Step 3: The Holder of Title — The Loan

In this chapter, we will be talking about the all important loan.

Only Get a Fixed Rate Loan!

In looking for a loan, go for a fixed rate loan. Repeat after me, Avoid the Adjustable Rate Loans! All of them. With a fixed rate, you have a set payment every month and you know exactly how much that payment will be. With that kind of predictability, you can plan out your finances with certainty. 

This is how a fixed rate loan works. You are expected to contribute a down payment to the purchase of the house. Let’s go back to our trusted example. Say the house that you want is $300,000.00, the bank will ask you to contribute twenty percent (20%) to the purchase of the house. $60,000.00 is twenty percent (20%) of the purchase of the house. The bank will loan you the balance, which would be $240,000.00.  

The bank will loan you this specific amount, and not a penny more. The bank charges a set amount of interest on the money that they loaned you. The bank will set a time frame for you to pay the money back. In any loan, these are the main terms: the amount borrowed, the interest rate, and the time frame to pay it back.

Do yourself a favor, go to the store and buy a calculator that has a mortgage calculator program, with instructions. The internet also has mortgage calculator programs. For convenience, I bought and carry my own mortgage calculator because I do not always have access to the internet. Plus, I feel like a cool weirdo having a mortgage calculator with me. It makes me feel extra smart. 

Now, in our example of a loan for $240,000.00 with an interest rate of 7.0% with a term of thirty years, the monthly payment would be $1,596.73. (Rates can be much lower or much higher than this; we are just using this rate as an example.) The terms should be that simple. A good loan is very simple. Nothing fancy. If there are lots of fancy conditions on these three principles in the paperwork, RUN the other way! It is not a good loan.   

And another thing – are you capable of reading? Well then, read every single document in full that you receive as part of your loan package. You will receive a large amount of paperwork when closing the loan.  

The amount listed as the monthly payment in the Note should be the exact amount that you came up with on your mortgage calculator. If the amount is different, there is something terribly wrong. Be smart; be a tough customer. The bank needs to make loans. Without the consumer, the bank goes out of business. Read the paperwork. This is your life. Use your common sense.

If the Note does make sense, and the terms regarding the amount borrowed, the fixed rate of interest, and the amount of time to pay it back are clear, such that you can calculate, to the penny, exactly what your monthly mortgage payment will be, and you can figure out exactly how the each of these terms will be carried out, then you are in good shape.  

Avoid the Adjustable Rate Loan!

In my opinion, the adjustable mortgage interest rate loan should be avoided at all costs. Lenders typically set the introductory rate on adjustable rate mortgages much lower than fixed rate mortgages. But, notice the word “introductory”. That is the rate that the bank starts with in order to entice you into getting the adjustable rate loan. The bank can then raise the rate according to the rate set by, for example, the six month Treasury bill. You will not be able to control the amount that you pay every month on the loan if you have an adjustable rate mortgage. Why? Because the rate adjusts and you cannot predict what the new payment will be. 

So, let’s say your loan terms are as follows.  

Again, you are borrowing $240,000.00 for thirty years but instead of a fixed rate of 7.0%, you start with an introductory rate of 5.0% for two years. After the first two years, the rate can increase by 2%. Finally, the terms state that the lifetime cap on the increased rate is 4%, meaning that the highest interest rate can be no more than 4.0 % more than your initial rate, or (9.0%).    

In the first two years, your payment would be $1,288.37. However, after the first two years, your interest rate and payment can rise up to 7.0%, and you would owe $1,596.73 per month. Finally, the interest rate and your payment, with the full 4% increase, could rise to $1,931.09 per month.  You could be stuck with that rate for the next 25 years. So, it is true that in the first two years, the payment is lower than with a fixed rate. But if the Treasury bill rates rise, so will your payment. 

To be fair, on an adjustable rate mortgage, the interest rate can also go down, if the interest rate, set by the government, goes down. But do you really want to rely on what the federal government does? Do you want to trust the actions of the government in setting the Treasury bill rate to be in control of something as crucial as your house payment? Do you believe that the government is watching out for you, rather than the banks? 

Additionally, make certain there is no prepayment penalty in your Note or in any other document that you are asked to sign. You do not want to pay the Note for the full term because home loan interest across thirty years, even on low rate fixed loans, is astronomical. You want to pay off the Note as soon as humanly possible. We will talk about this more below. For right now, strike any language in the Note that states there is a prepayment penalty. If the bank insists on that penalty, walk away. Most banks will be happy to snatch your business away from another lender and not require the prepayment penalty. Be smart. Be a tough customer. You will love yourself for it.  

What to Do If You Already Have an Adjustable Rate Loan

If you are in a position where you already have a loan that keeps adjusting upward, don’t despair. You can refinance and get a fixed rate loan. Hire a friend and get a mortgage broker. Talk to a wealthy person that you know. See who they use for a mortgage broker. Accountants usually know a lot of brokers. Don’t hire just anyone you hear about. Do some research and find a great broker who can get you a fixed rate loan and nothing else. A great mortgage broker is the best friend you will ever have.    

All Things Considered: Principal, Interest, Taxes and Insurance (PITI)

Principal and Interest

You know what principal and interest payments are because we have been talking about this stuff for two chapters now. You get the idea: put between 10% – 20% of the purchase for the downpayment. If you put less than 20% down, the bank will require that you have private mortgage insurance. Once the equity in your house is more than 20%, you can have the lender remove the private mortgage insurance. That is the strategy. Get a fixed interest rate loan. That is the interest strategy.

Taxes

Finally, in order to get a loan with a bank, the bank will want to see that you can not only make the monthly payments on the loan, but that you will also be able to pay the taxes imposed by the county. Go down to the county tax office and ask them what the anticipated yearly taxes would be on the property you want to buy. You can’t go by what the current owners are paying in taxes; taxes are gauged against the purchase price of the house. The seller bought the house years before you did, so their taxes are different from what you will be paying. You have to budget current tax rates amount into your housing budget. Taxes are paid yearly to the county in which the property in located. 

Insurance

In order to get a loan with a bank, you will be required to insure the house. The insurance protects the existence of the house. If a fire destroys your house, guess who the money goes to first?  That’s right, the insurance company will pay the lender first. That term is referred to as Lender’s Loss Payable in your insurance policy. (That is the California terminology, at least.  Believe me, your state has something similar.) In fact, you have to list the lender on your insurance policy. If the house is destroyed, the lender’s loan will be fully repaid. If you don’t have homeowner’s insurance, then you will be liable for the mortgage payment even if the house is gone. Lenders require that you have insurance to avoid this very problem. So, do some research and find the best insurance policy for your house. You have to price shop with homeowners insurance companies to find the best deal.

Again, the bank will lend up to three times your gross income, but they will not lend to you if your expenses show that you cannot contribute at least one third of your income to PITI (principal, interest, taxes, and insurance).  

If you have such heavy debt that you cannot contribute at least one third of your income to these four expenses, the bank will not give you a loan. So, again, clear up all your debt before you apply for a loan to buy a home. Budget for not just the home loan (principal and interest) but taxes and insurance, too. Your entire housing budget should not be more than one third of your income, otherwise, you won’t be able to afford having your friends over for dinner. 

Summary:

(1) Order your credit reports; repair any blemishes yourself. 

(2) To finance a loan, you will need to show you have a steady source of income and sufficient documentation of that income. Get the documents you need to prove your income to the bank.  

 (3) You need have at least 10% cash down payment of the purchase price of the house. A 20% downpayment is preferred, but you will qualify for a loan with 10% cash down payment. 

  (4) Borrow no more than twice your gross unrealized income. In the alternative, you can use the ratio of three times your gross income, but then you should have at least a 20% down payment.

  (5) Get a fixed rate loan. 

 (6) Avoid the adjustable rate loan! 

(7) The entire cost of your housing — principal, interest, taxes and insurance– should be no more than one third of your monthly income.  

The goal is to stabilize the cost of living, and improve your standard of living, by owning a home that you like, and having a monthly mortgage that you can easily afford. Chart a course for your future.  Begin today.

Now you’re educated on the documents, the money, and the loan. Now what? How do you know what kind of house to pick? Read the next chapter to find out!