Chapter 1. Tax Savings for Home Buyers
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Welcome to
Your New Shelter |
There are many reasons to buy a home rather than rent one. Owning your own home improves your lifestyle,
provides you with pride of ownership and starts you on a path to real wealth
building. Because of the stabling effect
property ownership has on its citizens, the government has a vested interest in making
sure that most Americans have the opportunity to become home owners. It is to this end that they have made home
ownership one of the best tax shelters available. From the time of its purchase to the time of
its sale, your home can provide you with substantial savings on your tax bill.
The New
First Time Home Buyers Tax Credit
If you are a first time home buyer (defined by the IRS) and have
an income of less than $75,000 single/$150,000 jointly, and you purchased a
home between April 9, 2008 and July 1, 2009 you are eligible for the Federal
Housing Tax Credit for First Time Home Buyers.
This is actually an interest free loan equal to 10%of the
purchase price of your home up to $7,500 for married couples and $3,750 for
singles. Two years after you claim the
credit you must start to pay it back.
The payback period is 15 years in 15 equal installments or $500 on your
tax return each year. When you sell your
home, you must pay the remainder that year from your profits. If there are no profits, you do not have to
pay back the remaining balance of the loan.
The Mortgage
Interest Deduction
In the early years of your mortgage loan, most of the monthly payment
will be going to the payment of interest.
Regardless of where you have gotten your loan, your lender will send you
a Form 1098, Mortgage Interest Statement at
the end of each year. It will usually be sent to you in
January. This form will list all of the
interest you have paid on your home loan for the previous year.
You are allowed to deduct interest on loans that are secured by either
your primary residence or a second home up to a loan amount of $1,000,000. If a loan is not secured by your home, it is
considered a personal loan and its interest would not be deductible. The IRS considers a home to be a house,
condominium, mobile home, boat, recreational vehicle or a similar property as
long it has sleeping, cooking and bathroom facilities. The deduction is limited to first and second
homes.
You can qualify for the interest deduction on your second home even if
you rent it out for most of the year.
The rule for qualifying is that you must occupy the home for at least 14
days out of the year.
As a new home owner be sure to hold onto the HUD-1 Form that was given
to you at your closing since it is possible in the first year your 1098 may not
be adequate to give you the entire interest amount. Let’s say you have closed on your home in the
middle of July. That usually means your
first mortgage payment will not be due until September 1. This payment will include an interest payment
for August. Many lenders, however, will
charge you interest from the middle of July to the beginning of August and you
will need a record of this amount when you file your taxes. You can use your Hud-1 statement to provide
you with a record of the additional interest payment for your first partial
month of home ownership.
With home ownership, you can decide which will give you the largest tax
deduction, the standard deduction or your total amount of interest payments for
the year. If you find that the standard
deduction will give you more of a write-off you may decide to stay with
it. If the situation changes and the
interest deduction is more, you may later use the interest deduction. You can alternate between the two options
every year or itemize for a few years and then return to the standard. The key is to make sure that you choose the
method that will give you the most tax savings for each year.
In order to claim the interest deduction, you will need to itemize and
file a Schedule A, Form 1040 which will allow you to take deductions such as
medical expenses, real estate taxes and charitable contributions as well as the
mortgage interest deduction.
Real Estate Taxes
Along with your mortgage payment, you will also be paying property taxes
which go to your town. The town uses this revenue to fund its schools,
pay for police and fire protection, to maintain roads and to fund other
services that are needed by its residents.
Real estate taxes are based on two factors: 1) property assessments, and 2) property tax
rates.
A property’s assessment is based on its market value or how much it
would sell for under normal circumstances.
The assessor estimates the market value of a property based on the sales
prices of similar properties. Comparable sales are used as well as the
appraisal method of adding and deducting monetary values according to the
property’s square footage, number of bedrooms, bathrooms and other features of
the home.
Value is also added for upgrades to your property. The town is made aware of an upgrade when
you file for a building permit. In most
towns a permit is necessary whenever a significant improvement is made to your
home such as an addition or remodeling.
The town’s tax rate is determined by the amount of the tax levy. The tax levy is based on a budget that has
been set by the town. First, the revenue
from all sources other than property tax (sales tax revenue, user fees, state
aid, etc.) is determined. This amount is
then subtracted from the budget and what is left must be collected through
property taxes. In order to ensure that
the correct amount is collected, the town decides on an appropriate tax
rate. An example of a tax rate would be 12.66
or $12.66 per thousand.
In your home search, you will find the tax assessment, tax rate and
annual property taxes in the public record and on the MLS listing sheets of
homes that you are viewing. Your bank or other lending institution will
need this information to calculate your monthly payment. Tax payments are usually divided into monthly
amounts and are escrowed and paid with your mortgage and insurance payment.
You may deduct real estate taxes in the year paid. They are also reported on the Form 1098, that
you will receive from your bank annually.
In addition, you can deduct any prorated taxes that were collected from
you at your closing.
Items you may not deduct include:
-
Special assessments or betterment charges;
-
Trash collection services, even if these are
included on your tax bill;
-
Home owners’ association assessments.
Home Office
Do
You Work at Home?
If you own your own business, you may be able to take advantage of the
home office deduction. Although the potential is an attractive one,
before you take this deduction, you should make sure that you meet with all of
the requirements.
To qualify as a home office for the purpose of the IRS, you must
comply with the following:
1. Your use of
the Business Part of your Home must be Exclusive, Regular and for your Trade or
Business.
This usually means that it should be a separate room in your home that
you use both regularly and exclusively for your business. A common area that you use in this way can
comply—as long as you use it exclusively for business.
If you have an additional business with another location, you cannot
perform any of that work in your home office.
For example, if you are claiming a home office as a real estate agent
and you have another job as a teacher, grading papers in your home office would
invalidate your use of the office for the real estate business.
Exclusive use also means that your children cannot use your office
computer to play computer games or do research for their school papers. An exclusion to this would be if you run a
daycare center and let the children use the computer for games and
applications.
Regular use means that you should be using the room on a continuing
basis whether that is daily or weekly and you should be able to back this use
with logs of phone calls or invoices on your computer that show how you used
the office. Be sure to keep any and all
records that prove your use of the office on a regular basis.
2. Your Home Office must be Your
You must be able to show that you use your home as your principal place
of business. To qualify you will need
to prove one of the following:
-
You meet patients, clients or customers at your
home,
-
You use a separate structure on your property
exclusively for business purposes.
This must be the place where you perform the most important part of your
work and you cannot perform a substantial portion of your administrative
activities at any other location. Some
of these activities would include:
-
Billing customers
-
Keeping books and records
-
Ordering supplies
-
Writing reports
-
Setting appointments
You could perform some of these activities elsewhere but your home
office must be where you perform your most substantial administrative
activities.
Expenses you can deduct for an office in your home may include the
business portion of real estate taxes, mortgage interest, utilities, insurance,
depreciation, painting and repairs.
Even if you do not qualify for the home office deduction, you can still
deduct the expenses you pay for your business such as the business telephone
bill, your on-line services and any other business expenses that are generated
from home.
Home Improvements
If you take out an equity loan to make substantial improvements to your
home, you can deduct the interest
paid on the amount borrowed for the improvement. You can
also add this amount to your tax basis for the purpose of the capital gains
exclusion when you sell. The IRS defines
improvements as those items that "add to the value of your home, prolong
its useful life, or adapt it to new uses."
The following are examples of home improvements that may qualify:
Additions: bedrooms, bathrooms, a deck, a garage, a porch or
patio.
Lawn & Grounds: landscaping, walkway, fence, retaining wall,
sprinkler, swimming pool.
Heating and Air Conditioning: heating system, central air, a
furnace, duct work a central humidifier, a filtration system.
Miscellaneous: storm windows, doors, a new roof, central vacuum,
wiring updates, a security system.
Plumbing: a septic system, water heater, water softening
system.
Interior Improvements: built-in appliances, kitchen modernization,
flooring, wall-to-wall carpeting, insulation, attic, walls, floors, pipes, duct
work.
Work that does not qualify as home improvements includes repairs such as
repainting, plastering, patching your roof, repairing broken windows, replacing
cracked tiles and fixing minor leaks.
Additional Home
Equity Loans
College
Tuition, Car Loans and
Debt Consolidation
You may decide to take out a home equity loan for reasons other than
home improvements. You can generally
claim an itemized deduction for interest on up to $100,000 (married couple filing jointly) worth of home equity debt.
These loans may be used to finance your son or daughter’s college
education, pay off a car loan or consolidate credit card debt. You could even use the money to buy
furniture. As long as the loan is
secured by your residence, its interest is deductible.
Be careful that you don’t create an upside down mortgage by ending up
owing the bank more than the value of your home. Your own good judgment must come into play
whenever you borrow against your home’s equity.
However; if you have plenty of equity and were going to incur these
expenditures anyway, you may want to make the choice to secure an additional
tax write-off by financing them through your home.
Points
Remember Those Extra 2 or 3 Points You Paid to
Make Your Interest Rate Lower?
In your mortgage application, you had the option of paying points to help
you to get a lower interest rate. A point is 1% of the principal and is usually
considered pre-paid interest. For example, one point on a $100,000 loan would
be $1,000.
To be treated as pre-paid interest the points have to be paid solely for
your use of the money and not for services performed by the lender. Even if the
lender calls this amount a loan origination fee, as long as it is a charge for
the use of the money, the fees are deductible on your income taxes.
To qualify for deduction of points on your income tax, you must meet the
following criteria:
- Your loan
is secured by your main home.
- Paying points is an established business
practice in the areas where the loan was made.
- The
points paid were not more than the points generally charged in your area.
- You use
the cash method of accounting. Most
people use this.
- Points
were not paid in place of normal settlement costs, such as appraisal fees,
etc.
- The funds
you provided at closing were at least as much as the points charged.
- You use
your loan to buy or build your main home.
- The
amount is clearly shown on the settlement statement (Form HUD-1).
Points can be deducted from your taxes by filing them through a Schedule
A, Form 1040 along with your other itemized deductions.
The Capital Gains Exclusion
This Will Apply When You Sell Your Home
Prior to May 7, 1997, home sellers needed to use the proceeds from the
sale of their home to buy a more expensive home in order to avoid paying taxes
on capital gains. The Taxpayer Relief Act of 1997 changed all
that. Now, rather than having to roll over into another residence,
home owners only need to comply with the following:
When you sell your home, provided you have occupied it for at least two
out of five years, you have a $250,000 exclusion from capital gains taxes on
this amount if you are single or a $500,000 exclusion as a married
couple. The property you are selling must be your principal
residence, not an investment property. However; if you hold a property
for five years, rent it out for the first three, and then live in for the last
two, you qualify for the tax exemption. Also, your habitation of the home
does not necessarily have to be sequential. You could live in the home
for a year, rent it out for three and live in it for the final year. It
is also not necessary for you to be residing in the home at the time of
sale. So, you could live in the house for a year, rent it out for two,
move back into it for another year and rent it out in the final year. The
rule is you must live in the home two out of any five years of ownership.
With regard to the married couple exclusion, you must both pass the use
test and that is that each of you must have lived in the residence for two
years. If you own a home for two years and your significant other marries
you six months before the two year time period, you can qualify for the
$500,000 tax exclusion, as long as you file jointly and your significant other
has lived in the property with you for the last two years. If he has not
lived in the property for the two year time period, or, if he owned and sold
his own property and claimed the exclusion within the two year period, then,
you do not qualify for the married couple exclusion.
These capital gains rules are a vast improvement over the previous ones
since you can now use the proceeds from your home to travel, buy clothes
or embark on a completely new venture. Also, there is no limit on the
number of times you can use the home-sale exemption. In fact, you can
have a tax-free profit of $250,000 (or $500,000 if married) every time you sell
a home provided that each sale is at least two years apart.
These are brief descriptions of the some of the possible tax savings
with home ownership. Before taking any deductions on your taxes, check
with your tax accountant, attorney or appropriate IRS publication which may be
found at www.irs.gov.
Qualifying For a Loan
There are two major factors that qualify you for home financing:
your ability to pay a loan and
your willingness to pay a
loan.
Your ability is determined by
verifying your current employment and analyzing your total income. Lenders
usually like to see that you have been employed by the same company for two years.
There can, of course, be exceptions to this.
If you change your job but stay in the same line of work, you should not
have a problem, particularly if the job change results in an increased amount
of income. Bonuses and any additional
income such as child support or alimony will also be considered if you are able
to bring documentation showing that these amounts are steady and reliable.
Other factors that are taken into consideration include the amount of
cash you have in your bank account, including savings, retirement accounts and
investments. You should be prepared to show recent bank statements,
including checking and savings, your most recent account statements for any
investments you have, interest in retirement funds, life insurance policies and
the value of personal property, including automobiles.
Your willingness to pay the
loan is determined by what is on your credit report. If you have been
consistent in paying your bills, credit card payments and repaying loans, this
will demonstrate that you can be counted on to pay any loans in the future.
Many home buyers are nervous about getting a mortgage loan because they
are under the misconception that they have no bargaining power and that is not
true. Keep in mind that banks are in the
business of loaning money and their business, like any other, is highly
competitive. If you have good credit
and can demonstrate your ability to pay for a mortgage, a good mortgage broker
is going to fight for your business.
Remember this fact when you talk with a mortgage broker about the
particular loan programs that he is willing or able to match you with. That also goes for closing costs and
application fees. Be sure to talk to
more than one mortgage broker or lending institution to get the best deal on
your home loan.
As for meeting lenders’ qualifications, there are usually two questions
that must be asked. First, is your
income large enough to service the expenses associated with the loan? Secondly, do you have cash on hand to meet
the up-front cash requirements of the home purchase? To
help lenders determine this, they usually employ expense ratios.
Mortgage Underwriting Guidelines
When a bank reviews your mortgage application to determine whether or
not to grant a loan, the following items are reviewed:
Income
This is the most important criteria for the bank. They will want to determine where the income
is coming from and the likelihood of it sustaining over the period of the
loan. These include:
-
Salary and Hourly Wages – Calculated on a gross
monthly basis, prior to tax deductions.
-
Part-time and Second Job Income – Not usually
considered unless it is in place for 12 to 24 months.
-
Commission, Bonus and Overtime – This can only be
used if you have received it for two previous years and your employer must
verify that it will likely be continued.
-
Retirement and Social Security – Must continue for
at least three years into the future for consideration.
-
Alimony and Child Support – Must be received for 12
previous months and proven to continue for the next 36 months.
-
Notes, Receivables, Interest, Dividend and Trust
Income – You must have proof of receiving funds for 12 previous months and also
show that income is due for 3 more years.
-
Rental Income – The only acceptable source is from
investment property. The bank will use
75% of the monthly rent minus expenses.
-
Automobile Allowance and Expense Account
Reimbursements – This must be verified with 2 years on tax returns and reduced
by expenses listed on Schedule C.
-
Self Employment Income – Lenders require two years
minimum ownership to consider self employed income.
Debt
Your outstanding debts are reviewed.
The bank needs to be assured that after all monthly liabilities are paid
there is adequate income left to make the mortgage payment.
-
Loans, leases and credit cards are factored in
while food, insurance, school costs, etc. are not.
-
A loan with less than 10 months remaining will
usually be disregarded.
-
The payment figure used is your minimum monthly
payment.
-
If you signed as a co-borrower for a friend or
relative you are accountable for that payment.
-
A loan can be paid off to qualify for a mortgage
but not a credit card. If the card is
paid off and the credit line still exists, the bank will consider it a possible
liability.
Credit
A bank will order a merged credit report from the
three main credit bureaus: Trans Union,
Equifax and Experian. The credit report
also searches public records for liens, judgments, bankruptcies and
foreclosures.
Most lenders use a national credit scoring system
to evaluate credit risk. An underwriter
will evaluate all of this information to determine whether or not to grant a
loan.
Savings
A lender will want to see that the borrower has
adequate savings since the more money the borrower has, the greater the
likelihood there will be of on-time payments.
The bank also wants the borrower to have his own funds invested into the
property. This lessens the probability
of the person walking away from his own life savings when faced with a possible
foreclosure.
In terms of funds that the bank considers, they
are:
-
Checking and Savings Accounts
-
Gifts and Grants
-
-
Secured Loans
-
Retirement Accounts
Ratios
Many banks will use a 28/36 ratio.
Simply defined, the first figure 28 represents the amount of your income
you can pay on a mortgage payment. The
total amount you should pay toward your mortgage payment, including principal,
interest, taxes and insurance is 28%.
The second figure 36 is the amount you pay in debt-related expenses,
including your mortgage, car loans, credit card payments and any other
debts. This figure should not exceed 36%
of your income.
Other lenders may use a 30/40 ratio.
This is to say that your house payment should equal 30% of your Gross
Monthly Income and your debt should be 40% of your Gross Monthly Income.
Ratios will vary, depending on the lending institution’s particular
guidelines.
If you are able to make a down payment of 20 per cent or more there are more
possibilities that open up. If you are a
good borrower with a high credit score you should be able to find a number of
lenders who will be able to fit you into a program that will be beneficial to
you and the bank.
Besides calculating ratios, there are other ways for you to see how much
you may qualify for and what your monthly payments will be. Go to any of the search engines on the
internet and type in “pre-qualify mortgage calculator” and it will bring up
some sites that will allow you to pre-qualify by filling out a form. If you wish to remain anonymous during this
process be sure to choose a site that does not require you to fill in any
personal information such as your name, address and social security
number. This does not replace a
pre-qualification with an actual lender but can give you a rough idea of what
you can afford in your pre-planning stages.
Determining
the
Once you have determined the loan amount that a bank will be willing to
lend you, keep in mind that you may not want to borrow the entire amount. Two items will come into play that will
determine the price range you should be looking in:
-
The amount of money you have to put down;
-
How negotiable prices are at the time of your
purchase.
In a soft or buyer’s market which we are currently in, you should
consider that the asking price of a home is probably not what the home will sell
for. Consider that homes may be selling
for 5 – 10% less than the asking price in this environment. To this end, it is important to know how long
the home has been on the market and, if you possible can, find out anything
about the seller’s motivation.
With these thoughts in mind you should be looking at homes in a slightly
higher price range than you can actually pay.
If you are using the services of a good buyer broker, he or she should
be able to negotiate a lower price than asking and possibly get more off at the
home inspection if any problems are discovered.
Most importantly, you will need to decide what you will eventually be
comfortable with for a mortgage payment.
If you feel secure in your employment and have expectations of higher
earnings in the future your comfort level may be greater than if you are
self-employed and need to worry about possible “rainy days.” In other words, this is your life and your
comfort level - not the bank’s, your family’s or your friends.
Checking Your Credit
To avoid any surprises, it's always best to get a copy of your credit
report before applying for a home loan. Under the Fair and
Accurate Credit Transactions Act of 2003 (FACTA), credit bureaus are required
to provide you with one free copy of your credit report each year. Prior to this ruling, you had to pay $9.50
each time you wanted a copy of your credit report. Congress recognized the benefits of
self-monitoring in the battle against identity theft and enacted FACTA so that
citizens could keep current on their credit status.
You can get a free report by logging onto www.AnnualCreditReport.com or by
calling 1-877-322-8228. Be aware of fraudulent copy cat sites that are
soliciting people to purchase their credit protection services. Never order a credit report on-line from a
source that you got from searching for “credit reporting services” or anything
similar since there is a danger in putting your social security number out on
the internet without protection. For a copy of the mail-in form from FACTA, go
to https://www.annualcreditreport.com/cra/requestformfinal.pdf.
It is wise to check your reports every year, not only to fight identity
theft, but also because credit bureaus can make mistakes and you want to make
certain your reports contain accurate information. Make sure those credit
cards you think you have canceled are showing up as closed.
If you find inaccuracies in your credit report, notify the credit
bureau. Do it in writing and keep a copy. Once the agency is
notified of an error, it has thirty days to make the correction. You have the right to provide credit bureaus
with a one hundred-word statement explaining any circumstances that pertain to
specific information in your report. This includes information about late
payments, divorce-related problems or a dispute with a company. The
credit bureau must then include these statements in your credit report.
What is a FICO
Score?
Most credit bureau scores in the
These scores are considered to be a fair and impartial judgment of whom
should be granted credit and what the limits should be. FICO cannot tell
if you are a single woman, a minority race or of any particular
religion. It looks only to your borrowing habits measured against the
patterns of hundreds of thousands of past credit reports.
FICO scores range from 300 to 850 and, though your scores among the
three major credit bureaus will not be far apart, they are never identical to
each other. Each agency has its own method of analyzing and
reporting the data in your files. It is wise to get a copy of each
score since that is exactly what some of the lenders do.
It's important to note that FICO only looks at information in your
credit report, while lenders look at a number of variables when making their
lending decisions, including your income and how long you have worked at your
current job. Your score considers both positive and negative
information in your report. Late payments will lower your score and
a history of making payments on time will make your score higher.
Your FICO score is based on five categories:
- Payment
History - This makes up 35% of your score. One of the most
important factors in a FICO score is whether or not you have paid past
accounts on time. However, it is just one piece of the
picture.
- Amounts
Owed - Approximately 30% of your score is based on this factor.
Having high balances on credit card accounts may show that you are
overextended and less likely to make future payments on time. If you
pay off your credit cards every month this indicates that you are a good
credit risk.
- Length of
Credit History - Approximately 15% of your score is based on
this. Having had accounts for a longer period of time is
viewed as more favorable than being a new credit customer. FICO
looks at how long accounts have been established and how long it has been
since you have used certain accounts.
- New
Credit - This accounts for approximately 10% of your score. People
who have not had credit for very long should not open too many new
accounts in a short amount of time. The scores are also affected by
having a large number of requests for credit, although FICO distinguishes
between a search for a single loan (such as a mortgage) and searches for
many new credit accounts. They do this, in part, by the length of
time over which the inquiries occur.
- Types of
Credit in Use - Approximately 10% of your score is based on this
factor. If you do not have a lot of other information on which to
base your score, opening a vast array of retail accounts, loans, and
credit cards will not necessarily be viewed favorably. The score
considers whether the loans and accounts are a healthy mix. It is
better to start off with a few accounts and establish a good payment
record with them than to open many that you do not need.
FICO Scores break down to the following, with the highest score getting
you the best interest rates:
760-850, 700-759, 660-699, 620-659,
580-619, 500-579
You can find out more information and purchase your FICO scores at www.myfico.com.
Getting Pre-Approved
After checking your credit and working out some preliminary numbers, it’s
time to go through the process of pre-approval for your home mortgage
loan.
One advantage of getting pre-approved is that it will give you a firm
idea of how much you can borrow and, therefore, what the price range will be of
your new home. With this in place, you
will not be wasting countless hours looking at homes that you may eventually
discover you cannot afford to buy.
In addition, it is a help to your realtor, who will be more willing to
spend time searching for and showing you properties if they can see in black
and white that you are approved for a specific amount of buying power. Sellers will also take any offer you make
more seriously if you are pre-approved.
In fact, most sellers will not accept an offer and take their home off
of the market without first seeing a firm letter of pre-approval.
Some preliminary screening of mortgage companies can be done online or
over the phone. You can go online to check their rates or call them
direct. Most lenders will give you a great deal of information on their
products and current programs. Take advantage of this information to help
you to become a more informed about the credit market.
It is important to start this process as soon as possible. That way, you will have ample time to correct
any possible mistakes that may show up on your credit report. Having negative information on your credit
report will cause you to be put into a higher interest rate program or could possibly
cause your application to be denied.
In light of the recent subprime loan crisis, early application for a
pre-approval has become crucial since many banks have become more strict on
their guidelines for issuing credit.
At the time of application for a pre-approval the lender will provide
you with information about various programs you qualify for and also what your
monthly payments will be. A mortgage
payment is made up of:
-
Principal – The total amount of money you are
borrowing after your down payment. This
is the actual amount you will be financing.
-
Interest – The money the lender is charging you for
the loan.
-
Taxes – Your property taxes are usually escrowed or
put into the hands of a third party until it is time for your taxes to be paid. This makes it easier for you to pay your
property taxes rather than to come up with a large lump sum at any given time.
-
Insurance – Your home insurance protects you
against any losses from fire, storms, or theft, or, if you have flood
insurance, against flooding.
Collectively, these pieces of your mortgage payment are referred to as
PITI.
Your lender will use financial information provided by you to obtain
approval for up to a specific loan amount.
The lender will ask questions regarding your current residence,
employment history, your salary and your outstanding debts. He will also require you to sign a number of
disclosure statements. Your application
will then be submitted to an automated underwriting process. Using this type of process, your approval
may be obtained in a matter of minutes. Once it is approved, you will receive a
pre-approval letter which outlines the terms of your pre-approval.
Exhibit A
Pre-Approval Letter
ABC Banking
November 1, 2008
RE: Loan Approval-property address-to be determined
Dear Mr. & Mrs. Smith:
Congratulations. ABC bank is pleased to inform you that
your application for a mortgage home loan for a purchase price of $600,000 has
been approved. Your approval is based on a review of the information and
the documents that you have provided as well as a full credit report.
This means your credit history, income, and assets, as reported to us meet the
guidelines of the loan program for which you have applied.
A final approval will be issued upon satisfactory compliance of
the following conditions:
- Fully executed sales contract.
- Satisfactory appraisal.
Thank you for choosing ABC Bank.
Sincerely,
Joan Bankcard
Loan Officer
Items Necessary for a Home Loan Application
Some lenders may not require all of these items,
but, just to be safe, you should have the following information ready:
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Your social security number;
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Employment history: employment for two years;
dates and addresses; salary; current pay stubs or W-2 forms.
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Checking and Savings Accounts and Certificates of
Deposits: location of bank accounts, account numbers and balances;
address of bank if out of town and be prepared to provide the last 3 months'
statements.
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Stocks, bonds, and investment accounts:
broker's name and address, description of stocks, bonds, etc. and the last 3
months statements or copies of stock certificates.
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Life Insurance Policy;
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Retirement Plan: approximate vested interest
value, copy of latest statement.
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Automobiles: make and model of automobiles,
their resale value, if possible;
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Other Assets: market value of personal and
household property.
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Liabilities and other non-mortgage debt:
creditor's names, addresses, account numbers, monthly payments and balances.
Now that you have been pre-approved for a home loan it’s time to start
thinking about the type of loan that will best suit your needs.
Conventional Loan Programs
For every home buyer there is a loan program. You can determine
which type of loan you fit into by your income, expenses and home ownership
goals. If you plan on spending many years in your new home, you are
probably best suited for a fixed-rate loan. By getting into a low
interest fixed-rate, you will have the security of knowing what your
monthly payment will be over the long term and you can make the rate even lower
by paying points up front. If, however, there is a good chance
that you will be moving in five years or less, an adjustable-rate mortgage may
be a better answer for you. Or, if your
income will be rising in the future, an ARM may give you more
purchasing power now.
Fixed-Rate
Mortgages
The most easily understood loan is the fixed-rate loan. It allows
the borrower to repay the principal and interest over a fixed period.
During this time, the interest and payment amounts stay the same. There
are currently fixed-rate programs available for 30 years, 20 years, 15 years
and 40 years. The most popular terms are 30 and 15 years.
With a 30 or 40 year loan your payments will be lower since the loan
amount is extended over a long period of time. However, if you can afford
a higher payment, a 15 year loan will pay off your mortgage in half of the
time and the loan will be at a lower interest rate.
The advantages of fixed-rates mortgages include inflation protection,
long-term planning and low risk. If you
plan on owning your home for more than 5 years, a fixed-rate mortgage will
ensure that, even if interest rates go up, your payment will not be
affected. This is a hedge against
inflationary times. Also, knowing what
your monthly expense will be for the entire term of the mortgage can help you
in your long-term planning and provide you with a low risk factor as opposed to
an adjustable rate mortgage which may go up and make planning more difficult
for the long run.
On the flip side, no matter how low interest rates get your payment will
not go down unless you choose to refinance.
Also, the interest rate on a fixed-rate mortgage will be higher to begin
with than an adjustable one which will offer you a low, initial rate to get you
into the loan.
The payments on fixed-rate fully amortizing loans are scheduled so at
the end of the term your mortgage is paid in full. The advantage to this
type of loan is in knowing what your payment will be for the life of the
loan. In a period of low interest rates, the fixed-rate loan is a popular
way to buy a home.
Fixed-Rate
Interest Only Loans
If you qualify, you may opt for an interest only loan. With this product, the loan is divided into
two periods. During the first period,
your monthly payment will be lower since this is when you will be paying only
the interest. In the second period, you
will be paying both interest and principle.
A typical fixed-rate interest only loan would be for 30 years during
which the first 10 years you will have a lower payment paying only the
interest. For the remaining 20 years you
will be paying both interest and principle.
While this option may seem attractive to some borrowers since you are
freeing up cash that you can use for other purposes, you need to remember that
during the first 10 years you are not reducing the principal or creating any
equity in your property.
It is more difficult to qualify for an interest only loan and this type
of loan should probably be reserved for a high end buyer who wants to increase
his purchasing ability and invest the money saved in a higher yield investment. It would not be recommended for first-time
home buyers since they would need to come up with a larger down payment and
miss the opportunity to begin wealth building in what is probably their largest
and most important investment.
Adjustable-Rate Mortgages (ARMS)
With an adjustable-rate mortgage, your interest rate will fluctuate with
the economy. Depending on your financial situation, this type of loan may
allow you to have more purchasing power now than a fixed-rate loan. This is due
to the fact that lenders offer introductory interest rates on ARMs that are
substantially lower than on fixed-rate loans. ARMs carry risks in periods
of rising interest rates, but, if interest rates drop, they can become less
expensive.
The rise and fall of ARM interest rates are tied to their relationship
to an index. The type of index varies and could include treasury
securities or the national average cost of funds to savings and loan
associations. If the index rate moves up, your payment does as
well. On the other hand, if the index rate goes down, so will your
monthly payment.
To get a better understanding of ARMs, you should become familiar with
the following terms:
The Adjustment Period
With an ARM, the interest rate and monthly payment change every year,
every three years or every five years, depending on which program you are
in. The period between one rate change and the next is called the
"adjustment period." For example, in a 1-year ARM the
adjustment period, i.e. when the interest rate can change, is 1
year.
The Margin
To determine the interest rate they will charge on a loan, lenders add a
few percentage points to the index rate. This is called the "margin."
Margins tend to vary from one lender to another. For example, both
lenders may use treasury securities as an index, but one uses a 2%
margin and the second uses a 3% margin. The larger margin will make your
monthly payment higher.
Discounts
To make a loan program attractive and, sometimes, to get you approved, a
lender may use a lower initial rate than what is standard for
them. These rates are referred to as discounted rates.
Often these loans are accompanied by large initial loan fees or "points."
The discount provides you with a lower monthly payment and also
qualifies you for more than you would otherwise be approved of.
Just be aware that, after the discount period expires, which is often at the
end of the first year, the savings from this period may be made up during the
life of the mortgage by a rise in your mortgage payment.
Interest-Rate Caps
Caps were put into effect to protect borrowers from extreme increases in
their monthly payments. A cap does this by placing a limit on how much your
interest rate can increase. A periodic
cap limits the rate increase from one adjustment period to another;
while, overall caps limit the
rate increase over the life of the loan.
For example: you have an ARM with a periodic cap of 2%. At
the first adjustment, the index rate goes up 3%. Because of your 2% cap,
your interest rate will only go up 2%.
Be aware that a drop in interest rates does not necessarily lead to a
drop in your monthly payment. Some ARMS have a carryover feature.
If your 2% cap has kept your interest rate to 2% during a 3% increase in the
index, the additional 1% can carry over to the next adjustment period. This
would raise your interest rate an extra 1% in that period even if the index
rate has not had an increase.
As an overall cap example: you have an overall cap of 5%.
The index rate increases 1% in each of the next nine years. Your payment
will not go up 9 percentage points, but will only go up 5%.
By law, all ARMs must have overall caps.
Payment Caps
Some ARM programs have payment caps. A payment cap will limit your
monthly payment increase at each adjustment, usually to a percentage of
the previous payment.
With payment caps you need to be aware of the possibility of negative
amortization. This can happen when your monthly payment amounts are not
large enough to pay all of the interest due on your mortgage. Since
payment caps deal only with payment increases and not with interest-rate
increases, there could be a time when your payment does not cover all of the interest
due on the loan. This shortage would then be added to your debt and may
have additional interest charged on the amount.
Since real estate values are usually appreciating, the extra charges in
the loan may be covered by an increase in your property value but this is a
possibility that you should carefully consider when looking at any adjustable
rate programs.
1-Year Adjustable Rate Mortgage
With this 30-year loan the interest rate changes every 12 months.
The amount of the adjustment is determined by an index, as previously
discussed. Whether it is the Treasury Bill Rates, Treasury Note Rates,
Federal Reserve Discount Rates or the Cost of Funds Index, these indices are
all published and readily available to the consumer. Your lender has no
control over the rate of increases or decreases.
One reason to consider a 1-year ARM is that the introductory interest
rate will be significantly below the rate on a fixed-rate loan which may help
you to qualify for the largest possible loan on your current salary. Your
part in this arrangement is that you will be taking a risk in that your payment
may change from year to year. If interest rates rise dramatically, you
could end up paying much more for a 1-year ARM than for a 30-year fixed rate
mortgage.
This loan usually comes with a 2% periodic cap and a 6% overall cap.
3/1 Adjustable Rate Mortgage
The interest rate on this 30-year loan will be at a low introductory
rate for the first three years. Then, like
the previous loan, the rate is tied to a predetermined index.
If you expect to move or refinance in three years, this could be a good
solution for you. It is also an opportunity to qualify for a larger loan
than you would under a fixed rate. In any event, you should have some
expectation of an increase in your income to be able to cover any possible
future adjustments.
5/1 Adjustable Rate Mortgage
This is a 30-year loan in which the interest rate is a low rate for five
years and then may change each year thereafter.
You will still be offered a lower rate than the rates on fixed-rate
mortgages. In exchange, you are willing to accept a small amount of risk
that your rate will go up.
This would be a good option if you expect to stay in the home for at
least 5 years. Once again, you should be confident that you income will
go up to be able to cover the possible increase in your payment.
Understanding Closing Costs
One of the most confusing aspects of home financing is determining
what is fair or competitive with regard to closing costs. These costs are
not fixed and can vary greatly depending on the lender, the lending program and
the amount of your loan.
When shopping for a loan, get estimated closing costs from
lenders. Ask for them to be in writing. This will help in your
comparison shopping. Once you have applied for your loan, The Real Estate
Settlement Procedures Act (RESPA) requires your lender to provide you with a
Good Faith Estimate of closing costs within three business days of your
application. Also, you must be provided with a disclosure estimating all
of the costs associated with your loan, including your total finance charge and
Annual Percentage Rate.
Although the categories of lending costs are standard, the amounts
charged for the fees are not. Below is an explanation of each of the
possible fees as they appear on the HUD (Department of Urban Housing and
Development) statement. Not all
lenders charge all of these fees.
Loan Fees
Loan Origination: A charge for the lender's work in evaluating
and preparing your mortgage loan, often expressed as a percentage of the
loan. Cost: varies from lender to lender.
A one percent loan origination fee is equal to 1% of the loan amount.
Discount Points: A point is a one-time charge imposed by the
lender to lower the interest rate the lender would otherwise charge. Each
point is equal to one percent of the mortgage amount. Usually, for each
point you pay for a 30-year loan, your interest rate is reduced by about 1/8th
(or .125) of a percentage point. Paying points can be good if you plan on
living in the home for a long time. Cost:
One point = 1% of the loan.
Appraisal Fee: This covers the cost of an independent appraisal of
the home you are purchasing. The lender requires this evaluation of the
property since it will serve as collateral for the loan.
Cost: $200 - $500.
Credit Report Fee: Covers the cost of a credit report to evaluate your
credit history. Cost: $45 – 50.
Mortgage Insurance Application Fee: If you are putting less
than 20% down on your home you will be required to take out mortgage insurance
(PMI) This covers the lender's risk in the event you should fail to make
loan payments. Cost: Varies from lender to lender.
Mortgage Broker Fee: Any fees paid to the mortgage broker would be
listed here. Cost: Approximately $500.
Items to be paid in advance
Interest: Lenders usually require borrowers to pay the
interest that accrues from the date of the settlement to the first monthly
payment. For example, if you closed on June 20 you would owe ten
days of interest payments to the end of the month.
Mortgage Insurance Premium: The lender may require you to
pay the first year's mortgage insurance premium in advance.
Flood Insurance: If the property you are purchasing is in a
flood zone, you would have to carry flood insurance.
Hazard Insurance Premium: You will be paying at least three
months of prepaid home insurance at the closing. Cost: Based on
your home's value. It is wise to get quotes from three different
insurers.
Property Taxes: You are required to pay three months of
property taxes which will be held in escrow with the hazard insurance by the
lender. Cost: Based on your home's value. The tax
amount can be found on your MLS listing sheet or from the public record
available from the town hall.
Title Charges
Settlement or Closing Fee: This is a fee paid to the settlement agent
or closing attorney. Cost: Approximately $600.
Abstract of Title Search, Title Examination, And Title Insurance
Binder: The title search is done to prove to the lender that the seller owns the
property you are purchasing. The search involves reviewing public
records, recorders of deeds, county courts, tax assessors and surveyors.
Also, records of deaths, divorces, court judgments, liens and contests over
wills are examined. Cost: Approximately $250.
Document Preparation: This is a separate fee that some lenders charge to
cover their costs of preparation of legal papers and the deed.
Cost: $50-$200.
Notary Fee: This is the cost of having a notary public sign the
documents and swear to the fact that the persons named are the
ones who signed them. Cost: $50-$100.
Attorney's Fees: You may be required to pay for legal services
provided to the lender such as examination of the title binder.
Cost: Approximately $600.
Title Insurance: The total cost of your title insurance as well as
the lender's. Title insurance protects you from an error in the title
search. Such an error could mean that you are buying a house from someone
who did not own it in the first place. Cost: Based on your
home's value.
Government Fees
Government Recording and Transfer Charges: These fees are
for recording the new deed and mortgage. Cost: Approximately
$50 - $150.
Additional Settlement Charges
Survey Fee: A survey, or an Improvement Local
Certificate, is done by a licensed surveyor and determines that your lot has
not been encroached upon. At a minimum, the lender will require evidence
that no additional structures have been added to the lot since the last survey
was conducted on the property. Cost: Approximately $200 -
$350.
Administrative Fee, Document Preparation Fee, Courier Fee and Certified
Copies: Costs vary.
Private Mortgage Insurance (PMI)
Will You Need It?
The determining factor as to whether or not you need to purchase private
mortgage insurance is your down payment amount. The bank is concerned
with the loan-to-value or LTV. If you are putting down only 10%, your LTV
is 90 percent. Since most lenders will only insure 80% of the loan, you
will have an exposure of 10% that must be covered. This is done through
private mortgage insurance.
What Does PMI Cost?
According to the Mortgage Bankers Association of America, PMI costs are
typically one-half of one percent of the loan.*
For example: You put down 10% on a loan of $200,000.
$200,000 minus $20,000 (10%) is $180,000. This is the amount
to be financed. The lender multiplies $180,000 by .005. The result
is $900. Divide $900 by 12 for your monthly PMI payment of $75.00.
*PMI costs may vary from lender to lender.
Avoiding PMI
Some lenders have programs in which you can avoid PMI by paying
more interest. The usual rate increase amounts to .75 % to 1% depending on the
lender and the amount of the loan. One advantage to this method is that
mortgage interest is tax deductible.
If you do end up with PMI payments in the structure of your loan,
keep track of your payments on the principal of the mortgage. When you
reach a point where your loan to value is 80% there are provisions which
mandate that you be notified. According to the Homeowner Protection
Act of 1998, Federal Public Law 105-216, the following rules apply:
Mandatory Initial Disclosure - At the time of the closing the lender must
provide a written notice of when PMI may be cancelled or that the lender will
notify the customer when the cancellation date is reached.
Borrower-Initiated Cancellation - When the balance of the mortgage reaches 80
percent of the original value of the property the borrower may request in
writing that the PMI be cancelled.
Automatic Termination - When the balance of the mortgage reaches 78
percent of the original value of the property the lender must automatically
terminate PMI, provided that payment is current.
