Mortgage Loans For Home Buyers

Finding the right mortgage can affect the cost of your home as much as negotiating the price you pay for your new home. It is important that you understand mortgages before you talk to a loan agent so that you can ask about the options and get the information you need to make a choice.

0.) Webinar (2023-08-12): Mortgages - Actions That Got A Better Loan

Webinar Recording

1.) Mortgage Basics

The interest rate you are charged depends upon the perceived risk of your loan. You will typically get the best conventional mortgage interest rate with a credit score of 780 and a 25% down payment. This is the interest rate that is often advertised.

1. The higher your credit score, the lower your interest rate.
2. A 20% or higher down payment can eliminate the need for private mortgage insurance.
3. A gift to you, can typically be used for at least part of your down payment, enabling you to get a better mortgage.
4. A second mortgage can often be used for at least part of your down payment, potentially enabling you to get a better first mortgage.
5. Your debt to income ratio limits how much money you can borrow.
6. Your assets can reduce the perceived risk, leading to a better interest rate or being able to borrow more.
7. Having a co-signer can get a better mortgage.
8. Longer terms have lower payments, enabling you to borrow more.
9. You will probably have to show that you have cash reserves.

These nine points above may seem so obvious that it is boring. Let's look at some examples.

1.1) Example #1: A Child In College

If you have a child who is a full-time student there can be advantages to buying a house near the campus rather than paying for a room at a dorm or apartment. A one bedroom apartment near San Jose State University rents for an average of $2,462 per month. A 3 bedroom home could be purchased for perhaps $1.2M. If a down payment of 35% was made, the monthly payment including tax and insurance would be about $5,700. Two bedrooms could be rented to other students for about $1600 each, paying $3200 of the $5,700 monthly payment leaving $2,500 to be paid on behalf of their child. $900 per month would be going towards paying principle.

1.2) Example #2: Newly Hired Child Without Adequate Income History

As a newly hired person, any restricted stock units or bonus can not help qualify the borrower for a loan. The child would have a debt to income of 55% for the desired home. The parents are self-employed and try to minimize their taxable income. The parents put 25% down and co-signed for the loan. The parents' savings, retirement, and business assets provided a reserve. They were not forced to take a non-qualified mortgage (non-QM), getting a much better interest rate.

1.3) Example #3: Multi-family Home Purchase

The child is paying $4,500 in rent and doesn't have enough income to purchase a house. The child wants to stay near his parents in the Bay Area.

The parents do not want to co-sign on a loan or to pay a monthly mortgage. The parents provided a 25% down payment so their child could purchase a 4-plex at $1.6M. The three additional units provided a $7,500 income. The child could then qualify for a $1.2M loan. His out of pocket expense was about $1.8K with $1K going towards principal.

1.4) Example #4: Foreign Student

An international student has an F1 visa and is studying for a 4-year undergraduate degree. His parents live abroad and do not have an income that can be verified.

The child purchased a single family $2M home. The parents gifted a 40% down payment. The child applied for a no-doc loan and got an interest rate that was only 0.375% higher than a conventional loan. (The parents could be the owner if they have a legal visa to be in the U.S.)

1.5) Recap

Reducing the risk a lender sees can be accomplished in many ways, making it possible to buy a home. Different programs and different lenders have their own ways of evaluating the risk. Sharing the loan obligations between people who trust each other reduces the risk the lender sees.

The knowledge of an experienced loan agent and of an experienced real estate agent makes wealth building choices possible.

2.) Five Main Nationwide Mortgage Categories

2.1) Conventional Mortgage

Conventional loans are not backed by the federal government, unlike FHA, VA and USDA loans. There are two categories of conventional mortgages: conforming and non-conforming. The Federal Housing Finance Agency (FHFA) sets the standards for a "conforming loan". Conforming loans are typically bundled together and sold on the secondary loan market.

The overall cost of a conventional mortgage tends to be lower than other loans even if the interest rate is slightly higher.

2.1.1) Conforming Loan

In 2023 the conforming loan limit in high-cost areas is $1,089,300 ($726,200 elsewhere). There are additional FHFA standards such as minimum borrower credit scores (620), down payment (20% to avoid mortgage insurance), loan to value, and debt-to-income ratio that need to be met for the loan to be conforming. The term conventional mortgage is sometimes considered synonomous with conforming loan.

About half of all mortgage loans that lenders make are sold to Fannie Mae or Freddie Mac. Fannie Mae and Freddie Mac are government sponsored entities (GSEs) that provide a ready market for lenders to sell their loans in. They were shareholder-owned, for-profit companies prior to the 2008 mortgage crisis. Fannie Mae and Freddie Mac only buy conforming loans. Typically you will not know if either Fannie Mae or Freddie Mac own your loan.

2.1.1.1) Fannie Mae HomeStyle Renovation Loan

The HomeStyle renovation loan allows you to borrow up to the conforming loan limit and allows luxury items in your project.

2.1.1.2 Freddie Mac CHOICERenovation and CHOICEReno eXPress Loan

Both programs allow you to finance the cost of buying and fixing up a home to the maximum conforming loan amounts with down payments as low as 3%. The CHOICEReno eXPress loan has easier qualification requirements if your renovation costs are below the location dependent 10% or 15% of the home value.

2.1.2) Jumbo Loan

A jumbo loan is a loan that is for a value higher than the conforming loan limit. These loans, like conforming loans, are not backed by the federal government. Often a jumbo loan will have tighter criteria and a higher interest rate. They are also often bundled together and sold on the secondary loan market. A common minimum credit score is 700 and a common required down payment is 10%.

2.2) Second Mortgage

A second mortgage is a loan, that during foreclosure, is paid after the first loan balance has been paid. They have more risk for the lender and almost always have higher interest rates. A second loan could "piggyback" your first, providing 10% of the 20% down payment needed to avoid private mortgage insurance. Your second mortgage could be an adjustable rate mortgage while your first mortgage is a fixed rate mortgage.

2.3) FHA Loan (minimum credit score 500, minimum down payment 3.5%, max loan $1,089,300)

FHA vs Conventional Loan Quick Summary Table

	CONVENTIONAL	FHA
Credit score	620	500
Down payment	3% to 20%	3.5% for credit score 580+ 10% for credit score 500-579
Loan terms	8 to 30 year terms	15 or 30 years
Mortgage insurance	PMI (if less than 20% down), 0.58% to 1.86% of loan amount	Upfront: 1.75% Annual: 0.45% to 1.05%
Interest rate type	Fixed-rate or adjustable-rate	Fixed-rate

FHA loans have lower credit rating requirements than conventional loans. Home loans insured by the Federal Housing Administration can have down payments as low as 3.5% with a credit score of 580 or 10% with a credit score of 500. FHA loans are fixed interest rate loans with either 15-year or 30-year terms. Mortgage insurance is required on all FHA loans. FHA loans allow up to 100% of the down payment to come from gift funds (few other loans allow this). FHA loans often have closing costs that aren't required by conventional loans.

To qualify for an FHA loan, you have to live in the home as your primary residence. Homes purchased must have an FHA appraisal and meet standards for health, safety, and conformance to local codes. FHA lenders are limited to charging no more than 3 to 5 percent of the loan amount in closing costs. The FHA allows up to 6 percent of the borrower's closing costs, such as appraisal fee, credit report, or title search, to be covered by the sellers, builders, or lenders. The additional requirements tend to require more time for an FHA loan to be approved and funded.

FHA loans require the borrower to pay two mortgage insurance premiums:

1. Upfront mortgage insurance premium: 1.75 percent of the loan amount. This can be included in the financed loan amount.
2. Annual mortgage insurance premium: 0.45% to 1.05%, dependent upon loan term, loan amount, and the initial loan-to-value ratio (LTV).

Loans with an initial LTV greater than 90 percent will have to carry insurance until the mortgage is fully repaid.

FHA Loan Limits

FHA loan limits	Most areas	High-cost areas	AK, HI, Guam Virgin Islands
Single unit	$472,030	$1,089,300	$1,633,950
Duplexes	$604,400	$1,394,775	$2,092,150
Triplexes	$730,525	$1,685,850	$2,528,775
Four units	$907,900	$2,095,200	$3,142,800

 

2.3.1) FHA 203(k) Loan - Purchase Plus Renovation

An FHA 203(k) loan enables homebuyers to buy (or refinance) a home and renovate it with one mortgage. A conventional renovation mortgage will likely have lower mortgage insurance premiums but requires better credit metrics.

2.3.1.1) Limited 203(k) Loan (max $35,000)

A limited 203(k) loan is for minor improvements and repairs. No structural work is allowed (adding rooms, removing walls). A licensed contractor must be involved but the borrowers many be allowed to do some of the work. A 203(k) consultant isn't required.

2.3.1.2) Standard 203(k) Loan (lesser of 110% of after-repair value or purchase price plus rehab costs)

A standard 203(k) loan is for major renovation or remodeling. Structural improvements, including adding rooms, are allowed. Luxury improvements such as swimming pools or outdoor fireplaces are prohibited. An FHA-approved 203(k) consultant must oversee the progress of the licensed contractor from estimate to completion. Read more at https://www.fha.com/fha_rehabilitation_loan.

2.3.2) FHA 245(a) Loan - Graduated Payment Mortgage (GPM)

GPMs are structured for people whose ability to pay is expected to increase. They have a fixed interest rate over 30 years, but the amount of principle paid changes and they have the potential for negative amortization in the first years. They can solve debt-to-income requirements for some borrowers. There are two different plans:

• During the 5-year initial period, the payment increases by 2.5%, 5%, or 7.5%
• During the 10-year initial period, the payment increases by 2 percent or 3%

GPMs require both upfront and annual morgage insurance premiums, a minimum of 3.5% down payment, and are only given for single-unit, owner occupied property.

A GPM is different from an adjustable-rate mortgage (ARM) because the interest rate does not change and although the payments change, the future payment amounts are known at the beginning of the mortgage. Read more at https://www.fha.com/growing_equity.

2.4) VA Loan (no down payment, lenders typically require credit score of 600+)

Loans backed by the Department of Veterans Affairs don't require a down payment or mortgage insurance but are only available to veterans, current service members and eligible spouses. If the appraised value is lower than the purchase price you may have to pay the difference. The VA doesn't specify minimum standards for FICO scores but VA mortgage lenders often require scores in the low to mid 600s. VA loans also require that the home has a VA appraisal and that it meets VA property requirements.

VA loans have an upfront funding fee that can be included in the loan amount. The fee ranges from 1.4% to 3.6%. If you can provide a 20% down payment and have good credit, you would probably be better off with a conventional loan. VA loans do not have a prepayment penalty. Read more about VA Loans at https://www.benefits.va.gov/homeloans.

2.4.1) VA Renovation Loan

A VA renovation loan enables up to 100% of the home's after-improved value to be borrowed. No down payment is required.

2.4.2) CalVet Home Loans

The California Department of Veteran Affairs also has a loan program. Information about it can be found at:

https://www.calvet.ca.gov/HomeLoans/Pages/Our-Products.aspx

2.5) USDA Loan (no down payment, no private mortgage insurance, maximum limit on family income)

The U.S. Department of Agriculture backs USDA loans. USDA loans do not require a down payment, don't require private mortgage insurance, and often have lower interest rates than conventional mortgages. The two most limiting criteria are the income limit ($91,900 family of 1-4) and that the property has to be in a rural area or eligible town.

The USDA loan program was created to encourage development in less-dense areas of the U.S. Typically a USDA-eligible city will have a population of less than 20,000, be rural in character, and have a lack of available credit. Often USDA-eligible homes can be found within 30 minutes of employers. View the USDA eligibility map.

2.5.1) USDA Renovation Loan

USDA renovation loans allow up to $35,000 to be borrowed but income limits apply.

2.6) Quick Loan Comparison Table

	Conventional	FHA	VA	USDA
Credit requirements	620	580	lender may require	640 is standard
Debt-to income (DTI)	up to 43%	up to 50%	up to 41%	up to 41%
Down payment	3% or 5%	3.5%	None	None

3.)Mortgage Types

3.1) Fixed-rate Mortgage

Fixed-rate mortgages, as the name implies, have a fixed interest rate for the life of the loan. Over the life of a 30 year mortgage, other typical expenses such as property taxes, insurance, and utilities will typically increase with inflation but your loan payment won't. If you go through a period of high inflation, your mortgage payment becomes a smaller portion of the total expenses. Another advantage is that should you decide in the future to buy additional real estate, your existing expenses are predictable when trying to get a new mortgage on the new property.

The disadvantage of fixed-rate mortgages is that they typically have higher interest rates. Also, they may have a prepayment penalty during, typically, the first three years of the mortgage. Lenders can not charge prepayment penalties on single family FHA loans, VA loans, USDA loans, any adjustable-rate mortgage (an old ARM may have a penalty), or any mortgage with a high interest rate (a subprime mortgage). Prepayment penalties normally only apply when the loan is paid off in full with a large payment, not when extra money is added to your regular payment or an occasional extra payment is made.

3.2) Adjustable-rate Mortgage

There are two main attractions for adjustable-rate mortgages. The initial interest rate is typically lower than a fixed-rate mortgage. A lower interest rate will often let you borrow more money. The second consideration is that adjustable-rate mortgages do not have prepayment penalties. If you decide to replace your loan with a new loan, you do not have to pay any penalties.

A risk with adjustable-rate mortgages is that if interest rates rise, not only do your payments rise but average home values tend to drop, making it difficult to refinance unless you have built up significant equity while your interest rate was fixed.

4.) Sanity Check For Your Interest Rate

The U.S. Government's Consumer Financial Protection Bureau has created a web page you can use to find current home loan mortgage rates based on location and credit score. This can help you see if the interest rates you are quoted are within the typical range. It can also help you see the affects of credit score and location.

Current home mortgage rates: https://www.consumerfinance.gov/owning-a-home/explore-rates/

4.1) TagMortgage Payment Calculator

The calculator provides a quick way to get a fairly accurate estimate of the monthly payment for a mortgage that is under consideration. It is often helpful to see what happens to the mortgage payment as interest rate and the mortgage length are changed.

4.2) Table of Monthly Mortgage Payment

This table shows the monthly mortgage payment (principle + interest) for a $100,000 mortgage for interest rates ranging from 4% to 10% and for a mortgage length ranging from 10 years to 30 years. This table provides a quick snapshot of the effect of interest rates and mortgage duration on the monthly payment.

Monthly Payment for $100,000 Mortgage
	10 yrs	15 yrs	20 yrs	25 yrs	30 yrs
3%	965.60	690.58	554.29	474.21	421.60
4%	1012.45	739.68	605.98	527.83	477.41
5%	1060.65	790.79	659.95	584.59	536.82
6%	1110.20	843.85	716.43	644.30	599.55
7%	1161.08	898.82	775.29	706.77	665.30
8%	1213.27	955.65	836.44	771.81	733.76
9%	1266.75	1014.26	899.72	839.19	804.62
10%	1321.50	1074.60	965.02	908.70	877.57

4.3) Freddie Mac Calculators

Freddie Mac has a number of different calculators which can help you analyze a home purchase. They can be reached from the Freddie Mac calculator page at https://myhome.freddiemac.com/resources/calculators.

Rent vs. Buy

Freddie Mac has an on-line calculator which can help you analyze renting vs. buying. The calculator can be brought up as a pop-up window Freddie Mac Rent vs. Buy Calculator.

Also be sure to take a look at our Rent vs. Buy information.

Tax Savings

The tax savings of owning a home can be analyzed using the pop up Freddie Mac Tax Savings Calculator.

How Much Can You Borrow

You can get a Freddie Mac estimate of how much you can borrow using their calculator.

4.4) Build Equity Quickly With Low Interest Rates

One thing that is often overlooked when comparing interest rates is how quickly equity builds. Everyone realizes that the monthly payment is lower for lower interest rates. Another big advantage is that even with the lower payment, equity builds faster with a lower interest rate. The graph of equity vs. time for the three different interest rates shows that an interest rate of 3% builds equity nearly twice a fast during the first five years as an interest rate of 6%. An interest rate of 3% builds equity nearly three times as fast as an interest rate of 9% during the first five years.

Equity vs Time For Different Interest Rates

Low interest rates provide a double advantage: lower payments and quicker build up of equity. The table below shows that in five years $20,739.96 more equity would be built up at 3% compared to 6%, even though the payment is $889.73 less per month.

 

If you want to see interest rate trends, the FreddieMac PMMS is an excellent source.