Mortgage Basics

Breaking Down the Basics

Your Guide to Understanding Mortgages

Below is a list of documents that are required when you apply for a mortgage. However, every situation is unique and you may be required to provide additional documentation. So, if you are asked for more information, be cooperative and provide the information requested as soon as possible. It will help speed up the application process.

 

Your Property

  • Copy of signed sales contract including all riders
  • Verification of the deposit you placed on the home
  • Names, addresses and telephone numbers of all real estate agents, builders, insurance agents, and attorneys involved
  • Copy of Listing Sheet and legal description if available (if the property is a condominium please provide condominium declaration, by-laws, and most recent budget)

Your Income

  • Copies of your pay stubs for the most recent 30-day period and year-to-date
  • Copies of your W-2 forms for the past two years
  • Names and addresses of all employers for the last two years
  • Letter explaining any gaps in employment in the past two years
  • Work visa or green card (copy front and back)

If self-employed or receive commission or bonusinterest/dividends, or rental income:

  • Provide full tax returns for the last two years PLUS year-to-date Profit and Loss statement (please provide complete tax return including attached schedules and statements. If you have filed an extension, please supply a copy of the extension.)
  • Schedule K-1 tax forms for all partnerships and S corporations for the last two years (please double-check your return. Most K-1s are not attached to the 1040.)
  • Completed and signed Federal Partnership (1065) and/or Corporate Income Tax Returns (1120) including all schedules, statements, and addenda for the last two years. (Required only if your ownership position is 25% or greater.)

If you will use Alimony or Child Support to qualify:

  • Provide divorce decree/court order stating the amount, as well as proof of receipt of funds for last year

If you receive Social Security income, Disability or VA benefits:

  • Provide an award letter from an agency or organization

Source of Funds and Down Payment

  • Sale of your existing home – Provide a copy of the signed sales contract on your current residence and statement or listing agreement if unsold (at closing, you must also provide a settlement/Closing Statement)
  • Savings, checking or money market funds – Provide copies of bank statements for the last three months
  • Stocks and bonds – Provide copies of your statement from your broker or copies of certificates
  • Gifts – If part of your cash is to close, provide a Gift Affidavit and proof of receipt of funds
  • Based on information appearing on your application and/or your credit report, you may be required to submit additional documentation

Debt or Obligations

  • Prepare a list of all names, addresses, account numbers, balances and monthly payments for all current debts with copies of the last three monthly statements
  • Include all names, addresses, account numbers, balances and monthly payments for mortgage holders, and contact information for landlords, for the last two years
  • If you are paying alimony or child support, include marital settlement/court order stating the terms of the obligation

What is an Appraisal?

An appraisal is an estimate of a property's fair market value. It's a document generally required (depending on the loan program) by a lender before loan approval to ensure the mortgage loan amount is not more than the value of the property. The appraisal is performed by an "appraiser," typically a state-licensed professional who is trained to render expert opinions concerning property values, its location, amenities and physical conditions.

 

Why get an Appraisal?

Obtaining a loan is the most common reason for ordering an appraisal; however, there are other reasons to get one:

  • Contesting high property taxes
  • Establishing the replacement cost for insurance purposes
  • Divorce settlement
  • Estate settlement
  • Using as negotiating tool in real estate transactions
  • Determining a reasonable price when selling real estate
  • Protecting your rights in an eminent domain case
  • A government agency requirement
  • A lawsuit

What are Appraisal Methods?

There are three common approaches, or appraisal methods, used by appraisers to establish property value. After thorough exercise of all three, a final value estimate is determined. When evaluating single-family, owner-occupied properties, the sales comparison approach is heavily weighted by an appraiser.

  1. Cost Approach – A formula is used to obtain the property value: land value (vacant) added to the cost to reconstruct the appraised building as new on the date of value, less accrued depreciation the building suffers in comparison with a new building.
  2. Sales Comparison Approach – The appraiser identifies 3-4 comps, or recently sold properties in the neighborhood, ideally sold in the previous six months and within a half-mile of the subject property. A comparison is done between the recently sold properties and the subject property, including square footage, number of bedrooms and bathrooms, property age, lot size, view and property condition. 
  3. Income Approach – The potential net income of the property is capitalized to arrive at a property value. Capitalization is the process of converting a future income stream into a present value. This approach is suited to income-providing properties and is used in conjunction with other valuation methods.

Can Another Mortgage Company be Used After the Completed Appraisal?

Yes. But be aware a new lender may insist on having its own appraisal, and you may end up paying for the second appraisal.

 
How can I assist my Appraiser?

It's to your advantage to help the appraiser perform the assessment by providing additional information:

What is the purpose for the appraisal?
Is the property listed for sale, and if so, for what price and with whom?
Is there a mortgage? And if so, with whom, when placed, for how much and what type (FHA, VA, etc.), at what interest rate or other type of financing?
Are any personal properties or appliances included in the property?
With an income-producing property, what is the income breakdown and expenses for the last year or two? A copy of the lease may be required.
Provide a copy of the deed, survey, purchase agreement or additional property papers.
Provide a copy of the current real estate tax bill, statement of special assessments or balance owed on anything, e,g., sewer, water, etc.

A closing cost is a payment required to finalize a home loan and is separate from a down-payment. Read about closing cost, their purpose, how you can pay them and more by clicking learn more below.

 

What happens at a closing?

"Closing" is the last step of buying and financing a home and when the property is officially transferred from the seller to you. At Closing you and all the other parties in the mortgage loan transaction sign the necessary documents.

Your Closing may include some or all of these entities: real estate agents, your attorney, the seller’s attorney, lender's representative, title and escrow firm representatives, clerks, secretaries, and other staff. Closing can take anywhere from 1-hour to several depending on contingency clauses in the purchase offer, or any escrow instructions needing to be executed.

Most paperwork in closing or settlement is done by attorneys and real estate professionals. You may or may not be involved in some of the closing activities; it depends on who you are working with.

Prior to closing you should have a final inspection, or "walk-through" to insure requested repairs were performed, and items agreed to remain with the house are there such as drapes, lighting fixtures, etc.

In most states the settlement is completed by a title or escrow firm in which you forward all materials and information plus the appropriate cashier's checks or bank wire so the firm can make the necessary disbursement. Your representative will deliver the check to the seller, and then give the keys to you.

 

Statutory Closing Costs

These are expenses you have to pay to state and local agencies, even if you paid cash for the house and didn't need a mortgage:

  1. Transfer Taxes – Required by some localities to transfer the title and deed from the seller to the buyer.
  2. Deed Recording Fees – To pay for the County Clerk to record the deed and mortgage, and to change the property tax billing.
  3. Pro-Rated Taxes – Property taxes may need to be split between the buyer and the seller since they are due at different times of the year. For example, if taxes are due in October and you close in August, you would owe taxes for 2-months, and the seller would owe for the other 10-months. Pro-rated taxes are usually paid based on the number of days, not months of ownership. Some lenders may require you to set up an escrow account to cover these bills. If not, you may want to set one up yourself to insure the funds are set aside for these important expenses.
  4. State & Local Fees – Other state and local mortgage taxes and fees may apply.

Third-Party Costs

There may be expenses paid to others like agents, attorneys, inspectors or insurance firms, even if you paid cash for the property:

  1. Attorney Fees – You may want to hire an attorney when purchasing a home. They usually charge a percentage of the selling price up to 1%, or some work on an hourly basis or for a flat fee.
  2. Title Search Costs – Usually your attorney will perform or will arrange for the title search to ensure there are no obstacles such as liens or lawsuits regarding the property. Or you may work with a title company to verify a clear property title.
  3. Homeowner's Insurance – Most lenders require you prepay the first year's premium for homeowners insurance, sometimes called hazard insurance, and must show proof of payment at the closing. This insures that the investment will be secured even if the property is destroyed.
  4. Real Estate Agent's Sales Commission – The seller pays the real estate agent's commission, and if one agent lists the property and another sells it, the commission is usually split. The commission is negotiable between the seller and the agent.

Lender Charges

  1. Origination Fee – For processing the mortgage application there may be a flat fee, or a percentage of the mortgage loan.
  2. Credit Report – Most lenders require a credit report on you and your spouse, or an equity partner. This fee is often a part of the origination fee.
  3. Points – One point is equal to 1% of the amount borrowed and can be payable when the loan is approved either before or at closing. Points can be shared with the seller which is negotiable in the purchase offer. Some lenders will let you finance points which will add to the mortgage cost. If you pay the points up front they are tax deductible in the year they are paid. Different deductibility rules apply to second home loans.
  4. Lender's Attorney's Fees – For your attorney to draw-up documents and to ensure that the title is clear, and for representation at the closing.
  5. Document Preparation Fees – There are several documents and papers prepared during the home-buying process ranging from the application to the closing. Lenders may charge for this, or the fees may be included in the application and/or attorney’s fees.
  6. Preparation of Amortization Schedule – Some lenders will prepare a detailed amortization for the full term of your mortgage. This is usually done for fixed mortgages or adjustable mortgages.
  7. Land Survey – Lenders may require that the property be surveyed to ensure it has not been encroached and to verify the buildings and improvements to the property.
  8. Appraisals – Professional Appraisers can do a comparison of the value of the property to that of other recently sold neighborhood properties. Lenders want to be sure the property is worth the value of the mortgage loan.
  9. Lender's Mortgage Insurance – If your down payment is 20% or less, many lenders require that you purchase Private Mortgage Insurance (PMI) for the loan amount. If you should default on your loan, the lender will recover their money. These insurance premiums will continue until your principal payments, plus the down payment equal 20% of the selling price and may continue for the life of the loan. The premiums are usually added to any amount you must escrow for taxes and homeowner's insurance.
  10. Lender's Title Insurance – Even with a title search for any property obstacles, liens or lawsuits, many lenders require insurance to protect their mortgage investment. This is a 1-time insurance premium usually paid at closing, and is for the lender only, not the homebuyer.
  11. Release Fees – If the seller has worked with a contractor who put a lien on the house and is expecting payment from the proceeds of the house sale, there may be fees to release the lien. The seller usually pays these fees which could be negotiated in the purchase offer.
  12. Inspections Required by Lenders – The lender may require a Termite Inspection if you apply for an FHA or a VA mortgage loan. In many rural areas a water test may be required to ensure the well and water system will maintain an adequate water supply to the house; for quantity not quality. Depending on the sales contract and property type, additional inspections may be required.
  13. Prepaid Interest – The first regular mortgage payment is usually due from 6-8 weeks from closings; however, interest costs begin at closing time. The lender will calculate the interest owed for that period of time, and that fraction of interest is sometimes due at closing.
  14. Escrow Account – Lenders often require that you set-up an Escrow Account, where you will make monthly payments to, for taxes, homeowner's insurance, and sometimes PMI (Private Mortgage Insurance). The amount placed in this account at closing depends on when property taxes are due and the timing of the settlement transaction. The lender can give you a cost approximation during the application process of your mortgage loan.

Other Up-Front Expenses

The major portion of other up-front expenses is the deposit or binder you make at the time of the purchase offer, the remaining cash down payment you make at closing, or can include:

  1. Inspections – Lenders may require inspections, and you can make your purchase offer contingent based on satisfactory completion of some other inspections such as structural, water quality tests, septic, termite, roof and radon tests. You and the seller can negotiate these inspection fees.
  2. Owner's Title Insurance – You may want to purchase title insurance in case of unforeseen problems so you're not left owing a mortgage on property you no longer own. A thorough title search ensures a clear title.
  3. Appraisal Fees – You may want to hire an Appraiser either before you sign a purchase offer, or after reviewing the lender's appraisal report.
  4. Money to the Seller – You'll need to pay for items in the house you want that were not negotiated in the purchase offer such as appliances, light fixtures, drapes, lawn furniture, or fuel oil and propane left in tanks.
  5. Moving Expenses – If you are changing jobs, your new employer may pay for your relocation, otherwise you must figure in the moving costs such as truck rentals, professional movers, cash for utility deposits like telephone, cable, electricity, etc.
  6. Repair Expenses – In the purchase offer, you can request that the seller set up an Escrow Account to defray any costs for major cleanup, radon mitigation procedures, house painting, appliance repairs, etc. Depending on the purchase offer contract and contingency clauses, you may discover that you have expenses upon moving in.
  7. Example: Your purchase offer contract has a clause making the purchase contingent on a satisfactory structural inspection, and it’s determined that the house needs a new roof. You can negotiate to have the seller arrange for the work to be done but, this will delay the closing date. You may have to agree to a higher price for house, or to pay some of the new roof repair expenses. Or you and the seller may split the cost using estimates from a contractor of your choice, and each of you will put funds into an Escrow Account. Or, the seller may be willing to reduce the sale price of the house, but either way cash will be needed for the new roof.
  8. Time Investment – One often overlooks major up-front costs in buying a home. The time and expenses invested in house-hunting, which can take up to 4-months, plus the time spent searching for the best mortgage for you, the right real estate agent, an attorney, and other related things that take up your valuable time.

What is RESPA?

The Real Estate Settlement Procedures Act (RESPA) contains information regarding the settlement or closing costs you are likely to face. Within 3 business days from the time of your mortgage application, your lender is required to provide you a "Loan Estimate" which is an estimate of settlement or closing costs based on their understanding of your purchase contract. This estimate will indicate how much cash you will need at closing to cover prorated taxes, first month's interest, and other settlement costs.

What is a credit report?

Your credit payment history is recorded in a file or report. These files or reports are maintained and sold by "consumer reporting agencies," also known as credit bureaus. You may have a credit record on file at a credit bureau if you have ever applied for a credit or charge account or a personal loan. Your credit record contains information about your debts, and credit payment history. It also indicates whether you have been sued, arrested, or have filed for bankruptcy.

 

Do I have a right to know what's in my report?

Yes, if you ask for it. You have a right to receive a free copy of your report from each of the major credit bureaus once a year; when you make that request, the credit bureau must send your complete record.  You can request your free annual credit report at www.annualcreditreport.com. No other website provides the free report to which you are entitled.

 

What type of information do credit bureaus collect and sell?

Credit bureaus collect and sell four basic types of information:

  1. Identification and Employment Information
    Your name, birth date, Social Security number, current employer, and spouse's name are routinely noted. The credit bureau also may provide information about your employment history, home ownership, and previous address, if a creditor requests this type of information.
  2. Payment History
    Your accounts with different creditors are listed, showing how much credit has been extended and whether you've paid on time. Related events, such as referral of an overdue account to a collection agency, may also be noted.
  3. Inquiries
    Credit bureaus maintain a record of all creditors who have asked for your credit history within the past year, and a record of those persons or businesses requesting your credit history for employment purposes for the past two years.
  4. Public Record Information
    Events that are a matter of public record, such as bankruptcies, foreclosures, or tax liens, may appear in your report.

What is credit scoring?

Credit scoring is a system creditors use to help determine whether to give you credit. Information about you and your credit experiences, such as your bill-paying history, the number and type of accounts you have, late payments, collection actions, outstanding debt, and the age of your accounts, is collected from your credit application and your credit report. Using a statistical program, creditors compare this information to the credit performance of consumers with similar profiles. A credit scoring system awards points for each factor that helps predict who is most likely to repay a debt. A total number of points – a credit score – helps predict how creditworthy you are, that is, how likely it is that you will repay a loan and make the payments when due.

The most widely used credit scores are FICO scores, which were developed by Fair, Isaac and Company. Your score on an application will fall between 350 (high risk) and 850 (low risk). You do not have one single FICO score, Fair Isaac has developed many different models, used for different types of credit; they change over time and it’s hard to predict which version a given lender is using. Different credit bureaus may have slightly different information in their files on you, and those differences may or may not matter for a particular scoring model. Some companies will offer to sell you a credit score. It’s important to understand that the number you get from one of those companies is not necessarily the same number a lender will calculate when it reviews your mortgage application. 

Because your credit report is an important part of many credit scoring systems, it is very important to make sure it's accurate before you submit a credit application. To get copies of your report, contact the three major credit reporting agencies:

Equifax: (866) 349-5191
Experian (formerly TRW): EXPERIAN (888) 397-3742
TransUnion: (800) 888-4213 
These agencies may charge you for your credit report.

You are entitled to receive one free credit report every 12 months from each of the nationwide consumer credit reporting companies – Equifax, Experian and TransUnion. This free credit report can be requested through the following website: https://www.annualcreditreport.com. No other website provides your once-a-year free report.

 

How is a credit scoring model developed?

To develop a model, a company selects a sample of similar customers and analyzes it statistically to identify characteristics that relate to the likelihood of their paying back their loans. Then, each of these factors is assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its own credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company.

What can I do to improve my score?

Credit scoring models are complex and often vary among creditors and for different types of credit. If one factor changes, your score may change – but improvement generally depends on how that factor relates to other factors considered by the model. Only the creditor can explain what might improve your score under the particular model used to evaluate your credit application and taking account of how the details in your credit report are affecting your score.

Nevertheless, scoring models generally evaluate the following types of information in your credit report:

  • Have you paid your bills on time? Payment history typically is a significant factor. It is likely that your score will be affected negatively if you have paid bills late, had an account referred to collections, or declared bankruptcy, if that history is reflected on your credit report.
  • What is your outstanding debt? Many scoring models evaluate the amount of debt you have compared to your credit limits. If the amount you owe is close to your credit limit, that is likely to have a negative effect on your score.
  • How long is your credit history? Generally, models consider the length of your credit track record. An insufficient credit history may have an effect on your score, but that can be offset by other factors such as timely payments and low balances.
  • Have you applied for new credit recently? Many scoring models consider whether you have applied for credit recently by looking at "inquiries" on your credit report when you apply for credit. If you have applied for too many new accounts recently, that may negatively affect your score. However, not all inquiries are counted. For example, inquiries by creditors who are monitoring your account or looking at credit reports to make "prescreened" credit offers are not counted.
  • How many and what types of credit accounts do you have? Although it is generally good to have established credit accounts, too many credit card accounts may have a negative effect on your score. In addition, many models consider the type of credit accounts you have. For example, under some scoring models, loans from finance companies may negatively affect your credit score.

Scoring models may be based on more than just information in your credit report. For example, the model may consider information from your credit application as well: your job or occupation, length of employment, or whether you own a home.

To improve your credit score under most models, concentrate on paying your bills on time, and managing your level of debt. It's likely to take some time to improve your score significantly.

 

What happens if you are denied credit or don't get the terms you want?

If you've been denied credit, or didn't get the rate or credit terms you asked for, you should receive a letter stating, in general terms, the reasons why. If the creditor used a credit scoring, you should also receive an explanation of what factors negatively affected your score. The explanation won’t go into detail, but it might say something like “Your income was low” or “You haven’t been employed long enough.” Instead of giving you these notices, some lenders will simply tell you that you have a right to learn the reasons you didn’t receive the credit you wanted, if you ask within 60 days. A notice like this should tell you who to contact. Send a request to get the explanation you are entitled to.  

Check whether those factors look accurate. If you are not offered the best rate available because of inaccuracies in your credit report, be sure to dispute the inaccurate information. The notice from your lender should give you contact information for any credit bureau whose information the lender used. You have a right to get a free report from a credit bureau within 60 days of being turned down for credit on the basis of a report from that bureau.

If a creditor says you were denied credit because you are too near your credit limits on your charge cards or you have too many credit card accounts, you may want to reapply after paying down your balances or closing some accounts. Credit scoring systems consider updated information and change over time. Be aware, though, that if you pay down a credit card this month, it can take some time for that information to appear in your credit report and then be reflected in a credit score.

What is a FHA Loan?

The Federal Housing Administration (FHA) is a federal agency that supports many mortgages through a range of guarantee and insurance programs. In the most common types of FHA loans, the agency ensures that if the borrower defaults, the lender will receive repayment from the insurance. That insurance encourages lenders to make loans they might otherwise consider too risky. 

FHA loans may be available to buy a house with as little as 3.5% down, especially for first-time homebuyers.  

 

FHA Loans vs. Conventional Home Loans

The main difference between an FHA loan and a conventional home loan is that an FHA loan may require a lower down payment for a borrower with a given credit history. This can allow those without a credit history, or with minor credit problems, to buy a home. 

 

If I've Had a Bankruptcy in Recent Years, Can I Get a FHA Loan?

If you have been through bankruptcy or had a foreclosure or similar mortgage problem, you may be able to get an FHA-insured loan sooner than a conventional loan. It’s best to have started rebuilding your credit with other credit accounts like a car loan or a credit card, and make sure you pay your debts on time.  

 

How big of a FHA Loan Can I afford?

Your monthly housing costs should not exceed 29% of your gross monthly income for an FHA loan. Total housing costs often lumped together are referred to as PITI.

P = Principal

I = Interest

T = Taxes

I = Insurance

Examples:

Monthly Income x .29 = Maximum PITI 
$3,000 x .29 = $870 Maximum PITI

Your total monthly costs, or debt to income (DTI) adding PITI and long-term debt like car loans or credit cards, should not exceed 41% of your gross monthly income.

Monthly Income x .41 = Maximum Total Monthly Costs 
$3,000 x .41 = $1,230 
$1,230 total - $870 PITI = $360 Allowed for Monthly Long-Term Debt

What is Private Mortgage Insurance (PMI)?

On a conventional mortgage, when your down payment is less than 20% of the purchase price of the home mortgage, a lender might require you to get Private Mortgage Insurance (PMI) to protect them in case you default on your mortgage. Sometimes you may need to pay up to one year's worth of PMI premiums at closing. If you don’t plan to make a 20% down payment, ask your broker if there are any loans available without a PMI requirement.

 

How Does Private Mortgage Insurance (PMI) Work?

PMI companies write insurance policies to protect approximately the top 20% of the mortgage against default. This depends on the lender's and investor's requirements, the loan-to-value ratio and the type of loan program involved. Should a default occur, the lender will sell the property to liquidate the debt and is reimbursed by the PMI company for any remaining amount up to the policy value.

 

Could Obtaining Private Mortgage Insurance (PMI) Help Me Qualify for a Larger Loan?

PMI can sometimes help you obtain a larger loan. If you can’t afford a down payment large enough for a given house and loan, you might still be able to pay for PMI that could let you obtain the loan.

 

How is Private Mortgage Insurance Paid?

PMI fees can be paid in many ways depending on the company used:

  • Borrowers can choose to pay the one year’s premium at closing, and then an annual renewal premium is collected monthly as part of the house payment.
  • Borrowers can choose to pay no premium at closing, but add on a slightly higher premium monthly to the principal, interest, tax and insurance payment.
  • Borrowers who want to sidestep paying PMI at closing but don't want to increase their monthly house payment can finance a lump-sum PMI premium into their loan. Should the PMI be canceled before the loan term expires through refinancing, paying off the loan or removal by the loan provider, the borrower may obtain the rebate of the premium.

 

What is the History of Private Mortgage Insurance (PMI)?

The private mortgage insurance industry originated in the 1950s with the first large carrier, Mortgage Guaranty Insurance Corporation (MGIC). They were referred to as "magic," as these early PMI methods were deemed to "magically" assist in getting lender approval on otherwise unacceptable loan packages. Today there are eight PMI underwriting companies in the United States.

 

Cancellation of Private Mortgage Insurance (PMI)

The Homeowners Protection Act of 1998 established rules for automatic termination and borrower cancellation of Private Mortgage Insurance (PMI) for home mortgages. These protections apply to certain home mortgages signed on or after July 29, 1999, for the home purchase, initial construction or refinance of a single-family home. It does not apply to government-insured FHA or VA loans, or to loans with lender-paid PMI.

With certain exceptions your PMI must be terminated automatically when 22% of the equity of your home is reached, based on the original property value and if your mortgage payments are current. It can also be canceled at your request with certain exceptions, when you reach 20% equity, again based on the original property value, if your mortgage payments are current.

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