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What is a
common mistake made when buying a home?
If you're like most people, purchasing a home is the biggest investment
you'll ever make. If you're considering buying a home, you're likely
aware of the complexity of the endeavor. Because of the numerous factors
to consider when purchasing a home, it's important to prepare as best
you can. Some common home-buying principles and caveats are presented
here for your consideration. By keeping them in mind, you'll help create
a successful and more enjoyable experience. The information contained
herein is presented as a primer. Since your home could cost you 25 to 40
percent of your gross income, it's important to conduct research, ask
questions and study the process carefully.
Buying a home
Looking for a home before being pre-approved. As a potential buyer
competing for a home, you'll have a better chance of getting your offer
accepted by being as prepared as possible. Consider this hierarchy of
buyer preparedness below. Offers are submitted and the buyer meets one
of the following criteria:
The buyer is not pre-qualified or pre-approved
Buyer is Pre-qualified
Buyer is Pre-approved
The benefits available at each level can be easily understood when
viewed from the seller's perspective. Imagine you're a seller in receipt
of multiple purchase offers. A complete stranger (buyer) is asking you
to take your property off the market for at least the next two to three
weeks while they apply for a loan. As the seller, lets consider the type
of buyer you'd prefer to deal with.
Neither pre-qualified nor pre-approved
This buyer provides no evidence that they can afford to purchase your
property. You may wonder how serious they are since they're not at least
pre-qualified.
Pre-qualified
This buyer has met with a mortgage broker (or lender) and discussed
their situation. The buyer has informed the broker regarding their
income, expenses, assets and liabilities. The broker may also have seen
their credit report. The buyer provided you with a letter from the
broker stating an opinion of what the buyer can afford.
Pre-approved
This buyer has completed a loan application, provided a broker or lender
with written evidence of income, expenses, assets, liabilities and
credit. All information has been verified by a lender. As a result, much
of the paperwork for this buyer's loan has been completed. This buyer
will probably be able to close quickly. They provide you with a letter
(pre-approval certificate) from the lender. You're as certain as
possible that this buyer can close.
As a potential buyer, you can see that being pre-approved will give you
the best chance of getting your offer accepted. This is critical in a
competitive situation.
Should I pay points? Does a zero point loan with no fees really exist?
The best way to decide whether you should pay points or not is to
perform a break-even analysis. This is done as follows:
- Calculate the cost of the points. Example: 2 points on a $100,000
loan is $2,000.
- Calculate the monthly savings on the loan as a result of obtaining a
lower interest rate. Example: $50 per month
- Divide the cost of the points by the monthly savings to come up with
the number of months to break even. In the above example, this number is
40 months. If you plan to keep the home for longer than the break-even
number of months, then it makes sense to pay points, otherwise it does
not.
- The above calculation does not take into account the tax advantages
of points. When you are buying a home the points you pay are
tax-deductible, so you realize some savings immediately. On the other
hand, when you get a lower payment, your tax deduction reduces! This
makes it a little difficult to calculate the break-even time taking
taxes into account. In the case of a purchase, taxes definitely reduce
the break-even time. However, in the case of a refinance, the points are
NOT tax-deductible, but have to be amortized over the life of the loan.
This results in few tax benefits or none at all, so there is little or
no effect on the time to break even.
If none of the above makes sense, consider this simple rule of thumb: If
you plan to stay in the home for less than 3 years, do not pay points.
If you plan to stay in the home for more than 5 years, pay 1 to 2
points. If you plan to stay in the home for between 3 and 5 years, it
does not make a significant difference whether you pay points or not!
What is a rate lock?
You cannot close a mortgage loan without locking in an interest rate.
There are four components to a rate lock:
Loan program
Interest rate
Points
Length of the lock
The longer the length of the lock, the higher the points or the interest
rate. This is because the longer the lock, the greater the risk for the
lender offering that lock.
Suppose on March 2 you obtain a 15-day lock for a 30-year fixed loan at
8 percent, 2 points. The lock will expire on March 17 (if March 17 is a
holiday then the lock is typically extended to the first working day
after the 17th). The lender must disburse funds by March 17th, otherwise
your rate lock expires, and your original rate-lock commitment is
invalid.
The same lock might cost 2.25 points for a 30-day lock or 2.5 points for
a 60-day lock. If you need a longer lock and do not want to pay the
higher points, you may instead pay a higher rate.
After a lock expires, most lenders will let you re-lock at the higher of
the original rate/points or current rate/points. In most cases you will
not get a lower rate if rates drop.
Lenders can lose money if your lock expires. This is because they are
taking a risk by letting you lock in advance. If rates move higher, they
are forced to give you the original rate at which you locked. Lenders
often protect themselves against rate fluctuations by hedging.
Why do interest rates change?
To understand why mortgage rates change we must first ask the more
general question, "Why do interest rates change?" It is important to
realize that there is not one interest rate, but many interest rates.
- Prime rate: The rate offered to a bank's best customers.
- Treasury bill rates: Treasury bills are short-term debt instruments used
by the U.S. Government to finance their debt. Commonly called T-bills
they come in denominations of 3 months, 6 months and 1 year. Each
treasury bill has a corresponding interest rate (i.e. 3-month T-bill
rate, 1-year T-bill rate).
- Treasury Notes: Intermediate-term debt instruments used by the U.S.
Government to finance their debt. They come in denominations of 2 years,
5 years and 10 years.
- Treasury Bonds: Long-debt instruments used by the U.S. Government to
finance its debt. Treasury bonds come in 30-year denominations.
- Federal Funds Rate: Rates banks charge each other for overnight loans.
- Federal Discount Rate: Rate New York Fed charges to member banks.
- Libor: : London Interbank Offered Rates. Average London Eurodollar
rates.
- 6 month CD rate: The average rate that you get when you invest in a
6-month CD.
- 11th District Cost of Funds: Rate determined by averaging a composite of
other rates.
- Fannie Mae-Backed Security rates: Fannie Mae pools large quantities of
mortgages, creates securities with them, and sells them as Fannie
Mae-backed securities. The rates on these securities influence mortgage
rates very strongly.
- Ginnie Mae-Backed Security rates: Ginnie Mae pools large quantities of
mortgages, secures them and sells them as Ginnie Mae-backed securities.
The rates on these securities influence mortgage rates on FHA and VA
loans.
Interest rate movements are based on the simple concept of supply and
demand. If the demand for credit (loans) increases, so do interest
rates. This is because there are more buyers, so sellers can command a
better price, i.e. higher rates. If the demand for credit reduces, then
so do interest rates. This is because there are more sellers than
buyers, so buyers can command a lower better price, i.e. lower rates.
When the economy is expanding there is a higher demand for credit, so
rates move higher, whereas when the economy is slowing the demand for
credit decreases and so do interest rates.
This leads to a fundamental concept:
Bad news (i.e. a slowing economy) is good news for interest rates (i.e.
lower rates).
Good news (i.e. a growing economy) is bad news for interest rates (i.e.
higher rates).
A major factor driving interest rates is inflation. Higher inflation is
associated with a growing economy. When the economy grows too strongly,
the Federal Reserve increases interest rates to slow the economy down
and reduce inflation. Inflation results from prices of goods and
services increasing. When the economy is strong, there is more demand
for goods and services, so the producers of those goods and services can
increase prices. A strong economy therefore results in higher
real-estate prices, higher rents on apartments and higher mortgage
rates.
Mortgage rates tend to move in the same direction as interest rates.
However, actual mortgage rates are also based on supply and demand for
mortgages. The supply/demand equation for mortgage rates may be
different from the supply/demand equation for interest rates. This might
sometimes result in mortgage rates moving differently from other rates.
For example, one lender may be forced to close additional mortgages to
meet a commitment they have made. This results in them offering lower
rates even though interest rates may have moved up!
There is an inverse relationship between bond prices and bond rates.
This can be confusing. When bond prices move up, interest rates move
down and vice versa. This is because bonds tend to have a fixed price at
maturity--typically $1000. If the price of the bond is currently at $900
and there are 10 years left on the bond and if interest rates start
moving higher, the price of the bond starts dropping. The higher
interest rates will cause increased accumulation of interest over the
next 5 years, such that a lower price (e.g. $880) will result in the
same maturity price, i.e. $1000.
What is an Annual Percentage Rate (APR)?
The annual percentage rate (APR) is an interest rate that is different
from the note rate. It is commonly used to compare loan programs from
different lenders. The Federal Truth in Lending law requires mortgage
companies to disclose the APR when they advertise a rate. Typically the
APR is found next to the rate.
Example:
30-year fixed 8 percent 1 point 8.107% APR
The APR does NOT affect your monthly payments. Your monthly payments are
a function of the interest rate and the length of the loan.
The APR is a very confusing number! Even mortgage bankers and brokers
admit it is confusing. The APR is designed to measure the "true cost of
a loan." It creates a level playing field for lenders. It prevents
lenders from advertising a low rate and hiding fees.
Ideally, one should be able to compare APRs from various lenders, then
select the loan with the lowest APR.
Unfortunately it's not that simple. Various lenders calculate APRs
differently! A loan with a lower APR may not be the best choice. A good
way to compare different lenders is to ask them to provide a Good Faith
Estimate of closing costs. Be sure you compare the same loan program
(e.g., 30-year fixed), interest rate and rate lock period. You may
ignore fees that are independent of the loan, such as homeowners
insurance, title fees, escrow fees, attorney fees, etc. Pay particular
attention to loan fees. The lender with the lowest loan fees will likely
have the best deal.
What fees are included in the APR?
The following fees ARE generally included in the APR:
Points - both discount points and origination points
Pre-paid interest. The interest paid from the date the loan closes to
the end of the month. Most mortgage companies assume 15 days of interest
in their calculations. However, companies may use any number between 1
and 30!
- Loan-processing fee
- Underwriting fee
- Document-preparation fee
- Private mortgage-insurance
The following fees are SOMETIMES included in the APR:
- Loan-application fee
- Credit life insurance (insurance that pays off the mortgage in the event
of a borrowers death)
The following fees are normally NOT included in the APR:
- Title or abstract fee
- Escrow fee
- Attorney fee
- Notary fee
- Document preparation (charged by the closing agent)
- Home-inspection fees
- Recording fee
- Transfer taxes
- Credit report
- Appraisal fee
Calculating APRs on adjustable and balloon loans is even more complex
because future rates are unknown. The result is even more confusion
about how lenders calculate APRs.
Do not attempt to compare a 30-year loan with a 15-year loan using their
respective APRs. A 15-year loan may have a lower interest rate, but
could have a higher APR, since the loan fees are amortized over a
shorter period of time.
Finally, many lenders do not even know what they include in their APR
because they use software programs to compute their APRs. It is quite
possible that the same lender with the same fees using two different
software programs may arrive at two different APRs!
Conclusion:
Use the APR as a starting point to compare loans. The APR is a result of
a complex calculation and not clearly defined. There is no substitute to
getting a good-faith estimate from each lender to compare costs.
Remember to exclude those costs that are independent of the loan.
What is Private Mortgage Insurance (PMI)?
PMI is normally required when you buy a home with less than 20 percent
down. Mortgage insurance is a type of guarantee that helps protect
lenders against the costs of foreclosure. This insurance protection is
provided by private mortgage insurance companies to protect the lender.
It enables lenders to offer loans with lower down payments. In effect,
mortgage insurance pays the lender a certain percentage of your original
purchase price to cover a lender's losses in the unfortunate event of
foreclosure. Therefore, without mortgage insurance, you would need to
make a 20 percent down payment in order to buy a home.
The cost of PMI increases as your down payment decreases. Example: The
cost of PMI on a 10 percent down payment is less than the cost of PMI on
a 5 percent down payment. Your PMI premium is normally added to your
monthly mortgage payment.
Cancelling your PMI:
Federal law requires PMI to be cancelled under certain circumstances,
and Fannie Mae guidelines provide for cancellation of PMI in additional
situations if the loan is owned by Fannie Mae. In general, PMI for a
loan originated on or after July 29, 1999, which is secured by the
borrower's one-family principal residence or second home will be
cancelled at the borrower's request when the loan-to-value ratio (LTV)
reaches 80 percent based on the value of the home at loan origination.
In order to cancel PMI under the rules of July 29, 1999, the borrower
must have a good payment history and the property value must not have
declined.
PMI on mortgages owned by Fannie Mae can also be cancelled at the
borrower's request when the LTV reaches 75 percent based on the current
value of the home as established by a new appraisal, provided that the
borrower has a good payment history and that the loan is at least two
years old.
If the borrower does not request PMI cancellation, the PMI servicer must
automatically cancel PMI on these loans when the LTV is scheduled to
reach 78 percent, based on the value of the home at loan origination,
provided that the loan is current at that time. For loans originated
before July 29, 1999, which are secured by the borrower's principal
residence or second home and that are owned by Fannie Mae, PMI will
generally be cancelled at the midpoint of the loan term, provided that
payments at that time are current.
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