Mortgage Basics

Adjustable or floating rate, 15-year or 30? How much mortgage can you afford? These are just a few of the many questions home buyers will find information on in this report.

Financing the American Dream
Buying a home is the biggest financial investment most of us will ever make. As with any large project or goal, it requires dealing with a variety of complex issues. The best approach is to divide the process into manageable tasks. The following deals with the first steps of gathering your records, determining what you can afford, and understanding mortgage options.

Put Your Own Financial House in Order
Before you go looking for a home, you should determine how much home you can afford. Most lenders will prequalify you to borrow up to a certain amount. Prequalification allows you to focus in on a realistic price range and makes you a more attractive buyer. Whether or not you want to prequalify, eventually you'll need to complete a loan application and it may take some time to gather and assemble the required information.

It's also a good idea to review your credit report. Contact local lenders to determine which credit bureaus they use. Then contact the credit bureaus and request a copy of your credit report (in most states, credit bureaus are required to provide individuals with a free copy of their report). Review your report to ensure that all information is correct. If you have past credit problems, don't lose hope. Be prepared to present a rationale for each slipup, and demonstrate an improvement in your ability to pay bills on time.

How Much Mortgage Can You Afford?
The Federal National Mortgage Association (Fannie Mae) is a government-sponsored organization that purchases mortgages from lenders and sells them to investors. Two income-to-debt ratios established by Fannie Mae are standard requirements for conventional mortgages. The first requirement is that monthly mortgage principal and interest payments (P&I), plus insurance and property taxes, cannot exceed 28% of the buyer's gross monthly income (some exceptions may apply to increase this limit to 33%). The second requirement limits total monthly debt payments (housing, credit cards, car payments, etc.) to 36% of gross monthly income. In addition to these requirements, you may have to pay 10% to 20% down on the total purchase price to qualify for a conventional mortgage.

Mortgage Rates and Minimum Incomes Needed to Qualify

Interest Rate	Monthly Payment	Minimum Annual Income
4%	$454	$21,770
5%	$510	$24,479
6%	$570	$27,340
7%	$632	$30,338
8%	$697	$33,460
9%	$764	$36,691
10%	$834	$40,017
11%	$905	$43,426
12%	$977	$46,905

Mortgage companies use ratios to analyze your mortgage payment. The above example shows the monthly payments of principal and interest, and income needed to qualify for a $95,000 mortgage at various interest rates, amortized on a 30-year schedule, assuming a payment ratio of 25%.

Source: National Association of Home Builders, Economics Division.

Types of Mortgages
How much house you can buy also depends on your mortgage's term and interest rate. The term is the length of time (usually 15 or 30 years) over which payments will be paid. The rate can be fixed (meaning it doesn't change over the loan's term) or adjustable (it fluctuates with market conditions). Thirty-year fixed-rate mortgages remain the most popular. The longer term lowers the monthly payment, while the fixed rate provides stability over the life of the loan. Given relatively low interest rates, these mortgages are attractive to buyers planning to stay at least six or seven years in their new home. The drawbacks are low principal payments in the early years, and the risk that market rates will decline over the term. However, if your credit history is sound and you have sufficient income, you can usually refinance your mortgage when rates decline.

A 15-year term lowers the interest rate, reduces total interest payments, and increases principal payments. But it also increases monthly payments. If you can't afford the higher payments now, you might opt for a 30-year mortgage. If there are no prepayment penalties, you can make additional principal payments as your income increases. Making just one extra monthly payment a year will pay off a 30-year mortgage in less than 22 years and can save tens of thousands of dollars in interest costs. If you plan to stay in a home no more than three years, you might want an adjustable-rate mortgage (ARM). ARMs offer initial rates that are lower than fixed mortgages. At some point, usually after the first year, rates are tied to market conditions and are subject to potential rate increases. Most ARMs include a cap on rate increases in any given year, as well as over the life of the loan. Some ARMs offer initial rates at least 2% below fixed rates and limit increases to 1% annually and 5% to 6% over the life of the loan. Many home buyers are attracted by the affordability of an ARM during the initial period. However, you should be confident that your future income will be sufficient if both interest rates and your monthly payments increase.

Another popular mortgage involves a balloon payment. A balloon is a lump-sum payment that pays off the loan in full after a fixed period of time. Generally the rates on balloon mortgages are 1/4% to 3/4% less than on 30-year fixed mortgages, but during an initial period of between 3 and 15 years, payments are similar. After this period, the remaining outstanding principal balance is either due in full or subject to refinancing. This is a good option for home buyers who plan to sell before the final payment is due. But because property values fluctuate, you may not be able to sell when you want. You may also face higher payments if you are forced to refinance at a higher rate, and there is also a risk that you may not be in a position to refinance when the balloon becomes due.

Three Steps to Finding the Right Mortgage

1. Estimate how long you expect to live in the house. If the answer is less than three to five years, consider an Adjustable Rate Mortgage (ARM), which typically starts out with a lower rate. If you plan to live in your new home longer than five years, a fixed-rate mortgage offers protection against rising interest rates.
2. Shop around for mortgage rates. Banks, credit unions, and mortgage companies all offer mortgages. Compare at least six lenders in your area.
3. Add up all the costs for each lender. Include fees, points, closing costs, etc., to arrive at the total mortgage cost for each lender.


Interest Rate Points
Points are interest paid in advance to reduce the rate on a loan. One point is equal to 1% of the mortgage amount. The general rule is that 1 point is worth 1/8 of 1% off the loan rate. The decision to pay points for a lower rate is based on how much the seller is willing to contribute to points, how long you plan to stay in the house, and how important lower payments are compared to higher closing costs. You will need to calculate the long-term value of points based on these factors, keeping in mind that points are generally tax deductible in the year paid.

Other Alternatives
If you cannot afford a conventional mortgage, there are a variety of alternatives. An anxious seller will sometimes offer owner financing. Federal Housing Administration (FHA) loans offer down payments as low as 3%, but may require the buyer to purchase mortgage insurance. (The FHA is a government agency responsible for insuring affordable housing mortgages.) The Veterans Administration (VA) offers no-money-down mortgages to qualified veterans of the U.S. military. Finally, there are local affordable housing advocates that offer low-cost, low down-payment loan alternatives. For further information, contact the FHA, VA, Fannie Mae, or your local mortgage lender or real estate broker.

Summary
* The first step in acquiring a home mortgage is to gather the information you'll need to include in a mortgage application.
* Review your credit report by ordering a copy from the credit bureaus used by local mortgage lenders.
* Prequalifying for a mortgage lets you know how much you can afford and makes you a more attractive buyer.
* Conventional mortgages limit housing costs to 28% of gross income and total debt payments to 36% of gross income.
* Mortgage terms are usually 15 or 30 years. The longer the term, the lower your monthly payment, but the higher your overall interest costs.
* Thirty-year loans often permit additional principal payments. One additional monthly payment per year will reduce a 30-year loan to 22 years.
* Interest rates are fixed or variable over the term of the loan. Variable rates may be best for buyers who plan to sell within three years.
* Generally speaking, one point is worth 1/8 of 1% off the loan rate.
* A balloon payment is a lump sum payable at the end of a specified term.
* Points and interest on mortgages or home equity debt are usually tax deductible.

Managing Debt and Credit

Avoiding credit card overload increases your opportunities to save and invest for important goals.

Managing Debt and Credit
Credit was once defined as "Man's Confidence in Man." But in fact, the definition of credit today is more like "Man's Confidence in Himself." Using credit today means you have confidence in your future ability to pay that debt. Forty years ago, your parents may have paid cash for their homes and their cars, a largely unheard-of event today. If they borrowed money at all, chances are it was from a relative or friend, and not a financial institution.

Today debt and instant credit are part of our everyday lives. The convenience of instant credit, however, has taken its toll. Many individuals use credit cards to spend more than they earn, and a few of these people actually build themselves a debt prison from which some never emerge. On the other hand, those who never use credit can be denied a loan or credit when they have a justifiable need or use for it. Using credit establishes a history of financial responsibility: Until you establish a credit history, your chances of qualifying for an important loan, such as a mortgage, are greatly reduced.

What is the balance between using credit wisely and staying out of overwhelming debt? Let's look at the facts and some pros and cons.

Installment Debt
Debt comes in many forms, and most types help us in our daily lives -- when used responsibly. Most people cannot buy a home without some financial help, and many cannot buy a car (especially a new one) without some sort of financing. The money borrowed to purchase large-ticket items is called installment debt: The debtor pays a portion of the total at regular intervals over a specified period of time. At the end of that time period, the loan with interest is paid off.

Installment debt allows you to purchase items at a competitive interest rate: for example, 5% to 7% for a 30-year home mortgage and 8% or 9% for a car loan. The loan is paid back on an amortizing schedule, monthly payments of a fixed amount that remain constant over the life of the loan. At first, most of the monthly payment consists of interest. In later years, principal begins to be paid down.

Installment debt is easily budgeted and the debt is eliminated on a predetermined date. Even for those who may actually have the cash to purchase the desired item, installment debt can make financial sense if you can earn a higher return (after taxes) on your investment of cash than you must pay on your installment debt.

Revolving Credit
A revolving line of credit, also called "open-ended credit," is made available to you for use at any time. Examples of revolving credit are credit cards such as Visa, Mastercard, and department store cards. When you apply for one of these cards, you receive a credit limit based on your credit payment history and income. When you use the credit line, you must make monthly minimum payments based on the total balance outstanding that month. Some lines of credit will also have an annual account fee.

While revolving credit is a convenient way to borrow, it can also become an endless pit of minimum payments that barely cover the interest due. Many cards charge annual rates of interest of 18% or higher. As you pay off your debt, the minimum payment is also reduced, thus extending your payoff period and, consequently, the interest you pay. Paying just the minimum due on a $2,000 credit card loan could mean making monthly interest payments for 10 or more years!

Revolving credit, in addition to being convenient, eliminates the need to carry a lot of cash and can help establish you as a creditworthy risk for future loans. The itemized monthly statements also can help you track your expenses. But some people can easily yield to the temptation that the convenience of credit cards offers. Impulse buying, failing to compare costs, and purchasing large items you can't afford are all downfalls brought on by always available purchasing power. Spending more than you earn in any given period is a dangerous practice at best, but doing it over an extended period of time can be financial suicide.

Using Credit Wisely
To use credit intelligently, start by examining the terms of the card(s) you are currently using. Keeping track of your cards, their rates, and your current balances will help you to be aware of how you use credit cards. Increased competition in recent years has led some credit card companies to offer enticing features to attract new cardholders, including no annual fees and low interest rates for an introductory period. (And credit card companies sometimes will give their introductory rates to existing cardholders so that they won't transfer their balances to another credit card company.)

Eliminating Credit Card Debt
If you think you may have too much credit card debt, begin to address it by honestly evaluating your spending habits. Examine your existing expenses to analyze how your money is spent. You will most likely be able to identify the problem areas where you are more likely to spend too much or too readily with credit cards. Then, based on your current spending practices, create a realistic budget to pay off your credit card debt in the shortest time possible while not adding any more debt to it. For assistance, you may want to turn to your financial advisor, who can help you to allocate your resources wisely to address your credit card debt.

The Role of Debt
Today, carrying installment debt is almost a fact of life. Mortgages, car loans, or small-business loans (to name a few) are part of almost everyone's life. On the other hand, carrying credit card debt is usually not a good idea. At interest rates of 16% and up, it's hard to justify keeping savings that could pay off that 18% department-store credit card in the bank at 2%.

Debt and credit play increasingly important roles in our lives. As the aging Baby Boomers get closer to their peak earning years, many are realizing the need to reduce debt and increase savings. Even though analyzing your spending habits and creating a budget to address your debt may seem a little overwhelming, the simplicity of the philosophy of the Depression era still stands: Never spend more than you earn. Once you have come to grips with this basic fact, managing your debt will become far easier and more rewarding.

Summary
* Installment debt means the loan is paid off in a specified period of time by making predetermined payments periodically.
* Revolving credit is a line of credit that is instantly available through use of a credit card (and sometimes a check).
* As you pay down your debt in a revolving line of credit, the minimum payment is also reduced, thus extending your payoff period and, consequently, the interest you pay.
* Spending more than you earn in any given period is a dangerous practice at best, but doing it over an extended period of time can be financial suicide.