Before I discuss purchasing a home, I would like to give you an idea of my background with this topic.
Over the years, I’ve personally purchased four homes in three different states and have worked in the finance and mortgage industry as a processor and underwriter for four years, both in “A” paper (people with good credit) and those sub-prime loans (those with not-so-great credit). I graduated from Georgia State University in 2000 with a Masters in Business Administration (MBA) with a real estate major. This is not real estate agent information, but more financial numbers, calculations, and overall understanding of the business.
Purchasing a home is probably the single most important and largest purchase that you will ever make in your life. Because of this fact, it can be very scary and overwhelming. The decision to purchase a home cannot be taken lightly and you need to plan, plan, and then plan some more for it. The planning could take many years when you’re factoring in a down payment and fixing any credit issues.
Let’s start by looking at some terminology related to loans.
· Secured vs Unsecured Loans
· Revolving vs Installment Debt
· Front End and Back End DTI (Debt to Income Ratio)
· Prime vs Subprime Loans
· Adjustable Rate Mortgages (ARM) vs Fixed Interest Mortgages
· Federal Housing Administration (FHA) loans, Veterans Administration (VA) loans, and Conventional loans
· Mortgage Insurance Premium (MIP), Premium Mortgage Insurance (PMI)
Secured vs Unsecured Loans
Secured loans use physical items as collateral. Some examples include a home mortgage, life insurance, a car loan, and furniture loan. Unsecured loans are not tied to any specific item. Examples include credit cards and student loans (they don’t repossess your degree).
Revolving vs Installment Debt
Revolving debt has no end date. A home equity line of credit (HELOC) and credit cards are perfect examples of this. Differing from revolving is installment debt where the loan is for a specific time for the loan. Examples include home mortgage, car loan, and student loans.
Front End and Back End DTI (Debt to Income Ratio)
Debt to Income Ratio is exactly what it sounds like. You take your monthly debts and divide it by your gross monthly income. What is the difference between the front end and back end? The front end includes housing only and the back end includes all debt. All loans carry a maximum percentage for each of these. This is a general guide and is not meant to be set in stone. Conventional loan rates are 38/45, FHA loans are 37/50 and VA loans are 29/41. See below for explanations of these types of loans. These amounts can vary per lender and situation, credit, down payment, etc. *Check with your local lender for your specific calculations and restrictions.
Let’s look at a simple example of a Conventional Loan for better understanding, (38/45). The borrower has a gross monthly income of $7,083 ($85,000 annually). That means that your housing payment (PITI-principal, interest, taxes, and insurance) shouldn’t be more than $2,691 (38% of $7,083) at MAXIMUM and this is the front-end calculation. The total amount of debt that you can have, including housing and all other debts is $3,187 (45% of $7,083). So that means if you’re fully extended on the front end, you can only carry $496 for all other debts. Comparatively, that’s not very much.
What happens if you have more debt? You either have to pay down debt to get to that monthly amount or you have to reduce your front-end DTI (the easier and smarter choice). Be aware that I would not recommend borrowing that much on the front end and instead try to stay more toward 25%, or $1,770 in this example, which would leave you $1,417 for credit cards, car payments, and any other items. That being said, I don’t think you should go that high on the back end either. I’d recommend staying closer to 25/36. Ideally, you should purchase much lower than you’re able to. I always tell my kids, just because you CAN buy something, doesn’t mean that you SHOULD.
Prime vs Subprime Loans
Prime loans are for those borrowers who have good credit scores and very little adverse financial history. Subprime Loans are for borrowers who have had such issues as bankruptcy, previous foreclosure, and late payments. With higher risk of default, the lender will charge a higher interest rate to make up for this risk.
Adjustable Rate Mortgages (ARM) vs Fixed Interest Mortgages
No matter if you are dealing with Subprime or Prime Lending, you have a choice of a mortgage with an ARM or Fixed rate. With fixed rates, the Annual Percentage Rate (APR) will not change for the entire term loan. For example, A 30-year mortgage loan at an interest rate of 4%, where the interest rate stays the same for the entire 30 years. Typical fixed rate loans are 10, 15, 20, and 30 years. Differing, you have an ARM where you have a variable interest rate that rises and falls with the market. Due to the volatility, they typically start at a lower APR than fixed rates to attract more borrowers.
ARMs are fixed for a period of time where you get the offered rate and then are variable another period in which it can adjust upward or downward depending on the market. The LIBOR (London Interbank Offered Rate) is a popular benchmark that is used for this purpose. Common examples of ARM loans are 5/6, 7/6, or 10/6. The first number indicates the fixed portion (in years) at the stated rate. The second number indicates how often it is reevaluated, in months. A 5/6 would have a fixed rate for 5 years and then adjust (per the market) every 6 months. Making it more palatable,
ARM loans do have caps. And that means how much the interest rate can change over the term of the loan or per adjustment period. So, an ARM with caps of 5/2/5 means that after the initial fixed period, the maximum that the interest rate can adjust is 5% up or down—that’s a heckuva jump, isn’t it? The 2% is for other adjustment periods throughout the loan and the 5% means the lifetime cap of 5% increase/decrease. If you have an 5/6 ARM with caps of 5/2/5… that means that you have a fixed rate for 5 years (the 5 of 5/6) and your rate will adjust every 6 months after that (6 of the 5/6). After 5 years, your rate will not adjust more than 5% up or down (5 of 5/2/5 cap). Every 6 months after, your rate is capped at a 2% (2 in 5/2/5) increase or decrease from the previous adjustment period. If inflation is increasing tremendously, you have a lifetime cap of 5% (last 5 in 5/2/5).
At the end of the fixed rate time period, you generally are allowed to refinance and change to a fixed rate at that point. However, there are no guarantees that you will be able to qualify with the current mortgage rules and programs. A lot can change in five years. Many people who own investment property for flipping or short-term ownership, choose ARMs since they will be selling or refinancing within the initial low-rate period.
With the downturn in the market in 08 and 09, most of the loans that defaulted were ARMs. What happened was that many borrowers qualified at the lower ARM interest rate hoping to get raises over the years and have the value of the home increase. Unfortunately, the market hit a bubble so home values plummeted dramatically. In addition to that and the rise in inflation and unemployment, many did not have the extra money to be able to pay for the increases in their mortgage payment (due to ARM adjustments) which caused an epidemic of foreclosures with job losses all throughout the housing industry. Fixed interest rate holders were sitting in a better position as it was not tied to the plummeting market. Only those that decided to sell during that time period felt the hit.
Federal Housing Administration (FHA) loans, Veterans Administration (VA) loans, vs Conventional loans
Even though there are countless different types and variations of loans that borrowers can procure within each category, let’s address the generic headings.
FHA
Down payment required……….3.5% of home value
Minimum credit score……….580 (or 500 with 10% down)
Maximum Debt to Income Ratio……….37/50% (Total Debt/Total Gross Income)
Maximum Loan Amount……….$356,362
VA
Down payment required……….0% of home value (depending on loan amount)
Minimum credit score……….640
Maximum Debt to Income Ratio……….29/41% (Total Debt/Total Gross Income)
Maximum Loan Amount ……….$356,362
Conventional
Down payment required……….3% of home value
Minimum credit score……….620
Maximum Debt to Income Ratio……….38/45% (Total Debt/Total Gross Income)
Maximum Loan Amount……….varies by area and entitlement
Upfront funding fee……….varies depending on down payment and whether you’ve used the VA before
***There are many variations in these numbers and should not be used in actual calculations to qualify.
Mortgage Insurance
A borrower who chooses a conventional loan and has less than 20% down payment is required to procure PMI (Private Mortgage Insurance). Because the lender is extending credit beyond the normal 80% (where they feel in good position), they need insurance (paid by you, of course) just in case of a default. There is a fee of 2.25% of the loan amount and it continues until the equity in the home gets to 20%. It is not uncommon for borrowers to choose to do an 80/10/10 to avoid PMI and the fee associated with it. An 80/10/10 is an 80% first mortgage, 10% second mortgage or HELOC, with a 10% down payment. It allows the borrower to avoid paying PMI and have less than 20% down. For FHA loans, they have a similar insurance, but through the government. It’s called MIP (Mortgage Insurance Premium) and carries an up-front cost of 1.75% of the loan amount and an annual rate of .85% of the loan amount—usually added into the monthly payment. The extreme downside of MIP is that it lasts for the duration of the loan or 11 years if you put 10% down.
Buying a home can be incredibly overwhelming since it’s like you’re speaking another language with all of the acronyms, calculations, and general lack of understanding of the process. I’m hoping that this little tutorial helped to clear the clouds. At least a little.
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