8-5-05
BY MIKE MCNAMARA
Part of what makes buying a home particularly daunting is the vast new set of terms and acronyms we are forced to digest in order to stay on top of the whole process. This article will focus on clarifying some of the jargon and phraseology which is often heard but often misunderstood when buying a home.
Equity
Equity is the homeowner’s financial interest in a property. It is calculated by subtracting the amount still owed on the mortgage from the fair market value of the property.
For example, let’s say you buy a place via 100 percent financing (i.e. no down payment) for $150,000. Your mortgage at this point is $150,000, the value of the property is also $150,000 so you have zero equity in the property. After being a homeowner for a little more than a year, similar properties in your neighborhood are selling for around $159,000, and your mortgage, after paying down a small amount of principal through your monthly payments, is at $149,000. So now you have $159,000-$149,000 = $10,000 of equity (or 7 percent) in your property.
Why is equity so important? Well for one, you can borrow against the equity you have in your home. You can secure a Home Equity Line of Credit (or HELOC, pronounced hee-lock) for that $10,000 mentioned above to handle personal expenses or to make improvements to your property. The other reason equity is so important is that homeowners with less than 20 percent equity in their property must pay Private Mortgage Insurance.
Private Mortgage Insurance (PMI)
PMI is an insurance policy offered by a private company to protect a lender against loss on a defaulted mortgage loan. It is paid for by the borrower and usually required when the down payment is less than 20 percent of the purchase price.
The general rule of thumb is to avoid PMI. You cannot claim it on your taxes and its purpose is to protect the lender, not you.
So how can we avoid this unnecessary expense? With a second mortgage. If you are not putting any money down, for example, you would have one mortgage for 80 percent of the financing and another for 20 percent. Neither mortgage would require PMI since neither covers more than 80 percent of the purchase price. This type of program is often referred to as an “80/20” or an “80/15/5” if you’re putting down 5 percent, an “80/10/10” if you’re putting down 10 percent. That second mortgage will have a considerably higher rate than the first, but that extra interest can be deducted on your taxes and is generally less than the added expense incurred with PMI. In a few years, if your property appreciates significantly, you can refinance and get rid of that second mortgage altogether.
Escrows
This is another important term to understand. An escrow account is basically a budget plan provided free-of-charge by the lender. Real estate taxes are collected every six months. Rather than having to come up with a sizable payment twice a year, you are able to break down your taxes into monthly installments, which are included with your mortgage payments. The lender then cuts the check to the government every six months for you.
Why is the bank being so friendly? Because it is also protecting its investment. If those taxes are not paid, the government could place a lien on the property that would have a higher priority than the bank’s lien, resulting in huge losses for the bank.
Depending on when during the tax period you close, the lender will collect one to four month’s worth of real estate taxes at closing to start out the escrow account. This is done to ensure that the bank will have enough money in the escrow account to pay any tax bill when it is due. If you have a surplus in your account at the end of the year, the lender will send you a refund.
Debt-to-Income Ratio (DTI)
Debt-to-income ratio (DTI) is exactly what its name suggests—the amount of money you owe each month divided by the amount of money you earn. In general, lenders want your DTI to be no higher than 38 percent; therefore, your DTI is critical in determining your borrowing potential. For example, let’s say you make $36,000 annually, or $3,000 per month. You might have a $200 car payment and $50 in minimum credit card payments. The maximum amount of debt you can have is $1,140 (38 percent of your $3,000 monthly income), so if we subtract the $250 of current debt from the $1,140 of potential debt, we find that you have $890 that can go toward your home payment. Your home payment includes your mortgage, real estate taxes, assessments (if you’re buying a condo), and insurance.
Fear not: there are several possible solutions if your DTI is a bit high. Lenders have much more flexibility with your DTI if you have a great credit score, a sizable down payment, or both. You can also bring in a co-signer, such as your parents or other family member that wants you to stop burning that rent money, to help lower your overall debt-to-income ratio. (For the record, I had to find a co-signer when I bought my place—it’s not so bad.)
Good Faith Estimate (GFE)
The Good Faith Estimate (GFE) provides you with an honest approximation of the closing costs, down payment balances, prepaid expenses and all other charges you will be responsible for at closing. The GFE is one of several government-required disclosures that you will receive at the time of or within three days of applying for a mortgage.
You should hold your mortgage consultant or loan officer to this estimate, with a reasonable amount of leeway. The lender can only estimate at the time of application what expenses such as attorney fees, title charges and other such variable costs will be. These expenses are set by other parties or chosen by the seller or buyer, not the lender. However, the lender should be accurate with its own fees. As a rule of thumb, you should be concerned if the final closing costs are more than 15 percent higher than the estimate.
The Good Faith Estimate is a great way to wrap up this article as it will be the primary focus of next month’s installment of “Owning a Home.” Yes folks, we’ll be digging into everyone’s favorite topic of conversation: closing costs! If that doesn’t spell fun and excitement, I don’t know what does.
In the meantime, if there are other terms or acronyms you would like clarified, feel free to call or e-mail me anytime. As always, send me any comments or suggestions about this article and let me know if there are topics you would like to see discussed.
Mike McNamara has been an actor in Chicago for seven years in theatre, commercials, television and film. He is also a Mortgage Consultant and Loan Originator with West America Mortgage Company. He can be reached anytime at 773/398-0021 or McNamara310@aol.com.