caps limit the increase or decrease per adjustment period, whereas a lifetime cap limits the amount that the rate can increase over the entire lifetime of the loan. For example, the lender may stipulate that the interest rate on an ARM can increase up to 2-percent a year, but not more than 5-percent over the life of the loan. A lifetime cap provides you with the most protection, but look for an ARM that offers both types of rate caps.
Don't confuse rate caps with payment caps. With a payment cap, there is a limit on how much your monthly principle and interest rates can increase, regardless of how high the interest rate rises. As a result, you may end up paying the lender less than the amount of interest you owe each month. The lender doesn't just forget about this. Instead, any unpaid interest is added to your loan balance. The result is that the amount you owe on your mortgage increases rather than decreases with each payment, a phenomenon called negative amortization.
Some ARMs include a provision allowing conversion to a fixed-rate mortgage at specified times, typically during the first five years of the loan. If the convertibility feature is an added expense (some lenders charge an extra point, for example), find out the exact terms of the conversion, and how much it would cost to convert your ARM to a fixed-rate loan. This will help you decide whether an ARM is a cost-effective option.