One of the most expensive things most people will ever buy is their home. For a few entrepreneurs, it might be a business, and for a few others it could end up being a college diploma, but by and large, it is a home that is our largest purchase. Despite this fact, most go into their first home purchase with extraordinarily little knowledge about the primary means of funding it, the mortgage.
Even if you have gone through the mortgage process once, it is not something you do often and there is little incentive to learn about them after the fact. This leads to a situation where you could be making your largest financial decision without a great understanding of how it works, multiple times throughout your life. To combat this, we will try to cover the basics, explain some of the terminologies, and provide a repeatable framework for making these decisions in the future.
Starting the mortgage process
The first step in the mortgage process is the pre-qualification or pre-approval process. These are two distinctly different things but are sometimes confused or used interchangeably. Let’s break these two down.
When a bank pre-qualifies someone, they are simply determining how much they might be approved for based on an estimate of their income, assets, and debt. There is no guarantee of approval and the information isn’t verified. This can be helpful just to get a range of what you may be approved for (Note: the size of mortgage you CAN get and the size you SHOULD get are not the same thing).
Another positive is that it doesn’t impact your credit score or come with any fees. Just be aware that it isn’t binding in any way and sellers may not take you seriously until you are pre-approved.
Pre-approval is a formal statement from the bank as to how much they are willing to lend you. It is only done after receiving, and verifying, financial documents such as pay stubs, account statements, tax returns, and credit reports. This should also be done by banks without a fee and provides more certainty around the size of mortgage you can get, which is what sellers want to see when you make an offer. This does have a minor negative impact on your credit score, but it will be temporary. In addition, if you are shopping for a mortgage from multiple sources it is best to do that all around the same time frame. The newest FICO score models count all hard credit checks, like those for pre-approval, done within a 45-day window as a single inquiry.
Surveys have shown that many first-time home buyers thought that they had to use the bank where they were first pre-approved, not realizing that they could, and should, have shopped around. The mortgage industry is extremely competitive and even a small improvement in your mortgage rate, compounded over many years, can save you tens of thousands of dollars in interest.
Mortgage Types 101
There are several different types of mortgages. Some describe the length, or term, of the mortgage while others describe how interest is charged. There are even terms related to who is issuing the mortgage. To make things more challenging it may require multiple terms used in conjunction with one another to really know what you are looking at. There is no “good” or “bad” mortgage type, it really depends on your situation. Still, going over a brief description of each should help when having discussions with mortgage brokers.
- Conventional Mortgage or Loan: This refers to a loan that is not offered by the government, meaning it is done by a private bank (or government sponsored groups like Fannie Mae or Freddie Mac).
- Government-backed Mortgages: These are loans guaranteed by a government agency. The two most common are FHA (Federal Housing Administration) or VA (Veterans Administration) loans. They provide competitive options to homebuyers with easier qualifications but may cost good credit candidates in higher mortgage insurance costs and can’t be used for vacation or investment properties.
- 30-Year, 15-Year, 10-Year: These terms just describe the length of your mortgage. The mortgage issuer uses this, along with the interest rate, to determine what your principal and interest payments will be each month to completely pay off the debt at the end of that term. Typically, the longer the term the lower your monthly payment, but usually comes with higher total interest paid over the life of the loan.
- Fixed-Rate Mortgage: This means the interest rate on the loan stays the same throughout the term of the mortgage.
- Adjustable-Rate Mortgage: The mortgages have a fixed rate for a short period of time and then the interest rate adjusts from year to year based on some form of market rate. They may be marketed as a 5/1 or 10/1 ARM. That would mean the interest rate is fixed for the first 5 or 10 years, then the rate adjusts annually (up or down) based on the current interest rate of a predetermined index plus a margin to compensate the lender.
- Jumbo Mortgage: Jumbo loans are used to purchase properties too expensive for conventional conforming loans. Jumbo loans are considered nonconforming because they don’t meet specific underwriting guidelines and financing limits, therefore they can’t be bought by Fannie Mae or Freddie Mac. This reduces their ability to be packaged and resold, which can lead to higher interest rates, credit requirements, and down payments. This dollar amount to be classified as a Jumbo loan is defined by the Federal Housing Finance Agency and varies by region but is generally above $510,400 as of 2020.
- Interest-only Mortgage: Mortgage where only the interest to the lender is due and the principal, or balance, is not reduced.
As we mentioned, it is common to see these terms tied together, like a “15-Year fixed rate conventional loan” or a 30-Year FHA loan. It’s good to know all the pieces so you have a greater understanding of the terms of the loan.
First, it is important to know that mortgage rates are not tied directly to any one financial index or proxy. For example, if the 10-Year Treasury rate is at 1% that doesn’t mean 10-Year mortgages would be anywhere near 1%. In addition, if the 10-Year Treasury rate doubled to 2% mortgage rates would not double. They usually trend in the same direction (moving higher or lower) but not at a set rate.
To see this in action you can look up the 30-Year treasury rate from 01/02/2020 at www.treasury.gov which was 2.33%. On 04/21/2020 it reached all the way down to 1.17% after dropping almost 50% in four and a half months! Average 30-Year mortgage rates during this same time went from 3.72% to 3.39% for a decrease of just under 9%. Since then the 30-Year has increased and the average 30-Year mortgage rate has continued to decrease. The point is if you hear a news segment about the Federal Reserve lowering rates, or a record drop in the 10-Year Treasury rate, don’t automatically assume it is the time to pull the trigger on a new house.
Another mystery on mortgage rates that we often hear is the difference between the stated interest rate and the APR (annual percentage rate). Essentially the APR takes other charges or fees you will be paying (like mortgage insurance, closing costs, discount points, or origination fees) and spreads them out over the life of your loan to give you a more accurate picture of the cost of the loan. Two lenders may have the same quoted interest rate but different APRs because of a difference in fees. This was put in place by the Federal Trust in Lending Act to allow consumers to compare total costs between lenders.
Finally, mortgage brokers may present the option of paying “points” on your mortgage. This is where you pay a lump sum up front in exchange for a slightly lower interest rate over the life of the loan. The typical formula is paying 1% of the home price for a .25% reduction in the interest rate. Borrowers who are considering this to lower their rate should make sure they plan to live at the home long enough for the interest savings to exceed the upfront cost plus their opportunity cost (what that lump sum could have earned if conservatively invested).
The closing costs mentioned above deserve their own little section so we can dive a bit deeper. A good way to think about these are lender fees, third party fees, and intentional prepayments.
The most common lender fees are for points paid, loan origination fees, or loan application fee. These can often be negotiated and will be the major source of difference between lenders (other than the actual loan interest rate).
Third party fees would be things you would pay anywhere and don’t go directly to the lender. These include home appraisal (can be waived by the lender), title search and insurance fees, and credit report fees to name a few. These are usually just passed on to the borrower from the lender. Unless your home appraisal or inspection is waived there is little room to change these.
The final category, intentional prepayments, group together common payments lumped in with a mortgage like property taxes and insurance. This is optional, but common. These prepayments are held in escrow until paid to the appropriate party and are included in your monthly payment. Think of it as a monthly forced savings, facilitated by the bank, to make annual tax and insurance payments for the new home.
You should receive a loan estimate from anyone you are considering using to compare costs side by side. In addition, you will receive a closing disclosure a few days prior to closing that spells out all the fees as well.
The single greatest thing to remember is that there is no such thing as a no-cost closing. If you don’t see any fees that just means that they are being collected in the form of a higher interest rate. There is real time and effort that goes into underwriting and issuing a mortgage that banks, and mortgage brokers, want to be compensated for. Be suspect of any institution that isn’t upfront about the total costs.
Refinancing: Should you do it?
A discussion about mortgages would not be complete in the current market environment without mentioning refinancing. With interest rates so low refinancing an existing mortgage may make a lot of sense. In this decision the three factors we feel are most important to pay attention to are the loan term, the refinance / closing costs, and the length of time you plan on staying in the home.
The loan term is important because most refinances happen several years after a home has been purchased. If your current loan was a 30-Year term and you have been paying on it for 7 years you only have 23 years left. If you choose to refinance back to another 30-Year mortgage, then the correct savings comparison would be between the remaining interest you would pay over those 23 years to the new 30-Year interest cost. It might still make sense, but make sure you are comparing the right interest expenses. Conversely, if the new rate is low enough there may be an opportunity to drop your loan term from the 23 remaining years to a new 20-Year mortgage without an increase in payment. Assuming you are not looking to refinance solely to reduce monthly expenses this is another option.
Once you have evidence that refinancing will save you interest over the life of the loan, the next step is to make sure that is still true after you add in the cost to refinance. For example, refinancing to reduce your mortgage interest rate .25% might not be enough of a savings to offset the cost.
If, after completing the first two steps, you are confident that refinancing will save you money above and beyond the costs to refinance, address the last and hardest question. No one has a crystal ball. Work or personal circumstances could change such that you need to move. According to the Census Bureau the average American moves more than 11 times in their life. A popular take on this statistic is that on average people move every 7 years (roughly calculated from life expectancy divided by 11).
Realistically we move much more in our late teens, twenties, and early thirties and much less as we age. Think about what phase of your life you are in, how stable your job is, and scenarios that would lead you to sell your home and move. If refinancing is saving you money it is doing it over time with a little bit of saving coming each month. Unfortunately, the costs to refinance are front loaded. Find out how many years it would take until your total interest savings would surpass the cost to refinance. That is how long you should plan to live there for the refinance to make sense.
Exceptions and Extras
As with anything, there are caveats. If you need to refinance strictly to immediately reduce month expenses, then moving forward while rolling the closing costs into the new mortgage could be the best move even though it will actually cost you more long term. Also, accepting slightly higher closing costs to keep your mortgage at the institution where you already bank may make managing it easier or save you money on other related services. Try to be aware of the trade-offs.
One extra topic which is related to the topic is private mortgage insurance, or PMI. PMI is often required by the lender (your bank) when your down payment is less than 20% of the purchase price. The cost for PMI typically between .5% and 1% of the loan amount on an annual basis. If we assume that the number is 1% and you purchased a $100,000 home, that would mean you will pay an extra $83.33 per month towards PMI ($100,000 x 1% / 12 months). There is one more catch regarding PMI.
Once you have built up 20% equity in your home PMI is no longer required, BUT most lenders won’t automatically remove it until you reach the 25% equity mark. If you have achieved 20% equity in your home contact your lender and find out their process for removing the requirement (it could require an appraisal and submitting a formal request in writing).
Buying a home can be a fun and exciting experience, but to be honest, learning about mortgages is not. Hiding behind lots of jargon, fees, and your strong desire to just get the process over with is one of the largest financial decisions of your life. We hope you slow down and take a minute during the mortgage process to be sure you know exactly what you’re signing. We know you won’t regret it.