Wednesday 3 December 2008

What Does My Credit Score Mean?

When a lender is considering your application, they will get a copy of your credit report. This report gives all the details about your financial history, payment records, total debt, and any bankruptcies.The information on this report is used to create your credit score or FICO score, a numerical rating of your creditworthiness. Credit scores range from 300 to 900, with most people falling somewhere between 600 and 700.The higher your credit score, the more appealing you are to a lender, and the more likely they will offer you good rates and loan terms. Factors affecting your credit score include the number and frequencies of your delinquencies, how long you've had credit, and how close you are to your credit limits.If you know you will be applying for a mortgage in the near future, it is wise to request a copy of your own credit report in order to look at it before the lenders do.It's estimated that almost 80% of credit reports contain errors, so this gives you a chance to correct them before you apply for a loan, as well as take basic steps to improve your credit score.You should look for credit cards you don't use anymore and close those accounts. Resolve any outstanding accounts, verify all listed account numbers to make sure they are yours, and check your loan balances and late payments. You may be required to explain these to lenders.To improve your credit score, pay all of your bills on time and reduce the amount of credit you have outstanding.

How Much Can I Borrow?

How do banks decide how much money to lend you? They base their decision on their estimate of your ability to repay the loan.To make this estimate, they look at your income, your available cash, your debt, and your credit history.There are two debt-to-income ratios that banks check based on the information you provide on your loan application.

Front-End Ratio
First, they check to see how much of your income would go toward the mortgage payment. This is called the front-end ratio. Their guideline is that your total payment, including principal, interest, and escrow payments, should not be more than 28% of your gross (pre-tax) monthly salary.To calculate this for yourself, take your annual salary and multiply it by .28, then divide it by 12. This number is your maximum total mortgage payment per month.

Back-End Ratio
Banks also check how much of your gross income is required to pay all of your debts combined. This is called your back-end ratio and includes the mortgage as well as car payments, credit card payments, student loans, and child support and alimony payments. Their guideline for this ratio is that your total debt payments should not be more than 36% of your gross income.To calculate this for yourself, take your annual salary and multiply it by .36, then divide it by 12. This is the maximum allowable amount of your total monthly debt payments.

Don't Be House Poor
Be cautious with these numbers however. Just because the bank says they are willing to lend you a certain amount, doesn't mean you need to borrow that amount!(Real estate agents and lenders make more commission on bigger houses and will naturally encourage you to borrow as much as you can.)Instead, consider your own budget and lifestyle, and make sure you don't end up with such a high mortgage payment that you can't put money away for retirement, go for a nice vacation, or even go out to eat. Some debt counselors recommend that your total payment should not be more than 28% of your net pay (after taxes), leaving you money for a comfortable lifestyle as well as the other costs of home ownership, such as repairs, maintenance, and higher utility bills. Another common rule of thumb is to not buy a house that costs more than two and a half times your current annual salary.

Comparing Fixed-Rate and Adjustable-Rate Mortgages

Fixed-rate mortgages and adjustable-rate mortgages (ARMs) both have their pros and cons. This article compares the two mortgage types.

Fixed-Rate Mortgages
The main benefit of a fixed-rate mortgage is that your payment remains the same through the life of the loan. This predictability makes planning easier. They are also much simpler to understand.However, if want to take advantage of dropping interest rates, you would have to refinance, which requires additional paperwork and costs.Also, if mortgage interest rates are high, they can be an expensive option since there are no initial rate cuts.Finally, fixed-rate mortgages are pretty standard from lender to lender, which means there is little room for customization of your loan.

Adjustable-Rate Mortgages (ARMs)
ARMs can allow you to afford a bigger mortgage. If you know your income will be rising or know you will be selling the house in less than five years, ARMs may be a good option for you.Also, if rates begin to fall, you do not need to refinance in order to see your payments go down; they will automatically be recalculated at the new, lower rates.However, with an ARM, your payment and interest rate can go up significantly during the life of the loan, even with caps in place. The initial rates are usually lower than market rates, so when you receive your first adjustment, it can be quite a change, especially since the caps don't always apply to the first adjustment. For example, an annually adjusted ARM for $150,000 may start at 5.75%, but a 6% cap could allow it to go to 11.75% within four years. This would raise the payment from $875 to $1,514, an increase of $639.

Types of Mortgage

There are two main mortgage types:
fixed-rate and adjustable rate mortgages or ARMs.

Fixed rate Mortgage:
Fixed rate loans mean you pay the same interest rate for the entire life of the loan. Most fixed rate mortgage loans are for 30 years, although you can also get them for 15 or 20 years. Shorter loans such as 15 or 20 year mortgages usually have lower interest rates, typically one-half or one-quarter of a percent lower than a 30 year loan, but the total monthly payment will probably still be higher than that of a longer term loan, because you have to make bigger payments in order to pay the loan off in the shorter time frame. You will pay less overall with a short-term loan, however, than if you'd borrowed the same amount with a longer loan. Depending on your situation, carefully consider a shorter loan.While a longer loan will generally give you a lower monthly payment, if you can afford the higher payment, you may save a lot of money in the long run and build equity much faster. For example, let's compare the payments and total interest paid for a $150,000 mortgage over 15 years and over 30 years. A fifteen-year loan may be at 6.1% with a payment of $1,274 per month and you will pay a total of $79,303 in interest. A thirty-year loan at 6.64% will have a payment of $962 per month and you will pay a total of $196,304 in interest. In this example, the difference in monthly payments is only $312 but the difference in total interest paid is $117,001.


Adjustable Rate Mortgage:
Adjustable-rate mortgages (ARMs) are the second major type of loan available. With an ARM, your interest rate, and therefore your payment, can go up or down through the life of the mortgage, depending on various economic factors.The rate is usually tied to a money market index, most commonly the one-year Treasury bill. The lender will usually add between two and four percentage points to the current rate for the Treasury bill to come up with your current adjustable rate. These extra percentage points are called the margin. The rate for an ARM mortgage usually begins lower than the fixed-rate mortgages available at the same time, sometimes by as much as two percentage points. This depends on the economic conditions at the time. The terms of the rate adjustments, including when they begin and how often they occur, will be specified in the terms of the loan. The amount of time before the first rate change ranges from one month to ten years, but one year is the most common. If rates drop, your payment could go down, but if they go up, your payment will go up also. ARMs do usually have a cap, which states the maximum amount a rate can change at one time, and the maximum amount it can vary from the original rate over the life of the loan.A few ARMs also come with a payment cap, which states the maximum amount the payment can go up over the life of the loan. This is stated in dollars and not percentage rates. Some ARMs also include something called a conversion option. It allows you to convert the adjustable rate mortgage to a fixed rate mortgage at some point in the future for a set fee. This is a good thing to check on, in case interest rates begin to rise.

Mortgage Basics

Many people dream of owning their own home, but the high cost of homes generally requires a home mortgage to make this become a reality.On this page, we discuss some of the basic terms and concepts related to mortgages.

Mortgage Terminology
A mortgage is a loan you obtain to pay for a home and any land it sits on. The home and land is used for collateral on the loan, which means that if you don't make your payments, the lender can take the home away to cover your missed payments.The loan principal is the amount you actually borrow to purchase the home. Interest is the amount the bank charges you to use their money; it is a percentage based on current economic indicators. Because the loan is for such a high amount, it is usually financed for between fifteen and thirty years. The amount of time is called the loan's term. Principal and interest together comprise most of your payment. The total is then divided into equal payments over the life of the loan using a process called amortization. With amortization your payments mostly go toward interest early in the loan and then more goes toward the principal later in the life of the loan.
For example, if you borrow $100,000 dollars with a 30-year loan at 7% interest, amortization will calculate your
payments something like this:
Payment Amount Interest Principal Balance
First Payment $665 $583 $82 $99,918At 5 Years $665 $550 $115 $94,132At 10 Years $665 $501 $164 $85,812At 20 Years $665 $336 $329 $57,300Last Payment $665 $4 $661 $0In this example, after thirty years you would have paid off the $100,000 you originally borrowed, but you also would have paid an additional $139,509 in interest. (Try our online amortization schedule calculator to experiment with your own figures.) Your total payment is more than just the principal and interest. The acronym PITI can help you remember all the parts of your payment. It stands for principal, interest, taxes, and insurance. If you put less than twenty percent down on the loan, the bank considers it a little riskier and requires an escrow account. They pay your annual insurance and taxes from this account and collect money monthly to gather the required amounts. If you have less than twenty percent down, your lender will probably also require you to include an amount for private mortgage insurance (PMI) in your payment. These are then added to the required principal and interest amounts to total your monthly payment.

Closing Costs and Refinance Risks

Remember the last time you moved? You probably incurred some expenses for truck rental, utility hook-ups, moving services, etc. Just like moving, refinancing comes with its own set of one-time expenses, commonly known as closing costs.

All about closing costs

There are a variety of closing costs, but the most common are:
Application Fee
Loan Origination Fee
Discount Points
Appraisal Fee
Title Search Fee
Title Insurance Fee
Prepayment Penalty on Existing Mortgage
The first three listed above are within your lender's control; the others are not. If you have great credit, you might be able to negotiate lower application fees, loan fees, and discount points. Be cautious if a lender offers to cover your closing costs; this may mean you'll be charged a higher interest rate. Closing costs have been known to change at the last possible moment. Your best protection against unpleasant surprises is to request a written estimate. Also find out what the lender's policy is on closing cost changes; some lenders guarantee their estimated costs, and others don't. If you're refinancing just to save money, be sure to weigh the closing costs against your monthly savings. If the new loan saves you $50 monthly, but you have to shell out $1,200 in closing costs, it will be two years before you break even. Risky businessAre there risks involved with refinancing? The short answer is yes. But there are also risks involved in relocating, like noisy neighbors, a house that's a potential money pit, and schools for the kids. Just like these examples, refinancing risks can be managed-if you're prepared. Here are the most common to watch out for: 1. Taking on too much debt. Reputable lenders are trained to find you a mortgage loan program that you can afford. Trust that they know what they're doing, and be honest about your financial situation. Over-burdening yourself with debt could put you on the fast track to bankruptcy. 2. Putting your home at risk of foreclosure. This should be a consideration if you want to consolidate credit card debt into your mortgage. When you consolidate such obligations with a mortgage refinance, your home becomes collateral for debt that was previously unsecured. 3. Increasing your total interest costs. If your old loan has 25 years left until its maturity and you replace it with a new 30-year loan, you'll be incurring interest costs for an extra five years.
In the end, you'll have to evaluate the risks and advantages of refinancing relative to your situation. Since you already have the basic knowledge in your back pocket, that evaluation process should be pretty straightforward. Just stay focused on one goal: a financially stronger you!

Refinance or Second Mortgage?

Understanding your options

Let's revisit the common refinancing objectives discussed in Chapter 1:
Lower your monthly payment
Shorten your pay-off term
Optimize your loan structure
Consolidate your debt
Fund large, one-time expenses
The first three can only be accomplished with a refinance. The last two-consolidating debt and funding one-time expenses-can be accomplished with either a refinance or a second mortgage.

To decide between a refinance and a second mortgage, compare your mortgage interest rate with current market rates. If you're paying more than what's available, a refinance will lower your overall interest costs. If you're paying less, a second mortgage might be the better option. When the two rates are roughly comparable, many borrowers prefer the efficiency of a refinance-one loan, one monthly payment. It's also worth noting that refinance loans generally carry lower interest rates than second mortgages.

You cannot, unfortunately, take your new debt for a test drive before signing up. Therein lies the importance of making informed decisions; refinancing your mortgage every year, after all, can get expensive. That leads us to the next topic: closing costs.