Financing Basics For First-Time Homebuyers

Many people who are considering buying their first home can be overwhelmed by the myriad of financing options available. Fortunately, by taking the time to research the basics of property financing, homeowners can save a significant amount of time and money. Having some knowledge of the specific market where the property is located and whether it provides incentives to lenders may mean added financial perks for buyers. Buyers should also take a look at their own finances to ensure they are getting the mortgage that best suits their needs. 

Loan Types

There are several mortgage loan types; these are differentiated by loan structure and the agencies that secure them.

1. Conventional Loans 
   Conventional loans are fixed-rate mortgages that are not insured or guaranteed by the federal government. Although they are the most difficult to qualify for due to their requirements for criteria such as down payment, credit score and income, certain costs, such as private mortgage insurance, can be lower than with other guaranteed mortgages. 
   
   
   Conventional loans are defined as either conforming loans or non-conforming loans. Conforming loans comply with the guidelines set forth by Fannie Mae or Freddie Mac. These stockholder-owned companies create guidelines, such as loan limits - $417,000 for single-family homes, for example - because they package these loans and sell securities on them in the secondary market. 
   A loan made above this amount is known as a jumbo loan and usually carries a slightly higher interest rate because of the lower demand for loan pools with these loans in them. Non-conforming loans, usually provided by portfolio lenders, have guidelines that are set by the particular lending institution underwriting the loan. 
2. FHA Loans 
   The Federal Housing Administration (FHA), part of the U.S. Department of Housing and Urban Development, provides various mortgage loan programs. An FHA loan has lower down payment requirements and is easier to qualify for than a conventional loan. FHA loans are excellent for first-time home buyers because in addition to lower upfront loan costs and looser credit requirements, they allow down payments of as low as 3%. FHA loans cannot exceed the statutory limit.
3. VA Loans 
   The U.S. Department of Veterans Affairs (VA) guarantees VA loans. The VA does not make loans itself, but guarantees mortgages made by qualified lenders. These guarantees allow veterans and service people to obtain home loans with favorable terms, usually without a down payment, and in most cases they are easier to qualify for than conventional loans. Lenders generally limit the maximum VA loan ($417,000 in 2008, $625,000 in Hawaii, Alaska, Guam and the U.S. Virgin Islands). Before applying for a loan, request eligibility from the VA. If you are accepted, the VA will issue a certificate of eligibility to be used in applying for a VA loan.
   In addition to these common loan types and programs, there are programs sponsored by state and local governments and agencies, often with the goal of increasing investment or home ownership in certain areas. 

Equity and Income Requirements

The pricing of home mortgage loans is determined by the lender in two ways, each of which determines the creditworthiness of the borrower. In addition to checking the borrower's FICO score from the three major credit bureaus, lenders will require information to determine two standard statistics, which are used to set the rate charged on the loan. These two statistics are the loan to value ratio (LTV) and the debt-service coverage ratio (DSCR).

LTV is determined by the amount of actual or implied equity that is available in the collateral being borrowed against. For home purchases, LTV is determined by dividing the amount being borrowed by the purchase price of the home. The higher the LTV, the more expensive the loan will be because the lender believes there is a higher risk of default. The idea here is that the more money the borrower is putting at risk (in the form of a down payment), the less likely he or she is to default on the loan.

LTV also can contribute to loan costs by determining whether a borrower will be required to purchase private mortgage insurance (PMI). PMI insulates the lender from default by transferring a portion of the loan risk to a mortgage insurer. Most lenders will require PMI for any loan with an LTV greater than 80%, meaning any loan where the borrower will have less than 20% equity in the home. The cost of mortgage insurance and the way it is collected are usually determined by the amount being insured and the mortgage program being used to obtain the loan. 

For the most part, mortgage insurance premiums are collected monthly with tax and property insurance escrows, and are supposed to be eliminated automatically after the loan has been paid down to a point where LTV is equal to or less than 78%. It may also be possible to cancel PMI once the home has appreciated enough in value to give the owner 20% equity and a set period of time has passed, such as two years. Some lenders, such as the FHA, will assess the mortgage insurance as a lump sum and capitalize it into the loan amount. 

There are ways to avoid paying for PMI. One is not to borrow more than 80% of the property value when purchasing a home; the other is to use home equity financing or a second mortgage to obtain the funds needed above 80% LTV. There are many programs that allow for this, but the most common is called an 80-10-10 mortgage. The 80 stands for the LTV of the first mortgage, the first 10 stands for the LTV of the second mortgage, and the third 10 represents the equity the borrower has in the home. Although the rate on the second mortgage will be higher than the rate on the first, on a blended basis it should not be much higher than the rate of a 90% LTV loan and for most people it will be cheaper than paying for PMI. 

This is an exceptional alternative for borrowers who wish to pay off their homes early because they can accelerate the payment of the second mortgage and eliminate that portion of the debt quickly. As a rule of thumb, PMI should be avoided if at all possible because it is a cost that has no benefit to the borrower. 

The debt service coverage ratio (DSCR) determines a borrower's ability to pay the cost of the mortgage. By dividing a borrower's monthly net income available to pay mortgage costs by the mortgage costs, lenders can assess the probability that a borrower will default on the mortgage note. Most lenders will require DSCRs of greater than one. The greater the ratio, the greater the probability that a borrower will be able to cover borrowing costs and the less risk the lender takes on. The greater the DSCR, the more likely a lender will negotiate the loan rate because even at a lower rate, the lender receives a better risk-adjusted return. For this reason, borrowers should try to find any type of qualifying income they can when negotiating with a mortgage lender. Sometimes an extra part-time job or other income-generating business can make the difference between qualifying or not qualifying for a loan or receiving the best possible rate. 

Fixed vs. Floating Rate Mortgages

Another thing to consider when shopping for a mortgage is whether to obtain a fixed-rate or floating-rate mortgage. A fixed-rate mortgage is one where the rate does not change for the entire period of the loan. The obvious benefit of getting a fixed-rate loan is that the borrower knows what the monthly loan costs will be for the entire loan period. However, a floating-rate mortgage, such as an interest-only mortgage or an adjustable-rate mortgage (ARM), is designed to assist first-time home buyers or people who expect their incomes to rise substantially over the loan period. 

Floating-rate loans usually allow borrowers to obtain lower introductory rates during the initial few years of the loan, allowing them to qualify for a larger loan than if they had tried to get a more expensive fixed-rate loan. Although the benefit can be great, these loans entail a substantial risk for those borrowers whose income does not grow in step with the change in interest rate. The other downside is that in most cases, the rate change is not known at the outset of the loan because it is usually pegged to some market rate that is determined in the future. 

The most common types of ARMs are a one, five or seven-year ARM. The initial interest rate is normally fixed for a period of time after which it is reset periodically, often every month. Once an ARM resets, it adjusts to the market rate, usually by adding some predetermined spread (percentage) to the prevailing Treasury rate. Although most ARMs by contract can only increase by so much, when an ARM adjusts, it can end up being more expensive than the prevailing fixed rate mortgage loan to compensate the lender for having offered a lower rate during the introductory period. 

Interest-only loans are a type of ARM in which the borrower is responsible for only paying mortgage interest and not principal during the introductory period until the loan reverts to a fixed, principal-paying loan. Such loans can be very advantageous for first-time borrowers because only paying interest significantly decreases the monthly cost of borrowing and will allow one to qualify for a much larger loan. However, because the borrower pays no principal during the initial period, the balance due on the loan does not change until the borrower begins to repay the principal. 

Borrowers must weigh the benefit of obtaining a larger loan with the risk. Interest rates typically float during the interest-only period and will often adjust in reaction to changes in market interest rates. Borrowers also have to contend with the risk that their disposable income won't rise along with the possible increase in borrowing costs. (Interest-only loans can be beneficial, but for many borrowers they represent a trap.

Conclusion

If you're looking to find a home mortgage for the first time, there are a few things that can be done to reduce the difficulty of sorting through all the financing options. The best approach is to put some time into deciding how much home you can actually afford and then finance accordingly. Homeowners who can afford to put a substantial amount down or who have enough income to create a high coverage rate will have the most negotiating power with lenders and the most financing options. Those who push for the largest loan will undoubtedly receive a higher risk-adjusted rate and then may have to deal with adjustable-rate mortgages and private mortgage insurance. A good mortgage broker or mortgage banker should be able to help steer you through all the different programs and options, but nothing will serve you better than knowing what you want and what you can ultimately live with.