Today, I will continue to talk about mortgages. I know, it is not the most fun of all the subjects I could talk about, but my goal is helping you guys to understand better how mortgages work. And I hope when you will see a lender, to buy your house, the few minutes you spent with me will save you hundreds or even thousands of dollars in the long run.
You can also watch my video “Mortgages – How to Choose and Save Thousands of Dollars (A primer – Part 2)” on my YouTube’s channel. Check it out!
For a short overview of the post, we will talk about fees, the points, rate locks, and the front-end and back-end ratios that will dictate how much you can borrow. So it is an essential subject, especially if you consider to buy a house, either to live in it or to invest and become a landlord. Even if you already are a property-owner, with dozens of tenants, you should learn a thing or two! So keep reading!
In the first post, “Mortgages: Fixed-Rate or Adjustable-Rate?”, I talked about what is a mortgage, what are fixed-rate and adjustable-rate mortgages. For adjustable-rate mortgages, if you read the article, you now understand how adjustments work.
Before we start, I am not a lender, nor an attorney, nor a CPA. I am just a guy on the Internet with experience managing billions, that’s all. And I am also a realtor in New Jersey. So everything I say is my opinion, and you should seek the advice of a professional before acting on anything. Investing in real estate is probably the most significant purchase of your life. So do talk to an attorney, a lender, or a CPA about your unique goals and circumstances. You will get advice tailored to your unique situation.
Do you think borrowing money is free? I am not talking about the interest rate the lender charges you, but do you have to pay something to get a loan before even the first monthly payment?
If you answer the interest until the end of the first month, I must thank you since you read my post “Yes! You can buy a house today!”. If you didn’t read it yet, do it! Especially if you rent! I reveal some tax breaks you can get, even as a renter, in New York City and New Jersey, but who knows maybe you have the same kind of tax breaks in your state. And I am showing you, in that post, how your landlord may owe you money to be credited toward your rent. This one is for New Jersey’s renters, but you may have similar statutes in your state. I am all in for helping you to save money, so check it out!
So, the interest until the end of the first month, I am not looking for that answer, because the interest you prepay at inception, is interest, and I excluded it in my question. If your answer is the loan origination fee and points, here we are, it is precisely what I was looking for.
Let’s start with the loan origination fee. If you have two loans proposals, one with a loan origination fee and one without or a lower one, all else equals, it is a no brainer! Take the less expensive one!
In theory, the loan origination fee, by itself has no impact on the interest rate you pay. On the other hand, points, which you also pay at the loan origination, lower the charged interest rate.
The reality can be more subtle though, because even the same lender, or same mortgage broker, can charge loan origination fees and points for a loan, and no loan origination fees, nor points for another one, both loans with different stated interest rates!
If you go to a website like bankrate.com, you see a lot of different offers from different lenders. Fees, points, and rates are all over the place! How can you even compare?
By the way, I like bankrate.com because they don’t ask you anything personal, no email, no phone number, no social security number. You only give the parameters of the loan you wish to get, and boom, you have a lot of lenders: banks and mortgage brokers. All of them willing to lend you money at the condition listed if you qualify. BankRate does not sponsor this post, it happens I like this website, especially for the privacy aspect, and I used them myself to get a very competitive mortgage.
So how can you compare those fees, points, and rates? There is a trick to do that!
Both fees and points are upfront costs, and the interest rate is charged every month on the remaining balance of the loan during its life. The trick is to find an equivalent interest rate that provides the same value for your lender, with no fee at all upfront. Before you quit this video, I know mathematical aspects can be frightening, don’t be afraid! You do not have to do anything. Your lender is required, by law, to give you that information. This figure is called the APR, meaning annual percentage rate.
And you see on the BankRate.com page; it is the third column. You can click on it, and sort it by ascending order. What does it mean for you? The lower the APR, the cheapest is the loan.
However, you must know the APR figures are computed using the loan term. If you prepay your mortgage or refinance it at some point, the cheapest loan may end up not be the one with the lowest APR.
So, even if the APR is an excellent starting point to evaluate how competitive or costly is a loan, it is not the whole story. You have to ask yourself if you want to prepay your mortgage at some point or refinance it!
Let’s say you want to refinance it in the future. Either because you anticipate the interest rate going down, or you make improvements and want to do a cash-out refinancing. Does it make sense to pay origination fees and points to get a lower APR? Maybe not!
Points are prepaid interest. Your lender is telling you I am willing to lend you money, for example at 4%. But if you give me 2 points upfront, I am prepared to go down to 3.5%. By the way, what does it mean 2 points? If points are prepaid interest, in dollars, what are they?
Points are a percentage of the principal, the money you borrow. For example, you want to borrow $500,000. 2 points means 2%. You have an upfront cost of $10,000.
Does paying $10,000 today, to have a lower 3.5% interest rate makes sense? It depends. The half-percent difference means, in our example, it will take roughly four years to recover the $10,000 spent up-front. If you want to refinance in one year, it makes no sense to choose the lower interest rate. By taking the 4% loan, it will cost you around $2,500 more than the 3.5% loan, for the first year ($500,000 x 0.005 [the half-percent difference]). I know it is not the exact value, but it is a good enough approximation. So why would you pay $10,000 instead of only $2,500?
It is that kind of question you have to ask yourselves, especially if you want to buy for investment purposes. Because if you go that way, you will probably want to refinance, to be able to purchase even more real estate.
One crucial thing about points: do you know they can be paid either by the buyer or the seller? It is a question of negotiation. If you are in a buyer’s market, and you are the buyer, you may be in an excellent position to get a seller either providing financing or paying the points for you; if it is a seller’s market, not so much. If the seller agrees to pay your points to help you to get a loan, the IRS will allow you to deduct them as if you had paid them. The seller is not entitled to deduct them.
One variation of the points is buydowns. Instead of having one discount on the interest rate, you may have multiple discounts following each other. For example in a 3-2-1 buydown, the interest rate you pay the first year is discounted by 3%, 2% in the second year, and 1% in the third. Frequently the seller will pay for that kind of arrangement. Why? Because without a buydown, the buyer cannot obtain a mortgage. The lender will approve the loan based on the monthly payment produced by the lowest interest rate. With an artificially low monthly mortgage payment, the buyer may qualify for the loan.
I guess you are wondering: why on Earth the seller would do that? Pay points or a buydown? The explanation is: he or she may do that to get a higher price for the property sold. It is that simple. Nobody in that game runs a charity, so every player has to have an economic incentive.
I digress a little, but for conventional loans, you know loans not backed by any federal or local agency, you have to pay a PMI if the down-payment is less than 20%. PMI stands for private mortgage insurance, and it protects the lender, not you, in case you fail to pay your mortgage. Overall it is not a big deal in the grand scheme of things, and I will talk about PMI in another post. Do you know that some lenders allow you not to have to pay a PMI, even with a low down-payment? How nice of them! No! They just hid the PMI in a higher interest rate they charge you. So instead of paying a PMI for a short period, a few years, you are paying a higher interest rate over the life of your loan. Does it make sense? Maybe, or maybe not. You have to figure that out. But at least you know what to look for, and questions to ask your lender!
So far, so good?
You have now found the perfect loan, what is the next most important question to ask? You must know what the rate lock is!
Buying real estate takes time. First, you have to be pre-approved by a lender. Without that, unless you pay cash, you will be in a weak position to buy. Then you find a house, you negotiate the price and maybe some terms of the sale. An attorney review may follow, and you may negotiate more. Inspections usually follow it. You finalize your mortgage approval. And you get to the closing. I cannot stress enough the importance of all the people that help you during this process: the right agent, who works hard for you, but also your lender, and your attorney.
So as you see, it takes time. When you get pre-approved, or more generally when you shop for a mortgage ask about the rate lock. Interest rates change constantly. With a rate lock, your lender keeps the quoted interest rate fixed for 30 to 60 days. You will not be surprised by an unexpected increase in interest rates.
Finally, let’s talk about how much you can borrow. If you guessed it is driven by how much you earn. Yes, absolutely! But there is another part of the equation: how much you spend on other debts each month. Together, your income and liabilities will determine how much you can borrow by allowing your lender to calculate your front-end and back-end ratios.
The front-end ratio also called the mortgage-to-income ratio, or the debt-to-income ratio (DTI), or even the housing ratio, shows what portion of your income goes toward your housing expenses. To get it you divide your mortgage payment, plus your property taxes, PMI if you have one, and Home Owners Association (HOA) fees if applicable, by your monthly gross income.
Ideally, it should be below 28%. The bigger the front-end ratio is, the riskier is the mortgage for the lender. Still, some lenders may allow you more than 28%, depending on numerous factors like what is your down payment, your credit score, your savings. Your lender wants to lend you and make money but at the same time does not like to lose it, so he or she looks at the whole picture.
The back-end ratio takes into account all your financial obligations. To your housing expense, you add up all your other monthly debt payments, like your car loan, your credit cards payments, your student loans. When you have that number, like for the front-end ratio, you divide it by your monthly gross income. And voilà, you have your back-end ratio.
Most lenders would prefer you to have a back-end ratio of 36% or lower. The back-end ratio is the most important ratio for conventional loans.
So what should you do before asking for a mortgage? Clean up your financial house. Keep enough cash for a down-payment and closing costs, but at the same time try to get rid of loans you can payback now. It has a real impact on how much you could qualify to borrow.
Do you believe it? After two posts on mortgages, we talked about so many aspects, and still, there is so much more! In future posts, I will speak of conventional loans, PMI and how to get rid of it, Federal Housing Administration loans, you know FHA loans, and VA loans, taxes, and a lot of other subjects. I think I will make those posts shorter, laser-focused on one item at a time. Still, I am happy to have made two great articles giving you a solid foundation in understanding how mortgages work. I am sure with that knowledge you will be able to make more educated choices. And you may end up saving thousands of dollars by knowing how to choose the right loan.
I am eager to read your comments, your questions, and your suggestions.
As always, to have more details about mortgages and to get specific information about your situation, talk to a lender.