Everything You Wanted to Know About Mortgages
Getting Your Mortgage Ready
There are several options for the first time buyer when it comes to mortgages. There isn’t necessarily one that is better than the other, perhaps one that might be a better fit for you.
Conventional (conforming) Mortgages
Conventional, or otherwise known as conforming, mortgages are loans that conform to the guidelines established by the Federal National Mortgage Association/Federal Home Loan Mortgage Corporation (Fanny Mae and Freddie Mac).
Guidelines will include the size of the mortgage, loan to value ratio and minimum credit score. Usually a conventional mortgage will get .25 or .5 of a percent better interest rate because of the stricter guidelines.
Requirements for a conventional mortgage:
1. Must have a credit score of 740 or higher
2. Loan amount of $424,000 for a single family home
3. Down payment of 5-20 percent. The higher the downpayment, the better your rate will be
Federal Housing Administration (FHA) Mortgages
FHA loans are a government backed loan insured by the Federal Housing Administration. FHA loans are more flexible on lending requirements than conventional mortgages. They don’t require such a high credit score and can have a downpayment as low as 3.5 percent.
As a result of the more flexible lending requirements, and the smaller down payment, the rate will be slightly higher than a conventional mortgage. With this type of loan, it may also be required for the buyer to pay mortgage insurance premiums along with the monthly mortgage payments. Again, this is a result of the more flexible lending requirements, which in actuality, create a higher risk for the lender.
Even though nobody wants to have a higher cost of borrowing, most first time buyers will end up with a FHA loan. Simply for the fact that most first time buyers are relatively young and have not had time to build up a high credit score or a large down payment.
Veteran Affairs (VA) Loans
VA mortgages are mortgages backed by the department of veteran affairs. These loans allow eligible military service members to buy a home with little to no downpayment. The approval process for these loans has been simplified for service members, veterans and their families, and because they are backed by VA, mortgage insurance isn’t required, which is a significant savings.
Who qualifies for a VA loan?
1) Active or retired duty members of the armed forces with at least:
– 90 days of consecutive service during wartime
– 181 days of service during peacetime
– 6 years of service in the national guard or reserves
2) Spouses of service members who died in the line of duty or as a result of a service related injury.
Fixed vs. Adjustable Rate Mortgages
Any of the above mortgages can be a fixed rate or adjustable rate mortgage. One is not necessarily better than the other, but one is probably better suited for you. It’s important to consider your circumstances and future plans when deciding on which type of mortgage to choose.
Fixed Rate Mortgages
A fixed rate mortgage is when the interest rate stays the same for the life of the loan. Fixed rate loans are ideal for people wanting to stay in their homes for longer periods of time. Terms for a fixed rate mortgage usually range from 10-30 years (1-10 years in Canada).
The advantage of a fixed rate mortgage is that you always know what your payments will be and it’s hard to put a price on that. Paying a slightly higher interest rate so that you can sleep soundly, knowing that if interest rates rise, your payment will stay the same and your financial situation will be unaffected.
The disadvantage of a fixed rate mortgage is that there may be some substantial penalties if you ever want to sell or move before your term is up.
Be sure to ask what the penalties are for breaking the term of your fixed rate mortgage before you sign. We all know how life has a way of changing even the best laid plans.
Adjustable Rate Mortgages (ARM)
Adjustable rate mortgages are generally 30-year mortgages where the first portion of the mortgage has a fixed rate and then the rate is adjusted periodically after that. These mortgages are usually described by their name.
For example: a 5/1 ARM would mean that the first 5 years of the mortgage is fixed and then the rate is adjusted once per year after that. Generally the fixed portion of these mortgages ranges from 3-10 years.
These are great mortgages for first time buyers. Often we don’t stay in our first home longer than 10 years, so we can benefit from the advantage of the fixed rate at the beginning, while not being locked in for the entire term of the loan, and therefore aren’t forced to pay penalties if we move or sell. The rates will also be lower on this type of mortgage, so it allows you build more equity in your home.
Loan discount points are prepaid interest. One point is equal to one percent of the loan. By paying points up front, it will decrease the interest rate on your loan. Different lenders will have different options for what they offer in the way of discount points.
Whether it’s worth it for you or not depends on how long you’re planning to stay in a home. It takes time to make the money back that you spend on points, and it may not be worth it depending on how long you stay in the house.
For most first time buyers, there is usually not a lot of extra money kicking around when you close on a home, so buying extra points is not often even an option.
APR? What Does That Even Mean?
APR stands for Annual Percentage Rate and provides a more complete analysis of the cost of borrowing. APR takes into account things like lender fees and mortgage points, as well as the interest rate to provide you with a more complete idea of the cost of borrowing.
The APR will be a higher percentage than the interest rate, because it includes more things. It will give you a fairer assessment between lenders, as one lender might have a lower interest rate with higher fees, and another might have a higher rate with lower fees. In both cases the APR might be exactly the same.
Knowing Your Down Payment Options
Everyone knows you can simply save up the money you need for the down payment, but that can be easier said than done and many people don’t realize there are other options.
For example, borrowing from a retirement savings account can be a good way to get part of your down payment. But be advised, this option is only if you’re unable to save enough money in a reasonable amount of time to make buying a home possible.
In a perfect world, you would leave your retirement savings where it is and save for the down payment in another account. However, sometimes circumstances don’t allow for this. In some areas people are fighting fast rising markets and are trying to buy a home before they become unaffordable.
In some cases, buying a home might actually decrease your monthly payments (maybe you’re planning to have a renter) allowing you to save money faster in the long term, so mathematically you come out ahead.
Either way, if you want to borrow from your retirement account for your down payment, you should definitely talk to your accountant to confirm the tax implications in your area and for the type of retirement account you have.
In the meantime, here are the basics of what you need to know :
Using Money From Your Roth IRA
Roth IRA is probably your best bet as far as taking money out of a retirement account goes. All the contributions to a Roth IRA have already been taxed, so you can withdraw them at any time, without paying a tax penalty.
However, there is a 10% early withdrawal fee for taking out the money before the age of 59 (this is known as a hardship withdrawal).
The good news is, there’s an exemption for first time home buyers that allows you to withdraw up to $10,000 as a lifetime limit to apply toward the down payment or closing costs of your new home, as long as the account has been open for five years.
Using Money From Your Traditional IRA
Using traditional IRA money also has the same first time homebuyer exemption on the 10% hardship withdrawal fee up to $10,000. The main difference here, you need to pay state and federal tax on the money you withdraw from a traditional IRA. You’ll need to take this calculation into account when deciding if this option is worth it or not.
Important Things to Note (about withdrawing money from any IRA for first time homebuyers):
1. The definition of a first time home buyer, is anyone who hasn’t invested interest in a property for at least 2 years. So, if you owned a home more than 2 years ago, you still qualify!
2. The exemption can be used for you AND your spouse if you both qualify, bumping your limit to $20,000 withdrawal without paying the 10% penalty
3. You have 120 days from the time of withdrawal to the time you use the money for qualifying home buying expenses (down payment and closing costs). For this reason, make sure you don’t withdraw the money until the last possible minute. If for some reason the closing on your home falls through, you could be stuck with the 10% hardship withdrawal fee because you took longer than 120 days to apply the funds to a qualified purchase.
Borrowing From a 401k
You can borrow up to $50,000 or half of the value fund, whichever is less, for the purchase of your home. There is no penalty or tax implications here because it’s a loan, not a withdrawal. You will however be required to pay interest on the loan (which you are actually paying to yourself), usually about two points above prime. There are some important things to note about borrowing from a 401k:
1. Every employer is different and has different rules. Talk to your HR department to learn about the rules for your 401k
2. Usually, you have five years to pay back the loan with interest
3. If you lose your job or quit your job, you will generally have 60-90 days to pay back the loan in full. And if you fail to do so, you’ll be forced to pay taxes on the money as well as a hardship withdrawal fee
One of the most important things to do before withdrawing money from any retirement account is to get advice from your accountant and financial advisor!
Everyone’s situation is different and tax laws can change. The information above has been reduced down to the simplest form to provide you with an easy understanding of the basics of getting money from retirement accounts for the purpose of buying a home.
It’s important to sit down with the professionals for a complete understanding of what this might mean for you in the short and long term and of course, the bigger picture of it all.
Remember, getting into a home sooner isn’t more valuable than retiring sooner, so make a long-term game plan and get all the information before making any decisions on dipping into your retirement accounts.