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What is Equity, and Why Is It Important?

Buying a home gives you stability, a sense of accomplishment; and since your home is your biggest asset, your home equity is the biggest part of your financial net worth.

Equity is the difference between what you owe on the mortgage loan and the home’s value. If the bank appraises your home at $230,000 and you owe the lender $100,000, your equity is $130,000. Equity builds slowly over time as your home appreciates in value and as you pay down your mortgage balance.

But even if you understand what equity is and how it works, you may not completely grasp the importance of equity. Here are five benefits of home equity.

1. You can use equity as down payment on a new home

Buying a home requires a down payment, but it can take years to save between 3.5% and 20% for a purchase. The good news is that existing homeowners can use proceeds from the sale of a property as down payment on their next home. Your home’s equity determines your profit once you sell the property. The more equity you have, the more cash you’ll walk away with, and you can put all or some of the proceeds toward your next purchase.

2. You can borrow from your equity

You don’t have to move to get cash from your home’s equity. If you refinance your property—which involves applying for a new mortgage to replace your old mortgage—you can request a cash out and borrow up to 80% of your home’s equity. Another option is applying for a home equity loan or home equity line of credit (HELOC). Both options feature interest rates lower than most credit cards, and you can use funds for any purpose such as debt consolidation, home improvements, college expenses, etc.

3. Get rid of private mortgage insurance faster

If you get a conventional mortgage and put down less than 20%, you’re required to pay private mortgage insurance (PMI). This insurance protects your lender in case you default, and you pay premiums each month with your mortgage payment. PMI can cost as much as 1% of the loan balance each year, which increases your monthly mortgage expense. However, the bank will remove PMI once you have 22% equity in your home.

4. Use equity to fund your retirement

Even if you have a 401(k) or an individual retirement account, your home’s equity can help fund your retirement. If you’re able to pay off the house before retiring, you could downsize to a smaller place and invest some of your proceeds from the sale. If you don’t sell, there’s the option of a reverse mortgage if you’re over the age of 62. You can convert some of your home’s equity into cash. Use the money for living expenses, healthcare costs, home improvements, etc. The loan doesn’t have to be repaid until you sell the house or die. If you die, your estate repays the loan.

Pros and Cons of a Fixed-Rate Mortgage

When applying for a mortgage loan, you have the option between a fixed-rate mortgage and an adjustable-rate mortgage. An adjustable-rate mortgage has an introductory fixed-rate, and then a rate that resets every year. A fixed-rate mortgage, on the other hand, has an interest rate that remains the same over the life of the loan.

Fixed-rate mortgages are considered a safer alternative. But it’s important to understand the pros and cons before deciding whether this type of mortgage is right for you.

Pros of a Fixed-Rate Mortgage Loan

Predictable, fixed monthly payment

With a fixed-rate mortgage, you don’t have to guess or predict what your mortgage payment will be from year-to-year. Since the rate on these mortgages never change, your mortgage payment remains the same for the entire mortgage term, whether you choose a 15-year, a 20-year or a 30-year mortgage. When you know your housing expense, it’s easier to plan ahead and budget for the future.

You don’t have to worry about mortgage rates

With an adjustable-rate mortgage, you might worry about the possibility of a higher interest rate. There’s no way to predict what interest rates will do from year to year. With each rate adjustment, your interest rate will change to reflect current market conditions. The rate could increase, remain the same or decrease. If your rate increases, so does your mortgage payments. And if rates skyrocket from one year to the next, your payment could increase significantly. You don’t have to fear payment shock when you choose a fixed-rate mortgage.

Cons of a Fixed-Rate Mortgage

Higher mortgage interest rates

Although fixed-rate mortgages offer predictable monthly payments and your rate will never increase, adjustable-rate mortgages can be cheaper. Adjustable-rate mortgages start off with lower rates compared to a fixed-rate mortgage. This can result in lower monthly payments, and a lower rate can help you qualify for a larger mortgage amount.

You have refinance to take advantage of a lower rate

An adjustable-rate mortgage comes in handy when mortgage rates are on the decline. Since your rate will adjust each year according to the market, you’re able to take advantage of lower mortgage rates without doing anything. This isn’t the case with a fixed-rate mortgage. Because the mortgage rate is fixed, refinancing the mortgage is the only way to benefit from falling rates. Refinancing involves applying and qualifying for a new mortgage, and paying closing costs.

A fixed-rate mortgage offers predictability, stability and peace of mind, and if you’re going to live in the home for many years, it’s the safer choice. But if you prefer moving every three to seven years, an adjustable-rate mortgage is a better fit. You can take advantage of the low introductory rate, and then sell the property before your first rate adjustment.

Why Getting a Mortgage Will Be Easier in 2016

Owning a home provides a sense of permanence and stability, and it’s a big step toward growing your personal net worth. But in previous years, tough lending requirements made it difficult for some to get a home loan. Thanks to new guidelines, banks have eased its standards, making it easier for many to purchase a home. If you’re applying for a mortgage, here is what you can expect.

Lower down payments on conventional mortgages

Qualifying for a standard conventional mortgage typically requires a minimum down payment of 5%. New lending programs, however, now make it possible for select borrowers to get a conventional loan with less upfront cash. Both the Conventional 97 and the HomeReady mortgage only require a 3% down payment. These loans are available to first-time homebuyers, repeat buyers and low-to-moderate income borrowers. The HomeReady program requires completion of an online homebuyer’s education course.

The down payment requirement has also been lowered for high-balance/jumbo mortgages over $417,000. These loans used to require a minimum down payment of 10%. Borrowers are now eligible with as little as 5%.

Relaxed income guidelines for self-employed borrowers

Similar to other applicants, self-employed borrowers must provide tax returns for income verification. But it’s sometimes harder for these individuals to qualify because self-employment income can fluctuate from year-to-year. In the past, rather than use a borrower’s most recent income for qualifying purposes, banks would average out the income over the past 24 months. This approach, however, didn’t allow some borrowers to benefit from increased earnings, and they would qualify for less than they could actually afford. Recent changes allow mortgage lenders to qualify self-employed borrowers based on their most recent year of returns.

Employee Expenses Don’t Hurt You

If you’re an employee and you spend your own funds on equipment, uniforms, business meals and other business expenses, you can write-off unreimbursed expenses when filing your taxes. Maximizing tax deductions can help you avoid a higher tax bill and help you receive a bigger tax refund, but deductions also lower your adjusted gross income, which is your income after deductions

Previously, the more job-related deductions, the less a borrower could spend on a house. This is because lenders would use an employee’s adjusted gross income when underwriting the mortgage application. Since deductions lowered the borrower’s qualifiable income, he would qualify for a smaller mortgage. The situation is different today. New mortgage guidelines state that job-related expenses will no longer count against an employee’s income. Mortgage lenders can use a borrower’s full W-2 income when underwriting the loan.

How “Not” Shopping Around for a Mortgage Can Cost You

According to the Consumer Financial Protection Bureau, “nearly half of all mortgage borrowers do not shop around when buying a home.” Some homebuyers make a lending decision based off a single loan quote, and they assume every lender will offer the same rate and terms. This couldn’t be farther from the truth.

When looking for a mortgage, you should comparison shop as you would with any other purchase. Mortgages vary from bank to bank, and if you don’t know your options, you could end up paying more than necessary for a loan.

1. You Could Pay a Higher Mortgage Rate

Shopping around and comparing rate information helps you gauge whether you’re getting a fair mortgage rate. Your interest rate affects your monthly payment and determines how much you pay over the life of the loan. The lower your mortgage rate, the lower your housing costs. Let’s say you borrow $200,000 for a home purchase. The difference between an interest rate of 3.98% and 4.3% is about $40 a month.

Getting a mortgage quote will involve providing the bank with information about your income and assets, and the bank will check your report history. Although rate shopping can trigger multiple credit report inquires, these inquiries have little impact on your credit score.

Credit scoring models are able to recognize a pattern of rate shopping. Multiple mortgage inquires that occur within a 45-day window count as one inquiry on your credit report.

2. You Could Pay Higher Closing Costs

Buying a house also involves closing costs, which can run between 2% and 5% of the loan balance. There is no set fee for closing, hence the importance of shopping around. Closing costs include a variety of fees, such as the loan origination, discount points, the appraisal, title search and the attorney fee. Some fees are a flat rate and you’ll pay roughly the same regardless of lender. But other fees vary by lender. Take the loan origination fee for example. One mortgage lender may charge 1% of the loan balance, whereas another lender charges 2% of the loan balance. Higher origination fees result in higher closing costs.

3. You Could Miss Out on Financing Specials

Meeting with different lenders gives you an opportunity to learn about different loan options and special financing programs. If you request a rate quote from only one lender, this lender may not offer any type of closing costs or down payment assistance, which means you’ll have pay these expenses out of your own funds. But if you shop around, you may find a lender offering programs that help with mortgage-related expenses, thus reducing your upfront costs.

Should You Get a Co-Borrower for Your Mortgage

The process of purchasing a house isn’t as simple as renting a house or an apartment. Mortgage lenders typically request more documentation than landlords; and whereas a landlord may overlook a poor credit history, lenders aren’t as forgiving. Mortgage applications are scrutinized, and unfortunately, banks reject a lot of applicants.

If you’re rejected for a home loan, a bank may reconsider its decision if you re-apply with a co-borrower. A co-borrower appears on the mortgage loan with you, and the bank takes this person’s income, credit and assets into consideration when determining whether to approve the application. A co-borrower can be anyone such as a spouse, a parent, sibling or child. This person has ownership interest in the property and is equally liable for the mortgage debt.

Having a co-borrower isn’t a requirement for a mortgage loan, yet it can be helpful if you’re having trouble getting a loan on your own. Before you proceed, here’s what you should know about adding a co-borrower to your mortgage.

Adding a Co-Borrower Doesn’t Guaranteed a Better Mortgage Rate

Mortgage borrowers with the highest credit scores qualify for the best mortgage rates. If you apply for a mortgage with a low credit score, you might think a co-borrower’s excellent credit history will help you qualify for a better mortgage rate, but this isn’t always the case.

When two people apply for a joint mortgage, mortgage lenders do not use the highest score or an average of both credit scores when determining the rate. Instead, the mortgage rate is based on the lowest credit score. It doesn’t matter if your co-borrower has an 800 credit score. If you have poor credit, the lender will use your score to underwrite the mortgage because it’s the lowest of the two.

A Co-borrower Helps Lower Your Debt-to-Income Ratio

Having a co-borrower can strengthen your mortgage application, especially if you have a high debt-to-income ratio (DTI). Your debt-to-income ratio is the percentage of monthly income that goes toward debt payments. To qualify for a mortgage, your DTI (including the mortgage payment) should not exceed 36%. A high DTI can reduce purchasing power.

Before approving a mortgage, the bank will review your income and debts to determine how much you can afford. The more you owe on credit cards, auto loans and student loans, the less you can spend on a property. If debt limits your purchasing power, a co-borrower may help. Since mortgage lenders include a co-borrower’s income and assets when underwriting the application, applying with a co-borrower can result in a lower DTI and help you qualify.

There’s just one caveat.

Some mortgage lenders do not allow non-occupant co-borrowers on mortgage loans, and depending on the type of loan program, a non-occupant co-borrower’s income cannot be used for income qualification purposes. If you’re thinking about adding a co-borrower, make sure you understand the bank’s guidelines.

How a New Job Can Affect a Mortgage Approval

A mortgage lender doesn’t lend money until an applicant can prove their work history. This is why lenders request copies of past tax returns and recent paycheck stubs before approving home loan applications. But getting approved for a mortgage involves more than having a job — you need stable employment. And unfortunately, getting a new job or starting a new career can jeopardize a mortgage approval.

If you’re pre-approved for a mortgage, a major change to your employment status can postpone or possibly cancel the loan. Even if you don’t have an employment gap and there’s a seamless transition from one job to another, any change will prompt your lender to take a second look at your application. The bank will verify your new employment and they’ll need to confirm that your income can support the mortgage.

A job switch might not stop a mortgage, but it will slow the process. Ideally, you should avoid any employment changes until after the mortgage closing. But if you find yourself job hunting after getting pre-approved, here are a few tips to protect your approval.

Find a Job in the Same Field

Mortgage guidelines vary from lender-to-lender. Some banks not only require two-years of consecutive income, they also require two-years of employment with the same employer or in the same field. If you get a new job after you’re pre-approved, the lender may be okay with the switch as long as you’re working in the same field. But you could run into problems if you’re starting a new career.

Since this is a new field for you, there may be a probationary period where your new employer can terminate your job if you’re not a good fit. How would you pay the mortgage if this were to happen? A new career can raise questions and put doubts in the lender’s mind, which can make is harder to qualify.

Make Sure Your Income Remains the Same or Increases

If you have to switch jobs after getting pre-approved for a mortgage, make sure your income remains the same or increases. If your new job pays less, the lender will reassess affordability. You may still qualify for the mortgage, but you’ll likely qualify for less money. In addition, the way you’re paid should remain the same. If you were pre-approved as a salary employee, but you’re now an hourly or commission-based employee, the lender might question whether you can afford the mortgage because your income may fluctuate from week to week. The bank will request additional information from your new employer and your most recent paycheck stub to get an idea of your expected earnings. If the lender isn’t confident in your ability to make the payment, the bank will cancel the mortgage.

Don’t Start Your Own Business

If you lose your job after getting pre-approved for a mortgage, this isn’t the time to take a leap of faith and start your own business. Even if you’re starting a business in a field you’re familiar with, a mortgage lender will not lend funds for a home purchase. It’s much harder to get a mortgage when you’re self-employed. Qualifying as a self-employed buyer will require at least two years of profitable tax returns. If you don’t want to jeopardize your mortgage approval, it’s important to find employment as soon as possible, preferably within the same field and earning the same income, and then transition into self-employment after closing on the mortgage loan.

How to Avoid Private Mortgage Insurance

Buying a house no longer requires a 20% down payment, but some banks will require private mortgage insurance (PMI) if you purchase with less money. PMI is a type of insurance that minimizes your lender’s risk and protects the bank in case you default. You purchase the policy, but your lender is the beneficiary. Annual premiums are typically between 0.5% and 1% of the loan balance and paid monthly as part of the mortgage payment. Since PMI can increase your monthly housing cost, you may look for ways to avoid this expense. Giving your lender a 20% down payment is the obvious solution, but like so many buyers, you may not have this type of cash lying around. Fortunately, there are ways to buy a house without the added expense of private mortgage insurance.

Piggyback Mortgage

Piggyback mortgage loans became practically extinct after the 2008 housing bust, but they’re slowly making a comeback. If you don’t have a 20% down payment, yet you want to avoid private mortgage insurance, these loans might be an option depending on your lender. With a piggyback mortgage, you’ll take out a first mortgage for 80% of the purchase price, a second mortgage for 10% of the purchase price, and then you’ll give the bank a 10% down payment from your own funds.

Special Mortgage Financing

Fannie Mae and Freddie Mac are two of the biggest buyers of conventional mortgage loans, and according to their home loan guidelines, a borrower must pay PMI if purchasing a property with less than 20% down. Most banks don’t have the capacity to retain every home loan they originate, so they must sell their mortgages. Since Fannie Mae and Freddie Mac only purchase loans that comply with their guidelines, many lenders require PMI. Some lenders, however, do not sell their mortgage loans. These banks have the flexibility to offer specialized financing, in which case they may waive PMI if you have excellent credit, or you might avoid PMI by paying a slightly higher interest rate. Special financing programs are more common with community banks and smaller mortgage lenders.

Apply for a VA Home Loan

If you’re active-duty military or a veteran, you may qualify for a VA home loan. These loans, which are backed by the Department of Veteran Affairs, make it easier for military personnel to buy homes. Not only can you get a VA home loan with no down payment, you don’t have to pay private mortgage insurance with these loans.

Make Higher Mortgage Payments

Even if you start off paying PMI, you can eliminate this expense and reduce your monthly housing cost. Mortgage lenders are required to cancel PMI once your loan-to-value ratio drops below 78%. The sooner you pay down your mortgage balance, the quicker you can get rid of PMI. You can pay down your mortgage faster by making larger mortgage payments every month, or by making an extra principal payment every year.

Rules for Using Gift Funds as Down Payment for a House

If you meet the lending requirements for a VA or USDA home loan, you may be able to purchase a house with zero down. Conventional and FHA mortgages, on the other hand, do require a down payment of 5% and 3.5%, respectively. A down payment is one of the biggest roadblocks to homeownership. The good news is that mortgage lenders recognize this challenge and they allow borrowers to use gift funds as down payment for a house. There are, however, specific rules with using gift money.

1. The Gift Must Come From a Family Member

When your mortgage application goes through underwriting, the underwriter will ask about the source of your down payment funds. And while banks do allow borrowers to use gift funds as down payment, they don’t allow all gifts. Some mortgage lenders only allow gifts from a family member, such as a parent, a grandparent or a sibling. Other lenders are more flexible and allow gift funds from a non-relative, such as a friend or godparent. However, the lender will inquire about your relationship with the giver. If you can provide an explanation or proof of a close relationship, the lender may approve the giver.

2. Gift Funds Cannot Be a Loan

Banks do not allow applicants to borrow funds for their down payment. If you’re using financial gifts from a family member or an approved non-relative, the giver must sign a letter stating that funds are in fact a gift, and not a loan. The gift letter includes information such as the giver’s name, address and phone number, their relationship to the borrower, and the exact amount of the gift. Some banks provide the letter, whereas others accept a notarized letter from the giver. Additionally, the giver must provide the lender with copies of their bank statements as proof of their ability to gift a down payment.

3. Gift Fund Limitations

There also rules regarding how much a giver can gift towards your down payment. Both FHA and conventional loans allow gift funds for down payments. With a conventional loan, gift funds can pay the entire down payment if you’re putting down 20% or more. If you put down less than 20%, you will have to contribute some of your own funds. The minimum contribution varies by lender. In the case of an FHA loan, gift funds can cover 100% of your down payment. But if you have a low credit score between 580 and 619, you’ll have to pay at least 3.5% of the down payment from your own funds.

Three Reasons Why You Should Choose a 15-Year Mortgage

Some homebuyers choose a 30-year mortgage without giving any thought to the possibility of a 15-year mortgage. Since a 15-year mortgage cuts the loan term in half, many borrowers assume they’re unable to afford the higher payment, so they never run the numbers to see if a shorter term is doable.

There are undeniable benefits of a 30-year mortgage, such as a more affordable payment and the ability to qualify for a larger loan. But there are also good reasons to choose a 15-year mortgage.

1. Build Home Equity Faster

A 15-year mortgage pays off your mortgage loan in half the time, and since you’re paying off your home faster, you can build equity quicker. Equity is the difference between your home’s value and what you owe your mortgage lender. Even if property values in your area don’t increase much from year to year, your equity value will rise as you pay down the mortgage balance. Also, the faster you build equity, the faster you can get rid of private mortgage insurance (PMI). This insurance compensates your mortgage lender if you default on your mortgage loan, and it’s required if you put down less than 20%. Mortgage lenders cancel PMI once your loan-to-value ratio drops to 78%.

2. Qualify for a Lower Interest Rate

Since you’re financing the home for a shorter length of time, 15-year mortgages typically feature lower mortgage rates than 30-year mortgages. This results in paying less interest over the course of your loan term. You’ll pay more on a monthly basis for the house, but the overall cost of the home will be lower. Understand, however, that a low interest rate isn’t guaranteed with a 15-year mortgage. Other factors also determine your mortgage rate, such as your credit score and the size of your down payment.

3. 15-Year Terms Don’t Double the Mortgage Payment

Some homebuyers never consider a 15-year mortgage because they believe cutting the loan term in half doubles the mortgage payment. This isn’t the case, however. You can expect a higher monthly payment with a 15-year term, but the payment may only increase by half. For example, a 30-year fixed-rate mortgage for $200,000 at 3.46% has a monthly payment of $1,101.96 (including taxes and PMI). If you were to shorten the mortgage term to 15 years, the monthly payment increases to $1,634. This is a monthly difference of only $533.

Four Common Myths about Refinancing Your Mortgage

If you’re looking for more affordable mortgage terms, refinancing your home loan can help you receive a lower interest rate and a lower monthly payment. For a smooth process, it’s important to understand how refinancing works before submitting an application. But even if you educate yourself, you could receive outdated information. To discern whether now’s the right time to refinance your mortgage, you have to distinguish truth from fiction.

Here are four common myths about refinancing a mortgage.

Myth #1: You can’t refinance without equity

Guidelines for refinancing a mortgage have changed in recent years. In the past, borrowers needed at least 20% equity to qualify for a mortgage refinance. Today, several conventional and FHA mortgage lenders offer refinancing with as little as 3% to 5% equity. Additionally, the Home Affordable Refinance Program (HARP) makes it possible for underwater homeowners to refinance their mortgage loans and take advantage of lower rates. Under HARP, borrowers can refinance up to 125% of their home’s value. To qualify for this program, your mortgage must be backed by Freddie Mac or Fannie Mae.

Myth #2: You have to pay out-of-pocket to refinance

Refinancing a mortgage loan creates a new loan, and just like the original loan, you have to pay closing costs or settlement fees. These costs range from 2% to 5% of the mortgage loan, and include the loan origination, title search fee, attorneys fee, appraisal, etc. There are, however, ways to avoid spending thousands out-of-pocket in upfront fees. Some lenders will roll mortgage refinancing fees into your loan balance, and other lenders may pay these costs if you agree to a slightly higher interest rate. This is commonly referred to as “no-cost” refinancing.

Myth #3: You can borrow as much as you want from your equity

A cash-out refinance lets you access your equity without selling the home. You can borrow cash from your equity and use the money for home improvement projects, debt consolidation, college tuition, and other purposes. But just because you have substantial equity in your house doesn’t mean you can borrow all of your equity. Typically, the lender will only let you borrow up to 80% to 85% of your home’s equity.

Myth #4: Your current mortgage lender will offer the best refinance options

Mortgage lending is a business, and understandably, your current lender wants to retain your business. This is likely the case if you’ve been an excellent customer over the years. Likewise, if you’re satisfied with the lender, you may prefer continuing the relationship. However, a long-standing history with your lender doesn’t mean the bank will offer the best deal on your refinance. Request a quote from your present lender, and then speak with two or three other banks and compare these offers. You may receive a lower interest rate and cheaper closing costs elsewhere.

Three Ways Bad Credit Affects Home Loan Terms

A low credit score doesn’t necessarily mean you can’t get a mortgage loan, but at the same time, you shouldn’t expect the most favorable loan terms. Several mortgage products are available to borrowers with low credit scores. You only need a 620 credit score to qualify for a conventional mortgage, and you can get an FHA mortgage with a credit score as low as 500. But while you might have options, it is important to understand how bad credit affects your home loan terms.

Higher Mortgage Interest Rates

Although mortgage lenders have relaxed their guidelines and will approve borrowers who have low credit scores, this doesn’t mean “everyone” with bad credit qualifies for a home loan. The lender will check your credit history and review your income. If you have more than one to two late payments in the past 24 months, you may not qualify. There are also rules for qualifying for a mortgage after a bankruptcy and foreclosure. In the case of a foreclosure, you have to wait at least three years to get approved for an FHA home loan, and seven years for a conventional home loan.

But even if your recent performance demonstrates good credit habits and you’re approved for a loan, getting a mortgage with a low credit score means you’ll pay a higher interest rate than an applicant with good credit. For example, a borrower with an 800 credit score may qualify for an interest rate of 3.8%, whereas a borrower with a 640 credit score qualifies for an interest rate of 4.6%. If you’re looking to buy a home at $200,000 with a 30-year term, that’s a monthly difference of $93.

Bigger Down Payment Requirements

Down payments are required with a conventional mortgage and an FHA mortgage. Both loans feature a low-down payment option which lets you purchase without a 20% down payment, but some banks will require a larger down payment depending on your credit score.

FHA mortgage loans only require a 3.5% down payment if you have a credit score of at least 580. If your credit score is between 500 and 579, the down payment increases to 10% of the purchase price. Conventional loans require a minimum down payment of 5%, but your lender may require 10% if you’ve had a bankruptcy, foreclosure or short sale within the past seven years.

Higher Private Mortgage Insurance Premiums

Private mortgage insurance (PMI) is a type of mortgage insurance with conventional loans. You’re required to pay this insurance if you purchase a home with less than a 20% down payment.

Some borrowers don’t understand how credit scores affect private mortgage insurance premiums. With an FHA home loan, mortgage insurance is 0.85% of the loan balance regardless of a borrower’s credit score. PMI premiums with a conventional loan vary and range between 0.5% and 1% of the loan balance. Conventional lenders take into account different factors when determining the cost of PMI, such as the mortgage balance, the size of your down payment and your credit score.

PMI protects lenders in case a borrower defaults on his mortgage. Since borrowers with low credit scores have a higher default risk, they typically pay higher mortgage insurance premiums than borrowers with excellent credit.

Four Questions about Fannie Mae’s 97% Loan Program

If you don’t have the standard 5% down payment to qualify for a conventional mortgage loan, you may be eligible for one of several low down payment options.

FHA mortgage loans are a popular choice because they only require a 3.5% down payment. However, these mortgages can be costly in the long run due to the loan’s upfront mortgage insurance premium (MIP), and the fact that borrowers have to pay mortgage insurance for the entire duration of the loan term. For these reasons, you may prefer a conventional mortgage.

The good news is that there are two ways to get a conventional mortgage with less than 5% down. Fannie Mae’s 97% standard loan and HomeReady program are both conventional products that only require 3% down. If you’re purchasing a house for $200,000, you’ll only need $7,000 with a 3% down mortgage compared to $10,000 with a 5% down mortgage.

But since these are not your typical conventional mortgages, here is what you need to know about 97% loan products.

What Credit Score Do I Need?

Minimum down payment requirements for a conventional mortgage vary widely depending on the lender. Some lenders require a minimum credit score between 660 and 680, whereas others will approve borrowers with scores as low as 620.

Fannie Mae’s 97% loan programs only require a minimum credit score of 620, making it easier for borrowers with challenged credit histories to qualify for mortgages.

What Type of Properties Can I Purchase?

Fannie Mae’s 97% loan programs can be used to purchase a variety of properties, including single-family dwelling, townhouses, condos and other one-unit properties. The only exclusion is that these loans cannot be used to purchase manufactured homes.

Are 3% Loans Available to All Borrowers?

Since these are specialized loan products, there are limits with regard to qualifying. With Fannie Mae’s 97% standard loan, you can only qualify for financing if you’re a first-time homebuyer, or if you haven’t owned within the past three years. This loan is designed to help people with high enough credit scores and income realize their dream of homeownership sooner.

Fannie Mae’s HomeReady program isn’t limited to first-time homebuyers, but these are income-based loans, and borrowers are required to complete an online home buying education course. Income requirements vary based on the location. For example, in some areas you can only qualify for this program if your income is below 80% of the area median income.

Do I Have to Pay Private Mortgage Insurance?

Private mortgage insurance (PMI) is required on any home purchase with less than 20% down. PMI is an insurance that protects lenders in the event that a borrower defaults on the mortgage. This is an annual premium paid every month with the mortgage payment, and it can range between .5% and 1% of the loan balance depending on your credit score and down payment. But don’t let private mortgage insurance stop you from getting a conventional loan. The bank will cancel PMI when your equity reaches 20%.

What’s the Difference Between an FHA and Conventional Mortgage Loan ?

A conventional loan and an FHA loan are both excellent products when you are ready to purchase a house. Because FHA mortgages are guaranteed by the Federal Housing Administration they’re generally easier to qualify for and may feature slightly lower interest rates than a conventional mortgage.

But while an FHA loan can open the door to homeownership, a conventional loan may be a better option depending on your circumstances. Here’s a look at a few key differences between an FHA loan and a conventional loan.

Down Payment Requirements

One primary difference between both products is the down payment requirement. Currently, FHA mortgages only require a down payment of 3.5%. Some conventional mortgage products have down payments as low as 3%, but these programs are often limited to first-time homebuyers and low-to-moderate income borrowers. The standard minimum down payment for a conventional mortgage is 5%.

Credit Score Requirements

Credit score requirements for a mortgage vary by bank. Typically, you need a minimum credit score of 620 to qualify for conventional mortgage products backed by Fannie Mae or Freddie Mac—although some lenders may require minimum scores between 640 and 660.

FHA loans offer flexible credit standards. You can qualify with a minimum credit score between 500 and 580, and it’s also easier to qualify for an FHA mortgage after a bankruptcy or foreclosure. With an FHA loan, you can purchase a home three years after a foreclosure and two years after a bankruptcy, versus seven years after a foreclosure and four years after a bankruptcy with a conventional mortgage.

Maximum Housing Ratio

FHA loans allow a higher housing ratio, which is the percentage of your gross income that goes toward your mortgage payment. With a conventional loan, your mortgage payment— including principal, interest and taxes—cannot exceed 28% of your gross income. With an FHA home loan, you can purchase a home with a mortgage payment up to 30% of your gross income. This increases purchasing power, allowing you to buy a more expensive property.

Mortgage Insurance

Since neither mortgage requires a 20% down payment, you are required to pay mortgage insurance with an FHA and conventional mortgage. Private mortgage insurance with a conventional loan costs between .5% and 1% of the mortgage balance annually, whereas FHA mortgage insurance is .85% annually. The amount paid for private mortgage insurance with a conventional product is based on your credit score. You might pay more for mortgage insurance with a conventional loan, but this doesn’t mean you’ll save money with a government loan.

Conventional loans are attractive because lenders eliminate private mortgage insurance once the loan-to-value ratio drops to 78%. This isn’t the case with an FHA loan. Mortgage insurance is required throughout the entire loan term with an FHA mortgage, and the only way to get rid of this insurance is to refinance the loan to a conventional loan. Additionally, FHA mortgages charge an upfront mortgage insurance premium, which is added to the loan balance and paid off over the term of the loan.

Is an Adjustable Rate Mortgage Right for You?

Fixed-rate mortgages offer greater stability and predictability, which is why these loans are a first choice for many homebuyers. With this type of loan, the interest rate doesn’t change over the life of the loan. The monthly payment remains roughly the same from year to year, so it’s easier to budget long-term.

But although a fixed-rate mortgage offers predictable housing costs, an adjustable-rate mortgage (ARM) may be a better option depending on the circumstances.

What is an Adjustable-Rate Mortgage?

Adjustable-rate mortgages have a reputation for being risky and dangerous because the interest rate adjusts or resets every year based on market trends. With each adjustment, the rate can increase, decrease or stay the same. This causes fluctuations in mortgage payments. But adjustable-rate mortgages also have an initial fixed rate, which is usually lower than the rate of a fixed-rate mortgage, resulting in significant savings during the early years.

For example, if you borrowed $150,00 at a rate of 4% with a 30-year fixed-rate mortgage, you’d pay about $716 a month (excluding taxes and insurance). But if you selected a 5-year ARM with a rate of 3.33%, your mortgage payment would drop to $656—a $60 monthly savings. An adjustable-rate can work if you’re looking to purchase a more expensive house, yet you need a low rate to keep payments within an affordable range.

But the fact that you can save money with an adjustable-rate isn’t the only reason to choose this option. The fixed-rate with an ARM is temporary. And since we can’t predict mortgage rates from one year to the next, there’s always the risk of your rate skyrocketing with each rate adjustment, resulting in higher housing costs. So while adjustable-rate mortgages are tempting, these loans aren’t the right choice for everyone.

When Does an Adjustable-Rate Mortgage Make Sense?

If you’re a first-time homebuyer who only plans on living in the house for a few years, or if you’re relocating for work within the next few years, an adjustable-rate mortgage might be a better choice than a fixed-rate mortgage. Since the rate with an ARM is fixed for the first three, five or seven years, you’ll most likely sell the property before your first rate adjustment.

Then again, maybe you plan to live in the house longer than seven years. An adjustable-rate mortgage isn’t as risky if you anticipate your income increasing over the next few years, and if you’re okay with the possibility of higher mortgage payments. Perhaps you’re currently the primary breadwinner while your spouse completes his or her schooling, and you expect your household income to double in the next couple of years once your spouse graduates.

But even if you don’t move and your income doesn’t increase, there is the option of refinancing an adjustable-rate mortgage to a fixed-rate mortgage before the first rate adjustment. Just know that there are no guarantees that you’ll be able to switch your mortgage. Refinancing involves applying for a new mortgage, at which time you’ll have to meet the lender’s income, employment and credit guidelines to qualify for the loan.

How to Turn a Mortgage Rejection Into an Acceptance

Between down payment requirements and tougher credit guidelines, qualifying for a mortgage is anything but easy. Mortgage lenders reject about 1 in 2 refinance applications, and about 30% of purchasers are denied a mortgage, according to Bankrate.com.

A mortgage rejection can come as a surprise and cause a lot of self-doubt, but you don’t have to take “no” for an answer. Here are four ways to turn a mortgage rejection into an acceptance.

Get your name off a cosigned loan

Some people don’t fully understand the impact of cosigning a loan. If you cosign a loan or credit card, this account shows up on your credit history and increases your debt-to-income ratio. Too much debt can make it harder to qualify for a mortgage and reduce purchasing power. You’re a joint borrower, so you can’t tell the bank to remove your name from the loan. But you can ask the primary signer to refinance the loan in his name only, which involves applying for a new loan to replace the old loan. Once the old loan is paid off, you’re no longer liable for the debt, which improves your debt-to-income ratio.

Build up your savings account

Banks require a lot of information from borrowers, including bank account statements. This is how lenders check to make sure applicants have enough assets to pay the down payment and closing costs. If you don’t have enough cash in savings, the bank isn’t going to approve the mortgage application and waste time going through the lending process.

Typically, you need a down payment between 3.5% and 5% to purchase a home. If you don’t have enough in reserves, the bank will reject your application until you’ve built up your savings.

Fix credit report errors

One of the biggest mistakes you can make when purchasing a house is forgetting to check your credit report beforehand. Lenders will pull your credit report to review your debt and payment history. And unfortunately, it only takes one error or mistake to trigger a mortgage rejection. It doesn’t matter if you’re a victim of fraud, or if creditors report wrong information on your credit report, you can’t qualify for a mortgage until the matter is resolved, which could take weeks or months.

If you’re thinking about buying a house, begin checking your credit report at least six to 12 months prior to submitting a home loan application. You can request a free credit report from each of the bureaus annually, and checking your own credit report doesn’t result in an inquiry. Visit annualcreditreport.com to order your copies.

Get a mortgage with a local or community bank

Big or national banks have tougher lending guidelines. If you don’t fit a certain criteria, it may be harder to get a mortgage. But if you work with a local or a community bank that doesn’t sell their mortgages to Fannie Mae or Freddie Mac it can be easier to qualify if you’re a self-employed borrower with irregular income, have a low credit score, or if you don’t have enough for a down payment. Smaller banks are sometimes more flexible with their lending standards and offer speciality products to assist borrowers who can’t qualify elsewhere.

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