MORTGAGE 101
Since buying a home is such a big investment and is something that people pay on for 30 years, I believe it is critical to understand the basics of the mortgage process and the different aspects of a mortgage. This page is designed to help you understand mortgages so you can make a better decision when purchasing a home. If you would like to learn more about a certain topic or would like help buying your next home, reach out to me, Blake Davenport, a licensed REALTOR® and local expert via the contact information on the footer of the website.
How Much Can You Afford?
When looking to buy a house, the first thing that you should do is get a rough estimate of much house you realistically can afford. Even if you are not ready to start the home buying process, it is very easy to get a rough estimate of your spending ability. There are great websites like realtor.com that provide calculators of how much your monthly payment would be given specifics like the loan type and interest rate, down payment, and your household income. After you enter those details, it will give you a rough estimate of what you can afford and what your monthly payment would be. To see how much you could afford, hit the button below.
Understanding the Different Types of Mortgage Loans
Fixed Rate vs Adjustable Rate Mortgages
Fixed rate mortgage loans mean that the interest rate stays the same across the entire life of the loan. Adjustable rate mortgage (ARM) loans have interest rates that change every year based on the world index.
While adjustable rates usually start off at a lower interest rate than fixed rate mortgages, they often can end up much higher. There are also hybrid ARMs such as 5/1 ARM which means that the interest rate stays fixed for 5 years, then adjusts every year after that. This type of mortgage might be good for a family that has to move to an area for a short amount of years. Since the future is unsure for a lot of people, the most common type of mortgage is a 30 year fixed rate loan.
Government Insured vs Conventional Mortgages
There are three type of government insured mortgages: FHA, VA, and USDA.
FHA (Federal Housing Administration) is a mortgage program ran by the Department of Housing and Urban Development (HUD) that insures the lender against a borrower defaulting. With this type of loan, you can make a down payment as low as 3.5% of the purchase price. While this sounds enticing, look at the mortgage rates explained section below to see how that affects the amount of money you pay over the course of the loan.
VA Loans are loans offered by the US Department of Veterans Affairs (VA) to military members and their families. Like FHA loans, VA Loans are insured by the government to protect the lender from a borrower default. In this type of loan, borrowers can receive up to 100% of the purchase price.
USDA (United States Department of Agriculture) is a type of government loan offered to rural residents who have a low income and cannot acquire a conventional loan. Since Arlington is not a rural area, this type of loan is not applicable to this area.
Conventional Mortgages are loans that are not insured by the federal government. Therefore, a lender is not protected from losses if the borrower defaults. Conventional mortgages are the most common mortgage.
Conforming vs Jumbo Loan
Conforming loans meet the guidelines set by Fannie Mae or Freddie Mac which means they are below $726,200.
Jumbo loans do not meet the guidelines set by Fannie Mae or Freddie Mac and thus are above $726,200. It is a high risk loan for the lender so usually they are only given to borrowers with excellent credit and big down payments.
Mortgage Rates Explained
Since a house is something that most people make payments on for a large majority of their life, I want to stress the importance of understanding compound interest. So let’s run through an example of the different types of mortgage loans at different interest rates so you can get a better understanding of how much you are really paying for the house over the set loan period.
Lets say you want to buy a 2bd/2bth condo in Clarendon and got a deal for $500,000. We will show four different mortgage loans and compare them to see how much different interest rates, down payments and loan periods affect the long term cost of the loan. The four different mortgage loans are Base Mortgage, Higher Interest Mortgage, Minimum Down Payment Mortgage and Shorter Loan Period Mortgage. See the comparison table below.
*PMI is usually 0.5-1.0% of the mortgage loan. A borrower has to pay PMI until they obtain at least 20% equity. In this example, the borrower will obtain 20% at roughly the 8 year mark.
The "Base Mortgage" is a typical 30 year fixed conventional mortgage with a 20% down payment. Your monthly payment would be $1,796.18 and the $500,000 house will end up costing $746,624.35.
The "Higher Interest" mortgage is also a typical 30 year fixed conventional mortgage with a 20% down payment and an interest rate of 4.5%; 1% higher than the "Base Mortgage." Your monthly payment would be $2,026.74 and the $500,000 house will end up costing $829,626.85. It is a good example of how just 1% can result in an extra $83,002.50 spent in interest over 30 years!
The "Minimum Down Payment" mortgage is a 30 year fixed FHA mortgage but you only put 3.5% down. Your monthly loan payment would be $2,166.64 + $275 for the PMI = $2441.64! It will be this much for roughly 8 years until you pay off 20% of the mortgage, then it will reduce to $2,166.64. So since you did not put down 20%, the PMI will cost an extra $26,400 over those 8 years. The $500,000 house will end up costing $823,890.62! It is a good example of how a low down payment can result in an extra $77,266.27 spent in interest over 30 years compared to the "Base Mortgage"!
The "Shorter Loan Period" mortgage is a 15 year fixed conventional mortgage with a 20% down payment. Your monthly payment would be $2,859.53 and the $500,000 house will end up costing $614,715.43. It is a good example of how 15 less years of payments can result in a savings of $131,908.92 in interest compared to the "Base Mortgage"! Also, shorter term mortgages have lower interest rates which could save you even more money.
These examples were not meant to scare you, however, just teach you how powerful compound interest can be. You might be thinking, I’ll never be able to afford a home. Well here is some advice: never try to live above your means. It is always easier to upgrade than downgrade. It is also important to note that your house will appreciate over the course of your life. On average, houses have appreciated around 2-3% per year over the past century. Therefore, purchasing a house is a long term investment.
These examples are also meant to teach you to shop around when obtaining a loan. A few percentage points or a couple of extra thousand dollars spent on the down payment can have a huge effect over the course of 30 years.
Also note, the above examples do not include Real Estate taxes or homeowners insurance so the monthly payment would be even higher. It is important to know that your monthly mortgage payment will include your real estate taxes (~1% of your home's assessed value in Virginia) and your home owners insurance (usually less than $100 per month).
-Figures in the above table were calculated from a mortgage calculator on www.BankRate.com.
Mortgage Process - Start to Finish
Get Pre-Approved – Go to a lender to see how much you can afford to spend on a home. A lender will do a credit check. You will need to bring items like your proof of income, proof of assets, employment verification, driver’s license and social security number. It is important to note that just because you get pre-approved with a lender does not mean you have to use them to get your loan.
Accepted Sales Contract – Find the home that you wish to purchase and obtain an accepted sales contract.
Loan application – Complete the loan application once you have the accepted sales contract. Once completed, the lender is responsible for sending you a Good Faith Estimate (GFE) and Truth-In-Lending Disclosure (TIL) within 3 days disclosing all the rates and expected fees for obtaining the loan.
Locking In Your Interest Rate – You will have the option to lock in your interest rate or choose to wait to lock it in at a later time.
Acquire Home Owners Insurance – Your lender will want to know who will be your home owner’s insurance provider.
Order An Appraisal – Loans are based off the market value of the house so it is important for the lender to prove that the house is worth their investment.
Loan Underwriter Review – Appraisal, asset, and income documentation is given to the loan underwriter for final approval. Once the loan underwriter approves, loan documents are ordered.
Escrow and Title Preparation – A title company or attorney will conduct title work and hold money and all documents until final mortgage approval.
Closing the Loan – Once the lender approves the loan, a cashier check is brought to settlement to be used in exchange for the title of the property.
*It is important to note that while these steps take place in obtaining a mortgage process, the order might be slightly different based on the lender and mortgage.
Hidden Fees / Closing Costs
Overall, typical closing costs are around 2-5% of the purchase price of the home. Here are a breakdown of some of the most common fees.
Origination fee – A lot of lenders will charge a fee for just creating a mortgage. This fee can be as high as 1% of the loan. Just remember these are negotiable depending upon how good the borrower’s credit is.
Discount points – Discount points can be viewed as prepaid interest in order to lower the interest rate on the mortgage loan. Each discount point generally costs 1% of the loan and can lower the interest rate by 1/8% to 1/4%. While this isn’t a requirement for a borrower, it is a way to save money over the duration of the loan.
Credit Report/Loan Application – Fee charged by your lender for applying for a loan. Usually costs less than a $100, but you can negotiate to remove this fee since you are already paying an origination fee.
Initial Interest – Your lender asks you to pay the first interest payment on the mortgage loan from the close date till the end of the month. Depending on the size of your loan and interest rate, it should be less than $1,000.
Private Mortgage Insurance – If you get a loan with a down payment less than 20% LTV (Loan to Value Ratio), you will have to get private mortgage insurance to protect the lender from your possible default on the property. LTV is the ratio loan to the property's value, not the sales price. Lender's require borrower's to get private mortgage insurance when the LTV is less than 20%. This can range from 0.5%-1% of the loan value. The borrower can request for this to go away once they acquire 20% equity of the property and it automatically terminates once the 22% equity is reached. This is a big a reason why it is good to have a larger down payment when buying a house.
Closing/Escrow Fee – There are usually title fees that occur when a loan is closed by the title company or attorney. The title company performs a search of the title and handles the legal side of the real estate transaction. These fees can range from $500 - $1,000.
Title Insurance – It is important to obtain title insurance to protect against any mishaps like improperly recorded legal documents, gaps in the chain of title, forged deeds, etc. This varies by company but is usually less than 0.5% of the purchase price.
Recordation Tax – The local government charges a fee to record the sale of the home. In Virginia, the recordation tax is $0.25 on every $100. So that comes out to $750 for a $300,000 house.
Property Taxes - If the previous owner prepaid the real estate property taxes for that year, then the buyer has to pay the prorated amount for the rest of the year.