Even though it's probably
the largest purchase they'll ever make, few consumers take the time to really
go "behind the scenes" to more fully understand the complex world of
mortgage lending. Learning the terms and working to understand your mortgage
can help save you time, money, and a whole lot of headaches.
Qualifying for a Mortgage
Whether you're looking for a
first mortgage on a new home, to refinance an existing mortgage, or take out a
second mortgage, the interest rate you'll be offered depends on the same
factors:
- Your total monthly household income compared to both the mortgage payment alone, (known as the "front-end ratio") as well as all of your monthly obligations including the mortgage (total debt-to-income ratio)
- The value of your property compared to the liabilities placed on it (otherwise known as the "loan to value," or LTV)
- Your credit report from the various credit reporting agencies such as Equifax and Fair Isaac (which compiles the well-known and commonly used "Fico score")
The "processing"
of your loan is the preparation of all relative documents to verify, prove, and
package together all information pertinent to these factors.
“A” vs. Sub-Prime First Mortgages
There are strict
requirements to qualify for so-called “Conforming A” loans, which generally
offer the lowest rates and terms available. Those who do not meet these
requirements have a great many options available to them in qualifying for
“Non-Conforming A” mortgages or Sub-Prime mortgages, at rates somewhat higher
than Conforming rates.
The best rates are usually
available to low-risk borrowers – those who meet Conforming A loan standards.
Generally speaking, requirements for Conforming A loans include: credit scores
in excess of 620 points, income ratios between 28% and 40%, and loan-to-value
ratios below 95% on new home purchases and no-cash-out refinances and below 80%
on cash-out refinances. A Conforming A loan must also be at or below a maximum
amount specified by the two federally chartered “repurchasers” of home loans,
Freddie Mac and Fannie Mae. For 2006, this limit is $417,000; loans above this
amount are called “jumbo” mortgages and generally carry a slightly higher
interest rate.
In the next tier are Non-Conforming
A loans. These are borrowers with good credit and loan-to-value ratios, but
whose income is either insufficient to accommodate a Conforming loan, or is not
easily verified. These loans are ideal for self-employed individuals or
small-business owners whose income is variable or difficult to verify.
For those who have credit
difficulties there are dozens of levels of credit rated from A- down to C-,
known as Sub-Prime mortgages. Rates on Sub-Prime mortgages vary widely based on
the borrower's individual credit scores, number of late payments in the last
two years, loan-to-value ratio, and other key factors.
When Does a Second Mortgage Make Sense?
A second mortgage is a loan
made to you in exchange for a lien against your property. This lien is subordinate
to the holder of your first mortgage - in the event of a default, the first
lienholder must be repaid in full before subsequent lienholders are repaid.
This makes the second mortgage a more risky investment for the lending
institution, and this risk is typically reflected in a higher interest rate.
Second mortgages are not
associated with the purchase of a new home, but rather are often taken out
simultaneously with a refinanced first mortgage or independently of any other
mortgages. The main reason for taking out a second mortgage is to take equity
from your home and turn it into cash in pocket. This cash is often used to
consolidate higher interest rate loans, pay late bills, pay taxes, purchase
vehicles or rental property, fund college expenses, and other uses.
It usually does not make
good financial sense to take out a second mortgage if you are having trouble
servicing all of your current debts, or if the second mortgage pushes you above
the 80% loan-to-value mark. Since interest on a second mortgage is generally
tax deductible, a home equity loan or line of credit can be a cost-effective
way to fund big-ticket items that would have to be purchased instead.
Ins and Outs of Mortgage Insurance
Mortgage insurance (MI) is a
monthly payment added to your mortgage used to establish a pool of funds to
indemnify lenders against default on first mortgages with "high"
loan-to-value ratios. Generally speaking, any first mortgage with a
loan-to-value ratio in excess of 80% requires mortgage insurance.
When refinancing a first
mortgage the same 80% ratio applies, unless cash is being taken out as well -
in such cases mortgage insurance is required for first mortgages with
loan-to-value ratios in excess of 75%. The cost of mortgage insurance increases
as loan-to-value increases, and the less equity you own in your home, the
greater the mortgage insurance payment.
Before you make any
decisions regarding your current mortgage, it's wise to review your current
financial situation, goals, and time horizon. Understanding more about how
mortgages work will help you make the best decision for your situation.
If we at Kemp Harvest Financial Group can
help you in any way with regard to your financial planning needs, please feel
free to contact
us.
For more topics like this, check out our radio show
“Retirement Plain and Simple” every Saturday morning at 8 on WNPV 1440 AM
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