FAQ Financing - Home Builders Association of Delaware

FAQ Financing

FREQUENTLY ASKED QUESTIONS - FINANCING

Mortgage Basics

A mortgage is a long-term loan that uses real estate as collateral. A mortgage loan is commonly used for buying a home. Mortgage loans are usually fully-amortizing, which means that the monthly principal and interest payment will pay off the loan in the number of payments stipulated on the note. Mortgage loans are also described by the length of time for repayment, such as 15, 30 or 40 years, and whether the interest rate is fixed or adjustable. A mortgage loan where the downpayment is less than 20% usually requires private mortgage insurance (PMI) or government insurance or guarantee.

Most mortgage loans require monthly payments of principal and interest plus additional payments that are set-aside in escrow accounts to pay property taxes, homeowners (hazard) insurance, and any condominium or homeowner association assessments. Monthly mortgage insurance premiums for loans that have private or government mortgage insurance are generally included as part of the regular monthly principal and interest payment.

Although it is rare in these days of tight credit markets, some lenders may still offer "nontraditional" mortgage loans such as interest-only loans, in which case the borrower pays only the accrued interest and none of the payment is used to reduce the principal balance, or loans where the borrower chooses each month whether to make a minimum payment, pay the accrued interest only, or pay the accrued interest and a portion of the principal.

Home buyers who opt for a nontraditional mortgage should be aware that, depending on the terms of the loan, sudden and significant changes can occur in the monthly payment due to changes in the interest rate and/or payment terms. It is the home buyer's obligation to fully understand the terms of their loan.

Homebuyers who can afford the higher monthly payment sometimes prefer a 15-year mortgage to a 30-year mortgage. Interest rates on 15-year mortgages usually are slightly lower than 30-year rates. In addition, a homebuyer financing a home purchase with a 15-year mortgage will repay principal substantially faster and will pay far less total interest over the term of the loan.

Conventional Mortgages
A conventional mortgage is one that is not insured or guaranteed by the government. Conventional loans with a downpayment of less than 20% require private mortgage insurance (PMI), which protects the lender if the homeowner defaults on the loan. For more information about conventional loans, please check the Web sites of Fannie Mae and Freddie Mac, the two primary puchasers of conventional loans. Please note that Fannie Mae and Freddie Mac do not lend money to home buyers, rather, these organizations and other investors purchase loans that have been made to home buyers by mortgage lenders.

FHA-Insured Loans
The Federal Housing Administration (FHA), which is a part of the US Department of Housing & Urban Development (HUD), operates several low-downpayment mortgage insurance programs that buyers can use to purchase a home. FHA-insured loans generally require the buyer to make a 3.5 percent cash contribution to the downpayment, not including closing costs. FHA-insured loans are available from most of the same lenders who offer conventional loans.
Your lender can provide details about FHA-insured mortgages and the maximum loan amount in your area, or find information on FHA's loan limits directly from HUD's Web site.

VA-Guaranteed Loans
If you are a veteran of military service, reservist, or on active military duty, you may be able to obtain a loan guaranteed by the Department of Veterans Affairs (VA), which requires little or no downpayment. Get more information about the VA Loan Guaranty program.

Rural Housing Service LoansThe Rural Housing Service (RHS), which is a part of the US Department of Agriculture, offers Section 502 Direct and Guaranteed Rural Housing loans to homebuyers located in rural areas. Section 502 Direct loans offer reduced interest rates to lower-income borrowers who qualify, and are arranged directly through local USDA County Agents or through USDA Rural Development state offices.

A limited amount of funding is available for Section 502 Direct loans, so some lenders also offer "Leveraged Loan" programs. Leveraged loans combine a Section 502 Direct loan that carries a low interest rate with a conventional, market-rate loan. The "blended" interest rate on the resulting loan is lower than the current market rate as a result of the combination of the rates on the two loans.

The Section 502 Guaranteed Rural Housing Loans are arranged through participating local lenders and are available to a broader range of borrowers. Find out more about RHS loan programs.

State Housing Finance Agency Loans
State Housing Finance Agencies (HFA) provide loans to first-time homebuyers and veterans of military service who have not previously received a loan through an HFA, often at below-market interest rates. Program availability and eligibility requirements vary from state to state. You should check with your state HFA for programs that are currently available. Find a link to your state's HFA from the National Council of State Housing Agencies' Web site.

Adjustable Rate Mortgages (ARMs)

With a fixed-rate mortgage, the interest rate stays the same during the life of the loan. But with an ARM, the interest rate changes periodically, usually in relation to a specific index such as a cost of funds rate or the Treasury bill rate. Payments may go up or down accordingly. Adjustable-rate mortgages (ARMs) are characterized by the time frame for adjustment, such as 1 year, or 3, 5, 7, or 10 years. Hybrid ARMs have grown in popularity because they may offer a favorable fixed rate of interest for a time, such as 3, 5, 7, or 10 years, after which the loan becomes a 1-year ARM.
Lenders generally charge lower initial interest rates for ARMs and Hybrid ARMs than for fixed-rate mortgages. This makes the ARM easier on your pocketbook at first than a fixed-rate mortgage for the same amount. It also means that you might qualify for a larger loan because lenders sometimes make this decision on the basis of your current income and the anticipated monthly payments for the few year or two. Moreover, if interest rates remain steady or move lower, your ARM could be less expensive over a long period than a fixed-rate mortgage.
Against these advantages, you have to weigh the risk that an increase in interest rates would lead to higher monthly payments in the future. It's a trade-off: you get a lower rate with an ARM in exchange for assuming more risk.

Here are some things to consider with an ARM or a Hybrid ARM:

Is my income likely to increase enough to cover higher mortgage payments if interest rates go up?
How long do I plan to own this home? (If you plan to sell soon, rising interest rates may not present the risk they do if you plan to own the house for a long time.)
Can my payments increase even if interest rates generally do not increase?
What index will be used to adjust the mortgage rate? Ask the lender for a table showing movements in the index over the previous 10 years to see how your mortgage payments would have changed.
How often will the interest rate be adjusted? Every year? Three years? Five years? The longer the adjustment period, the better you will be able to plan your future loan cost.
What is the initial mortgage interest rate? Does it include a special discount or "teaser?" If so, you could face a large increase in your monthly payments when the interest rate is adjusted for the first time.
What is the margin on the interest rate? The margin is the amount that the lender adds to the index rate to calculate your mortgage rate. For instance, if the index rate is 7 percent and the margin is 2 percent, your overall interest rate would be 9 percent.
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 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.
Is the loan convertible? If so, is there a cost to convert? Convertibility allows you to change your ARM to a fixed-rate loan at some designated time in the future.
Is there a prepayment penalty? If you refinance your loan with a new loan, you may be assessed a fee.

Financing Your Remodeling Project

One of the most important considerations for your home improvement project is financing. After all, the project will go nowhere if you can't pay for it.

Fortunately, there are several options that can provide the dollars you need. Four of the most common are a home improvement loan, a home equity line of credit, a home equity loan (second mortgage), and a cash-out refinancing of your current mortgage. However, the simplest method of financing is cash.

Cash
If you have cash in savings to pay for your remodeling project, this may be the best way to finance your home improvements. But be sure to consider the fact that, by paying in cash, you tie up money that could be earning interest in other investments. In other words, you need to look at the interest rate that you would be charged by financing the project and compare this to the interest you could earn by investing these funds.

Also remember that interest payments on a home improvement loan may be tax-deductible, while you can't write off the expenses of a remodeling project paid for in cash. Crunch the numbers and meet with a financial advisor to determine whether paying in cash will really pay off in the long run.

Home Improvement Loan
Two special loans administered through the Federal Housing Administration (FHA) are the Title I and Section 203(k) programs. A Title I loan allows you to borrow up to $25,000 for improvements to a single-family home. These are fixed-rate loans that FHA insures against the risk of default. Loans must be made by an approved Title I lender.

The 203(k) program is not as well known, but if you are looking to purchase a fixer-upper, it is a terrific opportunity. It allows home owners to receive a single, long-term, fixed or adjustable rate loan that covers both the acquisition and rehabilitation of the property. To obtain a loan under the 203(k) program, you must use an FHA-approved lending institution. Most mortgage lenders are approved to make loans through this program.

Home Equity Line of Credit
A home equity line of credit is a form of revolving credit in which your home serves as collateral. This allows you to tap into these funds whenever you need it. The credit line is usually set at 75 to 80 percent of the appraised value of your home minus the balance of the first mortgage. Your credit history and ability to pay may also be considered in determining the amount of credit available.

Home equity lines of credit usually carry a variable interest rate that is figured by adding a margin to the current Prime Rate or some other index. Other costs associated with setting up a line of credit may also apply and will vary from lender to lender.

Second Mortgage
If you are not comfortable with the open-ended nature of a line of credit (which requires discipline to ensure that you don't go way over budget), a home equity loan, or second mortgage, may be right for you. This is a fixed-rate, fixed-term loan based on the equity in your house that is paid back in equal monthly installments over a specific period of time.

Cash-Out Refinancing
If interest rates today are significantly less than when you first purchased your house, refinancing your mortgage may be a wise move. This refinancing alternative allows you to use the accumulated equity in your home to take out a new loan to pay off your existing mortgage and then use the remaining funds for your remodeling project.

Make sure you factor in the length of time you plan to live in the house and the number of years left on your current mortgage before you decide to refinance.

Keeping Your Budget in Line
Once you've decided how much you can afford to spend fulfilling your remodeling dreams, the real challenge is making sure you stick to this budget. So, how can you prevent your expenses from spiraling out of control?

Plan on spending only 80 percent of what you can afford. Put the additional 20 percent in reserve to cover changes, unforeseen problems, and miscellaneous charges.
Remember that anything not included in the original contract will cost extra. It's very easy to start tacking on hundreds and even thousands of dollars in change orders that will break both your budget and your timeline.
Stay focused on the task at hand. Stick to the project you have planned rather than deciding that now is the time to overhaul the rest of the house.

Financing Your Remodeling Project

One of the most important considerations for your home improvement project is financing. After all, the project will go nowhere if you can't pay for it.

Plan on spending only 80 percent of what you can afford. Put the additional 20 percent in reserve to cover changes, unforeseen problems, and miscellaneous charges.
Remember that anything not included in the original contract will cost extra. It's very easy to start tacking on hundreds and even thousands of dollars in change orders that will break both your budget and your timeline.
Stay focused on the task at hand. Stick to the project you have planned rather than deciding that now is the time to overhaul the rest of the house.