After selecting a suitable home in your price range, you must find somebody to lend you money for the purchase. With the proliferation of new types of mortgages, finding the right loan has become somewhat complicated. However, by understanding two concepts, your mortgage shopping will be made much simpler.

Mortgage calculations

Your monthly loan payment has two components: (1) the interest, which is what you pay the lender to borrow the money; and (2) the principal, which is the portion of the loan you are paying back. With your principal payment, you are increasing the portion of the house you own and decreasing the portion the lender owns. But it is the interest payment that is the key to understanding how most mortgages work.

The interest portion of your monthly payment is the monthly interest rate on your loan, times the outstanding balance of the loan. The monthly interest rate is simply the annual interest rate, divided by 12. For instance, if your mortgage rate is 12 percent, your monthly rate is 1 percent.

Looking at an example, suppose you have a $100,000, 30-year fixed-rate loan at 9 percent. Your monthly principal and interest would be $804.62. This payment stays the same for 30 years, but the portions you pay toward principal and interest change each month. In the first month, you owe the lender an interest payment of 0.75 percent of $100,000 or $750. The remaining $54.62 goes toward reducing your loan balance, making it $99,945.38. For your second payment, you owe the lender 0.75 percent of $99,945.38, or $749.59. The remainder of your $804.62 fixed payment, which is $55.03, is used to reduce your loan balance to $99,890.35.

Each month, your interest payment is slightly smaller because you are slowly reducing the balance you owe. In the last month of the 30th year when you make the final payment on your loan, the contribution to principal is large enough to pay off the remaining balance while still giving the lending institution all of its interest.

The same concept holds true for all types of mortgages, even adjustable rate loans that allow the interest rate to fluctuate over the life of the loan.

Negative amortization occurs when your payment is less than the monthly interest rate times the outstanding balance. In this case, the shortfall is added to your outstanding balance. In the example above, if your first payment had been only $725, you would have had negative amortization of $25, the difference between what you paid and the $750 you owed in interest.

Many lenders now offer 15-year loans, which allow buyers to increase equity much more quickly than the 30-year loans. For example, on a 15-year loan for $100,000 at 9 percent, the monthly payment would be $1014.27. The initial interest would still be $750, but the initial payment to principal would be $264.27 (instead of $54.62 with a 30-year loan). it’s as if you were paying the $209.65 difference in the initial payment to a savings account, only the savings account is in the equity in your home instead of a financial institution.

A 15-year mortgage can reduce interest payments substantially over the life of the loan. The 15-year, $100,000 loan at 9 percent would save more than $107,095 in interest over a comparable 30-year loan. Because you are paying down your principal quicker, your interest payments after the first month will be lower than in each comparable month in the 30-year loan. Depending upon your income tax situation, you may find a 15-year loan more beneficial than a traditional 30-year mortgage.

Annual percentage rates

The second concept you should understand will help if you shop for a mortgage through advertisements in your local newspaper. If an ad contains an interest rate, it is required by law to include an “annual percentage rate,” or APR. The APR is the annual cost of credit over the life of the loan, including interest, service charges, points, loan fees, mortgage insurance, and other items. Hence, the APR is almost always higher that the simple interest rate on which your monthly payment is calculated.

The annual percentage rate is the mortgage market equivalent of the unit prices on supermarket shelves. It provides a consistent standard for comparison shopping among mortgages with different terms and features. Each mortgage has only one APR. There is no such thing as a “first-year APR.”

With adjustable rate mortgages, you cannot predict the annual cost of credit because you do not know how your interest rate may change in the future. To calculate the APR for an adjustable rate loan, the lender must assume that current interest rates will remain in effect for the life of the loan. Hence the APR will not reflect what you will actually pay. You should carefully consider the annual percentage rate in addition to other features of adjustable rate loans.

Adjustable rate mortgages

An adjustable rate mortgage (ARM) is a loan whose interest rate is adjusted according to movements in an index rate, such as the national average mortgage rate or the treasury bill rate. Usually, when the interest rate changes your monthly payment will change also.

ARMs tend to be offered with lower initial rates than fixed-rate loans. Fixed-rate loans are usually more expensive because you are buying protection from future increases in interest rates. No matter how high rates go, your monthly payment will always be the same. With an ARM, the consumer assumes part of an increase in interest rates, and so may receive a price break on the initial interest rate from the lender. You must consider whether a lower initial rate on the ARM is worth the uncertainty about possible future increases in your payments.

When shopping for an ARM, these are some of the questions to ask:

1. What index will be used to adjust your mortgage rate? Try to obtain a table showing movements in the index over the previous 10 years to see how your mortgage payments could change.
2. How often will your mortgage be adjusted? One year? Three years? Five years? The longer the adjustment period, the better you will be able to plan your future household expenses.
3. What is the initial mortgage rate? Does it include a special discount? If so, you could have a large increase in your monthly payments when your rate is adjusted for the first time.
4. What is the margin on your mortgage rate? The margin is the amount the lender adds to the index rate to calculate your mortgage rate. For instance, if the index rate is 10 percent and the margin is 2 percent, your rate would be 12 percent.
5. What limits or caps have been placed on the adjustments? One of the most important items to discuss with your lender is the maximum amount that your mortgage rate can increase both in any single adjustment period and over the life of the loan. Find out the “worst case” situation in the event of a sharp increase in your index rate.
6. Can negative amortization occur? If an ARM has caps which prevent your payment from rising to the level dictated by the index, you may incur negative amortization. Find out what limits there are on negative amortization.
7. Is your loan assumable? Assumability allows you to pass your loan on to a creditworthy person who wants to buy your home. This can be an attractive selling feature.
8. Does your loan convertibility allow you to change your ARM to a fixed-rate loan at some designated time in the future?
9. Is there a prepayment penalty? If you sell your house and pay off your loan early, you may be assessed a fee.

Where to go for a loan

You should shop around to find the best possible terms for a loan. Your builder may be able to help arrange financing. Among other places to look are:

• Savings and loan associations and commercial banks -- Before the deregulation of financial institutions, savings and loan associations lent money primarily for home mortgages, while commercial banks specialized in commercial loans. However, both types of institutions have diversified and the distinctions between them have blurred with regard to home mortgages. Most commercial banks now offer highly competitive mortgage rates and programs, and many have the capability of placing the loan in their “portfolio,” should the loan not meet typical mortgage guidelines. This is a distinct advantage that the mortgage banker or mortgage broker usually cannot offer.
• Mortgage bankers -- Unlike other types of bankers, a mortgage banker (sometimes called a mortgage company) does not accept deposits from individuals or businesses. The mortgage banker borrows money from a bank, then lends it to consumers who want to buy homes, then sells the loans to an investor. The proceeds from the sale are used to repay the money (minus a processing fee) over to the investors who bought the loans. Mortgage bankers are listed in the Yellow Pages under “Mortgages.”
• Mortgage brokers -- A mortgage broker represents numerous lenders (some of whom may be from out of town), and can help you obtain an affordable mortgage. You usually pay for the service only if the broker finds a loan. This gives the broker an added incentive to help you.
• Credit unions -- If you belong to a large credit union which offers home loans, see if you can obtain a favorable rate on a mortgage.
• Family -- People often obtain money from family members to finance down payments. Lenders usually will not permit you to borrow money for a down payment but receiving a gift is permissible. Usually a gift must be from an immediate family member. Many lenders require that at least 5 percent of the down payment must come from your own funds. Both you and your family should check the tax implications of cash gifts. For tax purposes, it is usually more advantageous for your family to buy the house and rent it to you than to lend you the money you need to purchase the home.
• Housing finance agencies -- Most states offer a limited amount of below-market-rate home financing for low- and moderate-income households. The agencies raise money by selling tax-exempt bonds to the public. After a bond sale an agency will work with selected lenders (such as banks and S&Ls) to make the money available to home buyers. Eligibility for these mortgages may depend on your income and the price of the house. The money is reserved for first-time buyers or those who have not owned a home during the past three years.
• Other sources -- There are other sources of mortgage credit. Insurance companies and department store chains are now entering the mortgage lending business. The U.S. Department of Housing and Urban Development (HUD) offers a limited amount of money for lower-income families under the Section 235 program: mortgage interest costs can be reduced to as low as 4 percent. A limited number of mortgage loans are available under the Farmers Home Administration’s (FmHA) Section 502 program for low- and moderate-income families in rural areas to purchase new housing or to purchase or repair existing housing. Explore as many options as possible because a little extra searching could save you thousands of dollars over the life of the loan.

Loan Terms

• Mortgage insurance -- If your down payment is less than 20 percent, you will probably have to buy mortgage insurance, which provides protection to your lender if you default. Mortgage insurance is available from both private and government sources.
• Conventional loans -- When mortgage insurance is required on a conventionally financed home, you must buy the insurance from a private company. A conventionally financed loan involves a contract between you and the lender, which is secured by the home you are buying. The higher your down payment, the smaller the risks to the lender and usually the lower your mortgage insurance premium. You may have a choice between making a lump sum payment or settlement or making annual premium payments. The premiums are calculated as a percent of your loan. You usually do not need to continue paying for mortgage insurance once your equity has reached a certain level (usually 20 to 25 percent).
• FHA-insured loans -- Government-backed mortgage insurance is available through the Federal Housing Administration (FHA). Because the federal government is backing the loan, you may be able to obtain an FHA-insured mortgage with a down payment of less than 5 percent. The government limits the amount you can borrow with an FHA-insured loan. The limits vary depending upon the price of housing in the area. FHA-insured loans are available from most of the same lenders who offer conventional loans.
• VA-insured loans -- If you are a veteran, you may be able to obtain a loan insured by the Veterans Administration (VA). VA-insured loans require no down payments and generally carry lower interest rates than conventional loans. You should apply to a local lending institution (bank, S&L or mortgage company) that will then submit your application to the appropriate VA office. Eligibility requirements for veterans are determined by Congress. VA mortgages have no maximum loan amount, but you may have trouble finding a lender who will make a VA loan for more than $184,000. VA loans require a funding fee (a percentage of the loan amount), that can either be paid in cash at closing or included in the loan amount.
• What types of mortgage are available -- So many new types of mortgages have flooded the market recently that you may have trouble making sense of all the acronyms. After hearing about SAMs, GPAMs, PLAMs and RAMs, you may want to scream “HELP” (which would be unwise because there is a mortgage known as the “Home Equity Loan Program”). Many of the new mortgages are offered by only a few lenders in only a few parts of the country. Don’t waste your time learning about mortgages that are not available to you. If you understand the differences between fixed-rate mortgages and ARMs, and if you know about FHA and VA, there are only about five other types of mortgages you are likely to encounter. They are:
• Graduated payment mortgage (GPM) -- Most people expect their incomes to rise over time. The GPM begins with lower payments that rise annually over the first 5 to 10 years and then remain constant for the remainder of the loan. Unlike an ARM, a GPM is a fixed-rate, fixed-schedule loan. Even though the payments change, you always know exactly how they are going to change. The lower initial payments enable you to qualify for a GPM with less income than you would need for a comparable level payment loan. With 30-year GPMs, early payments are lower than the interest you owe to the lender, so negative amortization occurs. The payments level off at an amount higher than you would pay at the same point in a level payment loan, because you have to pay off the negative amortization in addition to the original amount of your loan. With 15-year GPMs, early payments generally are sufficient to cover most of the interest opted, so negative amortization, if any, is very low. Ask your lender to calculate possible negative amortization for you. You should avoid GPMs if your house is expected to appreciate slowly and you plan to sell it within a few years. Also be wary if you are uncertain that your household income will increase quickly enough to meet the rising payments. FHA and VA insurance is also available for GPMs.
• Growing equity mortgage (rapid payoff mortgage) -- Like the GPM, the growing equity mortgage is a fixed-rate, fixed-schedule mortgage with payments that change over time. There is no uncertainty about how they will change. The major difference is that you start paying the same amount as you would for a level-payment, fixed-rate mortgage at the same rate. The increases in your payments are used entirely to reduce the balance you owe. Because of the increased payments, you will usually be able to pay off a 30-year loan in 15 to 20 years, possibly less. If you want to build your equity quickly and expect your household income to steadily increase, you might consider a growing equity loan. A variation on the rapid payoff loan is the biweekly mortgage. Instead of making payments each month, you make half of your monthly payment every two weeks. To avoid extra paperwork, payments are usually made by automatic withdrawals from your bank account. You end up making 26 half-payments per year, the equivalent of 13 monthly payments. Simply making one extra monthly payment per year may enable you to pay off a typical 30-year fixed-rate loan in less than 20 years. By making extra payments to principal, you reduce the amount of interest you owe the lender and can devote a greater portion of each regular payment to reducing the balance you owe. The effect is small at first, but gradually snowballs, allowing for the rapid payoff. Before accepting a growing equity loan you should consider that any loan can become a rapid payoff loan when extra payments are made. Most lenders permit this. Because you are not obligated to a rapid payoff plan, you leave yourself the option of stopping the extra payment for a few months. You are not allowed to skip a regular monthly payment. You must pay each month at least what your mortgage contract specifies. Also check about prepayment penalties.
• Buydown -- A builder may contribute a subsidy, or buydown, to your mortgage. The buydown may last a specified number of years or the entire life of the loan. For example, if mortgage rates are 14 percent, a builder might pay a lender enough to reduce your loan to a rate of only 11 percent during the first year, making it easier for you to qualify. A popular type is the 3-year “3-2-1” buydown. The builder reduces your rate 3 percent the first year, 2 percent the second and 1 percent the third. Your payments rise gradually over the first three years, avoiding “payment shock” in the fourth year when the buydown expires. If the buydown lasts for only a limited period, find out how much your payments will increase when it is no longer in effect. Be especially careful if the buydown is on a loan with an adjustable rate. Also, determine whether the buydown is part of your contract with the lender. If it is provided separately by the builder, the lender could hold you liable for the unsubsidized rate should the builder develop financial problems and not be able to pay the subsidy.
• Balloon -- In movies from the 1920s, nasty villains in black suits made life miserable for innocent young damsels who could not make the final balloon payments on their mortgages. With a balloon mortgage, you make equal fixed payments at a fixed rate for a short period, usually 3 years, and then must pay your entire remaining balance. Sometimes, your payments cover interest only. Instead of tying you to the railroad tracks, many lenders now will guarantee that you can refinance the loan at whatever interest rate is being offered when the balloon comes due (rather than your original rate). If you choose not to refinance, you can sell the house. A balloon mortgage may be worthwhile if you plan to sell your home within a few years and expect the value of your house to appreciate quickly. Even if you anticipate a fast turnover on your unit, you should look for an automatic refinancing clause that could save you from being forced to shop for another mortgage and pay closing again when the loan comes due.
• Shared appreciation mortgage (SAM) -- If you cannot afford to buy a house on your own, you may be able to find a partner to help share the financial load. The partner in a shared appreciation mortgage can be a friend or family member. But if your partner left suddenly, you would either have to sell the house or buy out your partner’s share. Buying out your partner’s share may severely strain your budget, and may force you to take in tenants to make ends meet. If you have to sell the house, you will lose all of the money you paid in closing costs and may have to pay new closing costs for a less expensive home. Be sure there is a written agreement between partners specifying how repairs will be handled and what will happen if one person cannot make payments or wants to sell. Determine whether you want to be joint tenants (sharing ownership equally) or tenants-in-common (having separate equal parts). If one of you dies, a joint tenant would automatically inherit the entire property, whereas a tenant-in-common would not. In order to inherit the property, a surviving tenant-in-common would either have to be mentioned in a will or be made eligible through state inheritance laws.

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