Whether you’re an experienced property owner, or this is your first time buying or selling real estate, you probably have some questions about certain aspects of the process. The following is a guide to some frequently asked questions. Be sure to also check out the Resources page for some helpful guides and additional sources of information.
The information on this website is provided as a courtesy, and in no way implies any contractual or other liability of Gloria J. Graham or Long Realty, Inc. Specific questions and advice should be directed to a qualified, licensed Real Estate professional.
1. What is the next step after I find a house I like?
2. How much house can I afford?
3. Do the investment benefits of home ownership outweigh those as a renter?
4. How do mortgage loans work?
5. What are the differences between the various types of loans?
6. When should I pay points on a loan?
7. Can I deduct points on my income tax?
1. What’s the next step after I find a house I like?
Make an offer! It’s that simple. Your real estate professional can walk you through every step of the process, assisting you in determining an offer, submitting it to the seller, and acting as your representative in all aspects of the transaction, making it so easy you’ll wonder why you were so nervous! Contact Gloria Graham today, and she can assist you in making your dreams of home ownership a reality.
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2. How much house can I afford?
Understanding how much you can afford is one of the most important rules of home buying. Depending on your individual situation, your budget can affect everything from the neighborhoods where you look, to the size of the house, and even what type of financing you choose. Bear in mind, however, that lenders will look at more than just your income to determine the size of the loan. Likewise, you may find that there are some creative financing options that can help boost your purchasing power.
Loan Prequalification vs. Preapproval
One of the best ways to determine your budget is to have your real estate agent or lender prequalify you for a loan. Prequalification is different from preapproval, because it is only an estimate of what you’ll be able to afford. On the other hand, preapproval is a more formal process where a lender examines your finances and agrees in advance to loan you money up to a specified amount.
What factors are important to lenders? Banks and lending institutions will use several criteria to determine how much money they’ll agree to lend. These include:
• Your gross monthly income
• Your credit history
• The amount of your outstanding debts
• Your savings—or the amount of money you have available for a down payment and closing costs
• Your choice of mortgage (i.e. 30-year, FHA, etc.)
• Current interest rates
Two Important Ratios
Lenders also use your financial information to figure out two very important ratios: the debt-to-income ratio and the housing expense ratio.
Debt-to-Income Ratio Many lenders use a rule of thumb that the amount of debt you are paying on each month (car payment, student loan, credit card, etc,) shouldn’t exceed more than 36 percent of your gross monthly income. FHA loans are slightly more lenient.
Housing Expense Ratio It is generally difficult to obtain a loan if the mortgage payment will be more than 28 to 33 percent of your gross monthly income.
Down Payments Make a Difference
If you can make a large down payment, lenders may be more lenient with their qualifying ratios. For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.
Other Ways to Improve Your Purchasing Power
Gifts If you’re having trouble saving money, many lenders will allow you to use gift funds for the down payment and closing costs. However, most lenders require a “gift letter” stating the gift doesn’t have to be repaid, and will also require you to pay at least a portion of the down payment with your own cash.
Negotiating Closing Costs Through negotiation, some sellers may agree to pay all or most of your closing costs (for example, if you agree to meet their full asking price). If you choose to try this, make sure to ask your real estate agent for advice.
Loan Programs Many local governments have special loan programs designed to help first-time homebuyers. Loans may be available at reduced interest rates, or with little or no down payments. Check with your local housing authority for more information.
Loan Types Some homebuyers choose Adjustable Rate Mortgages (ARMs) because of low initial interest rates. Others opt for 30-year loans because they have lower monthly payments than 15-year loans. There are significant differences between different loans, so make sure to discuss the pros and cons of different loans with your agent or lender before making a decision.
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3. Do the investment benefits of home ownership outweigh those as a renter?
Home ownership is a big responsibility, and is not ideal for everyone’s circumstances. But how do you determine what would work best for you? Use the calculator, “Am I better off renting?”, to experiment with different scenarios, taking into account variables like your down payment and desired monthly outlay, as well as inflation and long-term tax rates.
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4. How do mortgage loans work?
Excluding property taxes and insurance, a traditional fixed-rate mortgage payment consists of two parts: interest on the loan, and 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 mainly applied towards the interest, and the later payments are primarily applied towards the principal.
To help calculate monthly payments for loans based on different interest rates, lenders long ago developed what are known as “amortization tables.” These tables also make it fairly easy to calculate how much money of each payment is interest, and how much goes towards the principal balance. For example, let’s calculate the principle and interest for the very first monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent interest:
According to the amortization tables, the monthly payment on this loan is fixed at $699.21.
The first step is to calculate the annual interest by multiplying $100,000 × .075 (7.5%). This equals $7,500, which we then divide by 12 (for the number of months in a year), which equals $625. If you subtract $625 from the monthly payment of $699.21, we see that:
$625 of the first payment is interest
$74.21 of the first payment goes towards the principal
Next, if we subtract $74.21 (the first principal payment) from the $100,000 of the loan, we come up with a new unpaid principal balance of $99,925.79. To determine the next month’s principal and interest payments, we just repeat the steps already described.
Thus, we now multiply the new principal balance (99,925.79) × the interest rate (7.5%) to get an annual interest payment of $7,494.43. Divided by 12, this equals $624.54. So during the second month’s payment:
$624.54 is interest
$74.67 goes towards the principal
(Note: In Canada, payments are compounded semi-annually instead of monthly.)
Equity
As you can see from the above example, even though you pay a lot of interest up front, you’re also slowly paying down the overall debt. This is known as building equity. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance—the difference between the sales price and the unpaid principle is your equity.
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).
Time versus Savings
To help illustrate how this works, consider our previous example of a $100,000 loan at 7.5 percent interest. The monthly payment is around $700, which over 30 years adds up to $252,000. In other words, over the life of the loan you would pay $152,000 just in interest.
With the aggressive repayment schedule of a 15-year loan, however, the monthly payment jumps to $927-for a total of $166,860 over the life of the loan. Obviously, the monthly payments are more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $85,000 in interest.
Bear in mind that shorter term loans are not the right answer for everyone, so make sure to ask your lender or real estate agent about what loan makes the best sense for your individual situation.
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5. What are the differences between the various types of loans?
Today’s homebuyer has more financing options than have ever been available before. 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.
Be sure to spend some time talking with different lenders before deciding on the right loan for your situation. You can also use the calculator, “Which is better, fixed or adjustable?”, to compare the differences over time between these two types of mortgage loans. In addition to more traditional fixed-rate and adjustable-rate mortgages, there are hybrid loans that combine features of both.
Fixed-Rate Mortgages
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.
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 Treasury Securities) that may rise or fall over time. 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 (i.e. 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 (i.e. no more than 6 percent). With these protections and low introductory rates, ARM loans have become the most widely accepted alternative to fixed-rate mortgages.
Hybrid Loans
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 adjustablerate 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.
Balloon Payments
A balloon payment refers to a loan that has a large, final payment due at the end of the loan. For example, there are currently fixed-rate loans which allow homeowners to make payments based on a 30- year loan, even though the entire balance of the loan may be due (the balloon payment) after 7 years. As with some hybrid loans, balloon loans may be attractive to homeowners who do not plan to stay in their house more than a short period of time.
Time as a Factor in Your Loan Choice
As has been discussed, the length of time you plan to own a property may have a strong influence on the type of loan you choose. For example, if you plan to stay in a home for 10 years or longer, a traditional fixed-rate mortgage may be your best bet. But if you plan on owning a home for a very short period (5 years or less), then the low introductory rate of an adjustable-rate mortgage may make the most financial sense. 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. FHA loans are insured to the actual lender and VA loans are guaranteed 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.
Conventional Loans
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.
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6. When should I pay points on a loan?
When it comes to comparing interest rates for a mortgage loan, homebuyers often have the option of choosing a loan with a lower interest rate by paying points. Simply put, a point is equal to 1 percent of the loan amount. For example, with a $100,000 loan, one point equals $1,000. Points are usually paid outof- pocket by the buyer at closing.
Paying points may seem attractive, because a lower interest rate means smaller monthly payments. But is paying points always a good idea? The answer generally depends on how long you plan to stay in the house. Let’s look at an example:
Bob and Betty Smith are shopping for loan rates on a $150,000 home. Their bank has offered them a 30-year loan at 7.5 percent with no points. This works out to a monthly payment of $1,049. However, their bank has also offered them a loan at 7 percent if they agree to pay 2 points (or $3,000). At this lower rate, their monthly payment drops to $998, or a savings of $51 per month.
By dividing the amount they paid for the points ($3,000) by the monthly savings ($51), we see that they will have to own the house for 59 months (or just under 5 years) before they will start to see savings as a result of paying points.
If Bob and Betty plan to stay in the house for many years, then paying points could make good sense. But if they see themselves moving to another house in the near future, they’d be better off paying the higher interest and no points. (Note: For simplicity, the above example does not take into account the time value of money, which would slightly lengthen the break-even time.)
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7. Can I deduct points on my income tax?
In the United States, one side benefit of paying points on a mortgage loan is that they are fully tax deductible for the same tax year as your closing. However, this does not apply to points paid for a refinance loan. For refinances, the IRS requires you to spread out the deduction over the life of the loan.
For example, if you paid $5,000 in points for a 30-year refinance loan, you can only deduct 1/30 of the $5,000 each year for 30 years. If you pay off the loan early, though, you can deduct the remaining amount that tax year. As with any information regarding tax situations, please check with your tax professional.
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