POSTED: Friday, Jul. 13, 2007

The fundamentals of buying a home

Understanding mortgage basics

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Buying a home is exciting and stressful at the same time. A house is the single largest purchase most people will ever make in a lifetime. It’s also the largest sum of money most people will ever borrow at one time. So here’s what you need to know before you sign on the dotted line.

According to David Schwab, a loan consultant for American Home Mortgage in Bellingham, the lending process should always begin with a face-to-face meeting with a mortgage advisor. Together you can:

• Determine how much house you can afford.
  
• Look at what monthly payments are for different amounts.
  
• Pre-qualify for a mortgage amount and obtain a pre-approval letter. Many sellers will not consider offers from buyers who have not pre-qualified.
  
• Go over closing costs and other fees.
  
• Lock in an interest rate.

“Then you’re ready to go shopping for a home,” says Schwab.

Nancy and Nathan Leavitt recently purchased their first home, a two-story, four-bedroom home built in 1903 and located on a quiet street in Lynden.

“We wanted to build equity in an investment,” explains Leavitt, 22. “My husband is a contractor, so we were looking for something that needed a little help and could be easily renovated and updated.”

As an office representative for State Farm Insurance in Bellingham, Nancy Leavitt had worked with many of the local mortgage companies. She was familiar with brokers, but not so savvy about the options available for home loans.

“Our goal was to keep our monthly payments low and have enough cash available to pay for improvements,” she says. “So we were initially looking at an interest-only mortgage with our 20 percent down payment.”

After meeting with Schwab, the Leavitts discovered that a conventional 30-year fixed-rate loan worked best for them. The low interest rate and a long term worked out to a manageable monthly payment that left room in the budget for remodeling costs.

“We looked at all the options available based on the mortgage broker’s recommendations and found one that fit our goals in the long run,” says Leavitt. “When you think about it, everyone buys a home. You have to have someone you trust advising you though the process.”

DIFFERENT LOANS FOR DIFFERENT FOLKS

“There are literally hundreds of different mortgage options available to buyers,” explains Marty Schroder, manager of the Washington Mutual Home Loan Center in Bellingham. “There are the traditional fixed-rate loans with terms of 30, 20 or 15 years. There are also a variety of adjustable-rate mortgages available to buyers as well. Interest-only loans have also become increasingly popular.”

With a fixed-rate loan, the interest rate charged by the lender doesn’t change over the life of the loan. The payment will always be the same.

Adjustable-rate mortgages (ARMs) have variable interest rates that go up and down with market fluctuations. Many adjustable rate loans are hybrids between the two, meaning the interest rate can be fixed for a certain period — three, five, seven or 10 years, for example — and then adjust periodically after the fixed rate term expires.

An interest-only mortgage is a loan where the scheduled monthly mortgage payment consists of interest only. The option to pay interest only lasts for a specified period, usually 5 to 10 years and borrowers have the right to pay more than interest if they want to. If the borrower exercises the interest-only option every month during the interest-only period, the payment will not include any repayment of principal. The result is that the loan balance will remain unchanged. There are many other mortgage options available. See a lender for more details.

SO WHAT LOAN FITS WHAT TYPE OF BUYER?

According to Schwab, fixed-rate loans benefit those who plan on staying in their home and keep their existing mortgage for an extended period of time. Borrowers on fixed incomes also often prefer fixed-rate loans to avoid the possibility of interest rate changes that can affect their payments.

Homebuyers who only plan on staying in their home for a few years before moving to another home may benefit from the lower rates and monthly payment of an ARM. Buyers can take advantage of lower interest rates for the short term and sell before the mortgage adjusts.

Interest-only mortgages are recommended for borrowers who have a valid use for a lower initial required payment, says Schroder. Borrowers with fluctuating incomes may value the flexibility an interest-only mortgage gives them. When finances are tight, they can make the interest payment, and when they are flush they can make a substantial payment to principal. Buyers should make sure they are disciplined enough to make the payment to principal when they aren’t obliged to.

HOW IMPORTANT ARE INTEREST RATES?

According to Schroder, interest rates are a critical factor, but there are many other criteria to consider when choosing a lender.

“A lender may advertise a fantastic rate, but it’s important to understand the actual cost of the loan,” he says. “If a borrower is paying excessive fees to ‘buy down’ the interest rate, the lowest rate may in fact cost the customer more than if they had taken a higher rate and paid fewer lender fees.”

A good loan consultant should be able to explain exactly what the net benefit of buying down a rate is and advise the borrower about the best solution.

DOWN PAYMENTS AND PMI

Down payments of 20 percent are the industry standard and lets buyers avoid Private Mortgage Insurance. PMI enables lenders to accept lower down payments than they would normally allow. In effect, mortgage insurance provides what the equity that a higher down payment would provide to cover a lender’s losses in the unfortunate event of foreclosure.

The cost of PMI increases as your down payment decreases. For example, PMI on a 10 percent down payment is less than the cost of PMI on a 5 percent down payment. Your PMI premium is normally added to your monthly mortgage payment. There have also been recent changes regarding the tax deductibility of PMI. Be sure to ask a mortgage advisor for more details if you are faced with PMI.

Lenders have developed many financing programs to help first time buyers who don’t have 20 percent to put down. See a mortgage consultant for more details.

WHAT SHOULD BUYERS WATCH OUT FOR?

There are many potential pitfalls buyers should be aware of when choosing a lender.

According to the Washington State Department of Financial Institutions, a mortgage broker or lender must provide a written document giving information about the loan within three days of filling out a loan application.

Disclosures are required at two major points in the mortgage transaction. Disclosures made at the point of origination are designed to give the borrower advance notice of the loan program and the costs associated with the program. Disclosures made at loan closing are designed to confirm for the borrower that they are receiving what they expected. If disclosures are not provided, do not do business with this lender or broker.

Schroder also recommends that buyers ask for a “good faith estimate” in writing from their lender that outlines all the costs and fees associated with the loan. They should also ask whether they can lock in their interest rate when they make an application. There should be no cost for this and lenders should provide a written document that verifies the rate and the lock.

Buyers should also be wary of negative amortization loans. Negative amortization occurs when the mortgage payment is smaller than the interest due, causing the loan balance to increase rather than decrease.

Negative amortization can only arise on ARMs with one or more of the following features:

• The initial payment does not cover the interest due.
  
• The interest rate adjusts more frequently than the monthly payment.
  
• Changes in the monthly payment are capped, usually at 7.5 percent.

But these borrower-friendly features have a downside. If interest rates rise persistently, the equity in your house will decline rather than rise unless the negative amortization is offset by house appreciation. In addition, negative amortization must be repaid, meaning your payment will rise in the future. The larger the negative amortization, the greater the increase will be in future payments.

Predatory lending practices have become an area of concern within the mortgage industry, and there are resources available to protect and educate buyers. The Web site www.stopmortgagefraud.com was developed by the Mortgage Bankers Association and is a useful tool for all buyers.

THE VALUE OF TRUST

Tony Pechthalt, 44, has lived in Bellingham all his life. Married with three kids, he is a financial adviser for Edward Jones in Bellingham. In 1998 he purchased the home he grew up in from his mother. Last April he decided to upgrade to a waterfront home in Edgemoor.

“I had made a lot of money in real estate and had substantial holdings,” he explains. “I had to decide whether to retire, or buy a nice home on the water.”

Pechthalt had very specific goals he needed to achieve with his mortgage.

“I wanted to have the ability to make large principal payments on my mortgage,” he explains. “I also wanted the principal to be recasted (adjusted for the payment to reflect the new lower principal amount) after I made a large payment.”

After he had two mortgage brokers put together options for him, he ended up with a 30-year fixed-rate recastable loan, and a home equity line of credit.

Pechthalt advises homebuyers to ask potential lenders four questions:

• What products do you suggest based on my goals and my situation?
  
• How is each one going to benefit me?
  
• What are the risks of each product?
  
• What is it going to cost?

“I feel mortgage lending has little to do with the institution that lends the money and more to do with the individual at the institution,” he says. “To me this is about relationships and working with someone I can trust. I totally trust my mortgage advisers.”

Schroder agrees.

“Typically I’ve observed that homebuyers receive better service when dealing with lenders that have a local presence in their market,” he says. “I would recommend using either a reputable bank or mortgage company with loan consultants that can meet you in person.”