Obtaining a Mortgage: Selection & Qualification Text Size:

A mortgage is a lien on property that secures a loan and is paid in installments over a set period of time. The mortgage secures your promise that you'll repay the money you've borrowed to buy your home. There are many different types of mortgage loans, each having advantages and disadvantages.

Choosing the Right Mortgage Loan

You need to decide on the type of mortgage loan you want. In addition to comparing interest rates, you'll want to consider closing costs, prepaid points, prepayment penalties and late payment penalties. Some of the most common types of mortgage loans are the fixed-rate mortgage loan, adjustable-rate mortgage loan, balloon mortgage loan and reverse mortgage loan.

Fixed-Rate Mortgage Loan

A fixed-rate mortgage loan is one where the interest rate does not change over the life of the loan. Since the rate remains constant, the monthly payment for interest and principal does not change. The primary advantage offered by this type of loan is that the borrower has a known monthly payment for the entire loan period.

Fixed-rate mortgage loans are typically available with either a 15-year or 30-year term. This is considered a good loan choice for borrowers who do not intend to sell their home in the next five years, who will have steady income and who can afford the current interest rate.

The disadvantage of a fixed-rate loan is that they typically have higher rates than other loans. Many borrowers prefer to pay a slightly higher interest rate and have the knowledge that their monthly payment will not increase over the loan term.

Adjustable-Rate Mortgage

An adjustable-rate mortgage (ARM) loan is an obligation for which the interest rate is adjusted periodically based upon a pre-selected index. The interest rate is usually based upon the index plus a margin. The margin is a specified percentage that is added to the chosen financial index to determine the interest rate of the ARM loan. For example, an ARM loan could have an interest rate of the 1-year Treasury Security Yield plus 3%. If the applicable 1-year Treasury Security Yield was 5%, the ARM loan interest rate would be 8%.

The monthly payment on this type of loan changes as the interest rate is adjusted. Many borrowers prefer adjustable-rate mortgages when interest rates are high, because these loans are offered at an interest rate several percentage points lower than fixed-rate mortgages.

ARM loans are a good choice for borrowers who plan on selling the home in the next two to five years and who expect that their income will rise. A primary advantage of an ARM loan is that the borrower can typically purchase more house for their money since the payment the borrower can afford will obtain a larger ARM loan than it would if the borrower were obtaining a fixed-rate mortgage loan.

Balloon Payment Mortgage Loans

A balloon payment mortgage is a mortgage where the lender is still owed a substantial amount of principal at the end of the loan term. Until the balloon payment's due date, the loan's repayment terms are as if the loan's term were for a longer period. The borrower's monthly payments will typically be the same as if the loan was to be repaid over a 30-year term. Once the balloon payment due date arrives, however, the borrower must pay the remaining balance owed on the debt. Otherwise, the borrower is in default and faces the possibility of a mortgage foreclosure. Since a large payment is required, many borrowers seek refinancing from a new lender

Reverse Mortgage

A reverse mortgage is a mortgage that lets homeowners who are 62 or older borrow money against the equity in their paid for home. The owner can choose to receive the money as a lump sum, a line of credit, annual payments or any combination of these. The loan does not have to be repaid until the homeowner, or in the case of a married couple, the last homeowner, leaves the residence. When the loan comes due, the lender sells the house to repay the entire loan. If the value of the house does not cover the total amount owed, the lender has to take the loss and cannot seek a deficiency payment from the heirs or the assets of the borrowers. If the heirs want to keep the house, they have the option to do so by simply repaying the full amount due on the loan.

15-Year versus 30-Year Mortgage Loans

A 15-year mortgage term produces substantial reductions in the total interest paid (usually more than one half) in comparison to a 30-year term. Yet, the extra amount of payments required each month is relatively low. The primary disadvantage to a 15-year mortgage is that the monthly payment will be 10% to 15% higher per month.

Biweekly Mortgage Loans

With a biweekly payment mortgage, the borrower makes 26 payments each year. In comparison to the standard monthly payment plan, the biweekly payments result in the payment of the equivalent of an extra monthly payment each year. The plan accomplishes increased reduction of the principal balance of the mortgage loan each year, resulting in significant savings on interest payments over the loan term. Most borrowers are surprised to discover that by paying the equivalent of 13 monthly payments over the course of a year, the time required to complete payment of the full mortgage debt is reduced to about two-thirds of the 30-year term. Generally, a 30-year loan paid biweekly will be paid off in about 22 years; a 15-year term is paid off in about 12 years.

Qualifying for a Mortgage Loan

A creditor decides whether or not a borrower is qualified by determining the borrower's ability to repay. The borrower's willingness to repay is determined largely by the applicant's past credit history. Lenders want to know if a borrower's income is large enough to service the new expenses associated with the loan, plus any existing debt obligations that will continue in the future. A lender also wants to know if the borrower has enough cash to meet the up-front cash requirements of the transaction.

The process of making a final determination on approval or rejection is called "underwriting." Underwriting involves verifying the information that was obtained from the borrower and that served as the basis for qualification, as well as assessing information on the applicant's credit worthiness.

Expense Ratios

In general, the lender assesses the adequacy of the borrower's income in terms of two ratios that have become standard in the trade. The first is called the "housing expense ratio" and is the sum of the monthly mortgage payment including mortgage insurance, property taxes and hazard insurance divided by the borrower's monthly income. The second is called the "total expense ratio" and it is the same except that the numerator includes the borrower's existing debt service obligations. For each of their loan programs, lenders set maximums for these ratios, which the actual ratios must not exceed.

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