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Getting a Mortgage

What is a mortgage?

A mortgage is nothing more than a loan that you obtain to close the gap between the cash you have for a down payment and the purchase price of the home that you're buying. Homes in your area may cost $70,000, $170,000, or $770,000. No matter -- most people don't have that kind of spare cash.

Mortgages typically require monthly payments to repay your debt. The mortgage payments are comprised of interest, which is what the lender charges for use of the money you borrowed, and principal, which is repayment of the original amount borrowed.

What is a balloon loan?

One type of mortgage, known as a balloon loan, appears at first blush to be somewhat like a hybrid loan. The interest rate is fixed, for example, for five, seven, or ten years. However, and this is a big however, at the end of this time period, the entire loan balance becomes due. In other words, you must pay off the entire loan.

Borrowers are attracted to balloon loans for the same reason that they are attracted to hybrid or ARM loans -- because balloon loans start at a lower interest rate than do fixed-rate mortgages. Buyers are sometimes seduced into such loans during high-interest-rate periods or when they can't qualify for or afford the payments of a traditional mortgage.

Balloon loans can blow up in your face. You may become trapped without a mortgage if you are unable to refinance (obtain a new mortgage to replace the old loan) when the balloon loan comes due. You may have problems refinancing if, for example, you lose your job, your income drops, the value of your property declines and the appraisal comes in too low to qualify you for a new loan, or interest rates increase and you can't qualify for a new loan at those higher rates.

The one circumstance under which to consider a balloon loan is if you absolutely must have a particular property and the balloon loan is your one and only mortgage option. If that's the case, you should also be as certain as you can be that you'll be able to refinance when the balloon loan comes due. If you have family members who could step in to help with the refinancing, either by cosigning or by loaning you the money themselves, that's a big back-up plus. If you must take out a balloon loan, get as long a term as possible, ideally for no less than seven years (and preferably for ten years).

What is a prepayment penalty?

Some mortgages come with a provision that penalizes you for paying off the loan balance faster. Such penalties can amount to as much as several percentage points of the amount of the mortgage balance that is paid off early.

When you pay off a mortgage early because you sold the property or because you want to refinance the loan to take advantage of lower interest rates, some lenders won't enforce their loan's prepayment penalties as long as they get to make the new mortgage. Even so, your hands are tied financially unless you go through the same lender.

Many states place limits on the duration and amount of prepayment penalty that lenders may charge for mortgages made on owner-occupied residential property. The only way to know whether a loan has a prepayment penalty is to ask and to carefully review the federal truth-in-lending disclosure and the promissory note the mortgage lender provides you. Many so-called 'no points' loans have prepayment penalties.

What is a hybrid loan?

Hybrid loans or what lenders sometimes call intermediate ARMs start out like a fixed-rate loan (the initial rate may be fixed for three, five, seven, or even ten years) and then the loan converts into an ARM, usually adjusting every six to twelve months thereafter.

Loans called 7/23s (which are fixed for the first seven years and then have a one-time adjustment and remain at a fixed rate for the remaining length of the loan term) are also available.

When should I consider a hybrid loan?

If you want more stability in your monthly payments than comes with a regular adjustable, and you expect to keep your loan for no more than five to ten years, a hybrid (or intermediate ARM) loan may be the best loan for you.

The longer the initial interest rate stays locked in, the higher it will be, but the initial rate of a hybrid ARM is almost always lower than the interest rate on a 30-year fixed-rate mortgage. However, because the initial rate of hybrid loans is locked in for a longer period of time than the six-month or one-year term of regular ARMs, hybrid ARMs have higher initial interest rates than regular ARM loans.

During periods when little difference existed between short-term and long-term interest rates, the interest-rate savings with a hybrid or regular adjustable (versus a fixed-rate loan) were minimal (less than 1 percent). In fact, during certain times, the initial interest rate on a seven or ten-year hybrid was exactly the same as on a 30-year fixed-rate loan. During such periods, fixed-rate loans offer the best overall value.

To evaluate hybrids, weigh the likelihood that you'll move before the initial loan interest rate expires. For example, with a seven-year hybrid, if you're saving, say, 0.5 percent per year versus the 30-year fixed-rate mortgage, but you're quite sure that you will move within seven years, the hybrid will probably save you money. On the other hand, if you think that there's a reasonable chance that you'll stay put for more than seven years, and you don't want to face the risk of rising payments after seven years, you should opt for a 30-year, fixed-rate mortgage instead.

How do I distinguish between fixed-rate mortgages and adjustable-rate mortgages (ARMs)?

Like some other financial and investment products, many different mortgage options are available for your choosing. Two fundamentally different types of mortgages exist, and they differ in terms of how their interest rate is determined: fixed-rate mortgages and adjustable-rate mortgages.

Before adjustable-rate mortgages came into being, only fixed-rate mortgages existed. Usually issued for 15 or 30-year periods, fixed-rate mortgages have interest rates that are fixed during the entire life of the loan.

- With a fixed-rate mortgage, your monthly mortgage payment amount does not change. No surprises, no uncertainty.

- Adjustable-rate mortgages (ARMs for short) have an interest rate that varies. The interest rate on an ARM typically adjusts every six to twelve months, but it may change as frequently as every month.

- The interest rate on an ARM is primarily determined by what's happening overall to interest rates. When interest rates are generally on the rise, odds are that your ARM will experience increasing rates, thus increasing the size of your mortgage payment. Conversely, when interest rates fall, ARM interest rates and payments generally fall.

What is the advantage of getting a fixed-rate mortgage?

Because the interest rate does not vary with a fixed-rate mortgage, the advantage of a fixed-rate mortgage is that you always know what your monthly payment is going to be. Thus, budgeting and planning the rest of your personal finances are easier.

What are some of the drawbacks of a fixed-rate mortgage?

If interest rates fall significantly after you have your mortgage, you face the risk of being stranded with your costly mortgage. That could happen if (due to a deterioration in your financial situation or a decline in the value of your property) you don't qualify to refinance (get a new loan to replace the old). Even if you do qualify to refinance, doing so takes time and usually costs money for a new appraisal, loan fees, and title insurance.

If you sell your house before paying off your fixed-rate mortgage, your buyers probably won't be able to assume that mortgage. The ability to pass your loan on to the next buyer (in real estate talk, the next buyer assumes your loan) can be useful if you're forced to sell during a rare period of ultra-high interest rates, such as occurred in the early 1980s.

Fixed-rate mortgages sometimes have prepayment penalties.

What do I need to consider when evaluating an adjustable-rate mortgage (ARMs)?

When considering an ARM, you absolutely, positively must understand what rising interest rates (and, therefore, a rising monthly mortgage payment) would do to your personal finances. Only consider taking an ARM if you can answer all of the following questions in the affirmative:

- Is your monthly budget such that you can afford higher mortgage payments and still accomplish other financial goals that are important to you, such as saving for retirement?

- Do you have an emergency reserve (equal to at least six months of living expenses) that you can tap into to make the potentially higher monthly mortgage payments?

- Can you afford the highest payment allowed on the adjustable-rate mortgage? The mortgage lender can tell you the highest possible monthly payment, which is the payment that you would owe if the interest rate on your ARM went to the lifetime interest-rate cap allowed on the loan.

- If you are stretching to borrow near the maximum the lender allows or an amount that will test the limits of your budget, are your job and income stable?

- If you expect to be having children in the future, how much will your household expenses rise and will your income fall with the arrival of those little bundles of joy?

- Can you handle the psychological stress of changing interest rates and mortgage payments?

If you are fiscally positioned to take on the financial risks inherent to an adjustable-rate mortgage, by all means consider taking one -- we're not trying to talk you into a fixed-rate loan. The odds are with you to save money, in the form of lower interest charges and payments, with an ARM.

Also recognize that, almost all adjustable-rate loans limit, or cap, the rise in the interest rate allowed on your loan. We certainly wouldn't allow you to take an ARM without caps. Typical caps are 2 percent per year and 6 percent over the life of the loan.

What is the main advantage of a 30-year mortgage over a 15-year mortgage?

The main advantage that a 30-year mortgage has over its 15-year peer is that it has lower monthly payments that free up more of your monthly income for other purposes. A 30-year mortgage has lower monthly payments because you have a longer time period to repay it (which translates into more payments). A fixed-rate 30-year mortgage with an interest rate of 7 percent, for example, has payments that are approximately 25 percent lower than those on a comparable 15-year mortgage.

What if I can afford the higher payments that a 15-year mortgage requires? Should I take it?

Not necessarily. What if, instead of making large payments on the 15-year mortgage, you make smaller payments on a 30-year mortgage and put that extra money to productive use?

A terrific potential use for that extra money is to contribute it to a tax-deductible retirement account that you have access to. Contributions that you add to employer-based 401(k) not only give you an immediate reduction in taxes but also enable your investment to compound, tax-deferred, over the years ahead.

If you have exhausted your options for contributing to all the retirement accounts that you can, and if you find it challenging to save money anyway, the 15-year mortgage may offer you a good forced-savings program.

When you elect to take a 30-year mortgage, you retain the flexibility to pay it off faster if you so choose. Just be sure to avoid those mortgages that have a prepayment penalty. Constraining yourself with the 15-year mortgage's higher monthly payments does carry a risk. Should you fall on tough financial times, you may not be able to meet the required mortgage payments.

Not all mortgages come in just 15 and 30-year varieties. You may run across some 20 and 40-year versions, but that won't change the issues.

Do all mortgages just come in 15 and 30-year varieties?

Not all mortgages come in just 15 and 30-year varieties. You may run across some 20 and 40-year versions, but that won't change the issues.

How much does my credit report cost and what is it used for?

Your credit report tells a lender how responsibly you've dealt with prior loans. Did you pay all of your previous loans back (and on time)? Credit reports don't cost a great deal, but you can expect to pay from $30 to $50 for the lender to obtain a current copy of yours.

If you know that you have blemishes on your credit report, address those problems before you apply for your mortgage. Otherwise, you'll be wasting your time and money applying for a loan for which you'll be denied.

What is an appraisal for and how much will it cost me?

Mortgage lenders want an independent assessment to ensure that the property that you're buying is worth approximately what you agreed to pay -- that's the job of an appraiser. Why would the lender care? Simple -- because the lender is likely loaning you a large portion of the purchase price of the property.

The cost of an appraisal varies with the size, complexity, and value of property. Expect to pay a few hundred dollars for an appraisal of most modestly priced, average-type properties.

How important is it to comparison shop for loans?

Whether you do the footwork on your own or hire someone competent to help you doesn't matter. But you must make sure that this comparison shopping gets done. Suppose that you're in the market for a 30-year, $100,000 mortgage. If through persistent and wise shopping you're able to obtain a mortgage that is, for example, 0.5 percent per year lower in interest charges than you otherwise would have gotten, you'll save about $14,000 over the life of the loan (given approximate current interest rates). Double those savings for a $200,000 mortgage.

Although we encourage you to find the lowest-cost lenders, we must first issue a caution: Should someone offer you a deal that is much better than any other lender's, be skeptical and suspicious. Such a lender may be baiting you with a loan that doesn't exist or one for which you can't qualify.