|Financing your New Home
Determining the Right Price Range
The first step in the buying process is to determine the price range that is right for you. You will need to consider how much cash
you are prepared to invest in your home and how much money you will need to borrow.
Your cash on hand will have to cover both the down payment and any closing costs associated with the purchase. Closing costs
vary significantly based on the terms of any loan you may obtain, but are generally 2% to 4% of the purchase price. Don’t forget to
budget for moving expenses.
You should also take into consideration how much your property taxes and insurance will cost in addition to a monthly mortgage
payment in determining the right price range.
Pre-qualifying for a Loan
An offer to purchase is given greater consideration by a seller when the offer is accompanied by a pre-qualification or, better yet, a
pre-approval letter from a reputable lender or mortgage broker. This gives assurance to the seller that you will be able to get the
proposed financing and will not tie up the property needlessly.
Factors to Consider when Shopping for a Lender
Ultimately, when choosing between lenders, home buyers should pick the lender that offers the best combination of highly
competitive rates and excellent service. Therefore, when evaluating lenders, borrowers should understand the distinction
between mortgage bankers and mortgage brokers.
Some lenders are only mortgage bankers or mortgage brokers. Not all lenders have the same connections and experience. It is
a good idea to make sure that your lender is both a direct lender and a mortgage broker and possesses a long history and a
good reputation in the business.
Financing Your Purchase: The Loan Process
Pre-Qualification vs. Pre-Approval
Financing the purchase of a home normally begins with the borrower pre-qualifying for financing. The pre-qualification process
involves the review of specific financial information including the applicant’s income, assets, debt, source of cash for a down
payment, credit and employment history.
In a market with many qualified buyers and a limited number of properties, it becomes important that potential buyers become
pre-approved. Since pre-approval strengthens their buying position greatly, buyers should not start their home search until
receiving a formal pre-approval. A pre-approval involves obtaining a completed loan application and verifying information
borrowers provide about their income, assets, debts, and credit history with supporting documentation such as pay stubs, tax
returns, bank statements and credit reports. Getting pre-approved with a good mortgage broker is a quick, easy process.
The loan agent submits this information to a preliminary review using an automated underwriting system which evaluates all of
the information and approves the loan. Upon receiving a pre-approval, the loan agent issues a pre-approval letter to the Realtor.
That letter is typically submitted to a seller when making a purchase offer.
Steps to Obtaining a Loan
Below is a brief explanation of some of the most commonly used loan programs:
More on ARMs:
Lenders usually charge lower initial interest rates for ARMs than for fixed rate loans because the borrower is sharing the risk if
interest rates go up. ARMs, therefore, are less expensive in the beginning than fixed rate loans. This may mean that a borrower
can qualify for a larger loan if they select an ARM. Borrowers run the risk of payments becoming burdensome, however, if rates
Indices: Index ARM’s
Interest rate changes are tied to changes in an index rate. An index usually moves with the general trend of the economy. The
most commonly used indices include:
To establish the actual ARM rate that is used to calculate payments, percentage points are added to the index value. These
percentage points are called the margin. The lender establishes the margin at the inception of the loan and it remains constant
for the term of the loan. To calculate the interest rate at the time of adjustment, add the index to the margin (Rate = Index +
Periodic & Lifetime Caps
The note supporting an adjustable rate loan contains a schedule that states the frequency of the adjustment. A typical example
would be a one-year ARM based on the One Year Treasury Index. This loan would have a low start rate. After the 12th month, it
would adjust, and would continue to adjust annually for the term of the loan. ARMs are usually named for the frequency of the
rate and payment adjustments. A loan that adjusts annually with the rate based on the One Year Treasury is called a One Year T-
To make ARMs an attractive alternative to fixed rates, lenders build in caps or limits so that the adjustment cannot be too severe.
For example, on the 1 Year T-Bill ARM, there is usually a 2.00% annual cap. This means that the rate for year two is a fully
indexed rate, i.e., the index plus margin. For example, if a loan starts at 5.00% and has a 2.00% annual cap, the maximum rate
for the second year would be 7.00% and the maximum for the third year would be 9.00% regardless of what index + margin your
loan may actually equal.
In addition to these periodic caps, ARMs will also contain a lifetime cap or ceiling. That is the maximum rate for the life of the
loan, regardless of what the market dictates. This amount can be considered the worst case interest rate and will usually exceed
current fixed interest rates.
Payment Caps and Deferred Interest (Negative Amortization)
In addition to periodic caps, there are payment caps. This is a fine, but important distinction. These loans will not have a built in
periodic cap, usually just a lifetime cap. What they offer is a payment cap. This is the maximum that the payment can increase
in any given period. Lenders still calculate the rate based on Index + Margin, but they offer a minimum payment that may be less
than one generated by a fully indexed rate. The difference in the payment is called deferred interest.
Lenders will review the loan to determine if the minimum payments have covered the fully indexed payment. This difference is
then added to the loan balance, hence the term negative amortization. A borrower may avoid negative amortization by making the
fully indexed payment. Cost of Funds (COFI) loans are usually structured this way.
11th District Cost of Funds ARMs and Monthly Treasury Index (COFI/MTA)
Called the “dinosaur” of the adjustable market, the COFI is the slowest moving adjustable index offered. The MTA is also a slow
moving index and used by some lenders instead of the COFI. Typically used for purchases, these programs will provide the
most stable adjustable payments over any other adjustable loan index while providing monthly payment options. These options
The Components of a Mortgage Payment
Your monthly housing expense is made up of several components: Principal, Interest, Taxes, and Insurance, commonly
referred to as PITI. A mortgage payment generally includes amounts for principal (P) and interest (I).
Terms of the loan may require, or borrowers may choose to pay, a pro-rated portion of annual taxes (T) and homeowner’s
insurance (I) monthly along with principal and interest.
Points represent interest paid at the time of the loan closing to reduce the interest rate. One point equals one percent of the loan
amount. For example, one point on a $300,000 loan equals $3,000 added to closing costs. A one-point loan will almost always
have a lower interest rate than a zero-point loan from the same lender. Therefore, paying points is a trade off between paying a
fixed amount of money at closing in order to receive a lower interest rate and lower monthly payments.
Generally speaking, you should only pay points if you plan to keep the loan for at least four to five years. Because points are
prepaid interest, the loan should be kept long enough to recoup these costs through lower monthly mortgage payments.
If you are considering moving again within a four-year period, or if the general interest rate market is declining, you should
consider a no-point loan. If the plan is to keep the property for an extended period of time and the interest rate market is
increasing, paying points is appropriate. Nonetheless, because each case is different, it is recommended that borrowers seek
the assistance of a financial advisor or mortgage planner before making a decision.
The tax treatment of points depends on what the loan is being used for. Points are normally 100% tax deductible in the year a
home is purchased. This is true even if the seller is paying for the buyer’s points.
In a refinance transaction, points must be amortized over the life of the loan. For example, on a 30-year loan, each year you can
deduct 1/30th of the points. If a property is subsequently refinanced or sold and the loan paid off, the remaining unamortized
points can be deducted in the year of the subsequent refinance or sale.
Closing Costs: Who Pays What?
Closing costs are the various charges made by the lender, the title company, real estate agents, and other service providers
necessary to complete a transaction. Although who pays for the various closing costs is negotiable between the buyer and
seller, the following sets forth the customary division in San Francisco County.
The Buyer customarily pays:
• Title insurance premium for lender and buyer
• Escrow fee
• Notary fees
• Contractor’s and pest inspection fees
• All new loan charges (points, appraisal, document processing fees, etc.)
• Interest on new loan from date of funding to 30 days prior to the 1st payment date
• Beneficiary fee for assumption of existing loan
• Home warranty (if specified in contract)
• Homeowner’s insurance for 1st year
• Earthquake insurance (optional)
• Private mortgage insurance (typically 2 months) if required by lender
• Private mortgage insurance impound account (1 year) if required by lender
• Property tax impound account if required by lender
• Move-in fee (for some condominiums)
• Miscellaneous charges
The Seller customarily pays:
• Real Estate commission
• Document preparation for deed
• Documentary transfer tax (amount is dependent upon sales price)
• Payoff of all loans in seller’s name
• Interest accrued on loans being paid off, reconveyance fees and re-payment penalties
• Home warranty (if specified in contract)
• Any judgment or tax liens against seller
• Reconveyance fees
• Property tax proration
• Unpaid homeowner’s dues (for condominiums)
• Bonds or assessments
• Delinquent taxes
• Move-out fees (for some condominiums)
• Notary fees and recordation fees
• Third party Natural Hazard Disclosure Statement
• Pre-sale pest inspection fee
• Underground storage tank report
• Miscellaneous charges
|Great Homes SF
|John Beeney, Realtor