Home Mortgage Loan

A mortgage is a loan secured by real property such as a home or land. In the home mortgage market, the subject of this section, the borrower approaches a mortgage lender for a loan. If approved, the home mortgage lender provides sufficient funds for the purposes of the borrower (usually funds to purchase the property or home) and the borrower signs a document agreeing to repay the loan, together with interest, according to some payment schedule. Since most home mortgage lending involves amortization of the loan principal, the payment schedule is sometimes called an amortization schedule. The document constitutes the mortgage. The borrower is called the mortgagor and the lender is called the mortgagee. The home mortgage must be serviced; that is, mortgage payments must be collected and recorded, real estate taxes must be collected and passed along to the appropriate taxing jurisdictions, and foreclosure proceeding.

In a conventional mortgage, which is becoming increasingly rare, mortgage rate is fixed for the life of the mortgage and the age payments are all of equal size. For the latter reason, these ages are often called level-payment mortgages. Payments on residential mortgages are usually made monthly, but other payment frequencies are possible. Mortgages amortize over their lives so ach payment includes both interest and principal. Since each payment includes some repayment of principal, the mortgage balance (the remaining principal) gets progressively smaller with each payment. This makes conventional mortgages self-amortizing forms of debt. Conventional mortgages typically have a term of 30 years, but shorter terms are not uncommon. Since each payment includes principal, each subsequent payment must include less interest the mortgage balance declines with each payment. If each payment is the same size but the interest component is declining, -principal component must get larger with each payment.

Mortgagors are usually permitted to make payments on their mortgages in excess of that which is required. Such excess payments are called prepayments and are credited directly against the mortgage balance.

Getting a Home Mortgage Loan

Borrowers often begin their home search with only the foggiest idea about how much they can afford to pay, which can result in wasted time and frustration. They should know approximately how much they can afford before they start to shop.

The amount you can spend on a house depends on your income, the amount of cash you can allocate to the transaction, and the mortgage terms available in the market at the time you are shopping. These include interest rates, points, term, down payment requirements, and the maximum allowable ratio of housing expense to income. In addition, affordability may be affected by your existing indebtedness, if this is higher than the indebtedness that lenders are willing to accept, and by closing costs, which vary from one part of the country to another.

From a home mortgage lender’s point of view, a “good loan” is one to a borrower who can demonstrate both the ability and the willingness to repay it. Qualification has to do with determining the borrower’s ability to repay only. The borrower’s willingness to repay is assessed largely by the applicant’s past credit history. For a home mortgage loan to be approved, the lender must be satisfied on both scores. This is the difference between “qualification” and “approval.”

Home mortgage lenders ask two basic questions about the borrower’s ability to pay. First, is the borrower’s income large enough to service the new expenses associated with the loan, plus any existing debt obligations that will continue in the future? Second, does the borrower have enough cash to meet the up-front cash requirements of the transaction? The home mortgage lender must be satisfied on both counts.

In general, the home mortgage lender assesses the adequacy of the borrower’s income in terms of two ratios that have become standard in the trade. The first is called the housing expense ratio. It is the sum of the monthly home mortgage payment including mortgage insurance, property taxes, and hazard insurance, divided by the borrower’s monthly income. The second is called the total expense ratio. It is the same, except that the numerator includes the borrower’s existing debt service obligations. For each of their loan programs, lenders set maximums for these ratios, such as 28% and 36%, which the actual ratios must not exceed. Maximum expense ratios actually vary somewhat from one loan program to another. Hence, if you are only marginally over the limit, nothing more may be required than to find another program with higher maximum ratios. This is a situation where it is handy to be dealing with a home mortgage broker who has access to loan programs of many home mortgage lenders.

The maximum ratios are not carved in stone if the borrower can make a persuasive case for raising them. The following are illustrative of circumstances where the limits may be waived.

• The borrower is just marginally over the housing expense ratio but well below the total expense ratio— 29% and 30%, for example, when the maximums are 28% and 36%.

• The borrower has an impeccable credit record.

• The borrower is a first-time homebuyer who has been paying rent equal to 40% of income for three years and has an unblemished payment record.

• The borrower is making a large down payment. If expense ratios exceed the maximums, one possible option is to reduce the mortgage payment by extending the term. If the term is already 30 years, however, there is very little that can be done. Few lenders offer 40 year home mortgage loans and, anyway, extending the loan to 40 years doesn’t reduce the mortgage payment much.

If you have planned to make a down payment larger than the absolute minimum, you can use the cash that would otherwise have gone to the down payment to reduce your expense ratios by paying off debt, paying points (points are fees the borrower pays the lender at the time the loan is closed) to reduce the interest rate, or funding a temporary buy-down. The last is the most effective. With a temporary buy-down, which some lenders allow on some programs, cash is placed in an escrow account. An escrow account is a deposit account maintained by the lender and funded by the borrower, from which the lender makes tax and insurance payments for the borrower as they come due. But in this scenario, cash is also used to supplement a borrower’s mortgage payments in the early years of the loan.

Recent years have seen the emergence of zero-down or 100% loans, as well as 107% and 125% home mortgage loans. These loans carry higher interest rates rather than mortgage insurance premiums and they generally require that the borrower have excellent credit.

The most important of the documentation requirements are as follows.

Full documentation: Both income and assets are disclosed and verified, and income is used in determining the applicant’s ability to repay the mortgage. Formal verification requires the borrower’s employer to verify employment and the borrower’s bank to verify deposits. Alternative documentation, designed to save time, accepts copies of the borrower’s original bank statements, W-2s, and paycheck stubs.

At one time, full documentation was the rule and it remains the standard. In recent years, however, other documentation programs have grown in importance. Stated income, verified assets: Income is disclosed and the source of the income is verified, but the amount is not verified. Assets are verified and must meet an adequacy standard, such as, for example, six months of stated income and two months of expected monthly housing expense.

Some loan providers prefer not to deal with self-employed borrowers, because getting them qualified and approved is more complicated and onerous than with borrowers who work for a salary. But there are plenty of others that welcome business from the self-employed. A major problem with lending to the self-employed is documenting an applicant’s income to the lender’s satisfaction. Applicants with jobs can provide lenders with pay stubs and lenders can verify the information by contacting the employer. With self-employed applicants, there are no third parties to verify such information.

Consequently, lenders fall back on income tax returns, which they typically require for two years. They feel safe in relying on income tax data, because any errors will be in the direction of understating rather than overstating income.

The two government-sponsored enterprises that purchase enormous numbers of home loans in the secondary market, Federal National Mortgage Association and Federal Home Loan Mortgage Corporation, have developed detailed guidelines for qualifying self-employed borrowers.

An interest rate is the price of money, and a mortgage interest rate is the price of money loaned against the security of a specific property. The interest rate is used to calculate the interest payment the borrower owes the lender.

The rates you see quoted are annual rates. On most home mortgages, the interest payment is calculated monthly. Hence, the rate is divided by 12 before calculating the payment.

Take a 6% rate, for example, and assume a $100,000 loan. In decimals, 6% is .06, and when divided by 12 it is .005. Multiple .005 times $100,000 and you get $500 as the monthly interest payment. Suppose the borrower pays $600 this month. Then $500 of it covers the interest and $100 is used to reduce the balance. One month later, when another payment is due, the balance is $99,900, and the interest is $499.50. The interest rate stays the same, but the interest payment is lower because the balance is lower.

In dollars, the down payment is the difference between property value and loan amount. If value is $240,000 and the loan is $198,000, the down payment is $42,000. In percent, the down payment is 1 minus the LTV— the ratio of loan to value. Since a loan of $198,000 is 82.5% of the value of $240,000, 1 - .825 is .175, or 17.5%. When the LTV is above 80%, the down payment is less than 20%, and the borrower must purchase mortgage insurance.

If you cannot afford the monthly payment on a 15 year loan, your choice is made for you. If you can afford the 15, you must decide whether you are a payment-minimizer or wealth-maximizer. The first group is concerned mainly with the present, the second with the future. The mortgage payment on a $100,000 30 year loan at 7% is $665 while on a 15 year loan at 6.75% it is $885. The payment minimizer is drawn to the lower payment on the 30. On the other hand, after 5 years the borrower who took out the 15 year loan has repaid $22,933 while the borrower who took out the 30 has repaid only $5,868. That amounts to a difference in wealth accumulation of $17,065. To me, that’s even more attractive; I’m a wealth maximizer. Some borrowers who can afford the 15 opt for the 30 because of the flexibility it provides. You can make the larger payment of the 15, they argue, but you don’t have to; if you get into a pinch, you can make the lower payment of the 30. Those who take a 30 but make the larger payment of the 15, however, don’t pay down the balance as rapidly as they would have if they had taken a 15 because they are paying the higher rate of the 30.

I have found that many borrowers who elect the 30 year option to obtain flexibility subsequently find that they really don’t want it after all! After a few years of being homeowners, they discover that what they really want is to build equity more quickly than the 30 allows. They discover, in other words, that they want to build wealth.

At that point some of those who took out 30 year loans begin systematically making additional monthly payments in order to build equity faster. Of course, they would have been better off taking the 15 year at the outset and enjoying the lower interest rate, but better late than never.

If the rates on the 30 and 15 are 7% and 6.75%, for example, a 10% investment yield would not put you ahead for 63 months. At investment yields of 12%, 14%, and 16%, the periods are 41, 30 and 24 months, respectively. If the rate on the 15 is 6.5%, the periods are almost twice as long.

One complication of mortgages is that their “price” has at least three components. ARMs have even more. Interest rate is the number that is multiplied by the loan balance to get the interest payment due the lender. The rate quoted on a mortgage is an annual rate, but it is applied monthly. On a 6% mortgage with a $100,000 balance, for example, the monthly interest due is .005 times $100,000, or $500.

On a fixed-rate mortgage (FRM), the interest rate is preset for the life of the loan. On an adjustable-rate mortgage (ARM), the rate is preset for an initial period, ranging from one month to 10 years, and then can change.

Points are up-front charges expressed as a percent of the loan amount. Two points amount to 2% of the loan. Points are related to the interest rate. If a lender offers a 30 year FRM at 8% and zero points, for example, he might charge 1.75 points for a 7.5% loan. Rebates are points paid by the lender for high-rate loans. The lender who charges 1.75 points for a 7.5% loan, for example, might rebate 2 points for a 9% loan. The 2 points would be available to defray the borrower’s settlement costs.