Your Savings and Down Payment
Your First Step Toward Buying a Home
When preparing to buy a home, the first thing many Homebuyers do is look at “homes for sale” ads in newspapers, magazines and listings on the internet. Some potential buyers read “how-to” articles like this one. The next thing you should do – before you call on an ad, before you talk to a Realtor, before you shop for interest rates – is look at your savings.
Because determining how much money you have available for down payment and closing costs affects almost every aspect of buying a home – including how you write your purchase offer, the loan programs you qualify for, and shopping for interest rates.
If you only have enough available for a minimum down payment, your choices of loan program will be limited to only a few types of mortgages. If someone is giving you a gift for all or part of the down payment, your options are also limited. If you have enough for the down payment, but need the lender or seller to cover all or part of your closing costs, this further limits your options. If you borrow all or a portion of the down payment from your 401K or retirement plan, different loan programs have different rules on how you qualify. Of course, if you have enough for a large down payment, then you have lots of choices. Your loan choices include such varied programs as conventional fixed rate loans, adjustable rate mortgages, buydowns, VA, FHA, graduated payment mortgages and all the varieties of each.
A very important reason you need to have at least some idea of your down payment is for shopping interest rates. Some loan programs charge a slightly higher interest rate for minimal down payments. Plus, the interest rates for different loan programs are not the same. For example, conventional, VA, and FHA all offer fixed rate loans. However, the rates vary from one program to another. If you shop lenders by phone, the loan officer will be able to tell which programs fit and quote you rates accordingly. However, if you are shopping on the internet, you have to have some idea of your loan program on your own.
Writing Your Offer
Another reason you need to have a clue about your down payment is because it affects how you write your offer to purchase a home. Not only are you required to put your down payment information in the offer, but different loan programs have different rules which also affect how you write your offer. This is especially important when dealing with FHA and VA loans. If you are asking the seller to pay all or part of your closing costs, you have to be certain your loan program allows what you are asking. For smaller down payments, lenders allow the seller to pay less closing costs than for larger down payments. Some loan programs will allow a seller to pay certain types of costs, but not others. Finally, your down payment also affects your ability to qualify for a loan. When you make a small down payment, lenders are fairly strict about having you conform to their underwriting guidelines. For larger down payments, they will tend to make allowances or exceptions to the rules.
As you can see, the down payment affects every choice you make when you buy a home. Although you should look at ads, familiarize yourself with neighborhoods, learn about prices, and read as much as you can – when you get ready to take action – the first thing you should do is figure out how much money you have available for the purchase.
Documenting Your Assets
Verifying Your Down Payment
When buying a home, it is not enough to just “come up” with the money. With the exception of “no asset verification” loans, lenders want to verify where the money comes from. If you can document the funds comes from your personal savings, the lender is more confident of your strength as a borrower. In addition, if you can verify you have additional assets that are not needed for the down payment, it is important to document those, too. Additional assets are “reserves” you can draw upon during times of trouble, such as unemployment, medical emergencies, and similar occurrences. Additional assets can also help to document that you have a history of saving money, which makes you a more dependable borrower. It is extremely important to completely document the paper trail of any funds you use for down payment and closing costs. The sections below provide guidance on both verifying assets and documenting them as a source of your down payment.
Checking, Savings, & Money Market Accounts
The quickest and easiest way to document funds in your bank account is to provide your lender with copies of your most recent bank statements. Most lenders request two months bank statements, but some still ask for three. Some lenders still send a “Verification of Deposit” to your bank in order to determine your current bank balances and average balance for the last two months. However, that is the old way of doing business and most lenders nowadays prefer to have bank statements. If the money you are using for the down payment and closing costs has been in the bank for the entire period covered by the bank statements, you’re fine. These are known as “seasoned funds.” However, if your statements show any large or unusual deposits the lender will ask you to explain them and document their source.
Stocks, Bonds, Mutual Funds, etc.
Most of those who own stocks get a monthly or quarterly statement from their brokerage. You will need to supply statements for the most recent sixty or ninety days in order to document these assets. Though it is rare nowadays, some people actually have stock certificates instead of having a brokerage account. When this is the situation, make copies of the certificates and provide those copies to your lender. You might also want to supply tax records to indicate you have owned these stocks for some time. If part of your down payment will come from the sale of stocks and investments, you will need to keep all documentation that applies to the sale. Provide these copies to your lender as well.
Especially when buying a first home, some borrowers need help coming up with the down payment. This help should come in the form of a gift from a close family member. Lenders will require the donors to sign a special form called a “gift letter.” The gift letter states the relationship between the parties, the address of the purchased property, the amount of the gift, and sometimes the source of the funds used to make the gift. The gift letter also clearly states that the funds are a gift and not required to be repaid. With most lenders, the donor will have to also provide evidence that they have the ability to make the gift. This can be in the form of a bank or stock statement to show they have the funds available. You should also make a copy of the check used to make the gift and keep a copy of the deposit receipt when you deposit the gift funds into your bank account or escrow.
401K or Retirement Accounts
It is important to provide documentation about your retirement accounts or 401K programs because this is another asset you could draw upon as reserves in case of a problem. It is also another way to show you have a savings history. Just provide a copy of your most recent statement to your lender. Many people use these accounts as a source of funds for their down payment, too. Some employers allow you to “cash out” a portion of the 401K and some allow you to borrow against it. Be sure to keep copies of all paperwork involving the transaction. If they cut you a check, be sure to make a photocopy of that, too, including any receipt for deposit into your personal bank account. If you are borrowing against your 401K, some lenders will count this as an additional debt to go along with car payments, credit cards and other obligations. This may seem kind of silly because you are borrowing your own money, but from the lender’s viewpoint it is still a monthly obligation that you must come up with and should be taken into account. If you are “tight” on your debt-to-income ratios in qualifying for a home loan, this could be an important consideration. It may affect whether you choose to cash out the account and pay any tax penalty, or simply borrow against it.
Some companies provide down payment assistance for their employees. They may feel that Homeowners are more stable and reliable employees, or that providing down payment assistance fosters an environment of higher morale and loyalty to the firm. Just make copies of all the paperwork, including a copy of the check and the receipt when you deposit the funds into your personal bank account. It is important that these funds do not require repayment.
If you have Savings Bonds, they are a financial asset, too. Since you hold the actual bonds in your possession, the easiest and best way to verify them for your mortgage lender is to make photocopies of them. If you choose to cash them in for down payment or closing costs, you should do this at your local bank. Be sure to keep copies of the paperwork the bank provides because that will establish the current value of the bonds and show that you received their cash value.
Personal Property – Cars, Antiques, etc.
Personal property includes automobiles, vehicles, boats, furniture, collections, heirlooms, antiques, art, clothing, and practically everything you own except for real estate. The mortgage application asks you to estimate the value for these items. The larger the loan amount, the more important it is for you to provide details on your personal property. This is because larger loans usually indicate larger incomes, and lenders check to see if your personal property matches your income. If it does not, this sends a “red flag” to the underwriter and they take a closer look at your application. You are not required to document the value of personal property unless you intend to sell them to come up with your down payment.
Selling Personal Property
For those Homebuyers who do sell personal property in order to come up with their down payment, the verification process can be arduous. Lenders are much stricter about documenting this method of coming up with your source of funds. Selling a car is perhaps the easiest to document. First, you need to photocopy the registration that shows you actually own the vehicle. You will have to provide a copy of the page in the “Blue Book” that shows your model and its value. Then you need to photocopy the bill of sale showing the transfer to another individual and a copy of the check used to purchase the vehicle. Do not get paid in cash because that makes it impossible to show you actually received the funds. Make a copy of the receipt when you deposit the funds into the bank. Other types of personal property are more difficult because you have to show that you actually own the property and that it actually has the value that you sold it for. This is a little harder to do for most assets than it is for automobiles. If you have records to show you purchased the property, that would be helpful. You could also provide an old inventory that documents ownership. To determine value, you may have to contract with an independent appraiser or a specialist who has the knowledge for that particular type of property. If you cannot document the item’s value, the lender will not view the sale as an acceptable source of funds. Just like selling a car, you have to prove you own the item, make a copy of the bill of sale, copy the check used to purchase the item, and make a copy of your receipt when you deposit the funds into your bank.
The Biweekly Mortgage – Who Needs It?
Have you received an advertisement offering to save you thousands of dollars on your thirty-year mortgage and cut years off your payments? With email “spam” becoming more pervasive as everyone tries to “get rich quick” on the internet, these ads are popping up with troublesome regularity. The ads promote the “Biweekly Mortgage” and for the most part, do not come from a mortgage lender. Exclamation points punctuate practically every claim:
- No closing costs!
- No refinancing!
- No points!
- No credit check!
- No appraisal!
- Save thousands!
- Cut years off your mortgage!
To achieve these wonderful savings all you have to do is allow half of your mortgage payment to be deducted from your checking account every two weeks. It’s easy. Of course, there is a small “set-up fee” and usually a “transaction fee” with every automatic deduction. Essentially, the ads are truthful in almost every respect. They just want to charge you money for something you can do on your own for free.
Normally, you make twelve mortgage payments a year. Since there are fifty-two weeks in a year, a biweekly mortgage equals 26 half-payments a year. The equivalent would be making thirteen mortgage payments a year instead of twelve. By applying that extra payment directly to the loan balance as a principal reduction, your loan amortizes more quickly, requiring fewer payments. You save money. The ads are true.
How it Actually Works
You cannot simply mail in half a payment every two weeks to your mortgage lender. Since they do not accept partial payments for legal and accounting reasons, the mortgage company would just mail your half-payment back to you. Instead, the biweekly mortgage company is an intermediary between you and your mortgage lender. They automatically debit your checking account every two weeks for half of your mortgage payment, then place your funds into a trust account. Basically, this is just a holding account for your money. In another two weeks, there is another automatic deduction from your checking account, and so on. When your mortgage payment is due, your funds are withdrawn from the trust account and forwarded to your mortgage lender. Since you are placing funds into the trust account faster than your mortgage payments are due, you eventually accumulate enough money to make an “extra” payment. The way the cycle works, this occurs once a year. The extra payment is applied directly to your principal balance, which causes your loan to amortize faster, pay off more quickly and save you thousands of dollars.
Potential Problems with the Trust Account
Because your funds are held in the trust account until your mortgage payment is due, there are potential dangers. Not only are your funds held in this account, but so are the funds of everyone else enrolled in the biweekly program. That is a lot of money. Most likely, there will be no problems. However, if there are accounting errors, mismanagement, or even fraud, your mortgage payment might not get made. The first hint of a problem will probably be a phone call or letter from your mortgage lender, but not until after your payment is already late. Since responsibility for making the payment rests with you and not the biweekly payment company, you may find yourself digging into your personal savings to make the payment directly — even though the biweekly payment company has already collected your funds. Later you can work out the trust account problem with your biweekly payment company.
The Cost of the Biweekly Mortgage
There is usually a set-up fee that runs between $195 and $350, depending on how much sales commission is paid to the individual or company setting up the account for you. You also pay a transaction fee each time there is an automatic deduction from your checking account and sometimes also when the payment is made to your mortgage lender. There may also be a periodic “maintenance fee.” Meanwhile, whoever controls the trust account is earning interest on your money.
Savings of the Biweekly Mortgage
By making principal reductions using the biweekly mortgage program, your mortgage will amortize more quickly, saving you money. How quickly your loan pays off depends on your interest rate and when you begin making the biweekly payments. On a $100,000 loan at today’s interest rate of eight percent, your first principal reduction would probably be a year from now. Assuming the principal reduction is equal to one monthly payment ($733.76), you would save $43,852 over the life of the loan and pay it off almost seven years early. However, you have to deduct from those savings any amounts you paid in set-up, transaction, and maintenance fees.
No-Cost Alternatives to the Biweekly Mortgage
Instead of hiring a company to manage your biweekly payment, you could accomplish essentially the same thing on your own for free. Just take your monthly payment, divide it by twelve, and add that amount to your monthly mortgage payment. Be sure to earmark it as a principal reduction. The first way you save is that you do not have to pay any fees to anyone. It’s free. In addition to not paying fees — using the same example as above — your total savings on the mortgage would be $45,904. Plus the loan would be paid off three months quicker than with the biweekly mortgage. The reason you save more is because you are making a principal reduction each month, instead of waiting for funds to accumulate so that you can make one principal reduction a year.
The biweekly mortgage companies claim that homeowners are not disciplined enough to follow through with principal reduction plans on their own. They suggest the reason for setting up the biweekly mortgage enforces discipline upon you, and by doing so, they save you money. However, in this internet age, banking on line and automatic deductions are readily available. You can set up your own automatic deductions including the additional principal reduction and have it go directly to your mortgage lender. Since the deduction occurs automatically, just like with the biweekly mortgages, self-discipline is not a problem. Once again, you don’t have to pay anyone to do it for you and you save even more money.
The biweekly mortgage plans do not really do anything except move your money around and charge you for it. Plus, even though the danger is negligible, you must trust someone else to hold your money for you. If you can do the very same thing for free, plus save yourself even more money by doing it on your own, why pay someone else? The biweekly mortgage plan – who needs it? If your goal is principal reduction and saving money, then it is a good plan. If you do it on your own instead of paying someone else to do it for you, then it is a great plan.
Closing Costs When Buying or Refinancing a Home
This is a detailed summary of costs you may have to pay when you buy or refinance your home. They are listed in the order that they should appear on a Good Faith Estimate you obtain from a mortgage lender. There are two broad categories of closing costs. Non-recurring closing costs are items that are paid once and you never pay again. Recurring closing costs are items you pay time and again over the course of home ownership, such as property taxes and homeowner’s insurance. Some of the items that appear here do not traditionally appear on a lender’s Good Faith Estimate and lenders are not required to show all of these items.
Non-Recurring Closing Costs Associated with the Lender
Loan Origination Fee – The loan origination fee is often referred to as “points.” One point is equal to one percent of the mortgage loan. As a rule, if you are willing to pay more in points, you will get a lower interest rate. On a VA or FHA loan, the loan origination fee is one point. Anything in addition to one point is called “discount points.”
Loan Discount – On a government loan, the loan origination fee is normally listed as one point or one percent of the loan. Any points in addition to the loan origination fee are called “discount points.” On a conventional loan, discount points are usually lumped in with the loan origination fee.
Appraisal Fee – Since your property serves as collateral for the mortgage, lenders want to be reasonably certain of the value and they require an appraisal. The appraisal looks to determine if the price you are paying for the home is justified by recent sales of comparable properties. The appraisal fee varies, depending on the value of the home and the difficulty involved in justifying value. Unique and more expensive homes usually have a higher appraisal fee. Appraisal fees on VA loans are higher than on conventional loans.
Credit Report – As part of the underwriting review, your mortgage lender will want to review your credit history. The credit report can be as little as seven dollars, but normally runs between $21 and $60, depending upon the type of credit report required by your lender.
Lender’s Inspection Fee – You normally find this on new construction and is associated with what is called a 442 inspection. Since the property is not finished when the initial appraisal is completed, the 442 inspection verifies that construction is complete with carpeting and flooring installed.
Mortgage Broker Fee – About seventy percent of loans are originated through mortgage brokers and they will sometimes list your points in this area instead of under Loan Origination Fee. They may also add in any broker processing fees in this area. The purpose is so that you clearly understand how much is being charged by the wholesale lender and how much is charged by the broker. Wholesale lenders offer lower costs/rates to mortgage brokers than you can obtain directly, so you are not paying “extra” by going through a mortgage broker.
Tax Service Fee – During the life of your loan you will be making property tax payments, either on your own or through your impound account with the lender. Since property tax liens can sometimes take precedence over a first mortgage, it is in your lender’s interest to pay an independent service to monitor property tax payments. This fee usually runs between $70 and $80.
Flood Certification Fee – Your lender must determine whether or not your property is located in a federally designated flood zone. This is a fee usually charged by an independent service to make that determination.
Flood Monitoring – From time to time flood zones are re-mapped. Some lenders charge this fee to maintain monitoring on whether this re-mapping affects your property.
Other Lender Fees
We put these in a separate category because they vary so much from lender to lender and cannot be associated directly with a cost of the loan. These fees generate income for the lenders and are used to offset the fixed costs of loan origination. The Processing Fee above can also be considered to be in this category, but since it is listed higher on the Good Faith Estimate Form we did not also include it here. You will normally find some combination of these fees on your Good Faith Estimate and the total usually varies between $400 and $700.
Document Preparation – Before computers made it fairly easy for lenders to draw their own loan documents, they used to hire specialized document preparation firms for this function. This was the fee charged by those companies. Nowadays, lenders draw their own documents. This fee is charged on almost all loans and is usually in the neighborhood of $200.
Underwriting Fee – Once again, it is difficult to determine the exact cost of underwriting a loan since the underwriter is usually a paid staff member. This fee is usually in the neighborhood of $300 to $350.
Administration Fee – If an Administration Fee is charged, you will probably find there is no Underwriting Fee. This is not always the case.
Appraisal Review Fee – Even though you will probably not see this fee on your Good Faith Estimate, it is charged occasionally. Some lenders routinely review appraisals as a quality control procedure, especially on higher valued properties. The fee can vary from $75 to $150.
Warehousing Fee – This is rarely charged and begins to border on the ridiculous. However, some lenders have a warehouse line of credit and add this as a charge to the borrower.
Items Required to be Paid in Advance
Pre-paid Interest – Mortgage loans are usually due on the first of each month. Since loans can close on any day, a certain amount of interest must be paid at closing to get the interest paid up to the first. For example, if you close on the twentieth, you will pay ten days of pre-paid interest.
Homeowner’s Insurance – This is the insurance you pay to cover possible damages to your home and other items. If you buy a home, you will normally pay the first year’s insurance when you close the transaction. If you are buying a condominium, your Homeowners’ Association Fees normally cover this insurance.
VA Funding Fee – On VA loans, the Veterans Administration charges a fee for guaranteeing your loan. If you have not used your VA eligibility in the past, this is two percent of the loan balance. If you have used your VA eligibility before, it is three percent of the loan. If you are refinancing from a VA loan to a VA loan, it is three-quarters of a percent of the loan amount. Instead of actually paying this as an out-of-pocket expense, most veterans choose to finance it, so it gets added to the loan balance. This is why the loan balance on VA loans can be higher than the actual purchase amount.
Up Front Mortgage Insurance Premium (UFMIP) – This is charged on FHA purchases of single family residences (SFR’s) or Planned Unit Developments (PUDs) and is 2.25% of the loan balance. Like the VA Funding Fee it is normally added to the balance of the loan. Unlike a VA loan, the homebuyer must also pay a monthly mortgage insurance fee, too. This is why many lenders do not recommend FHA loans if the homebuyer can qualify for a conventional loan. However, condominium purchases do not require the UFMIP.
Mortgage Insurance – Though it is rare nowadays, some first-time homebuyer programs still require the first year mortgage insurance premium to be paid in advance. Most mortgage insurance (when required) is simply paid monthly along with your mortgage payment. Mortgage insurance covers the lender and covers a portion of the losses in those cases where borrowers default on their loans.
Reserves Deposited with Lender
If you make a minimum down payment, you may be required to deposit funds into an impound account. Funds in this account are your funds, and the lender uses them to make the payments on your Homeowner’s insurance, property taxes, and mortgage insurance (whichever is applicable). Each month, in addition to your mortgage payment, you provide additional funds which are deposited into your impound account. The lender’s goal is to always have sufficient funds to pay your bills as they come due. Sometimes impound accounts are not required, but borrowers request one voluntarily. A few lenders even offer to reduce your loan origination fee if you obtain an impound account. However, if you are disciplined about paying your bills and an impound account is not required, you can probably earn a better rate of return by putting the funds into a savings account. Impound accounts are sometimes referred to as escrow accounts.
Homeowners Insurance Impounds – your lender will divide your annual premium by twelve to come up with an estimated monthly amount for you to pay into your impound account. Since a lender is allowed to keep two months of reserves in your account, you will have to deposit two months into the impound account to start it up.
Property Tax Impounds – How much you will have to deposit towards taxes to start up your impound account varies according to when you close your real estate transaction. For example, you may close in November and property taxes are due in December. Your deposit would be higher than for someone closing in May.
Mortgage Insurance Impounds – When required, most lenders allow this to simply be paid monthly. However, you may be required to put two months worth of mortgage insurance as an initial deposit into your impound account.
Non-Recurring Closing Costs not associated with the Lender
Closing/Escrow/Settlement Fee – Methods of closing a real estate transaction vary from state to state, as do the fees. For purchases, a general rule of thumb that usually works in calculating this closing cost is $200 plus $2 for every thousand dollars in price. For refinances there is usually a flat fee around $400 to $500.
Title Insurance – Title Insurance assures the homeowner that they have clear title to the property. The lender also requires it to insure that their new mortgage loan will be in first position. The costs vary depending on whether you are purchasing a home or refinancing a home, so we will not provide a range here.
Notary Fees – Most sets of loan documents have two or three forms that must be notarized. Usually your settlement or escrow agent will arrange for you to sign these forms at their office and charge a notary fee in the neighborhood of $40.
Recording Fees – Certain documents get recorded with your local county recorder. Fees vary regionally, but probably run between $40 and $75.
Pest Inspection – also referred to as a Termite Inspection. This inspection tests not only for pest infestations, but also other items such as wood rot and water damage. The inspection usually runs around $75. If repairs are required, the amount to cover those repairs can vary. The seller will usually pay for the most serious repairs, but this is a negotiable item. Usually (not always) the pest inspection fee is paid by the seller of the home and is not normally reflected on the Good Faith Estimate.
Home Inspection – Since it is the Homebuyer’s choice to obtain a home inspection or not, this cost is not usually reflected on a Good Faith Estimate. However, it is recommended. Keep in mind that the home inspector has a certain set of standards he uses when inspecting a home, and those standards may be higher than required by local building codes. An example is that an inspector may note there is no spark arrestor on a chimney but the local building code may not require it. This sometimes leads to conflicts between buyer and seller.
Home Warranty – This is also an optional item and not normally included on the Good Faith Estimate. A Home Warranty usually covers such items as the major appliances, should they break down within a specific time. Often this is paid by the seller.
Refinancing Associated Costs (but not charged by the new Lender)
Interest – When you close the transaction on your refinance, there will most likely be some outstanding interest due on the old loan. For example, if you close on August twentieth (and you made your last payment), you will have twenty days interest due on the old loan and ten days prepaid interest on the new loan. Your first payment on the new loan would not be until October 1st since you have already paid all of August’s interest when you closed the refinance transaction (since interest is paid in arrears, a September payment would have paid August’s interest, which has already been paid in closing).
Reconveyance Fee – this fee is charged by your existing lender when they “reconvey” their collateral interest in your property back to you through recording of a Reconveyance. This fee can vary from $75 to $125.
Demand Fee – your existing lender may charge a fee for calculating payoff figures. If they do, this fee may run in the neighborhood of $60.
Sub-Escrow fee – though it sounds like an escrow fee, this fee is actually charged by the Title Company (and I’ve never been able to figure out exactly what it is for). Assume it is an income-generating fee similar to some of the lender fees mentioned above. Title representatives who want to explain this fee can send us an email.
Loan Tie-in Fee – though it sounds like a lender fee, this cost is actually charged by the Escrow Company (like the sub-escrow fee, I’ve never been able to understand this fee, either). Escrow officers who want to explain this fee can also send an email.
Homeowner’s Association Transfer Fee – If you are buying a condominium or a home with a Homeowner’s Association, the association often charges a fee to transfer all of their ownership documents to you.
Asking the Seller to Pay Closing Costs – Rules and Advice.
It has become common to ask the seller to pay some or all of the closing costs when you purchase a home. Essentially, this is financing your closing costs since you will probably pay a little bit more for the property than you would if you were paying your own costs. Keep in mind a few simple rules. On conventional loans you can only ask the seller to pay non-recurring costs, not prepaids or items to be paid in advance. If you are putting ten percent down or more, the most the seller can contribute is six percent of the purchase price. If you are putting less down, the most the seller can contribute is three percent. On VA loans, you can ask the seller to pay everything. This is called a “VA No-No,” meaning the buyer is making no down payment and paying no closing costs. On FHA loans, the seller can pay almost any cost, but the buyer has to have a minimum three percent investment in the home/closing costs. Most refinances include the closing costs and prepaids in the new loan amount, requiring little or no out-of-pocket expenses to close the deal. If you didn’t get bored as you read through this, now you know everything…a lot, anyway…about closing costs.
Which ARM is the Best Alternative?
How would you like a mortgage loan where you did not have to make the whole payment if you did not want to? Or would you like a loan with an interest rate about one percent below a thirty-year fixed rate mortgage and pay zero points? Or a loan where you did not have to document your income, savings history, or source of down payment? How would you like a mortgage payment of only 2.95 percent? You can have all that with the 11th District Cost of Funds (COFI) Adjustable Rate Mortgage. Sound too good to be true? Sound like a bunch of hype? Each statement above is true. However, it is also only part of the story and loan officers do not always tell you the whole story when promoting this loan. Then other loan officer try to scare you away from the adjustable rate mortgages. However, once you become aware of all the details of the loan, it is an excellent way to buy the house of your dreams, especially when fixed rates begin to go up.
ARMs in General
Adjustable rate mortgages all have certain similar features. They have an adjustment period, an index, a margin, and a rate cap. The adjustment period is simply how often the rate changes. Some change monthly, some change every six months, and some only adjust once a year. Indexes are simply an easily monitored interest rate that moves up and down over time. Adjustable rate mortgages have different indexes. The margin is the difference between your interest rate and the index. The margin does not change during the term of the loan. So if you have an adjustable rate mortgage and you wanted to calculate your interest rate on your own, all you have to do is look up the index in the paper or on the internet, add the margin, and you have your rate.
Indexes and the 11th District
The “Prime Rate” you hear about in the news is one interest rate index, although it is very rare that mortgages are tied to this index. It is more common to find adjustable rate mortgages tied to different treasury bill indexes, the average interest rate paid on certificates of deposit, the London Inter-Bank Offered Rate (LIBOR), and the 11th District Cost of Funds. Currently, the Cost of Funds Index is the lowest of these indexes, though this is not always true. To simplify, the 11th District Cost of Funds (COFI) is the weighted average of interest rates paid out on savings deposits by banking institutions in the the 11th district of the Federal Home Loan Bank (FHLB), which is located in San Francisco. The 11th District includes the states of California, Nevada, and Arizona. The COFI index moves slower than the other indexes, making it more stable. It also lags behind actual changes in the interest rate market. For example, when rates begin to go up, the COFI index may continue to decline for a couple of months before it also begins to rise. However, when interest rates start to decline, the COFI index may continue to go up for another couple of months, too. It lags behind the market.
The Margin and Interest Rates
The margin on the COFI ARM can be on either side of 2.5%. For example the COFI index as of July 31, 1998 is 4.504%. With a margin of 2.44%, your interest rate would be 6.944%. During this same time, thirty year fixed rate loans on conforming mortgages are close to eight percent. Fixed rates on jumbo loans (above $240,000) are higher.
Monthly Adjustments Sound Scary, but…
Although you can get a COFI ARM with an adjustable period of six months, you can get a lower margin if you go for the monthly adjustment period. Since the margin plus the index equals your interest rate, the lower margin is an advantage and most people choose the monthly adjustment. Monthly adjustments sound scary to the uninitiated, but keep in mind that this is a slow moving index. Most other ARMS have an annual cap of two percent a year. Since 1981, when the FHLB began tracking the index, the most it has moved during any calendar year is 1.6%. So why get a higher margin just to get a rate cap that you probably will not use anyway? The “life-of-loan” cap for the COFI ARM is usually 11.95%. The most recent year that this cap could have been reached was 1985. Plus, most experts do not expect a return to the interest rates of the early 1980’s when interest rates were pushed up artificially to combat the inflation of the 1970’s.
Make Only Part of Your Payment?
This is the really interesting feature of the loan. You do not have to make the whole payment. Each month you get a bill that has at least three payment options. One choice is the full payment at the current interest rate. A second choice allows you to pay only the interest that is due on the loan that particular month, but does not pay anything towards the principal. Finally, the third option gives you the choice to pay even less than that and is called the “minimum payment.” The minimum payment when you start your loan can be calculated as low as 2.95 percent. Keep in mind that this is not the note rate on your loan, but just a way to calculate your minimum payment.
Deferred Interest and Amortization
Of course, if you only make the minimum payment each month, you are not paying all of the interest that is currently due that month. You are deferring some of the interest that is currently due on the loan and you will pay it later. The lender keeps track of this deferred interest by adding it to the loan and the loan balance gets larger. Neither you nor the lender wants this to continue forever, so your minimum payment increases a bit each year. The payment cap on the loan is 7.5%, which also has nothing to do with the interest rate. All it means is the most your minimum payment can increase from one year to the next is seven and a half percent. For example, if your minimum payment is $1000 this year, next year the most it could be is $1075. This continues each year until your payment is approximately equal to the payment at the full note rate. Just in case, there are fail-safes built into the loan. If you continue making the only the minimum payment and your current balance ever reaches 110 percent of the beginning balance, the loan is re-amortized to make sure you pay it off in thirty years (or forty years, whichever option you chose). Every five years the loan is re-amortized to make sure it pays off within the term of the loan.
Stated Income and Other Features
Many COFI lenders allow Homebuyers with good credit to apply without documenting their income, assets, or source of down payment. Of course, you have to make a twenty or twenty-five percent down payment on your home purchase. This is helpful for self-employed borrowers or those who have jobs where it is difficult to document their income. Plus, some people just do not like the bother of supplying W2 forms, tax returns and pay-stubs. Anyway, it makes for a quick and easy loan approval.
Sub-Prime COFI ARMs
Some people have less than perfect credit and they are used to being charged outrageous rates for past problems. Some COFI lenders offer this same loan but have a slightly higher starting payment and a higher margin. The end result is that your interest rate would be about one percent higher. As of August 18, 1999, that would be around eight percent on this loan instead of seven percent.
Who Should Get This Loan?
In my personal experience, most people who get the COFI ARM are purchasing a home between $300,000 and $650,000, but it is not limited to that. It is a real favorite of those working in the financial industry and those with higher incomes. One reason they like it is because they consider any deferred interest to be an extended loan at a very attractive rate. By making the minimum payment, they do other things with the money. Homebuyers whose income has peaks and valleys, such as self-employed or commissioned salespeople also like the loan, because it provides flexibility in the monthly payment. During a slow month they can make the minimum payment if they choose. Another reason borrowers like the loan is because it allows for tax planning. The borrower can defer interest payments and at the end of the year, analyze their tax situation. If it serves their tax interests, they can make a lump sum payment toward any interest that has been deferred and deduct it for tax purposes.
Skipping the Starter Home or Move-Up Home
If you’re buying a home with the intention of living in it for only a few years before you move up to a bigger home, the COFI ARM makes sense, too. With this loan and its low start payment you can often qualify for a larger home than you can when applying for a fixed rate loan. This allows you to skip the intermediate purchase and move up immediately to the home you really want, which makes more sense and saves you money. If you buy a home, then sell it to move up to a bigger home, you are going to have to pay Realtor’s commissions and closing costs. On a $300,000 house, this would be around $25,000. If you skip buying that home and buy the home you really want, you save that money. Plus, you save money in another way. Say you live in your intermediate purchase for five years, then move up and buy another home with another thirty year mortgage. That is thirty-five years of home loans. If you buy your ideal home now, you save five years of mortgage payments. Depending on your loan amount, that can be a lot of cash.
So, when rates start going up this is an attractive alternative to fixed rates. It even makes sense for some borrowers when rates are low. Something we also did not mention is that most COFI lenders also give you a fourth option on your monthly mortgage statement which allows you to pay it off quicker.
FICO Score – a Brief Explanation
When you apply for a mortgage loan, you expect your lender to pull a credit report and look at whether you’ve made your payments on time. What you may not expect is that they seem to be more interested in your “FICO” score. “What’s a FICO score?” is a common reaction.
Each time your credit report is pulled, it is run through a computer program with a built-in scorecard. Points are awarded or deducted based on certain items such as how long you have had credit cards, whether you make your payments on time, if your credit balances are near maximum, and assorted other variables. When the credit report prints in your lender’s office, the total score is displayed. Your score can be anywhere between the high 300’s and the low 800’s. Lenders wanted to determine if there was any relationship between these credit scores and whether borrowers made their payments on time, so they did a study. The study showed that borrowers with scores above 680 almost always made their payments on time. Borrowers with scores below 600 seemed fairly certain to develop problems. As a result, credit scoring became a more important factor in approving mortgage loans. Credit scores also made it easier to develop artificial intelligence computer programs that could make a “yes” decision for loans that should obviously be approved. Nowadays, a computer and not a person may have actually approved your mortgage.
In short, lower credit scores require a more thorough review than higher scores. Often, mortgage lenders will not even consider a score below 600. Some of the things that affect your FICO score are:
- Too many accounts opened within the last twelve months
- Short credit history
- Balances on revolving credit are near the maximum limits
- Public records, such as tax liens, judgments, or bankruptcies
- No recent credit card balances
- Too many recent credit inquiries
- Too few revolving accounts
- Too many revolving accounts
FICO actually stands for Fair Isaac and Company, which is the company used by the Experian (formerly TRW) credit bureau to calculate credit scores. Trans-Union and Equifax are two other credit bureaus who also provide credit scores.
WHAT’S A FICO?
What is a FICO Score?
FICO stands for Fair Isaac & Company and is the name for the most well known credit scoring system, used by Experian. The credit bureau’s computer evaluates a complete credit profile and assigns a score, which is used to estimate credit worthiness. Each of the three bureaus (Experian, Trans Union, Equifax) employs its own scoring system, so a given person will usually have 3 separate scores. Someone with a higher score will be viewed as a better risk than someone with a lower score. Typically, scores will range from about 600 to 700 or above, although some cases will be outside this range.
What Kind of Score Do I Need for a Home Loan?
There are as many answers to this question as there are loan programs available. Most lenders will take the average of all 3 scores to evaluate an application. “Niche” loans, such as Easy Qualifier and low down payment loans will have the higher FICO requirements.
How is My Score Determined?
The FICO model has 5 main elements:
- Past payment history (about 35% of score) The fewer the late payments the better. Recent late payments will have a much greater impact than a very old Bankruptcy with perfect credit since. Myth – paying off cards with recent late payments will fix things. Payoffs do not affect payment history.
- Credit use (about 30% of score) Low balances across several cards is better than the same balance concentrated on a few cards used closer to maximums. Too many cards can bring down the score, but closing accounts can often do more harm than good if the entire profile is not considered. BE CAREFUL WHEN CLOSING ACCOUNTS!
- Length of credit history (15% of score) The longer accounts have been open the better for the score. Opening new accounts and closing seasoned accounts can bring down a score a great deal.
- Types of credit used (10% of score) Finance company accounts score lower than bank or department store accounts.
- Inquiries (10% of score) Multiple inquiries can be a risk if several cards are applied for or other accounts are close to maxed out. Multiple mortgage or car inquiries within a 14 day period are counted as one inquiry.
How Can I Raise My Score
Your score can only be changed by the way that item is reported directly to the credit bureaus (Experian, TU, Equifax). Written confirmation from the creditor is required. It is best to make these corrections before you try to purchase a home, because you can never be sure the exact impact a change will have on your score.
What Does This Mean to Me?
You should have your credit reviewed BEFORE you look for a home, and work with a PROFESSIONAL loan officer to make sure your loan is based on the most accurate information.
FICO Scores and Your Mortgage
Three years ago, credit scoring had little to do with mortgage lending. When reviewing the credit worthiness of a borrower, an underwriter would make a subjective decision based on past payment history. Then things changed. Lenders studied the relationship between credit scores and mortgage delinquencies. There was a definite relationship. Almost half of those borrowers with FICO scores below 550 became ninety days delinquent at least once during their mortgage. On the other hand, only two out of every 10,000 borrowers with FICO scores above eight hundred became delinquent. So lenders began to take a closer look at FICO scores and this is what they found out. The chart below shows the likelihood of a ninety day delinquency for specific FICO scores.
|FICO Score||Odds of a Delinquent Account|
|595||2 to 1|
|600||4 to 1|
|615||9 to 1|
|630||18 to 1|
|645||36 to 1|
|660||72 to 1|
|680||144 to 1|
|780||576 to 1|
If you were lending a couple hundred thousand dollars, who would you want to lend it to?
FICO Scores, What Affects Them, How Lenders Look At Them
Imagine a busy lending office and a loan officer has just ordered a credit report. He hears the whir of the laser printer and he knows the pages of the credit report are going to start spitting out in just a second. There is a moment of tension in the air. He watches the pages stack up in the collection tray, but he waits to pick them up until all of the pages are finished printing. He waits because FICO scores are located at the end of the report. Previously, he would have probably picked them up as they came off. A FICO above 700 will evoke a smile, then a grin, perhaps a shout and a “victory” style arm pump in the air. A score below 600 will definitely result in a frown, a furrowed brow, and concern. FICO stands for Fair Isaac & Company, and credit scores are reported by each of the three major credit bureaus: TRW (Experian), Equifax, and Trans-Union. The score does not come up exactly the same on each bureau because each bureau places a slightly different emphasis on different items. Scores range from 365 to 840. Some of the things that affect your FICO scores:
- Too many accounts opened within the last twelve months
- Short credit history
- Balances on revolving credit are near the maximum limits
- Public records, such as tax liens, judgments, or bankruptcies
- No recent credit card balances
- Too many recent credit inquiries
- Too few revolving accounts
- Too many revolving accounts
Sounds confusing, doesn’t it?
The credit score is actually calculated using a “scorecard” where you receive points for certain things. Creditors and lenders who view your credit report do not get to see the scorecard, so they do not know exactly how your score was calculated. They just see the final scores. Basic guidelines on how to view the FICO scores vary a little from lender to lender. Usually, a score above 680 will require a very basic review of the entire loan package. Scores between 640 and 680 require more thorough underwriting. Once a score gets below 640, an underwriter will look at a loan application with a more cautious approach. Many lenders will not even consider a loan with a FICO score below 600, some as high as 620.
FICO Scores and Interest Rates
Credit scores can affect more than whether your loan gets approved or not. They can also affect how much you pay for your loan, too. Some lenders establish a “base price” and will reduce the points on a loan if the credit score is above a certain level. For example, one major national lender reduces the cost of a loan by a quarter point if the FICO score is greater than 725. If it is between 700 and 724, they will reduce the cost by one-eighth of a point. A point is equal to one percent of the loan amount. There are other lenders who do it in reverse. They establish their base price, but instead of reducing the cost for good FICO scores, they “add on” costs for lower FICO scores. The results from either method would work out to be approximately the same interest rate. It is just that the second way “looks” better when you are quoting interest rates on a rate sheet or in an advertisement.
FICO Scores and Mortgage Underwriting Decisions
FICO Scores as Guidelines
FICO scores are only “guidelines” and factors other than FICO scores affect underwriting decisions. Some examples of compensating factors that will make an underwriter more lenient toward lower FICO scores can be a larger down payment, low debt-to-income ratios, an excellent history of saving money, and others. There also may be a reasonable explanation for items on the credit history which negatively impact your credit score.
They Don’t Always Make Sense
Even so, sometimes credit scores do not seem to make any sense at all. One borrower with a completely flawless credit history had a FICO score below 600. One borrower with a foreclosure on her credit report had a FICO above 780.
Portfolio & Sub-Prime Lenders
Finally, there are a few “portfolio” lenders who do not even look at credit scoring, at least on their portfolio loans. A portfolio lender is usually a savings & loan institution who originates some adjustable rate mortgages that they intend to keep in their own portfolio instead of selling them in the secondary mortgage market. They may look at home loans differently. Some concentrate on the value of the home. Some may concentrate more on the savings history of the borrower. There are also “sub-prime” lenders, or “B & C paper” lenders, who will provide a home loan, but at a higher interest rate and cost.
Running Credit Reports
One thing to remember when you are shopping for a home loan is that you should not let numerous mortgage lenders run credit reports on you. Wait until you have a reasonable expectation that they are the lender you are going to use to obtain your home loan. Not only will you have to explain any credit inquiries in the last ninety days, but numerous inquiries will lower your FICO score by a small amount. This may not matter if your FICO is 780, but it would matter to you if it is 642.
Don’t Buy A Car Just Before Looking for a Home!
In conclusion, a word of advice not directly related to FICO scores. When people begin to think about the possibility of buying a home, they often think about buying other big ticket items, such as cars. Quite often when someone asks a lender to pre-qualify them for a home loan there is a brand new car payment on the credit report. Often, they would have qualified in their anticipated price range except that the new car payment has raised their debt-to-income ratio, lowering their maximum purchase price. Sometimes they have bought the car so recently that the new loan doesn’t even show up on the credit report yet, but with six to eight credit inquiries from car dealers and automobile finance companies it is kind of obvious. Almost every time you sit down in a car dealership, it generates two inquiries into your credit.
Credit History is Important
Nowadays, credit scores are important if you want to get the best interest rate available. Protect your FICO score. Do not open new revolving accounts needlessly. Do not fill out credit applications needlessly. Do not keep your credit cards nearly maxed out. Make sure you do use your credit occasionally. Always make sure every creditor has their payment in their office no later than 29 days past due. And never ever be more than thirty days late on your mortgage. Ever.
Items You Need for When Applying For a Loan
Have These Items Ready When You Apply For a Loan
It used to be that lenders mailed out verifications to employers, banks, mortgage companies, and so on, in order to verify the data supplied by borrowers. Nowadays, the interest is often in speed and getting answers quickly, so “alternate documentation” has become more widely used. Alternate documentation means that underwriting answers can be obtained with information supplied directly from the borrower instead of waiting around for verifications to come back in the mail. The following is required for most standardized loans as part of alternate documentation processing. Items may differ according to whether your loan is a conforming (Fannie Mae or Freddie Mac), non-conforming (jumbo) loan, government loan, or a portfolio loan. Verifications are still mailed out, but usually as part of quality control procedures.
These are the things you need to supply to your lender to get a quick approval using alternate documentation
- W2 forms for the last two years
- Pay stubs covering a 30 day period
- Federal tax returns (1040’s) for the last two years, if:
- you are self-employed
- earn more than 25% of your income from commissions or bonuses
- own rental property
- or are in a career where you are likely to take non-reimbursed business expenses
- Year-to-Date Profit and Loss Statement (for self employed)
- Corporate or partnership tax returns (if applicable)
- Pension Award letter (for retired individuals)
- Social Security Award letters (for those on Social Security)
- Bank statements for previous two months (sometimes three) on all accounts. All pages.
- Statements for two months on all stocks, mutual funds, bonds, etc, etc.
- Copy of latest 401K statement (or other retirement assets)
- Explanations for any large deposits and source of those funds
- Copy of HUD1 Settlement Statement on recent sales of homes
- Copy of Estimated HUD1 Settlement Statement if a previous home is for sale, but not yet closed
- Gift letter (if some of the funds come as a gift from a family member)
- Gifts can also require:
- Verification of donor’s ability to make the gift (bank statement)
- Copy of the check used to make the gift
- Copy of the deposit receipt showing the funds deposited into bank account or escrow
- Landlord’s name, address, and phone number (for verification of rental)
- Explanations for any of the following items which may appear on your credit report:
- Late payments
- Credit inquiries in the last 90 days
- Copy of bankruptcy papers if you have filed bankruptcy within the last seven years
- Copy of purchase agreement (if you have already made an offer)
- To document receipt of child support (if you desire to show it as income)
- Copy of Divorce Settlement (to show the amount)
- Copies of twelve months canceled checks to document actual receipt of fund
- Copy of Social Security Card (or other documentation of social security number)
- Copy of Driver’s license
- Copy of DD214
- Copy of Note on existing loan
- Copy of HUD1 Settlement Statement on existing loan
- Name, address, phone number, loan number of existing loan/lender
Where Does the Money Come From for Mortgage Loans?
In the “olden” days, when someone wanted a home loan they walked downtown to the neighborhood bank or savings & loan. If the bank had extra funds laying around and considered you a good credit risk, they would lend you the money from their own funds. It doesn’t generally work like that anymore. Most of the money for home loans comes from three major institutions:
- Fannie Mae (FNMA – Federal National Mortgage Association)
- Freddie Mac (FHLMC – Federal Home Loan Mortgage Corporation)
- Ginnie Mae (GNMA – Government National Mortgage Association)
This is how it works:
You talk to practically any lender and apply for a loan. They do all the processing and verifications and finally, you own the house and now you have a home loan and you make mortgage payments. You might be making payments to the company who originated your loan, or your loan might have been transferred to another institution. The institution where you mail your payments is called the “servicer,” but most likely they do not own your loan. They are simply “servicing” your loan for the institution that does own it.
You see, what happens behind the scenes is that your loan got packaged into a “pool” with a lot of other loans and sold off to one of the three institutions listed above. The servicer of your loan gets a monthly fee from the investor for servicing your loan. This fee is usually only 3/8ths of a percent or so, but the amount adds up. There are companies that service over a billion dollars of home loans and it is a tidy income. At the same time, whichever institution packaged your loan into the pool for Fannie Mae, Freddie Mac, or Ginnie Mae, has received additional funds with which to make more loans to other borrowers. This is the cycle that allows institutions to lend you money. What Freddie Mac, Ginnie Mae, and Fannie may do after they purchase the pools, is break them down into smaller increments of $1000 or so, called “mortgage backed securities.” They sell these mortgage backed securities to individuals or institutions on Wall Street. If you have a 401K or mutual fund, you may even own some. Perhaps you have heard of Ginnie Mae bonds? Those are securities backed by the mortgages on FHA and VA loans. These bonds are not ownership in your loan specifically, but a piece of ownership in the entire pool of loans, of which your loan is only one among many. By selling the bonds, Ginnie Mae, Freddie Mac, and Fannie Mae obtain new funds to buy new pools so lenders can get more money to lend to new borrowers. And that is how the cycle works.
So when you make your payment, the servicer gets to keep their tiny part, and the majority is passed on to the investor. Then the investor passes on the majority of it to the individual or institutional investor in the mortgage backed securities. From time to time your loan may be transferred from the company where you have been making your payment to another company. They aren’t selling your loan again, just the right to service your loan.
There are exceptions. Loans above $227,150 do not conform to Fannie Mae and Freddie Mac guidelines, which is why they are called “non-conforming” loans, or “jumbo” loans. These loans are packaged into different pools and sold to different investors, not Freddie Mac or Fannie Mae. Then they are securitized and for the most part, sold as mortgage backed securities as well. This buying and selling of mortgages and mortgage backed securities is called “mortgage banking,” and it is the backbone of the mortgage business.
Types of Mortgage Lenders
Mortgage Bankers are lenders that are large enough to originate loans and create pools of loans which they sell directly to Fannie Mae, Freddie Mac, Ginnie Mae, jumbo loan investors, and others. Any company that does this is considered to be a mortgage banker. Some companies don’t sell directly to those major investors, but sell their loans to the mortgage bankers. They often refer to themselves as mortgage bankers as well. Since they are actually engaging in the selling of loans, there is some justification for using this label. The point is that you cannot reliably determine the size or strength of a particular lender based on whether or not they identify themselves as a mortgage banker.
An institution which is lending their own money and originating loans for itself is called a “portfolio lender.” This is because they are lending for their own portfolio of loans and not worried about being able to immediately sell them on the secondary market. Because of this, they don’t have to obey Fannie/Freddie guidelines and can create their own rules for determining credit worthiness. Usually these institutions are larger banks and savings & loans. Quite often only a portion of their loan programs are “portfolio” product. If they are offering fixed rate loans or government loans, they are certainly engaging in mortgage banking as well as portfolio lending.
Once a borrower has made the payments on a portfolio loan for over a year without any late payments, the loan is considered to be “seasoned.” Once a loan has a track history of timely payments it becomes marketable, even if it does not meet Freddie/Fannie guidelines. Selling these “seasoned” loans frees up more money for the “portfolio” lender to make more loans. If they are sold, they are packaged into pools and sold on the secondary market. You will probably not even realize your loan is sold because, quite likely, you will still make your loan payments to the same lender, which has now become your “servicer.”
Lenders are considered to be direct lenders if they fund their own loans. A “direct lender” can range anywhere from the biggest lender to a very tiny one. Banks and savings & loans obviously have deposits they can use to fund loans with, but they usually use “warehouse lines of credit” from which they draw the money to fund the loans. Smaller institutions also have warehouse lines of credit from which they draw money to fund loans. Direct lenders usually fit into the category of mortgage bankers or portfolio lenders, but not always.
One way you used to be able to distinguish a direct lender was from the fact that the loan documents were drawn up in their name, but this is no longer the case. Even the tiniest mortgage broker can make arrangements to fund loans in their own name nowadays.
Correspondent is usually a term that refers to a company which originates and closes home loans in their own name, then sells them individually to a larger lender, called a sponsor. The sponsor acts as the mortgage banker, re-selling the loan to Ginnie Mae, Fannie Mae, or Freddie Mac as part of a pool. The correspondent may fund the loans themselves or funding may take place from the larger company. Either way, the loan is usually underwritten by the sponsor. It is almost like being a mortgage broker, except that there is usually a very strong relationship between the correspondent and their sponsor.
Mortgage Brokers are companies that originate loans with the intention of brokering them to lending institutions. A broker has established relationships with these companies. Underwriting and funding takes place at the larger institutions. Many mortgage brokers are also correspondents. Mortgage brokers deal with lending institutions that have a wholesale loan department.
Most mortgage bankers and portfolio lenders also act as wholesale lenders, catering to mortgage brokers for loan origination. Some wholesale lenders do not even have their own retail branches, relying solely on mortgage brokers for their loans. These wholesale divisions offer loans to mortgage brokers at a lower cost than their retail branches offer them to the general public. The mortgage broker then adds on his fee. The result for the borrower is that the loan costs about the same as if he obtained a loan directly from a retail branch of the wholesale lender.
Banks and Savings & Loans – Banks and savings & loans usually operate as portfolio lenders, mortgage bankers, or some combination of both.
Credit Unions – Credit Unions usually seem to operate as correspondents, although a large one could act as a portfolio lender or a mortgage banker.
The Advantages of Different Types of Mortgage Lenders
What kind of lender is “best?”
If you ask a loan officer, “What kind of lender is best?” it is going to be whatever kind of company he works for and he will give you a list of reasons why. If you meet the same loan officer years later, and he works for a different kind of lender, he will give you a list of reasons why that type of lender is better. Realtors will also have differing opinions, and their opinions have changed over time. In the past, it seemed like most would often recommend portfolio lenders. Now they usually recommend mortgage bankers and mortgage brokers. Most often they direct you to a specific loan officer who has demonstrated a track record of service and reliability.
This article discusses the advantages and disadvantage of different types of institutions, not the individual loan officers. However, it is often more important to choose the correct loan officer, not the institution. The loan officer has many responsibilities, one of which is to act as your representative and advocate to the lender he works for or the institutions he brokers loans to. You want someone who has proven dependable and ethical in the past. Regarding the institutions, the truth of the matter is that each type of lender has strengths and weaknesses. This does not even take into account the variety of other factors that influence whether a lender is “good” or “bad.” Quality can vary, depending on the loan officer, the support staff, which branch or office you are obtaining your loan from, and a variety of other factors.
Savings & Loans are quite often portfolio lenders, as are some banks. Portfolio lenders generally promote their own portfolio loans, which are usually adjustable rate loans. They will often pay more compensation to their loan officers for originating a portfolio product than for originating a fixed rate loan. You may also find that they are not as competitive as mortgage bankers and brokers in the fixed rate loan market. However, it is often easier to qualify for a portfolio loan, so borrowers who may not qualify for a fixed rate loan may be able to obtain a loan from a portfolio lender. A borrower may be able to qualify for a larger loan from a portfolio lender than he could obtain from a fixed rate lender.
Portfolio lenders also can serve as “niche” lenders because certain things are more important to them than meeting the more standardized underwriting guidelines of a mortgage banker. An example would be a savings & loan which is more concerned with an individual’s savings history than being able to fully document income, among others things. If you apply for a loan with a portfolio lender and you are declined, you usually have to start the process over with a new company.
If we are talking about the larger mortgage bankers, you can count on them having several strengths. For the biggest ones, you will recognize the “brand name.” Usually, they are much better at promoting special first time buyer programs offered by states and local governments, that have lower interest rates and costs than the current market rate. These programs are often available to buyers who have not owned a home in the last three years and fall within certain income guidelines. Mortgage bankers may have problems just because they are “too big” or they may operate like well oiled machines. If you are buying a home and you need a VA or FHA loan and the development you are buying in has not yet been approved, they will be better at getting it approved than other lenders.
If your home loan is declined for some reason, many mortgage bankers allow their loan officers to broker the loan to another institution. However, because your loan officer is so used to promoting the company’s product, he may not be familiar with which institution may be the best one to submit your loan to. Another reason is because wholesale lenders do not expect to get many loans from direct mortgage bankers, so they do not expend much marketing effort on them.
BANKS and SAVINGS & LOANS
Their major strength is that you will recognize their name. In addition, they will usually be operating as a mortgage banker. a portfolio lender, or both, and have the same weaknesses and strengths.
The major strength of mortgage brokers is that they can shop the wholesale lenders for which lender has the best rate much easier than a borrower can on his own. They also learn the “hot points” of certain wholesale lenders and can hand-pick the lender for a borrower which may be unique in some way. He will be able to advise you whether your loan should be submitted to a portfolio lender or a mortgage banker. Another advantage is that, if a loan gets declined for some reason, they can simply repackage the loan and submit it to another wholesale lender. One additional advantage is that mortgage brokers tend to attract a high number of the most qualified loan officers. This is not universal. Mortgage brokers also serve as the training ground for those just entering the business. If you have a new loan officer and there is something unique about you or the property you are buying, there could be a problem on the horizon that an experienced loan officer would have anticipated. A disadvantage is that mortgage brokers sometimes attract the greediest loan officers, too. They may charge you more on your loan which would then nullify the ability of the mortgage broker being able to “shop” for the lowest rate.
Borrowers cannot get access to the wholesale divisions of mortgage bankers and portfolio lenders without going through a broker.
When Realtors or Builders Recommend a Lender
If your Realtor or builder make a suggestion for a lender, be sure to talk to that lender. One reason Realtors and builders make suggestions has to do with the fact that they have regular dealings with this lender and have come to expect a certain amount of reliability. Reliability is extremely important to all parties involved in a real estate transaction. On the other hand, a recent trend in mortgage lending has been for real estate companies and builders to own their own mortgage companies or create “controlled business arrangements” (CBA’s) in order to increase their profitability. These mortgage brokers sometimes become used to having what is essentially a “captured market” and may not necessarily offer you the lowest rates or costs. Some real estate companies also offer different types of incentives to their Realtors to recommend their company-owned mortgage and escrow companies or lenders with whom they have CBA’s. Dealing with one of these lenders is not necessarily a bad thing, though. The builder or real estate company often feel they have more ability to expedite matters when they own the company or have a controlled business relationship. They cannot usually influence the underwriting decision, but they can sometimes cut through “red tape” to handle problems or speed up the process. Builders are especially forceful on having you use their lender. One reason is that there are certain intricacies in dealing with new homes. If you use a loan officer who usually deals with refinances or resale home loans, he may not even be aware of how different it is to close a mortgage on a new home and this can lead to problems or delays. It is in your interest to know if there is any kind of ownership relationship or controlled business arrangement between the real estate or builder and the lender, so be sure to ask. Do not automatically disqualify such a lender, but be sure to be more vigilant on getting the best interest rate and the lowest costs.
Make sure to do a little shopping for yourself. By knowing the interest rates of the market and making sure your loan officer knows you are looking at rates from other institutions, you can use that as leverage to make sure you are obtaining the best combination of service and lowest rates.
The No-Cost Thirty Year Fixed Rate Mortgage
There really is no such thing as a “no-cost” mortgage loan. There are always costs, such as appraisal fees, escrow fees, title insurance fees, document fees, processing fees, flood certification fees, recording fees, notary fees, tax service fees, wire fees, and so on, depending on whether the loan is a purchase or a refinance. The term “no-cost” actually means that your lender is paying the costs of the loan. All a “no cost” loan means is that there is no cost to you, the borrower.
- Except that you pay a higher interest rate
- Understand How Loans Are Priced
A variation of the no-cost loan is the “no points” loan, or even the “no points, no lender fees” loan. On these loans you pay all the costs associated with buying a house or refinancing, but you do not have to pay the lender associated fees or points. However, since lenders and loan officers do not do anything for free, the profit has to come from somewhere.
So where does it come from?
First, you have to understand how loans are priced and how mortgage lenders and loan officers earn income. Each morning mortgage companies create rate sheets for loan officers. The rates usually change slightly from day to day. In volatile markets they change several times a day. On the rate sheet, there are many different programs, including the thirty year fixed rate. There will be one column which will lists several different interest rates and another column that lists the “cost” for that particular rate. For example:
In the above example, 6.75% has a “par” price, which means it has a zero cost. The lower in rate you go, the higher the cost, or “points.” A point is equal to one percent of the loan amount. The parentheses in the cost column for the higher interest rates indicates a negative number. For example, (1.500) equals -1.500, which means instead of having a cost associated with the loan, the lender is willing to pay out money for those interest rates. This is called “premium” or “rebate” pricing.
Zero Cost Loans
How Mortgage Companies and Loan Officers Make Money
The above rate sheet is not a rate sheet designed for public review. In fact, most lenders have a policy that the public cannot see their internal rate sheet. This rate sheet is designed for loan officers and the cost column is the loan officer’s cost, not the cost to the borrower. When the loan officer quotes you an interest rate, he will add on a certain amount, usually one to one and a half points. Most companies leave it up to the loan officer’s discretion how much to add on to the base cost. However, they usually require at least a minimum add-on, which is usually one point. The loan officer’s commission depends on his “split” with the company and can vary. He receives a portion of the add-on and the rest goes to the company. If we assume the loan officer is adding on one point, and you were willing to pay one point for your loan, then your rate would be (according to this rate sheet) 6.75%. You would pay one percentage point and receive an interest rate of six and three-quarters. If you wanted a lower rate and were willing to pay two points, you could get six and a half percent. If you wanted a “no points” loan, then your rate would be seven percent. The loan officer and the mortgage company would split the one point rebate, listed as (1.000) on the rate sheet.
See how it works?
In addition to the cost noted on the rate sheet above, lenders have certain other fees they like to collect, too. These can include document fees, processing fees, underwriting fees, warehouse fees, flood certification fees, wire transfer fees, tax service fees, and so on. Usually, you will not be charged all of these fees, it is just that different lenders call them different things. Some of them are legitimate costs to the lender and some of them are simply fees designed to generate additional income to the mortgage company. They are customary in today’s mortgage market and can vary from around $600 to $1300. In addition, there will usually be an appraisal fee and a credit report fee. Appraisals and credit reports are usually contracted out to independent companies even though these are considered to be lender fees. Note that it is common for companies who charge higher fees to have a slightly lower interest rate and companies that charge lower fees will usually have a slightly higher interest rate. So if you shop entirely based on fees, you may actually spend more money in the long run because your interest rate may be higher.
The point is that if you want a “no points – no lender fees” loan, then on our rate sheet above, you may get an interest rate of 7.125%. That is because the loan officer has to bump the interest rate even further than on a “no points” loan in order to cover his own company’s fees. If you want a “no cost” loan, then the loan officer has to bump your interest rate even further. That is because all of the costs on your purchase or refinance do not come from the lender. The escrow or settlement company involved in your transaction will charge a fee which must be paid. The lender will require title insurance and the title insurance company charges a fee for providing this insurance. If your new lender requires information from your homeowner’s association (if you have one) then the homeowner’s association will most likely charge a fee for providing those documents. If you are refinancing, your current lender will usually charge at least two fees: a “demand” fee, and a “reconveyance” fee. The demand fee is charged simply for providing payoff information. The reconveyance fee is charged because your current lender prepares a document which releases your property as collateral for their outstanding loan. This document is called a reconveyance. These charges will add about another point to how much the loan officer must collect in premium pricing in order to cover the costs associated with your refinance or purchase. For a zero cost loan, he will normally need to collect somewhere in the neighborhood of two and a half points. Because points are a percentage of your loan amount and most of the costs are fixed, it takes fewer points to provide zero costs on higher loan amounts. On smaller loan amounts it takes more. One percent of $200,000 is two thousand dollars and one percent of $100,000 is only $1000, so you can see how it is easier to cover costs on larger loans.
Does it makes sense to do a zero cost loan?
On a $200,000 thirty year fixed rate loan, the difference in monthly mortgage payments will be about $87, using the example rate sheet on the first page. Over thirty years, it works out that you will pay more than $30,000 extra for getting a zero cost loan. So if you intend to remain in the home for a long period of time it just doesn’t make sense. Suppose you intend to stay for only five years? On a purchase, using the $200,000 example, if you stayed longer than fifty-five months, it would make more sense to pay your own costs and get the lower interest rate. If you kept the loan for a shorter time, then it makes more sense to pay zero costs and get a higher interest rate.
Except for one thing
If you knew you were only going to be staying in the home for five years you would probably not want a thirty year fixed rate, anyway. You would get a loan which has a fixed payment for the first five years, then convert to an adjustable or whatever fixed rates are five years from now. These loans have an interest rate almost a half percent lower than thirty year fixed rate loans. Since it is practically impossible to do a zero cost loan on this type of loan, you would have to compare a zero cost thirty year fixed rate loan to paying points on a loan with a fixed payment for five years. The difference in payments would be about $150. The two and a half point rebate equals $5000. Working out the math, if you stayed in the home longer than thirty-three months, it would make more sense to pay the points and get the loan with the five year fixed rate.
Finally, carry the discussion one step further. Suppose you know you are going to be in the new loan for less than three years? Doesn’t it make sense to get a “zero cost” loan then?
Then you get an adjustable rate loan. As long as the start rate is two percent lower than the current fixed rate, you cannot lose. The first year you will save a lot of money. The second year you will probably break even. The third year, you will probably give up some of the savings from the first year, but not all of them.
“Zero cost” loans just don’t make sense for Homebuyers. But they sound really good in an advertisement.
On a FHA Streamline Refinance Without an Appraisal (not a purchase – which is what the article talks about), it makes sense to do a zero cost loan. This is mostly because the new loan has to be exactly the same amount as the existing balance of the current loan. If the Homebuyer only has enough money for down payment and none to cover closing costs, PLUS no arrangement can be made for the seller to pay closing costs, then zero costs may make sense (however, I would still recommend negotiating terms with the homeseller – be willing to pay a higher price in exchange for the seller paying your costs)
An alternative to a non-conforming loan is the use of a land contract, which is allowed in some states. A land contract is an agreement between a buyer and a seller, where the buyer agrees to make periodic payments to the seller. The title to the property only transfers to the land contract buyer on fulfillment of the land contract obligations.
A land contract can be helpful for those who need time to establish or improve their credit rating. There are only small closing costs, and payment can help establish a good mortgage payment record. This can help establish an overall good credit rating, and it is possible for the buyer to later refinance the land contract with a conforming loan.
On the other hand, there are risks associated with land contracts. Land contract purchases are not necessarily recorded in the public record, and there are no guarantees that the seller will be able to transfer a clear title to the buyer upon fulfillment of the land contract. There also is no lender assuring that the purchase price for the property is justified, and no inspection of the property’s condition.
Another alternative to a non-conforming loan is assuming the seller’s mortgage. By assuming a mortgage, if the mortgage is assumable, it is possible to save on closing costs, and may allow you to obtain a favorable interest rate.