Understanding conventional, FHA, and adjustable rate mortgages

Home Mortgage Summary

The general subject of home mortgages can be daunting and complex to many people. However, there is no mystery or ambiguity to how they work. Rather, they are pretty simple to render and perceive once the basics are known. This report shall cover basic mortgages, Federal Housing Administration (FHA) mortgages, adjustable rate mortgages (ARM's) as well some general advice and items to consider. Mortgages should not be (and cannot be) entered casually in light of the financial implications and the recent history surrounding the industry. However, mortgages are the single largest way to create wealth for most Americans.

Home Mortgages

Even with the recent upheaval and problems relating to the mortgage industry, the basic structure and formulations that lead to mortgages being created has not changed. There has simply been a reform of who gets mortgages and what hoops they have to jump through to get said mortgages. Even after the changes, the three main types of mortgages are conventional, Federal Housing Administration (FHA) loans, and adjustable rate mortgages (ARM's). They all work similarly but there are noticeable differences from one to the other. This report will explain how they all work and there will also be a quick listing of other factors that should be taken into account.

Federal Housing Administration (FHA) Loans

The next major type of loan is done by the Federal Housing Administration. At this time, the minimum required payment is 3.5%. It was three percent before the housing crash of 2008-2010. However, the rate was raised just a bit so as to make the standards a little tighter. However, the reduced down payment of the FHA loan program as well as a break on the typical penalties for doing such a small down payment relative to the value of the house make this an attractive option for many first-time buyers. That being said, the costs of executing and creating the mortgage can be a little higher (but sometimes less) than a conventional mortgage. However, it depends on the circumstances. Lastly, the highest purchase price allowed for FHA loans is either $271,050 (for lower-cost markets) or $625,500 (for higher-cost markets). Examples of the higher-cost markets include parts of California, Washington DC and New York City. These amounts are adjusted every year based on inflation and cost of living. Like conventional mortgages, the interest rate on these loans is fixed and stays the same for the life of the loan. Also like conventional mortgages, the term of the loan is usually fifteen or thirty years, the rate is usually fixed and the interest rate varies based on the term of the loan (FHA, 2015).

Adjustable Rate Mortgages

The last major type of home mortgage loan is adjustable rate mortgage. As the name suggests, these are loans where the rate is not fixed. At fixed points, usually once a year, the interest rate of the loan jumps up or down based on the interest rates set by the Federal Reserve. When one hears about references to payments shooting up to a point where they could not be afforded during the recent Great Recession, these are typically the loans that those people were talking about. Interest rates have since collapsed and were in the basement from 2010 to 2014. They are just now starting to edge up a bit. Regardless, adjustable rate mortgages can be attractive if the prevailing interest rates are low. However, the payment will shoot up if the interest rate shoots up and home buyers using this mortgage type need to be aware of this. Typically, there is a several year period where the rate stays fixed. However, it is adjustable thereafter and typically this lasts for the life of the loan (Bank Rate, 2015).

Other Considerations

In addition to the qualifications above, there are a few other odds and ends that need to be discussed. First, there are also loans known as "interest only) loans where the person borrowing the money only pays the interest and nothing else. This leads to the principal amount owed being flat but can be useful if a person wants to own and control a property but not actually have to pay down against the principal. Also, there are fairly consistent income and debt guidelines that people must adhere to when requesting a loan. A common set of ratios used is the 31/43 ratio. This references that a borrower's prospective house can be no more than 31% of their income and their total debt (including said house payment) can be no more than forty-three percent of their income. For people with poorer credit or with certain high-risk lenders, those percentages might be lower. For the more affluent and well-off, those ratios can be much higher with the overall debt percentage number being as high as fifty percent (Consumer Finance, 2015).

However, prospective home buyers need to bear in mind that the home market crash was brought on by a number of factors. The lenders, buyers and lax government oversight that led to the crash have been corrected. Some say there has been an over-correction. Lenders are typically much more careful about who they lend to and when. The amount of paperwork and hoop-jumping required to get a loan is often much higher nowadays than it used to be. Regardless of what a given lender does, typical proofs and requirements include proof of income, proof of taxes paid, proof of good credit history and so forth. Credit history could include a review of whether there are missed payments, bankruptcies, charge-offs, too much debt, too little debt/credit history and so on (HLLC, 2015).

People that seek to buy a house need to keep several things in mind before taking the plunge. First, a lower a credit score will almost always mean a higher rate. Having a good amount of income is certainly helpful and will help a loan go through more often than it does not. However, if there is any sort of pervasive history of missed payments, late payments, non-paid accounts, balances that are too high, too many accounts with balances, too many inquiries for credit and so forth, those items greatly reduce the likelihood that a loan will be extended. If/when a loan is extended, a lower credit score and/or poor credit profile will lead to a loan that costs the borrower a lot more. This is common practice of banks and lenders as they are taking a higher statistical risk when they lend to such people. After all, one of the best predictors of future behavior is prior behavior (HLLC, 2015).

Also, borrowers need to make sure that they house they are set to borrow is not a mess when it comes to its condition and whatever repairs or remodels are needed. Some people are very good about keeping their house updated and in good shape. However, many other houses fall behind in terms of modernity and upkeep. The person selling the house might be willing to make repairs or knock money off the house price. However, they might not do so. As noted before, the bank or lender will typically lend based on the appraised value of the house. In addition to that affecting what the bank will lend, that will also tend to affect the purchase price of the home. If the market is weak, there is a strong chance that the home will sell for less (if not much less) than the appraised value of the house. Other factors include people that are really needing to sell due to moving or monetary/debt issues. On the other hand, if a house is in high demand and the market is strong, there can be a bidding war and the homeowner might get more than the appraised value of the house. For those that are doing the bare minimum payment, that can present a problem (HLLC, 2015).

Finally, homeowners need to understand that while renting has tradeoffs, the same is true of buying. When renting a house or apartment, a broken water heater or other similar problem is typically solved by a quick phone call and a visit from maintenance. If the problem is normal wear and tear, there is usually no expense to the renter as it is the responsibility of the property owner or manager to deal with that. However, homeowners are on their own whether it is their fault or not. Further, the person putting in the water heater is going to expect to be paid up front or via some mutually agreed payment arrangement. Repairing or keeping up a house is fairly complicated and expansive. This goes double for older houses that are structurally unsafe or that have asbestos. There are considerations such as plumbing, electrical, paint, flooring, and so forth. These factors become especially important when selling the house because home buyers will typically run the other way if a house is clearly not being cared for. They will either say "no" outright, will demand that repairs be done before agreeing to anything or they will expect an offset on the price of the house so that they are not bearing the cost (or at least all of it) of getting the house up to acceptable condition. That being said, there are people that actively seek out houses that are in disrepair. They will purchase a house, fix it up quickly and then quickly sell it. This is known as "flipping" the house. However, these buyers typically offer bottom-end prices as they are looking to get a profit and thus they will never pay the appraised value of a house. If a homeowner demands too high a price, the flippers will balk and they will move on. The main point to all of the above is that homeowners would be wise to keep up their house and for more than one reason. Anyone unwilling to commit to that should rent (HLLC, 2015).

Conclusion

It is clear from the above that buying a home is one of the more exciting yet challenging parts of life. However, it is something that a good amount of Americans do at least once over the course of their life. However, one should have their financial affairs in order before they buy house. After the house is bought, it is important to at least maintain the house and then make sure that failing infrastructure and materials in the house are updated or at least restored as the house ages.