How to finance your new home

Most of us can't pay cash for that new home. Here are tips on financing.

You love the neighborhood, the yard, the schools and shops nearby and the house--even with those few quirks you hadn't anticipated. Your dream home has fairly new windows, a high-quality gas heater and maybe even a new appliance or two.

Before you move forward you need to make sure you have good financing. Precious few people can afford to pay for a new home in full, so take the time now to ensure that you secure a loan you can live with for years to come.

After all, you spent plenty of time and energy choosing your home, and most likely you will have the loan for as long as you have the home. So use the same care financing your home as you did choosing it.

The first step in the financing process actually starts long before your search for a home, when you decide how much you are able to spend. Traditional recommendations range from two to two-and-one-half times your annual salary. Other standards dictate that homeowners spend about 38 percent of their annual salaries (after taxes) on total housing costs--including mortgage, insurance and utilities.

You need to be the judge of how much your family can afford. Do you anticipate your income will stay the same, increase or decrease over the years? Will your monthly costs level out, decrease when children move out on their own, or increase with a growing family or added education costs?

Your lender will also review how much you can afford to spend. To make that decision the lender will want to review some of your financial documents. Those documents could include the purchase contract for the house, bank account numbers, bank branch addresses, recent bank statements, pay stubs, W-2 forms, information about all loans, debts and credit cards, mortgage or rental payment receipts and a Certificate of Eligibility from the Veterans Administration if you want a VA-guaranteed loan. If you are self-employed, the lender may also want to review business tax returns and balance sheets from the past two or three years.

In the past, the majority of consumers secured 30-year fixed-rate mortgages (FRMs) to finance a home purchase. Today's market, however, offers consumers a number of different types of loans.

A conventional FRM carries the same interest rate and the same monthly payments throughout the life of the loan. These loans are generally offered in 15- or 30-year terms.

Two obvious benefits of a 15-year term are an earlier payoff date and a significantly lower overall interest charge. The monthly payments on a 15-year loan will be higher than those on a 30-year loan, though.

Because interest rates fluctuate from week to week and even from day to day, the rate a lender quotes when you are shopping around could be very different from the rate available when you finalize. Those rates can also increase after you apply for the loan, but before finalization. A few percentage points can dramatically increase (or decrease) the total interest you pay over the life of the loan.

Many lenders offer a lock-in on a quoted interest rate and sometimes on the number of points quoted. (A point equals one percent of the amount borrowed. Points are usually due at closing to secure the loan.) The lock-in ensures that if interest rates increase before finalization, the borrower can still secure the loan at the terms previously discussed.

A lock-in can also prevent the borrower from securing a lower rate if interest rates drop during that period. Some lenders, however, are willing to lock in at the lower rate. Lenders often charge a fee for the lock-in, which lasts for a pre-determined amount of time--usually between 30 and 60 days.

Written documentation that details the terms of a lock-in helps the borrower understand all the elements. A tangible record is also helpful if a dispute occurs between the borrower and the lender.

An increasingly common type of home financing is the adjustable-rate mortgage (ARM). The interest rate of an ARM adjusts periodically throughout the life of the loan.

Many lenders advertise ARM interest rates that are much lower than those for fixed-rate mortgages. Those rates often last for a short time and, after that initial period, the rates are adjusted on a regular basis. The time between rate changes--called the adjustment period--is usually one year. Three- and five-year adjustment periods are also available.

Lenders base those adjustments on a variety of indexes that fluctuate with the general movement of interest rates. Common indexes include the rates on Treasury securities, and the national or regional average cost of funds to savings and loan associations.

Be sure to find out the index used by your lender and take a look at that index's history. The lender then tacks a few percentage points onto the index rate to determine the final interest rate. That margin varies from lender to lender, so find out those terms also. The difference between a two- and a three-percent margin could mean thousands of dollars to you in the long run.

An ARM allows borrowers to take advantage of low initial rates. If interest rates drop over the life of the loan, you could also save money over an FRM.

Interest rates rise as often as they drop, though. A borrower who secures an ARM takes on the risk that interest rates could go up. Before assuming an ARM, evaluate how your finances will change in upcoming years. Can you afford monthly payments that could be higher than those you started with?

Lenders offer some options that reduce the risk assumed by ARM borrowers. Some ARMs also include the option to convert the loan to an FRM at a specified later date.

Federal regulations require that all ARMs include an overall cap on how much an interest rate can increase over the life of the loan.

Periodic interest-rate caps limit the increases between adjustment periods. Some ARMs limit the increase of your actual monthly payment from one adjustment period to the next. While a payment cap can keep down monthly costs, it can also cost you money down the road. If a cap keeps your monthly payments down as interest rates increase, your mortgage balance could also increase.

This negative amortization happens when your monthly payments are too small to cover the monthly interest. The difference is then tacked on to your debt. Some ARMs limit how much negative amortization a loan can accrue.

The key to finding the best mortgage for you and your family is to shop around, ask questions and seek professional advice. Talk to your real estate agent, your lender and, if possible, a real estate lawyer. Keep an eye on the shelter section of local and national newspapers to monitor the going rates.

A mortgage could be the most important and the longest-lasting financial decision you will ever make. A little time and education could make the difference between a catastrophe and a wise investment in your future.
 

GLOSSARY OF TERMS

Adjustable-Rate Mortgage - ARM: a mortgage where the interest rate changes during the life of the loan; also referred to as Adjustable Mortgage Loan or Variable-Rate Mortgage.

Amortization: When monthly payments are large enough to pay the interest and also reduce the principal on a mortgage; negative amortization occurs when monthly payments do not cover interest costs so the balance due increases.

Annual Percentage Rate - APR: a measure of the cost of credit, expressed as a yearly rate, including interest as well as other charges; this rate provides a good basis for comparing costs of loans.

Cap: A limit on how much the interest rate or the monthly payment can change, either at each adjustment or during the life of a mortgage.

Conversion Clause: A provision in some ARMs that allows you to change the ARM to a fixed-rate loan at some point during the term; usually allowed at the end of the first adjustment period.

Equity: A buyer's initial and increasing ownership rights in a house as he/she pays off the mortgage; buyer has 100 percent equity when the mortgage is paid in full.

Farmers Home Administration - Government loans: available to citizens with limited incomes in rural communities.

Federal Housing Authority: Insures loans made by banks and other lenders; sets a maximum mortgage limit and usually requires a lower down payment than a traditional loan.

Fixed-Rate Mortgage - FRM: a mortgage where the interest rate stays the same throughout the life of the loan; usually paid over 15- or 30-year terms.

Index: The measure of interest rates.

Lock-in: A lender's promise to hold a certain interest rate and a certain number of points for the borrower, usually for a specific amount of time; also called a rate-lock or a rate commitment.

Margin: The number of percentage points the lender adds to the index rate to calculate the ARM interest rate at each adjustment.

Points: One percent of the principal amount of a mortgage; lenders often charge points to increase the yield on a mortgage and to cover loan closing costs; the home buyer, seller or both can assume this cost, usually due at closing.

Veterans Administration - VA: insures loans made by lenders for eligible veterans and their spouses; encourages lenders to write loans for people with lower incomes.