Mortgages for First Time Buyers

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For some buyers, picking out their mortgage can be the most stressful part of the home buying process. Since most buyers are either former renters or were living with mom and dad, they are suddenly going from thinking about their finances in terms of month to month or year to year, to thinking in five year, ten year or thirty year terms.
The reality is that mortgages don’t have to be that complicated.

For some buyers, picking out their mortgage can be the most stressful part of the home buying process. Since most buyers are either former renters or were living with mom and dad, they are suddenly going from thinking about their finances in terms of month to month or year to year, to thinking in five year, ten year or thirty year terms.

The reality is that mortgages don’t have to be that complicated. The first step is generally to call either your bank or one of the big national lenders, such as Wells Fargo, E-Trade Bank or Countrywide, and see what they will approve you for based on your credit score. If you can put 20 percent down and have a decent income, you will generally be in good shape.

If not, don’t despair, you just have a little more work to do. But you probably want to figure out what mortgages you are looking at before you start going to open houses and get your heart set on one particularly property.

The Download on Down Payments

The most important numbers you need to know in terms of down payments are 20 percent, 5 percent, and 3 percent.

As stated above, if you can make the 20 percent down payment on your first home, then you should have plenty of options. The only redflags that may impact you would be otherwise poor credit or a lack of “assets” (as in savings or retirement funds) or “income” (as in, your salary) that would indicate an ability to make the monthly payments.

Your lender may ask to see your tax return or W-2 from the past two years, and they will most likely ask to see bank statements from the past two months to show you have some cash reserves to make three months worth of monthly payments.

If you don’t have either the assets or the income, you can generally do what they call a low or no documentation loan, but you will pay a slightly higher percentage on your loan.

But the main reason it’s important to put 20 percent down if you can, is that lenders charge a kind of insurance called PMI if you don’t. PMI was recently made tax deductible, but it’s still a few extra percentage points that you may want to avoid.

If you don’t have 20 percent to put down, you are not alone. Many, if not most, first time buyers don’t have the ability to put that kind of cash down. A government program called FHA allows you to buy homes for 3 percent down, but you may expect to jump through a few extra hoops and fill out some extra forms to make sure the home qualifies.

You can find an FHA approved lender here:

http://locator.fha.gov/cgi-bin/answers_hud_loc.cfg/php/loc/enduser/loc.php

If you have less than 20 percent and more than 3 percent down, you still shouldn’t have too hard of a time finding a lender if you can meet the asset and income requirements.

A good place to find lenders in your area at both 20 percent down and 5 percent down, is bankrate.com.

If you want to avoid paying PMI, you can take out a loan for 80 percent of what the property is worth, and then get a second mortgage or “home equity loan” for the remainder. The interest on the second mortgage is deductible, but it will have a higher rate than your primary mortgage. The more conservative approach is to just do 5 percent down or whatever you are comfortable with, and then pay off your first mortgage down to 80 percent of what your home is worth as quickly as possible.

This is important for two reasons, 1) at that point, you should be able to call your lender and ask them to cancel the PMI, which will reduce your monthly payment and 2) when it comes time to sell your home, you want to have that 20 percent in equity or more that you can roll over into another home, which will likely be even more expensive than your first home. Also, once you get 20 percent equity in your home, you should have a fairly easy time refinancing your mortgage if rates go down further.

Fixed vs. Adjustable

The most common mortgage is the 30 year fixed rate. By spreading your payments out over 30 years, you get a stable monthly payment that is fairly low.

However, especially for first time buyers, you generally aren’t going to keep the property for anywhere close to 30 years. The average American moves once every seven years.

Also, the way mortgages are structured, you are paying mostly interest at the beginning, so it’s not like you are paying in $100 or $200 per month for the whole mortgage. In the first year, your equity will only increase by a very small amount, so if you sell after one year, you won’t have much if any equity to show for it.

That is why main first time buyers turned to adjustable rate mortgages, which generally (but NOT always) have a lower interest rate, but are only fixed for the first few years of the mortgage. If you knew at the beginning of your mortgage, that you were going to live in the house for only three years, a 3/1 ARM could be a very good mortgage for you. However, you don’t want to be uprooted after 36 months just because your interest rate is going to adjust, so a conservative approach would be to get a 5/1 ARM or a 7/1 ARM. There is also a 10/1 ARM, but at that point, the interest rate is often the same to a fixed-rate, so there’s really no incentive to go with the adjustable rate mortgage over the fixed.

Another option would be a shorter term fixed rate mortgage. If you can afford the higher payments, a 15-year or 20-year fixed rate mortgage will get your house paid quickly, so even if you did move out after 7 years, at least you’d have a significant amount of equity to show for it. But the payments will be significantly higher.

In some parts of the country, a 40-year fixed rate mortgage is offered because home prices are so high, buyers need to spread the payments out to make them affordable.

Interest Only and Negative Amortization

You may have heard of loans where people ended up “owing more than their house was worth.” Interest-only mortgages allow you to make a lower monthly payment, but are based on the assumption that you will pay down the principal on your own, say when you get a tax return or a bonus check at work or an inheritance. Much like a credit card, if you just pay off the interest, the principal will never change. If the value of your home goes down, and you didn’t make any payments against principal, then you may end up owing a bank more than what your house is worth, which makes it hard to sell. If you are confident that home prices are going up in your area, and you think your income will increase, an interest only mortgage can be a viable option, but you will pay a slightly higher rate.

Another option often called Flex Pay or Flex Option, allows you to make payments that are even lower than the interest only payments. As a result, the amount of principal owed actually goes up each month. This was a popular option for people who wanted to have a lower payment for a year or two when they first moved into the house, assuming they’d have more income to make the higher payments later on. In this case, since the interest is being added to the principal, your $300,000 mortgage could increase to $310,000 in a year, and then you owe interest on that larger amount. This mortgage is not a good idea for the majority of home buyers.

Paying Points

If you are planning on keeping the house for 10 years or longer, you may want to consider paying points to lower your interest rate. Generally you pay a point or two as a fee to get the lender to lower your rate by a percentage point or more. This makes sense for two reasons: 1) the points are deductible, so it will help you get a bigger tax return the year after you first buy, and 2) eventually, you will the money back and more because you are paying a lower interest rate.

However, if you aren’t sure if you will be in the home for long enough to recoup the cost of the points, then better to keep your closing costs as low as possible. You will already be putting a large amount of money down, and who knows what other costs you may encounter after you first move, including upgrades and repairs.

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