Loan Basics — Home Loans

Home Loans

Buying a home is a significant purchase and it requires a significant amount of money before you can really make the dream of homeownership come true. It takes planning—including saving for a down payment—and a realistic consideration of what you can afford to buy.

How much home can you afford?

First, review your budget and finances, and be realistic. From the lender’s point of view, what you can afford and the size of the mortgage you can qualify for will depend on your:

  • Credit History—With good credit, you are likely to qualify for a mortgage and potentially get a lower interest rate on your mortgage, which will save you thousands of dollars over the life of the loan.

Tip: When you decide you want to buy a home, get a free copy of your credit report from each of the three credit bureaus. Give yourself time to review the report and correct any errors. Start taking steps to improve your credit score if necessary (paying bills on time, paying down existing debt) Go to or call 877-322-8228 to get your free credit reports.

  • Debt-to-Income Ratio—When you apply for a mortgage, lenders compare your income to your housing costs and other debts to see how much you can afford to spend each month on mortgage payments. Lenders usually want to see your total debt (including credit card debt and car payments) equal no more than 36 percent of your income. This is called your debt-to-income ratio. Lenders generally want your housing costs (mortgage, real estate taxes, and insurance) to total no more than 28 percent of your pre-tax (gross) income.
  • Down Payment—The larger your down payment, the less you need to borrow. The down payment is usually expressed as a percentage of the sale price or appraised value, whichever is lower. Borrowers today may need to provide as much as 20 percent of the sale price as a down payment.

Tip: There are a number of mortgage calculators available on the Internet that can be used to help you figure out how much home you can afford.

Types of mortgage loans

Understanding the various mortgage loan options and how they work will help you make an informed decision about which mortgage is right for you. Loans and interest rates can vary widely from lender to lender—but they generally break down into two broad categories: fixed-rate and adjustable- (or variable-) rate loans.

  • Fixed-Rate MortgagesFixed-rate mortgages carry the same interest rate throughout the life of the loan. The advantage is predictability. Your monthly mortgage payment would always stay the same. Lenders generally offer 15-year and 30-year mortgages, but a “30-year fixed” is the most common because the extended payment period offers a much lower monthly payment.
  • Adjustable Rate Mortgage (ARMs)—Unlike a fixed-rate mortgage, the interest rate on an Adjustable Rate Mortgage can change periodically and your monthly payments may go up or down. Initial monthly payments on an ARM can be much lower than on a fixed-rate mortgage, however there could be a significant difference in your monthly loan payment once the mortgage adjusts.

    There are also Hybrid ARMS which are a combination of a fixed and an adjustable rate loan. These loans generally offer a fixed interest rate for a limited time period (generally 3, 5, 7 or 10 years) and once the fixed-rate period is up, the loan shifts to an adjustable rate, which can then change annually. If you’re considering an ARM, ask how frequently rates can change and ask if there is an annual cap—or limit—on how much the rate can change.

Other mortgage options

While fixed-rate and adjustable rate home loans are the most common, there are other kinds of mortgages available, including:

  • Interest-Only Mortgage—These loans are structured so that only the interest expense is paid off in the initial stages of a loan. Although the initial payments can be much lower than a fixed-rate mortgage, once the “interest only” period expires (which is generally 5–10 years) the increase in the monthly mortgage payment can be substantial.
  • Federal Housing Administration (FHA) Loan—For borrowers with less than stellar credit, an FHA-insured loan is an option to explore. Because these loans are insured by the FHA, lenders are more willing to give loans with lower qualifying requirements—including lower down payments—making it easier to qualify. There are certain price restrictions for FHA loans. The FHA’s web site provides additional information about these loans.

Home equity loans

A home equity loan (or line of credit) is a second mortgage that lets you turn your home’s equity (which is the difference between how much the home is worth and how much you owe on the mortgage) into cash. Home equity loans can be used in a variety of ways—home improvements, debt consolidation, college education or other expenses.

  • Home equity loans net you a set amount of cash in a lump sum that is paid off in a set time frame. They have a fixed rate and you make the same payment each month.
  • Home equity lines of credit (HELOC) offer you access to a certain amount of cash, meaning you can borrow up to that set amount. These loans work more like variable rate credit cards, so you can withdraw money from the line of credit as you need it, and as you pay back what you borrowed, you can use the credit again.

Your home is used as collateral for all home equity loans. If you don’t make your payments and default on your loan you could lose your home to the lender.

Refinancing a home loan

When you refinance a home loan, you are basically taking out a new loan at a new, lower interest rate. Refinancing doesn’t reduce the debt you owe – but, with a new, lower interest rate, it can lower your monthly payments and save you a significant amount of money over the life of the loan.

Knowing when and if to refinance a home can be a challenge. For some people, refinancing makes great financial sense, and for others, it may never be worth it because the costs outweigh the benefits. Asking yourself a few questions to help you decide if refinancing your mortgage is right for you, such as:

  • How much lower will the interest rate be on your new loan? You should always know your mortgage rate and keep an eye out as rates fall, particularly if you have an adjustable rate-loan. Getting a lower, fixed-rate can save you hundreds or even thousands over the life of your loan.
  • How long do you plan to stay in your home? If you don’t plan on living there for long, refinancing may not be in your best interest.
  • What are the closing costs for the new loan? Be sure to include the closing costs in your calculations to see if you’ll be saving enough money to make refinancing worth it.
  • How much equity have you built up with your current loan? You can cash-out the equity or get a home equity loan. Talk to your lender and consider the pros and cons of both options before you decide.

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