Mortgage Basics

Because a big part of buying a home is applying for and getting a mortgage, we recommend you begin with a quick lesson:

Your monthly mortgage payment is made up of four parts: principal, interest, taxes and insurance (known as PITI).

• Principal is the amount of money you borrow. It is based on the sales price of the home minus the amount of your down payment. In short, principal is the amount you borrow.
  
  
• Interest, is the cost of borrowing the principal. The amount of interest you will be charged is a percent of the total amount you are borrowing. The interest percentage, or rate, can vary from lender to lender and from one type of loan to another.
  
  
• Property Taxes are due to the local government and are usually assessed annually as a percentage of your property’s assessed value.
  
  
• Insurance and taxes are not always a part of your monthly mortgage payment. With the lender’s agreement, you may opt to pay for your home’s insurance and property taxes separately. Insurance is required by the lender when you use the house as collateral for the loan during the entire term of the mortgage.
  
  

 Understanding PITI

Over the life of a standard mortgage loan, usually 30 or 15 years, the entire loan amount is scheduled to be fully paid off, or amortized accordingly. In the early years of your mortgage term, the monthly payment is mostly applied toward interest and a very small percentage goes toward paying down the principal. As you continue to make payments through the years, a smaller portion of the monthly payment goes to paying the interest and a larger portion goes to paying off principal. In other words, the first payment you make will be nearly all interest but the final payment will be nearly all principal.

An estimate of annual insurance and property taxes are computed by the lender and added to your monthly mortgage payment due. The lender deposits your tax and insurance money into a separate escrow account and then uses that money to pay your tax and insurance bills as they come due.

 "The Four C's" of Application Approval

Lenders use four basic standards to approve your application for a mortgage. Different mortgage products have varying guidelines within those standards. But basically, they evaluate you as a borrower based on “the four C’s”: capacity, character, capital and collateral.

• Income (Capacity)
  The lender will determine if you have a steady and sufficient income to make the monthly payments. This income can come from a primary, second, or part-time job(s), commissions, self-employment, retirement benefits, pensions, child support, alimony, disability payments, rental property income, and a variety of sources. You will be asked to show documentation to substantiate all your sources of income.
  
  

• Credit History (Character)
  Have you paid back money you have borrowed in the past? Have you been late in making any of your payments? Have you filed for bankruptcy? Take a look at your credit report and talk to your Realtor about how you can improve your credit score if you foresee any problems.
  
  

• Savings (Capital)
  The lender will verify you have the funds to make the down payment and to pay for your share of the closing costs. They will also be interested in how much debt you have in the way of car loans, credit cards or other substantial money owed. In short, they will want to ascertain that you will have enough cash flow to make your monthly mortgage payment, and then some.
  
  

• Property (Collateral)
  Finally, your lender will require an appraisal on the home you plan to buy to determine its market value in comparison to similar homes that have sold recently in the neighborhood.
  Lenders will generally calculate your debt-to-income ratio to determine how much money they will lend, to compare your anticipated monthly housing payment to your gross (pre-tax) monthly earnings and your other monthly debt requirements. By adding up your additional debt, including credit cards, car loans, student loans, consumer loans and any other monthly financial obligations, you can figure out your debt-to-income ratio.

Traditionally, lending institutions use 28/36 ratios, which means you are allowed 28 percent of your gross monthly income for housing expenses, and 36 percent of your gross income to pay for housing plus any other debt. In some cases, those numbers can be bumped up slightly. Check with your lender.

A quick way to estimate a reasonable purchase price is to estimate two and a half times your annual income.

Once the lender has a complete list of your income and expenses, and can calculate these ratios, your lender will give you a maximum loan amount.

Armed with a maximum loan amount, you are ready to start shopping.