Financial Awareness Bulletin

Vol. XII, No. 8
July 2004

Mortgage Financing Strategies

Summary Home ownership has many benefits and financial advantages. Most people buy a home by using lender financing called a "mortgage." Lenders commonly use two formulas (qualifying ratios) to calculate how large a mortgage one can reasonably afford. Mortgages can either be fixed rate or variable (adjustable) rate. Financing more than 80 percent of a home's purchase price usually requires private mortgage insurance.

INTRODUCTION

Over 68 percent of Americans owned their homes in 2003. In some areas of the country, home building has increased at record pace. This Financial Awareness Bulletin reviews the different ways U.S. consumers can attain the American dream of home ownership.

HOME OWNERSHIP

Home ownership remains the premier goal of most people because of its many benefits. Owning a home brings with it a sense of security and belonging that cannot be found elsewhere.

A home is a valued investment that can have many financial advantages and tax benefits. The amount of interest you pay on a home loan and the real estate taxes you pay on your property are among the few major federal tax deductions. Owning a home is the primary way most people build wealth.

A "mortgage" is a loan obtained to purchase real estate. The mortgage is a lien (a legal claim) on the home or property that secures the promise to pay the debt. All mortgages have two features in common: principal and interest.

The purpose of a home mortgage is to make the purchase of property affordable. For many people, buying a home or property is their most costly investment. Generally, the length of the mortgage loan varies between 15 to 30 years, and interest rates differ among lenders. As with an auto loan, no additional security is needed because the property itself secures the loan. Mortgages can be obtained from commercial banks, mortgage companies, savings and loan associations, credit unions, and even the federal government.

WHAT CAN YOU AFFORD?

Before we review the different types of home financing, it's important to understand how the size of a mortgage is determined. There are two basic formulas commonly used by lenders to calculate how large a mortgage you can reasonably afford. These formulas are called "qualifying ratios" because they estimate the amount of money you should spend on mortgage payments in relation to your income and other expenses. The ratios discussed below are guidelines only--ratios vary from lender to lender, and each loan application is handled on an individual basis.

Generally speaking, to qualify for conventional loans (loans that are not obtained under a government-insured or guaranteed program), the first qualifying ratio imposes that housing expenses should not exceed 26% to 28% of your gross monthly income (the Federal Housing Administration loan ratio is 29% of gross monthly income). Monthly housing costs include the mortgage principal, interest, taxes and insurance (often abbreviated PITI). For example, if your annual income is $30,000, your gross monthly income is $2,500, times 28% = $700. So you would probably qualify for a conventional home loan that requires monthly payments of $700. Any expenses that extend 11 months or more into the future, such as a car loan, are considered long-term debt. The second qualifying ratio involves all long-term debt as it relates to gross income. Total monthly costs, including PITI and all other long-term debt, should equal no greater than 33% to 36% (41% for FHA loans) of your gross monthly income for conventional loans. Using the same example, $2,500 x 36% = $900. So the total of your monthly housing expenses plus any long-term debts each month cannot exceed $900.

One way to determine how much to spend for housing is to use the online calculator at http://partners.leadfusion.com/leadfusion/neacalc/home17/tool.fcs to determine how much money you can spend on housing. Be sure to only include income you can definitely count on.

When budgeting to buy a home, it is important to allow enough money for additional expenses such as maintenance and insurance costs. Homeowner's insurance or property insurance is another cost you will have to consider. The lending institution holding the mortgage will require insurance in an amount sufficient to cover the loan. However, to protect the full value of your investment, you should purchase insurance that provides the full replacement cost if the home is destroyed.

TYPES OF HOME MORTGAGES

Mortgages can either have a fixed interest rate or a variable interest rate.

Fixed-Rate Mortgages

With a fixed-rate mortgage, the interest rate does not change and the monthly principal and interest payment will always remain the same throughout the term of the loan. Fixed-rate mortgages are generally 15- or 30-year loans and are especially suited for those who expect to remain in their homes for a number of years. Your mortgage payment is unaffected if interest rates in the general market go up. Since your monthly payments are set, you can more easily budget your finances.

This table helps you calculate your monthly housing costs, not including taxes and insurance. For example, assume you have a 30-year mortgage and the interest rate is 8 percent. The chart shows that the monthly payment amount per $1,000 borrowed is $7.34. If you want to borrow $75,000, you can estimate the monthly payment by multiplying 75 x $7.34, which equals $550.50 per month.

There is no rule that states you have to finance a fixed-rate mortgage with a 30-year note; you can finance with a 25-, 20-, or even a 15-year loan. As you can see from the preceding table, the shorter the term, the higher the monthly payment. But doing so will ultimately reduce the amount of interest paid.

Adjustable Rate Mortgages

Generally, the initial interest rate of an Adjustable Rate Mortgage (ARM) is lower than that of a fixed-rate mortgage. The lender bases its calculations on the index and margin of the mortgage. The index is a base rate that the lender adds at each adjustment period to determine a new interest rate. Be sure to check the type of index your mortgage lender is using, because some fluctuate more than others.

The primary advantage of an ARM is that the interest rate you pay will generally drop if prevailing interest rates go down. Low start rates can reduce your initial payments, making it easier to qualify for some mortgages. But if prevailing interest rates start to increase, then the base rate will also increase, along with your mortgage payment.

A special type of adjustable rate mortgage loan is a Balloon Mortgage. Principal and interest payments remain constant for the term of a balloon mortgage, which is usually 5-7 years, although principal and interest are amortized (calculated) over 30 years. At the end of the 5-7 years, you can pay off the mortgage or apply to refinance. Balloon mortgages are typically offered at lower interest rates than other fixed-rate products, making them more affordable. If you know you'll be in your home for less than the term of the mortgage, this may be a product you should consider.

MORTGAGE INSURANCE

If you finance a home for more than 80 percent of the purchase price, the lender will require you to carry private mortgage insurance (PMI). PMI protects the lender if the homeowner defaults on the loan. Studies have shown that homeowners who have 20 percent or more equity in their homes are less likely to default on their mortgage loans.

While PMI has paved the way for millions of people to obtain a mortgage, the insurance payment is not tax deductible. Some lenders will offer ways to obtain a mortgage for less than 20 percent equity without PMI. Lenders will provide a first and second mortgage, plus the down payment, to secure the loan. For example, a lender may offer you an 80-10-10:

• 80 percent financed by a first mortgage
  
• 10 percent financed by a second mortgage (usually 1.5 - 2.0 percent higher than a first mortgage interest rate)
  
• 10 percent down payment

This type of financing allows the homeowner to deduct the interest off the first and second mortgage. Lenders may also offer 80-15-5 loans where 15 percent is financed by the second mortgage and 5 percent is the down payment.

VETERANS ADMINISTRATION LOANS

If you are currently in the United States military, or if you have ever served in the U.S. armed forces, you may be eligible to get a loan guaranteed by the Veterans Administration. If you qualify, this special government benefit for veterans might be a good option for you, as it allows you to purchase a home with no down payment.

NEA MEMBER BENEFITS

Do you have any questions about home mortgages, or would you like to see how much you can afford? If so, call the NEA Home Financing Program at 1-800-NEA-4-YOU (1-800-632-4968), Monday through Friday, 8:00 a.m. to midnight, or Saturday, 9:00 a.m. to 5:30 p.m. (ET).

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