Archive for October, 2008

How Construction Loans Work

The simple definition of a construction loan is a loan used to build a home. A construction loan is very different from a typical mortgage loan. A construction loan may sometimes be more difficult to acquire than a traditional home loan, because there isn’t anything to be used as collateral for the loan. This in turn usually also means slightly higher interest rates on a construction loan.

Construction loans still offer different loan types as well as different financing terms. Typical construction loans include the 30 year fixed, 15 year fixed, 1 year ARM, 3/1 ARM, 5/1 ARM, 7/1 ARM, 10/1 ARM and interest-only loans. You can also get a short term loan usually one year while the house is under construction and then refinance into a lower interest rate term once construction is complete. This however requires two loan closing, in turn costing you two sets of closing costs. A more popular construction loan today is known as a construction to permanent loan. This type of loan only charges you 1 set of closing costs.

Before you get a construction loan you will have to get pre-qualified for the loan just like you would a regular mortgage loan. Also, just like a typical mortgage the better your FICO score and the more equity you have in the land you are building your home on will determine what type of interest rates and how much you can borrow.

Another thing to understand about construction loans is that you have to start making payments on the loan before your house is completed. This can be done by simply making the monthly payment or by setting up an interest reserve fund. An interest reserve fund basically pays your monthly payment for you while your land is being built. It’s not a free service however, this amount is added back into the loan. Basically the bank estimates how much your interest will be over a year and adds that amount onto the loan. This does however help the consumer if they are paying rent or another house payment while their home is being buit.

Private Mortgage Insurance (PMI)

Private Mortgage Insurance (PMI) is basically a third party insurance policy that covers a lenders risk when the buyer doesn’t have at least 20% equity in a home. So if you don’t pay down 20% or you don’t purchase your home for 20% less than what it appraises for then you will usually be required to pay private mortgage insurance or PMI.

The creation of PMI has allowed many buyers to purchase homes that normally would not be able to own their own home. For as little as 3% to 5% down potential buyers can purchase a home without having to save for a large down payment.

One important aspect of PMI you should always keep in the back of your mind is that once you have 20% equity in your home you are no longer required to pay this insurance policy. Some lenders require this 20% to be from the original purchase appraisal and others will allow a new appraisal amount at the current time. This is a big benefit if your home has increased in value over a short period of time. Usually you will have to contact the lender once you have 20% equity in your home in order to cancel the PMI. However, usually lenders are required to automatically terminate PMI once you have paid down the mortgage to 78% of the original apprasial value.

There are ways to avoid paying PMI. The first and most obvious is by paying down at least 20% of the loan at the time of purchase. The second method is a piggy back loan or taking out a second mortgage at the time of purchase. Before you choose an option consider the pros and cons of each type of loan.

Should you pay points on a mortgage loan?

What is a point when referring to a mortgage loan? A point is simply a percentage point of the overall loan amount that is paid up front, usually included in closing costs. For example if you are financing $200,000 and paying 1.5 points, you will have to come up with $3,000.

Why pay points toward a mortgage loan? Usually paying points lowers the interest rate you get on the loan. Before paying points you should always calculate if it’s worth the extra cash to get the lower interest rate. A simplified, real world example would go something like this.

A local movie rental business is offering a special promotion on various memberships. Regular movies cost $3.50 to rent per night, but with these new memberships you get special discounted rates. A gold membership costs a one time payment of $100 and it allows you to rent unlimited movies forever for only $1. You could quickly do the math ($100 / $2.50) and find out that it would take you 40 movie rentals before you started seeing real savings but from that point on you would save $2.50 off every movie you rented.

There are many things to consider before taking the deal. What if you only rent 1 movie per month? It would take you over 3 years before you started seeing any savings. What if the movie rental place went out of business? You would wast the one time payment. What if you move far away from the movie rental place? You might have to spend more in gas to get to the movie rental place than you would save from the movie rental deal.

Just with the movie rentals you have to decide how long you expect to stay in your home. If you are only planning on staying a couple of years, it’s probably not worthing paying the extra points. On the other hand if you plan to stay in the home 10 or more years you will probably save money by buying the points and paying the extra up front money.

Here is a great mortgage point calculator that will help you decide if paying the points is worth it for your situation.

A Mortgage Buy Down Program Right For You?

A mortgage buy down program or reverse mortgage may be an acceptable option for someone living on a fixed income who has no other means to earn money to pay for their current expenses.

Many financial experts agree that mortgage buy down programs are a bad investment, but I believe for some it may be an acceptable option. Buy down programs allow you to take advantage of the equity you have built up in your home and provide yourself a steady monthly income. You get a monthly payment sent to you each month until you have no equity left in your home.

The MAJOR downside to this program is in the end the mortgage company will own your home. Typically you will not have to give up your home while you are still living, but when you die the home basically goes back to the mortgage company.

As stated above this type of program can be an acceptable option if you have no other means to generate income and you don’t care what happens to your home when you die. If you have put everything you own into your home over the years and it’s basically all you have then you can view this type of reverse mortgage as something similar to your retirement program.

Again, I tend to lean toward the side stating that mortgage buy down programs are a bad investment and you should never plan to use this type of program as a retirement plan especially if you are young and still working. Take full advantage of your working years and put away plenty of money for your retirement years. Use a mortgage buy down as a last resort option for getting cash!

Borrowing from your 401k for down payment on a home

Should you borrow money from your 401k for a down payment on a home? A home is one of your most valuable assets but is it worth your retirement funds? I’m going to give you several reasons why you SHOULD NOT borrow from your 401k retirement fund to purchase a home.

First, when you contribute to your 401k fund you do so with pre-tax dollars. You are required to pay back the loan and that money will be with after tax money, that money will be taxed again when you decide to take it out at retirement.

Second, if you borrow from your 401k then many lenders will view this as an additional debt, just like a car loan or credit card loan. This could hurt your debt to income ratio, in turn giving you a higher interest rate on your mortgage loan or reducing the amount of money you can borrow for a home.

Third, as mentioned above this will become another monthly debt and you will be obligated to repay the 401k loan, usually over a course of time shorter than the mortgage loan. This payment will be in addition to the mortgage payment, which could put an extra strain on your monthly budget.

Next, you could have to repay the loan early if you lose your job for any reason. There is usually a clause in the 401k loan documents that requires you to repay the loan in full within 30 days if you leave your job for any reason or you are fired. If you don’t repay the loan you will face early withdrawal penalties of 10% as well as having to pay income taxes on the money. This will not only put a strain on you now, but will destroy much needed funds for your future.

Finally, some 401k funds will not allow you to contribute extra funds toward retirement until the loan is paid back in full. Not only does this limit the growth potential of your normal deposit, but you also lose any matching funds from your employer.

If you are going to need to pay money down for a new home there are other alternatives. Cut back spending and save the extra cash, pick up a part time job, look into a piggyback mortgage, etc. Avoid borrowing from your 401k at all costs.

30 Year vs 15 Year Mortgages

Many times whey people think about mortgages their main focus is on the interest rates, however there are many other factors to consider. Another often overlooked decision is the term of the loan. Many times buyers assume that a 30 year term is the best option for a mortgage term; however, you should examine other terms carefully to see all the advantages of a shorter term mortgage. The title of the article compares a 30 year mortgage term versus a 15 year mortgage term, but there are many other options to suite your needs.

When discussing a mortgage potential buyers tend to focus on how to qualify for the most money and keep their monthly payments as low as possible and what is the lowest interest rate they can get on the mortgage. These are two very important factors, but not the only choices to make.

The term or length of time you will pay back the borrowed money is a very crucial part of a mortgage. Choosing the right term can save you hundreds of thousands of dollars as well as build equity at an accelerated rate.

The longer term you choose the more total interest you will pay and the less equity you will build each month. Sure you will have a lower payment by choosing a longer term, but you have to decide if it’s worth the end result. Choosing a 20 or 25 year term over a 30 year term won’t change your monthly payment a significant amount, but it will save you thousands of dollars in interest.

A real world example
John and Jane want to purchase a $300,000 home. They have 20% to pay down so the remaining balance to finance is $240,000. They have the following options to finance the home

Term     Rate     Payment     Total Interest
30         7%       $1,596        $334,821
25         6.875% $1,677       $263,154
20         6.75%   $1,824       $197,969
15         6.625% $2,107       $139,293

As you can see the savings in interest alone from a 30 year term to a 15 year term is almost enough money to purchase the home again; Almost $200,000 in savings. I realize that the payment is about $500 more per month but their is a happy medium. For example 20 year term is only about $200 more per month and you will still save $136,000 in interest!

So, before you decide what term to choose for your mortgage consider all the pros and cons of each term. Ask yourself, is buying a home on a 30 year mortgage term worth losing hundreds of thousands of dollars?

How much should a mortgage down payment be?

Deciding how much down payment to pay on your home mortgage affects many aspects of purchasing a home. Before you talk to a realtor or call about a home listing you should figure out how much money you can pay down on your home. Your down payment can affect your interest rate, the amount of  money you save, and the type of loan you qualify for.

The interest rate you qualify for on a home mortgage loan is very important. A single percentage point can change your monthly payment by hundreds of dollars. It will also affect the amount of interest you pay over the life of the loan by thousands of dollars. Many times the more down payment you put down the better interest rate you will get.

Paying any down payment will save you thousands of dollars over the course of 30 years. A down payment of $10,000 on a $250,000 loan at 6% for 30 years will save you an additional $11,000 in interest over a 30 year mortgage.

There are different types of loans to consider when purchasing a home. Some are more beneficial than others depending on your financial situation.  The different loan choices available include: conventional fixed rate loans, (ARM) or adjustable rate mortgages, VA, buydowns, FHA, graduated payment mortgages and all the variations of each. The more down payment you have the better loan program you will qualify for.

There are many important choices when it comes to purchasing a home. Home quality, neighborhood, affordability and pricing are all important aspects of a home purchase; however your down payment could be one of the most important decisions. Maximize your buying power with the best down payment you can afford!

Debt to Income Ratios, accurate?

A debt to income ratio is a guideline used by lenders to determine your maximum mortgage amount. It’s calculated as a percentage of your monthly gross (before taxes) income that is used to pay your monthly bills or debts. There are two types of calculations, a “front” and “back” ratio which lenders use to determine your maximum loan amount.

The front ratio is a percentage of your current housing costs. Anything related to your housing costs including rent, mortgage principal, interest, taxes, insurance, etc. will be included. The back ratio is calculated the same, but also includes all of your consumer debt payments. Items such as credit cards, student loans, car loans, or other similar debt payments.

A typical debt to income ratio is front 33% and back 38%. These percentages are just base guidelines and leders will be more relaxed or strick on lending based on other financial factors. A larger down payment and high credit scores will allow the lender to be more relaxed. Smaller or no down payment and bad credit will cause the lender to be much more strict with their lending power.

So with these base percentages if you have a combined monthly bring home pay check of $6000 a month your maximum monthly housing expenses should be no more than $1980 and your consumer credit expenditures should be no more than $2280.

So how accurate are these debt to income ratios? Should you depend on these nubers when you decide to purchase your next home? Remember these are just guidelines to follow and everyone’s financial situation is different. Debt to income ratio calculators don’t consider many other monthly expenses such as chariatable contributions, day care, food, enertainment, etc. They only assume the remaining percentage of income will cover these expenses. You should complete a detailed monthly budget before purchasing your next home. Make sure you can afford the payment and don’t take a lenders word!

Mortgage preapproval doesn’t mean you can afford it

You should always get a mortgage preapproval from a lender before shopping for a home. A pre approval letter lets the buyer know you are a serious buyer. More importantly it gives you a general price range of the houses you should be considering. However, just because you get a preapproval from a lender for a certain amount of money doesn’t necessarily mean you can afford that much house.

Many times borrowers will get pre approved for a certain amount of money, but buying a home at this price may stretch your budget too thin. There are many budget items that a bank doesn’t look at when deciding to give a preapproval amount. For example, I just used a preapproval calculator online with my own personal finances. I would be preapproved for a home loan of $456,000. Currently our home is less than half this amount and we don’t really have a lot of money left each month to save.

Many things the lenders don’t consider when giving a preapproval mortgage amount include daycare, enertainment, clothing, groceries, tithe or donations, etc. Sure most of these things aren’t completely necessary but you will need some type of budget for these items.

You should always get a mortgage preapproval before shopping for a loan, but do a detailed budget to find out how much home you can really afford. Part of the problem with the current credit and bank crisis is because of what I have just discussed. Don’t leave it up to someone else to do your homework, do your own research. After all no one else knows your money better than you!

A Bigger Home Means Bigger Expenses

If you think you are ready to purchase a bigger home you may want to reconsider. There are many hidden costs associated with upgrading your home that may max out your monthly budget. Consider all the extra costs and expenses associated with a larger home before you take out your mortgage.

Examples of expenses include: more expensive heating and cooling bills, higher home maintenance costs, increased property tax and insurance costs, additional furnishing costs.

The largest portion of your gas or electric bill is your heating and cooling system. Buying a bigger home will obviously increase your utility and energy bills. It’s something that’s easy to overlook when calculating how much you can afford in your budget for your new monthly mortgage payment. Don’t put yourself in a bind because of this overlooked expense.

Home maintenance costs will also increase. Every house will require general maintenance over time. From leaky pipes to a new roof at some point you will face repairs. With a bigger home these expenses will only increase.

Property taxes and insurance are both based on the value of the home. Usually the bigger your home the more valuable it is to you, the insurance company and government. The more your home is worth the more you will pay in annual property taxes and incurance premiums.

Additional furnishings will have to be purchased to fill up that extra space in your new home. Why would you buy a bigger home if you weren’t going to take advantage of the space? Be prepared to shell out some extra cash on furniture if you’re going to buy a bigger home.

Don’t get depressed when reading this article. I’m not trying to tell you you’re stuck forever in your starter home, I’m just saying be smart and plan ahead. Once you commit to a mortgage you’re usually committed for a while.