How Mortgage Loans Work
Excluding property taxes and insurance, a traditional mortgage payment consist of two parts: (1) interest on the loan and (2) payment towards the principal, or unpaid balance of the loan. Many people are surprised to learn, however, that the amount you pay towards interest and principal varies dramatically over time. This is because mortgage loans work in such a way that the early payments are primarily interest with little reduction in principle, and the later payments are primarily towards the principal. To help calculate monthly payments for loans based on different interest rates, lenders utilize what are known as "amortization tables." These tables make it fairly easy to calculate how much of each payment will be allocated to interest, and how much goes towards the principal balance.
A full mortgage payment often includes more than just principal and interest though. Most lenders these days collect property taxes and insurance as well. This total payment is referred to as P-I-T-I (Principal, Interest, Taxes, Insurance). You lender will collect these for you as part of each monthly mortgage payment and then submit them to your insurance provider and to Whatcom county. This is to protect their interest in your property - to make sure you aren't defaulting on property taxes or not paying for insurance on their collateral (the house!).
Are interest rates negotiable?
Some lenders are willing to negotiate on both the loan rate and the number of points (fees collected up front - 1 point = 1% of the purchase price) but this isn't typical. Nevertheless, it pays to shop around for loan rates and know the market before you go in to talk to a lender. You should always look at the combination of interest rate and points and get the best deal possible. Lenders are also required to give you a Good Faith Estimate (GFE) which spells out the costs of their loan and interest rate. It is a good way to compare apples to apples when looking at different lenders by getting a GFE from each lender.
Even though you pay a lot of interest up front, you're also slowly paying down the overall debt. This is one part of building equity. The other is appreciation. Equity is the difference between what you owe on the house and how much the house is worth if sold on the open market. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance. In order to build equity faster--as well as save money on interest payments--some homeowners choose loans with faster repayment schedules (such as a 15-year loan). In actuality, the common way that homeowners build their equity is through simply holding the property for a while. So the mere act of owning it over the years makes it more valuable. Another option is to remodel your home to create equity.
Understanding Different Types of Loans
Today's homebuyer has more financing options than have ever been available before. From traditional mortgages to adjustable-rate and hybrid loans, there are financing packages designed to meet the needs of virtually anyone. While the different choices may seem overwhelming at first, the overall goal is really quite simple: you want to find a loan that fits both your current financial situation and your future plans. Most loans fall into three major categories: fixed-rate, adjustable-rate, and hybrid loans that combine features of both. It is best to spend time talking with your lender or loan broker before deciding on the right loan for your situation. Don't worry about the loan decision…a good mortgage broker will be able to ask you a few questions and easily asses what type of loan is best for you and will educate about why.
As the name implies, a fixed-rate mortgage carries the same interest rate for the life of the loan. Traditionally, fixed-rate mortgages have been the most popular choice among homeowners, because the fixed monthly payment is easy to plan and budget for, and can help protect against inflation. Fixed-rate mortgages are most common in 30-year and 15-year terms, but recently more lenders have begun offering 20-year and 40-year loans. A shortened loan term can save you a significant amount of interest over the life of the loan. However, despite the interest savings of a 15 or 20-year loan, they're not for everyone. For one thing, the higher monthly payment might not allow some homeowners to qualify for a house they could otherwise afford with the lower payments of a 30-year mortgage. The lower monthly payment can also provide a greater sense of security in the event your future earning power might decrease. Furthermore, with a little bit of financial discipline, there are a variety of methods that can help you pay off a 30-year loan faster such as increased principal payments when you can afford it or bi-weekly payment programs.
Adjustable-Rate Mortgages (ARM)
Adjustable-rate mortgages differ from fixed-rate mortgages in that the interest rate and monthly payment can change over the life of the loan. This is because the interest rate for an ARM is tied to an index (such as US Treasury Bills) that may rise or fall over time. The margin (also known as the "spread") is a percentage added to the index to calculate your interest rate. The margin generally stays the same over the life of the loan (the changing index is what causes your monthly payments to change). For example, when you hear someone say a loan is "prime plus 2" they mean that the loan's interest rate is currently 2% above the Prime interest rate. In order to protect against dramatic increases in the rate, ARM loans usually have caps that limit the rate from rising above a certain amount between adjustments (e.g. no more than 2 percent a year), as well as a ceiling on how much the rate can go up during the life of the loan (e.g. no more than 6 percent). Another element of ARMs is the adjustment period, or how often your interest rate may change. Many ARMs have one-year adjustment periods, which means the interest rate and monthly payment is recalculated (based on the index) every year.
One tricky aspect of ARMs is when they have a payment cap. This differs from rate caps by placing a ceiling on how much your payment may rise during an adjustment period. While this may sound like a good thing, it can sometimes lead to real trouble. For example, if the interest rate rises during an adjustment period, the additional interest due on the loan payment may exceed the amount allowed by the payment cap--leading to negative amortization. This means the balance due on the loan is actually growing, even though the homeowner is still making the minimum monthly payment. Many lenders limit the amount of negative amortization that may occur before the loan must be restructured, but it's always wise to speak with your lender about payment caps and how negative amortization will be handled.
Due to some of the built-in protections of ARMs, ease of qualifying and low introductory rates, ARM loans have become the most widely accepted alternative to fixed-rate mortgages. However, ARMS are not for everyone. Before choosing an ARM consider how long you plan to own the property, how frequently your monthly payment will change, your comfort level with risk and your expected income in the future.
Hybrid loans combine features of both fixed-rate and adjustable-rate mortgages. Typically, a hybrid loan may start with a fixed-rate for a certain length of time, and then later convert to an adjustable-rate mortgage. However, be sure to check with your lender and find out how much the rate may increase after the conversion, as some hybrid loans do not have interest rate caps for the first adjustment period. Other hybrid loans may start with a fixed interest rate for several years, and then later change to another (usually higher) fixed interest rate for the remainder of the loan term. Lenders frequently charge a lower introductory interest rate for hybrid loans vs. a traditional fixed-rate mortgage, which makes hybrid loans attractive to homeowners who desire the stability of a fixed-rate, but only plan to stay in their properties for a short time.
Time as a factor in your loan choice
The length of time you plan to own a property may have a strong influence on the type of loan you choose. It is advised to discuss your circumstances and future plans with your lender so they may help you choose what's best for you. In general, ARMs have the lowest introductory interest rates, followed by hybrid loans, and then traditional fixed-rate mortgages.
FHA and VA loans
U.S. government loan programs such as those of the Federal Housing Authority (FHA) and Department of Veterans Affairs (VA) are designed to promote home ownership for people who might not otherwise be able to qualify for a conventional loan. Both FHA and VA loans have lower qualifying ratios than conventional loans, and often require smaller or no down payments. Bear in mind, however, that FHA and VA loans are not issued by the government; rather, the loans are made by private lenders but insured by the U.S. government in case the borrower defaults. Remember too, that while any U.S. citizen may apply for a FHA loan, VA loans are only available to veterans or their spouses and certain government employees. There are no set interest rates for FHA and VA loans. The FHA stopped regulating rates in 1983 and the VA followed suit soon after.
If you are obtaining a VA or FHA loan in order to finance your purchase, you must include that information in your offer. This is because government loans place additional financial and performance obligations on the seller. First, VA and FHA loans prohibit buyers from paying certain types of fees that are often charged by lenders, escrow companies, settlement agents, and title companies. They are called "non-allowable" fees. They still get charged anyway, but as the buyer, you are "not allowed" to pay them. The result is that the seller ends up paying them instead of you. Most of these "non-allowable" fees come from your lender. By the time you are making an offer you should have already been pre-qualified by a lender, so you or your real estate agent can ask how much the lender's non-allowable fees will be. Since these are fees the seller would not pay on an offer with conventional financing, this information must be included in your offer. You should also realize that since the seller will be paying these additional fees, they may be a little less negotiable on the price. Also, home appraisals on FHA and VA loans are a little more detailed than on conventional loans (and more expensive). The appraisers are required to perform certain minimum inspections as well as evaluate the market value of the property. Sometimes repairs are then required to get your loan processed.
A conventional loan is simply a loan offered by a traditional private lender. They may be fixed-rate, adjustable, hybrid or other types. While conventional loans may be harder to qualify for than government-backed loans, they often require less paperwork and typically do not have a maximum allowable amount.