Mortgage loans basically fall into one of two categories: government or conventional. Government loans are normally insured by the Federal Housing Administration (FHA) or the Veteran's Administration (VA). Some offer lower down payments and most offer favorable terms.

Conventional loans can be either conforming or non-conforming. Conforming loans follow the guidelines set forth by The Federal National Mortgage Administration (Fannie Mae) and The Federal Home Loan Mortgage Corporation (Freddie Mac). These types of loans can be either fixed or adjustable. Each is tied into a specific rate, term and limit which can vary from lender to lender. Non-conforming loans, on the other hand, do not adhere to any strict guidelines.

How do fixed-rate mortgages work?

Fixed-rate mortgages retain the same APR throughout the life of the loan. However, the property tax and homeowner's insurance, if built into the cost of the loan, may change over time. The most popular type of fixed loan is a 30-year term.

For those who prefer a shorter timeframe, a 15-year fixed mortgage may be a better option. While the amount of time it takes to repay is shorter, you can usually secure a better interest rate (.25-.50% lower than a 30-year fixed). Besides a 15- and 30-year term, fixed loans are also available 40- and 20-year terms.

Here are some other benefits and drawbacks that a conforming fixed loan has to offer.

How do adjustable rate mortgages work?

Unlike fixed-rate mortgages, Adjustable Rate Mortgages (ARMs) are based on shorter term securities that fluctuate upward or downward based on today's leading indexes (e.g., Constant Maturity Treasury (CMT), London Interbank Offering Rate (LIBOR), or Treasury Bill). A margin is added on top of the index rate by the lender to calculate the interest rate.

Because ARMs are adjustable, they go up and down at pre-set intervals during the duration of the loan. Some offer a low teaser rate to qualify potential buyers which accelerates to a higher rate thereafter. ARMs can adjust once a year, every month, or three to five years, and are typically amortized over a 30 year period. Some offer a lifetime cap which sets the maximum rate that can be charged during the life of the loan with some states having their own percentage limits.

Here are some of the benefits and drawbacks that an adjustable loan has to offer.

Lower your payment with an Interest-only ARM loan

Another variation of the ARM is the Interest-only adjustable rate mortgage. This loan makes it affordable for borrowers to qualify for a loan by giving them the option to pay only the interest (not the principal) for the first 3-10 years of the loan. Monthly payments are usually more affordable. Afterwards, the interest rate adjusts to a traditional ARM at the current indexed interest rate with new principal and interest payments calculated for the remaining term of the loan.

Example

A 30-year ARM loan of $250,000 at 7.50% APR has interest-only payments for 5 years. The payment during this time would be $1,522 per month. After 5 years, the payment would increase to $1,816 per month.

A comparison of all the different loan types shows the potential cost savings you can achieve during the first five years of an interest-only loan versus other conventional loans.

* APR based on national average and may vary.

** Monthly payment includes principal and interest except Interest-only ARM which is interest-only for the first 5 years then jumps to $1,816.59 for the remaining 25 years (principal and interest included.)

Sub-prime loans

Borrowers who have a low FICO score will usually fall into the less than perfect mortgage category. As a result, they'll qualify for a loan but at a much higher rate. Lenders may apply stiffer pre-payment penalty fees in the form of interest payments to dissuade borrowers from building up any equity in their home. Some lenders may require a " balloon" payment to pay off the remaining balance of the loan after a fixed period of time.

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One of the components a lender uses to help determine what loan amount to approve is your down payment. A down payment not only serves as a commitment on a borrower's behalf to make good on a loan, but also acts as a lender's guarantee to minimize risk in case a borrower defaults on a loan. The more of your own cash that you can put down for a loan, the easier it is to qualify for a higher loan amount or a lower mortgage payment.

Alternative sources of funding

Since most borrowers do not have large cash reserves on-hand for a down payment, there are other alternative sources for funding. Besides tapping into your own savings accounts, other resources may include relatives, 401(k) plans, proceeds from stock sales, appraised assets, even a co-signer.

Many cities, looking to expand their communities, even offer their own down payment subsidy programs for first time homebuyers. It's not uncommon to be gifted $5,000 to $30,000 without expectation of re-payment.

Loan-to-value ratio

A down payment is always expressed as a percent of the sales price and often referred to by lenders at the "loan-to-value ratio" or LTV. For instance, a $250,000 mortgage with an LTV of 80% would require 20% down or $50,000. Using a down payment calculator can help you see what influence a different down payment can have on your monthly mortgage.

Other down payment options

Some banks even offer zero-down percentage loans which require no down payment. These types of loans are typically directed at first-time buyers with good credit who are qualified to make the monthly payment but cannot come up with a down payment. However, without a down payment the buyer has no equity in the house and the lender is at greater risk, so the interest rate could be higher.

Another alternative to buying a home without committing to a down payment is to consider a lease option to buy. As a renter, you have an option anytime during the term of the lease to buy the property at an agreed upon price from the owner. In some instances, the money you've put toward rent can be fully or partially applied toward the down payment.

Sellers can also assist buyers with their down payment. By offering a carry-back mortgage, sellers can sell their house faster in a competitive market and buyers can purchase a home they otherwise might not be able to afford.

Nearly two years ago (March 2009), the Treasury Department of the federal government introduced a program that was designed to help people who were having trouble paying their mortgages. It was called the Home Affordable Modification Program, or HAMP for short. It was supposed to provide billions of dollars from the massive stimulus package to help people modify their mortgages so they could make their monthly payments rather than lose their home. To accomplish this, banks would receive incentives from the government to modify mortgages for homeowners.

But many Republicans who are on the House Oversight Committee think the program has proven to be nothing more than a “colossal failure.” Three prominent Republicans – Jim Jordan, Darrell Issa and Patrick T. McHenry – are spearheading legislation that would put an end to HAMP because, as they say, it has “hurt the very people it promised to help” and it is “one more example of why government interference….doesn’t work and that’s why it should be repealed.”

The decision to attempt to repeal HAMP was based on information received by the Special Inspector General on the Troubled Asset Relief Program. The report said the program has many problems and it “continues to fall dramatically short of any meaningful standard of success.” Out of nearly 3 million homeowners that began going through foreclosure last year, just a little more than a half million of those began modifications that were initiated by HAMP. In addition to that, experts say that the rate of foreclosures this year could increase by about 20 percent. That would include about 3 million homes. If these numbers are correct, HAMP has not been a huge help except for the half million people it actually helped.

The legislation is scheduled to go to the House Financial Services Committee for a vote. McHenry is a member of that committee. However, Democrats hold a majority in the Senate. As a result, the repeal is unlikely to go through. Many Republicans, especially the ones in charge of this pending legislation, plan to continue to point out the problems with HAMP and why something else is needed to help homeowners who are having problems paying their mortgage bill. If the Republicans had a more effective solution, the Democrats may be more willing to hear what they have to say.

Once you've been approved for a mortgage, found a house, made an offer, and the offer has been accepted, you are close to calling your property home. What's left is to finalize the documents which will transfer ownership of the house from the seller to the buyer. The "close" or "settlement" usually involves the seller, real estate agent, lawyer, escrow agent, mortgage lender and buyer, and title company.

How the process works

The escrow agent and title company will present you with a variety of documents to examine and sign; title, insurance, escrow, and others - each with their own fees. Expect to pay 3-5% of your mortgage amount toward closing costs. Most fees are negotiable, with lenders picking up some of the costs upfront, while others require some costs to be paid by the borrower upfront, or built into the cost of the loan.

Settlement Costs Estimates

FEE - Average Cost(s)

Administration - $250.00

Application - $250.00

Appraisal - $300.00

Attorney fees - $300.00

Credit report - $25.00

Document preparation - $150.00

Escrow - $735.00

Fire insurance - $300.00

Flood certificate - $20.00

Hazard insurance - $300.00

Origination fee (points) - $2,500.00

Pest Inspection - $150.00

Private Mortgage Insurance (PMI)** - $2,500.00

Processing - $4,500.00

Recording fee - $475.00

Tax services - $60.00

Title examination - $150.00

Title insurance - $300.00

Underwriting - $300.00

TOTAL = $9,165,000 (3.66% of $250,000)

* Based on a $250,000 mortgage. Costs may vary by lender.

** If down payment is less that 20% of the loan amount.

For a description of the terms above, please see our mortgage glossary.

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What is Private Mortgage Insurance?

Your lender may advise you to set up an escrow account should your down payment be less than 20% or if you're a high credit risk. Less money down means the greater the risk the lender needs to assume. So to guarantee your property tax payments and private mortgage insurance (PMI) premiums, a small percent of your mortgage will be set aside each month to cover your payments. Your PMI rate will vary based on the mortgage amount and covers the lender in the event you default on your payment.

Should you pay extra for points?

Should you secure a lower interest rate on your mortgage you can expect to pay a certain percentage to the lender in the form of points. Points or origination fees are what lenders charge in interest to reduce the rate of the loan. It can be paid upfront or built into the cost of the mortgage. One point is equal to 1% of the mortgage amount (e.g., one point on a $250,000 loan equates to $2,500) which goes to the lender at closing.

Read an article on whether or not it makes sense to pay mortgage points.

Knowing how much house you can afford begins by listing the type of features you'd like to have in a home. Your individual needs, location requirements, style and the amount of effort you are willing to put into finding your dream house, all factor into the equation. How important is it for you to be near a school? How long will it take you to commute to work? How much will you spend on gas to commute to work? How safe is the neighborhood? These are all legitimate questions that can help you choose your ideal home.

Have a range in mind before you go house hunting. What is the minimum and maximum amount you can afford to buy? Compare mortgage rates. For instance, if you're considering purchasing a house in the $200,000 to $250,000 range, a down payment of $20,000 could be the difference between an additional $200-$300 monthly on a higher priced home.

Why debt ratios are important to lenders

Your debt-to-income ratio is a simple way of showing lenders what percentage of your income is available for a mortgage payment after taking all of your other debt obligations into consideration. You may see conventional loan debt limits referred to as the 28/36 qualifying ratio with FHA and VA loan ratios typically running higher at 29/41. Both numbers are percentages that are used to examine two unique aspects of your debt load.

The first number, or the front-end ratio, indicates the maximum percentage of your monthly gross income that the lender is willing to allow for housing expenses. This total includes payment on the loan principal and interest, private mortgage insurance (PMI), property taxes, and hazard insurance, collectively referred to as PITI, and homeowner's association fees, if any.

The second number, or the back-end ratio, indicates the maximum percentage of your monthly gross income that the lender is willing to allow for housing expenses plus recurring debt. This total includes credit card payments, child support, car loans, and other obligations that extend beyond 6-10 months to repay.

If you're unable to come up with a down payment to obtain a loan close to what you're paying for rent, then consider lowering your debts to decrease your back-end ratio to pre-qualify for a higher loan amount. However, depending on the lender, some have been known to approve back-end ratios as high as 60%. More aggressive lenders even offer 100% financing with no stated income, no ratio pre-determination, and no income verification mortgages.

Once you have an idea of how much additional debt you might qualify for, then you can experiment using a mortgage rate calculators by inserting different variables (e.g., expenses, credit card loan balances, down payments, etc.) to determine how much home you can afford.

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A home is one of the most expensive purchases most of us will ever make during our lifetime. Whether you decide to rent or buy, either choice comes with its own rewards and risks. Homeownership offers many advantages over renting including:

While owning your own home has many benefits, there are still risks to consider:

However, all things considered, homeownership is by far one of the best single investments you can make given the potential long-term benefits.

When does it make sense to buy?

People who have rented for several years want to purchase a home for various reasons. One reason is that owning something of value with a chance of watching their investment appreciate. Purchasing a home to save money over the long-term is another.

Example

Assume you're currently renting a 2-bedroom, 2-bath apartment with a monthly rent of $1,000. You find a 2-bedroom, 2-bath home at a market price of $250,000 (roughly the national average.) You have $25,000 saved - enough for a 10% down payment. For the purpose of this example, you're looking to finance $225,000 which includes closing costs. Compare mortgage rates.

Assuming a 6.20% APR mortage loan, your monthly payment would be approximately $1,385. If you assume a 1% property tax rate and and a 4% annual appreciation in value your effective monthly payment over five years would average $499 per month.

Costs Savings of Buying versus Renting

Source: Ginniemae.gov. These calculations are estimates only. You should always seek the guidance of financial or tax experts before making any buying decisions.

The outcome could dramatically change should an unforeseen economic downturn or financial hardship occur (e.g., home improvement costs, catastrophic damage, etc.). While, no one can predict if home appreciation values will spiral downward, or if mortgage interest rates will rise, it's clear that under the right circumstances home ownership can be financially rewarding.

Once you are on your way to homeownership there are certain precautions you will want to take to further minimize your risks. Here are some tips to make your buying experience a more positive one:

Know what you are paying for upfront. Throughout the mortgage lending process, you will be faced with a list of fees. From origination and escrow fees, to title insurance and property taxes, some may seem inflated while others fall in line with your expectations. You should always question a fee you are uncertain about.

Try to avoid an early pre-payment penalty. Everyone wants to have the flexibility of paying off their 30 or 40 year mortgage early or refinancing when rates go down. The reward is not only owning your house outright but saving on interest charges. Work with a lender who is willing to waive any pre-payment penalties or can offer you the ability to refinance your mortgage at a better rate.

Watch out for the classic bait-and-switch. A lender may try to reel you in with low interest rates, no money down, or no closing costs, only to inform you that you have a less than perfect FICO score. If you feel you are not getting the best rate and loan options, look for a lender you feel more comfortable with.

Don't let real estate agents pressure you to buy. Real estate agents are motivated to sell homes in order to earn a commission. They may convince you the property meets your needs, but you should make the decision without feeling pressured. Remember, the real estate agent works for you and has a fiduciary responsibility to protect your best interests. Always comparison shop for the best rates and programs.

Buy only what you can afford. Stay within your debt-to-income ratios and this can help prevent you from over-extending your debt. Compare mortgage rates and, if necessary, use an affordability calculators to determine the minimum and maximum amount you can afford before going house hunting and stick with your estimate.

Never buy a home on impulse. At some point during your search for a home you may decide to settle for less or get caught up in a bidding war for a house you do not necessarily want to buy. Staying within your budget can be a real challenge, especially if a lender approves you for a higher loan amount then you feel comfortable with. Give yourself time to think about your options and walk away if you feel it is a questionable deal and see how you feel about it the next day.

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