Mortgage Basics
A mortgage is loan that allows you to borrow a substantial amount of money to purchase a property. After the purchase, a mortgage serves as the security instrument that obligates you to pay back that loan, using the property itself as collateral.
In other words, let's say that you want to buy a $300,000 home, but you don't have $300,000 lying around to make that purchase. You still want that home, so you work with a lender to borrow $300,000 to buy that house. In return, the lender wants you to pay back that $300,000 over the next 30 years, with some interest on top to make it worth their while. Should you ever decide to stop paying the lender back, they can take ownership of the house their money bought through a process called foreclosure.
That's the cool thing- everyone who wants to purchase a property is allowed to pursue a mortgage to finance that purchase. That said, you need to ensure that they qualify with their lender and abide by all local laws to ensure that their mortgage can be lawfully written. At a minimum, you need to be old enough to sign legally binding documents. Beyond that, lenders have their own set of minimum standards you'll need to prove, such as FICO score, credit history, or even fall within certain income brackets.
Your credit score is a mathematical representation of how well you manage your personal finances, compared to hundreds of millions of other folks. Whenever you take on a secured debt, such as a car loan or a new credit card, your payment performance is reported to three credit bureaus- Experian, Equifax, and Trans Union. These bureaus then collate your data and run it through their own proprietary algorithms to more effectively qualify your financial management skills.
The exact algorithms that each bureau uses is a closely guarded secret, but it's safe to say that those with a higher credit score tend to have less missed payments on their record, while someone with a lower credit score is likely to have missed some payments in the past, or even have collections accounts registered against them.
Be careful- negative marks on your credit history can last upwards of a decade and has a direct impact on how you get financed in the future and the interest rates you're able to secure. Simply put- the lower your credit score, the higher a risk a lender takes in giving you money, which results in higher payments and interest rates.
A down payment is a chunk of money that lenders require you to bring to the table in order to prove that you have a personal stake in the property you're about to purchase.
The reasoning here is twofold. Let's say that you're purchasing a $300,000 house, and your lender requires you to put $10,500 down. The lender's reasoning is that if you're ten grand into the property, you're statistically less likely to miss payments on repaying your loan, as to do so would forfeit the money you've invested in the event of a foreclosure. Additionally, should the worst happen and you get foreclosed upon, the lender at least has a tiny bit of equity in the property, which will help offset the financial loss that it might take to turn around and liquidate the property.
Down payments are oftentimes governed by the type of loan that is being written, though some lenders have special loans that deviate from the norm.
Closing costs are costs that you are expected to pay in order to complete your real estate purchase. Closing costs include, but are not limited to:
- Origination Charges (underwriting fees, processing fees, discount points)
- Loan-specific costs (appraisals, flood certifications)
- Title expenses (title fees, title insurance, notary fees)
- Taxes
- Insurance
In the last few years, closing costs average around 3-5% of the value of the loan, depending upon the qualifications of the borrower and the property (if you're buying a log cabin in the middle of nowhere, expect your insurance costs to be a bit higher due to the added risk of a fire totaling your house.)
It's worth noting that oftentimes realtors are able to negotiate seller concessions that can be used to cover all or part of closing costs.
Seller concessions are financial incentives that the seller gives the buyer at closing as a way to incentivize them to complete the purchase of the property. For example, as we learned above, closing costs can get fairly pricy. If you're looking to sell your house for $300,000, you might agree to pay for your buyer's closing costs, so that they can actually afford to buy your house.
Seller concessions aren't always sums of money to cover closing costs, however. Occasionally, seller concessions take the form of cash in lieu of repairs, which is where the seller agrees that part of their house needs to be repaired, but rather than delay the house purchase by getting a repair crew involved, they simply offer cash to the buyer for them to fix the problem after the sale. Seller concessions can also take the form of furniture and appliances that are left in the home for the buyer. VA borrowers can also use seller concessions to pay off personal debt!
Seller concessions are not infinite, though, and are limited by the type of the loan backing the purchase.
An overlay is an additional set of rules that individual lenders can impose to restrict the kinds of borrowers that can use their products.
For example, even though the VA loan program does not have a minimum FICO requirement, an individual lender may impose their own requirement of a 620 FICO minimum in order to secure a loan backed by their organization.
Not every lender uses overlays, and even between two companies that do use overlays, it's highly unlikely that both companies impose the exact same restrictions.
Advanced Mortgage Topics
Your Debt to Income ratio (DTI) is one of the major qualification tools that a lender will use to determine if you can afford a mortgage. In order to roughly calculate your DTI, you need to first identify how much money you make in a month, as well as add up all the money you pay to obligated debt*.
**Obligated debt is debt that shows up on your credit report- things like car payments, credit card payments, student loans, and installment loans. Essentially- any kind of debt that, should you miss a payment, gets reported to the credit agencies.
When you calculate your DTI, you're first going to need to add up all of your monthly obligated debt payments. Then, add your estimated mortgage payment (including taxes and insurance). Once you have this total, simply divide that by your monthly income. (You can convert this number to a percentage by multiplying it by 100.
Let's run a quick example. If you've got a car payment of $500, credit card payments totaling $200, and a $1800 estimated mortgage payment, your total monthly debt load will total at $2500. If you're bringing in $5000 each month in pay, your DTI will be calculated as $2500/$5000, or .5 (50%).
DTI can be broken down into front-end DTI and back-end DTI. Front end DTI is calculated only using your mortgage payment, while back-end DTI is calculated using all of your debts, like we did above.
As you explore the Mortgage Academy further, you'll learn that many loans have a limit to how high a borrower's DTI can be in order to proceed with the loan. This is done to ensure that borrowers don't inadvertently buy a house that they cannot afford and putting themselves in a very bad spot.
Fannie Mae and Freddie Mac are entities that regulate the secondary mortgage market. To do so, they put out a series of guidelines by which government regulated loans must abide by, if the lenders who write those loans have any hope of selling those loans to back end investors.
A Qualified Mortgage (also called a QM loan) is one that has been written in accordance with federal requirements intended to reduce the risk that a particular loan will fall into foreclosure during its lifetime, adding a layer of security to the mortgage backed securities that the loan will eventually support. These requirements prohibit certain "risky" loan options, such as interest-only payments, excessive loan costs, or payments that extend beyond thirty years.
Loans that adhere to QM regulations are inherently less risky, and therefore eligible to be backed by government agencies, such as the HUD, VA, or USDA.
A Non-Qualified Mortgage (Non-QM loan) is one that does not adhere to the federal regulations governing Qualified Mortgages. Because of this, non-QM loans cannot be backed by government agencies, which oftentimes results in higher interest rates to compensate for riskier investments.
This isn't always a bad thing, though, as by not following those federal requirements, non-QM lenders are free to customize their product offerings as they see fit, oftentimes resulting in specialized loans that meet certain market niches that would otherwise be ineligible for traditional financing.
Let's run a quick example. Let's say that you're a small business owner who earned $100,000 last year. Your tax expert kicked all the butt, and managed to use deductions and depreciation to reduce tour taxable income to $20,000. Using QM rules, if you wanted to buy a house, you'd have to use that $20,000 as your yearly income, likely eliminating the possibility that you could finance your house, despite the fact that you earned five times as much. On the other hand, a non-QM lender might use your bank statements to prove your income, rather than your tax return, and instead qualify you using your hard-earned $100,000.
An Automated Underwriting System (or AUS) is a tool that is used to impartially assess the financial background of a potential borrower, and judge whether the risk posed by said borrower is sufficiently low to secure financing.
There are three primary AUS's in use for government-backed loans:
-Desktop Underwriter and Loan Product Advisor for FHA, VA and conventional loans
-Guaranteed Underwriting System for USDA loans
Additionally, several non-QM lenders are now using in-house AUS's to more effectively manage their own loans.
AUS's are carefully managed to ensure a fair judgement process, and their rulings are usually final. For example, if you're looking to secure a VA loan using Desktop Underwriter, and the system determines that you are ineligible for VA financing, no lender will be able to write you a VA loan until you address your financial situation sufficiently enough that when your information is re-submitted to the AUS, it'll determine your risk as acceptable.