Loan Basics

A lot of first time buyers want to know what kind of a loan to get. I recommend 30 year fixed because the interest rate never changes, although in some cases a 15 year fixed can be ok. In general I never recommend adjustable rate mortgages, or interest only mortgages- these are speculative products that could expose you to unnecessary risk.

With the 30 Year fixed loan, you can choose between a “1 point loan” or “no point loan”. What is a point? A point is a buyer closing cost paid in escrow. 1 point equals 1 percent of the loan amount.

For Example: Lets say you are buying a $600,000 house with 20% down. That means you will have a loan amount of $480,000. 1 point or 1% of this amount would be $4,800. This $4,800 will be cash paid out of pocket by you the buyer before closing and will raise your closing cost.

Why do buyers choose to pay a point? Because paying a point will lower the interest rate for the life of the loan. Let’s say that the interest rate for no points is 4.25% and that by paying a point you can lower the interest rate by 1/8 of a percent or 0.125 so that the new rate would be 4.125% and that it’s the $480,000 loan we talked about above.

No Point Loan 1 Point Loan
Interest Rate 4.25% 4.125%
Discount Points 0 $4,800
Monthly Mortgage Payment $2,361 $2,326
Monthly Savings $35

 

You can now calculate how long it will take for this point to pay for itself, by taking the cost of 1 point and dividing by the monthly savings. $4,800/$35 = 137 months or 11.5 years. In this example if the buyer were planning to stay in the property for 11 years this might make sense to do, otherwise I would stick with the no point loan. Over 10 years 4.25% loan will pay $186,000 in interest while 4.125% will pay $180,000 in interest.

The problem nowadays with paying points is lenders aren’t giving very big discounts, if the discount for a point was ¼ or ½ a percent, that would be a lot more attractive for buyers. You will have to decided for yourself.

The next thing that buyers want to find out is how much you can buy. For stated income loans that come in and out of the market you can claim whatever income you want- although a lot of these buyers tend to get over their head. A great example would be a sales person in their first year who made 4K, 4K, 6K, and 14K in their first four months. They probably will assume from now on, they will always make 14K a month or more. If you get a loan payment that you can’t afford you will risk losing your down payment so be conservative if you are stating your finances.

For most of us, we will need documented income to qualify for a loan. This means the income that shows up on your taxes. The bank will look at your NET income, and not your gross. So lets suppose you own a small business, and you made $150,000 gross income, but then wrote off in your schedule C $140,000 in business expenses- that means your net income is $10,000 and that’s the income the lender is going to use to qualify you.

The bank takes an average of two years income. If your income increased they average it. So if you made $60,000 net income last year and $75,000 net income this year, they will give you $67,500 income. If your income decreased from this year to last year, the bank takes the lower income. Lets suppose you made $75,000 net income last year and $60,000 net income this year, they will give you $60,000 income.

How much can I borrow?

Use this great online tool, it’s the easiest way:

https://www.smartasset.com/first-time-home-buyer/affordability/how-much-mortgage-can-i-afford

The mortgage amount you can qualify for is directly related to your net income. First the bank will subtract any debt payments (for example a credit card payment or car payment) from your net income, then with what remains they will not loan more than a 35-40% debt to income ratio. If you are currently paying rent, and plan to live in the property as your primary residence then rent won’t be counted against you because they assume you will be living in your new home. If you are buying the property as an investment, your monthly living expense will also be subtracted from your net income.

 

 

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