Mortgage 101

The first step toward buying a home is getting pre-approved for a mortgage. A mortgage is an advance of money from a lender that covers the finances of a property. A mortgage is made up of two parts: principal and interest. Principal is the actual amount borrowed. Interest is the lender’s fee you are charged for borrowing.

Several formulas exist to help determine how much a lender will allow a consumer to borrow. Generally, the income guideline to purchasing a home is 2-3 times your annual household income. However, this guideline has been expanded and now allows homebuyers with good credit greater purchasing opportunities. Other important factors to consider are the percentage of your gross (before taxes) monthly income and installment debts. Installment debt with less than 10 months of payments is often excluded from the debt to income ratio.

Pre-approval is just as it sounds, getting approved for a mortgage prior to shopping for a home. Lenders use not only basic information, but also electronic credit reporting to determine whether they will loan you money. You will have a better negotiating position when you are pre-approved for a mortgage. The pre-approval letter lets agents and sellers know you are a serious buyer. A pre-approved buyer can also close on a property more quickly, which is another major consideration for a motivated seller.

Pre-qualification is not a full mortgage approval, but gives an estimate of what you can afford and what a lender is willing to lend you before you start looking at homes. It indicates you are creditworthy enough to obtain a loan but does not guarantee you the loan. When you pre-qualify for a mortgage, the lender takes into account your current income, financial and credit history, federal tax returns, and long-term debt, and then uses this information to calculate an approximate mortgage amount.

When applying for a mortgage you will need to gather documentation regarding your income, job tenure, employment stability, your assets (property, cars, bank accounts, and investments) and your liabilities (auto loans, installment loans, mortgages, credit card debt, household expenses, child support, etc.).

The Definition

PMI is the hidden portion of your monthly mortgage payment that exists to protect your lender (not you) against your default on the loan. Commonly, this is added to a loan transaction where the loan-to-value ratio is 80% or greater. Statistically, borrowers who put down less than 20% are more likely to default on their loan; therefore, the lender requires PMI to recover their investment. Normally, the lender would not make the loan but they are willing to take the risk as long as PMI is paid.

How to Avoid PMI

There are ways of avoiding PMI and providing less than a 20% down payment. One way is through a loan called an 80/10/10. This is where you have two loans—a first mortgage of 80% of the home’s value, a second mortgage of 10% of the home’s value, and a 10% down payment. Another possibility is an 80/15/5. However, these combo loans often incur higher interest rates.

You may also build the PMI into the interest rate. With this option the lender agrees to loan you more money than normal and you agree to pay a higher interest rate. This saves the hassle of making two loan transactions and the interest is still tax deductible.

How to Eliminate PMI

Unlike mortgage interest, PMI is not tax deductible. Therefore, you want to eliminate it as quickly as possible. Just take a look at your most recent mortgage statement and divide the remaining principal balance by the original purchase price of your home. If that number is below 80% contact your lender about removing PMI.

Even if you haven’t been paying on the loan for very long you may still be able to have PMI removed. This can occur if your home has appreciated to the point where the mortgage balance is less than 80% of the current market value. In other words, this value, known as the PMI Threshold Value, is the minimum value your property must have in order to reveal the required 20% equity level. The lender will probably require an appraisal of the home (approximately $300), but you will quickly recoup this cost.

Points, also known as discount points, are a percentage of the loan amount paid at closing that affect your interest rate. Each point equals 1% of your loan amount. For example, on a $100,000 loan, 1 point = $1000. Essentially, if you pay points, you are “buying” down your interest rate. A general rule of thumb is that one full discount point will lower your fixed interest rate 0.250% or your adjustable rate 0.375% These points lower the interest rate for the entire term of the loan.

The discount points you pay may be tax deductible. They are usually deducted under Schedule “A” of your IRS 1040 tax return. If you do not itemize your deductions (by taking the Standard Deduction) for other tax-related reasons, you may not be able to deduct the cost of the points when filing your tax returns. Consult your tax preparer or the IRS to obtain a qualified opinion and the best expert advice.

The annual percentage rate reflects the total cost of your mortgage. To compute the APR, the lender takes into account the interest rate on your loan, the term of the loan, and other loan fees such as closing costs, points, etc. Your monthly mortgage payment is calculated based on the mortgage note rate, not the APR. The APR will be higher than your interest rate, particularly if you are paying any points.

The Loan Estimate  provides itemized information about the charges you will incur over the life of the loan, including the Annual Percentage Rate (APR), the amount of interest you’ll pay, the amount financed and schedule of payments, the total of your payments, and late payment charges.