Mortgages Guide

1. What is a Mortgage?
A mortgage is nothing more than a loan. Like most loans, it requires some collateral (the thing you'll lose if you don't pay the lender back). In this case, the collateral is a house or apartment you want. A bank lends you money to buy a house, and if you don't pay them back when they say to, they get to seize the house, put you out on the street, and sell your home so they can get their money back.

It could be worse. Kneecaps could be involved.

Almost all home purchases involve a combination of money you cough up (the down payment) and money supplied by a bank (the mortgage). Now, the standard advice is that you should have enough of your own cash to pay for 20% of the house you're planning on buying upfront as a down payment. Doing so gives you a nice chunk of equity (the portion of the house you own) right off the bat and will mean your lender won't charge you private mortgage insurance (PMI). PMI is something banks require (and you pay for) when they think there's a possibility you could default on the loan. People who put less than 20% down automatically fall into this category, and they wind up paying an extra $50 or more per month on top of their regular monthly mortgage payment.

Not all mortgages are the same. Here's how the most common ones break down:

Length of Term- This means how long you'll be paying the bank back. Most mortgages have a 30-year term, but there are mortgages that are for 20, 15 or 10 years. The shorter the term, the higher the payment, since you have less time to pay it off. On the other hand, the shorter the loan, the less interest you'll pay over the life of the mortgage.

There are also longer terms, such as 40 years, but you should avoid them-they're designed to lure people in with low monthly payments, but since they're so long, you'll pay gobs more in interest over the length of the loan.

Fixed Rate vs. Adjustable Rate Mortgages (ARMs)- A fixed-rate mortgage is a loan with the exact same monthly payment for the life of the loan. An adjustable-rate mortgage has a rate that is usually fixed for a specified time and then adjusts, either annually, semi-annually or even monthly. Most adjustable-rate mortgages assume a 30-year term.

If you see a "5/1 ARM," that means that the rate is fixed for five years, and then adjusts once every year for the next 25 (the adjustment depends on what the prime rate is on the day of the adjustment. Bank set their own prime rates, although the Federal Reserve targets a specific rate and the majority of banks follow suit.) ARMs have lower rates than fixed-rate mortgages at the beginning of their term, but they're riskier. If interest rates are higher when the fixed-rate expires, your monthly payment can go through the roof. That's what happened to many of the borrowers caught up in the sub-prime mortgage crisis that began in 2007.

Another thing about ARMs: If you don't plan on living in your place for a very long time, they can be a good idea. A 7/1 ARM has a fixed rate for seven years. Let's say that, after living in your place for six years, you decide you want to move. And let's say you successfully sell your house for $400,000, and at the time of the sale, you still have $325,000 left on your mortgage. You write a check to the bank for $325,000 and pocket the rest. In this scenario, your mortgage interest rate never changed, as it was fixed for seven years, and you sold your house after six.

Interest-Only Mortgages- With most mortgages, you're paying off the interest and paying down the principal at the same time. Interest-only mortgages ("I/O mortgages") allow you to make payments only on the interest for a fixed period of time (usually between three and 10 years). This means low, low monthly payments at the beginning of your loan. But after the interest-only period expires, you'll need to make payments on the interest and principal, which will raise your monthly payment, sometimes very sharply.

Also keep in mind that most I/O mortgages are also ARMs, so in addition to having to pay principal after the I/O period ends, your interest rate may go up as well, raising your monthly payment even higher.

Payment-option ARMs - This is probably the riskiest type of mortgage out there. With this loan, you don't have to pay down the principal, like an I/O, but you also don't have to pay all the interest, either.

What this means is an incredibly low monthly payment, but it also means that any interest you don't pay off at first will be added to your loan balance. This can result in a nasty little scenario called "negative amortization," which is just a fancy way of saying you're screwed: Because you didn't pay off all the interest when it was originally due, and because that unpaid interest is tacked on to your principal, the amount of money you owe the bank can actually grow over time, not shrink.

So why would anyone want one of these loans? Well, they're cheap…at first. With a super-low monthly payment, you can either spend very little to get the same size loan as say, a 30-year fixed-rate mortgage, or you can spend the same amount each month as a 30-year fixed mortgage and borrow a lot more money. If you were dead certain that your home's value was going to skyrocket for the time that you owned it, and you planned on selling before the loan came due, sure, an option ARM might work, but it's almost always better to go with something where you're certain to be paying off at least a bit of principal each month.

Here are a few more terms you're going to hear a lot about:

Mortgage Points- Towards the end of the loan process, you'll be asked if you want to buy points. One point costs one percent of the loan. A point usually lowers the interest rate by around .25% (one quarter of one percentage point), thereby lowering your monthly payment.

Whether or not this is the right move for you depends on how long you plan on living in your house. Say you had a $200,000 mortgage with a 6% interest rate. Your monthly payment would be $1,199. Buying one point (which would cost you $2,000) lowers your interest rate to 5.75%, resulting in a monthly payment of $1,167, saving you $32 a month. But since you coughed up $2,000 at the beginning, it'll take you a little more than five years before you break even. If you plan on selling before then, points are a bad idea.

Rates versus APRs- Under most circumstances, forget about the APR (which stands for "annual percentage rate")-just pay attention to the rate.

APR is a way to show the total cost of a mortgage over its entire life. APR takes into account the cost of the interest rate, but also the cost of any fees or points you paid when you first got the loan. It then expresses this total expense (interest+fees and points) as a percentage.

The problem is that those costs are being spread out over the life of the loan, and most people don't hold on to their mortgage that long. If you cash out early, the points you bought are less beneficial and the fees aren't spread out over as many months. That's why most people can ignore the APR.

2. How Can You Get a Mortgage?
If you're never applied for a mortgage before, you may not realize that you're about to have every crevice of your financial life looked over by banks who consider you for a loan. You'd better make sure your financial house is in order.

Check Out your Credit Report and Score
Start your search by ordering copy of your credit report and finding out your credit score. Read more about how to get, understand, and improve your credit score and reports here.

If you're worried that your score is looking kinda low (say, below 750) check out this Wall Street Journal article to find out some ways you can boost your score in a relatively short time. Just understand that "a relatively short time" in this case means months, not days. Which goes to a bigger point: If you're thinking about buying a home, give yourself six to 12 months to get everything in order.

Pull Together your Financial Records and History
You'll be amazed how much paperwork is involved with getting a mortgage. You'll be asked to supply your tax returns from the last few years, pay stubs, bank statements and other bits and pieces from your life. Start gathering that info now, well before you even apply.

Collect and Deposit Family Gifts as Soon as Possible
A lender will view gifts from family members (and always call them "gifts," even if you intend to pay your dad back-banks don't like "loans" from third parties) differently than savings you diligently set aside over time. If it's feasible, you should deposit any contributions from other people to your housing fund at least six months before you apply for a loan. That way, when your lender goes over your last few bank-account statements, it will appear as if the money was always yours and it won't raise any questions.

Get Pre-approved
It's a good idea to get pre-approved for a mortgage if you haven't found your house yet (if you have found a place, then just go ahead and apply for the mortgage). What pre-approval means is that a lender has checked your credit and verified that you make and owe what you said you make and owe. The lender will also issue you a letter that you can show off to brokers and sellers, indicating that the bank has agreed to lend you a certain amount of money.

There are two big benefits to getting pre-approved: It shows sellers that you are serious, and it gives you a head start on the mortgage application process (so long as you decide to get a mortgage from that lender-you're under no obligation to get a loan from the lender that pre-approved you).

3. Advice on Getting a Good Deal
The size of your down-payment affects how much you pay in interest and other fees down the road. Paying for 20% of your house upfront is great. It's the gold standard. It's also not entirely realistic for everyone. Paying 20% on a $350,000 home is still $70,000-a considerable chunk of change. Use our mortgage calculator to see how much different sized mortgages would cost you. If you can't swing 20%, you have options, but they come with costs-some more than others. Here's what you can do:

• See if you qualify for a Federal Housing Authority Loan - First-time homebuyers may qualify for government assistance, in the form of loans that allow you to put as little as 3% down. There are limits as to how big a loan you can get (go here to find out what the limit is in your area), and there is mortgage insurance fees, but it's only a slightly higher monthly payment than a standard 30-year-fixed loan.
• Ask about LPMI - Lender-Paid Mortgage Insurance is different than Private Mortgage Insurance, in that your lender pays for it and passes on the cost to you in the form of a slightly higher rate. LPMI can be cheaper than PMI, but remember one thing: If you pay a loan down long enough, PMI goes away (you've paid in enough to have bought 20% of your home, therefore, no more PMI). LPMI lasts until you sell the place or pay off the entire mortgage. For most young homebuyers, this isn't a huge concern, since the first place you buy is usually not your last.
• Check in with a mortgage broker - A mortgage broker is someone who shops around from bank to bank and tries to find the best mortgage for you. These brokers come with a price tag. While you often don't have to pay them anything out of your own pocket, the mortgage broker does make money off of your loan, in the form of rebates or commissions from the bank and built-in fees.

Sometimes, that's ok, since the broker is going to find you such a sweet loan that, even with the fees and rebates, it's still a better deal than what you'd find on your own. Another reason brokers can be useful is if you have lousy credit-they can find lenders who won't laugh the moment they see your FICO score.

Why wouldn't you go to a broker? Well, you might find a better loan yourself, or through a deal your employer has with a bank. Bottom line: You're not obligated to get a loan from a mortgage broker who's offered to try and help you, so have one shop around for you, but also do some research on your own. Whoever finds the best mortgage wins.

Also, don't forget to:
Compare estimates of closing costs - Closing on your mortgage always involves an assortment of little fees and charges. One way to get a sense of what those fees and charges will be is to look over what is called a Good Faith Estimate, which any prospective lender or mortgage broker should provide. The estimate is just that, an estimate, but it can be a good way to compare the total costs of two loans if they have the same rate and term.

Watch for junk fees - Some lenders and mortgage brokers love to add in a slew of little fees at the last minute. Don't let them get away with it. Go over each fee and make sure someone tells you exactly what it's for, and who collects it. Keep a sharp eye out for generic fees such as "administrative" or "processing" fees-those are often bogus, and can be reduced or even eliminated if you make enough of a stink about it. Remember-most fees are negotiable.

4. Grilling Guide: Questions to Ask When Shopping For a Mortgage
Does the rate you're quoting me include any points?
You'll have to run the numbers yourself to see if it's worth it, but you should know if points are involved right at the beginning of this process.

Is there a prepayment penalty if, at any time, I decide to make a larger-than-usual payment?
There really shouldn't be. Don't get a mortgage that has one.

How long can I lock in my interest rate while waiting to close on my home purchase?
30 to 60 days is the norm.

How much does it cost to extend the lock-in period?
It depends: Some lenders charge a flat fee, others use a percentage of the loan. Either way, negotiate. Many lenders will extend for a few days for free. If you need more time, the fee should be a small fraction of a percentage of your loan, like .125% or a couple of hundred dollars.

Will you guarantee the Good Faith Estimate? If not, why not?
They should. If they don't, they better have a damn good reason. Actually, we can't think of any. They just should.

How long will it take to get approval?
It depends, but it can take as little as a week or as much as a month.

Do I have to have homeowner's insurance in order to get this loan?
Most lenders will require you to get homeowners insurance in order for them to grant you a loan. For their purposes, your insurance policy only has to be big enough to cover the cost of the mortgage (after all, they don't care about your home, they just want to protect their investment). You should get more coverage than that, though-enough to rebuild your home if were destroyed. You can, and should, shop for homeowners insurance on your own. Check out this guide to learn more about it.

Do you charge an extra fee for your bi-weekly payment plan?
You should be able to pay your mortgage off more frequently, but you shouldn't pay for the privilege.

Here are the basics: Say you had a monthly mortgage payment of $1,000. If you make payments monthly, which is the normal schedule that lenders expect, you'll pay $12,000 in a year. But say you made a $500 payment every two weeks. Since there are 52 weeks in the year, that means you'd make that payment 26 times. 26 x $500 = $13,000. Basically, you're just tricking yourself into paying more per year. But that's good-you'll pay off your mortgage faster by sending in that extra $1,000 each year.

Many lenders have automated-payment plans that will dip into your bank account and make a withdrawal every two weeks, and they'll charge you a one-time fee of, say, $350 to do it. Compared to what you're saving over the life the loan (tens of thousands of dollars in interest) by making these biweekly payments, $350 doesn't seem like a lot. But the better option is to do it yourself. Most loans today allow you to pay back more per month than the standard payment. Just double-check that your mortgage does, as there may be a few loans still out there with "prepayment penalties" that actually fine you for trying to pay off your mortgage faster. Any mortgage that has a prepayment penalty should be avoided.

Here's how to figure this out: Divide your monthly payment ($1,000) by 12 ($83.33) and add that amount back to your monthly payment (totaling $1,083.33). By the end of a year, you'll still have sent $13,000 to the bank, and you'll still have your $350.