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Anatomy of a Mortgage Loan

When purchasing a home (or a rental property), most people jump straight to a mortgage loan application. Even those who have the cash may prefer to seek loan financing before purchasing a property. While some might question the reasons for choosing to finance over paying cash, financing does have its benefits.

In the first place, having cash on hand can help with emergencies or other situations. For instance, having extra cash also means you can make moves on other investment opportunities and potentially grow your wealth faster. After all, if your rate of return on your investments exceeds the interest rate for your mortgage, you make more money over time.

So, a mortgage is not always a bad idea. That said, they do come with several fees you should understand before choosing a lender. After all, the fees and interest rates they provide can cost you more for a home over time or eat into your cash flow for investment properties. 

Before we get too far ahead of ourselves, we first need to qualify for a loan, so let’s see what’s needed. After all, if you can’t get past this step, the rest may not matter.

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Qualifying for a Loan.

Many first-time loan applicants have no idea what goes into a loan’s approval. Consequently, some second and third-time applicants don’t either. However, the purpose of the application process is to determine whether the loan is a good investment for the lender. 

So, lenders apply several factors to help determine whether an applicant is a sound investment. These factors may vary slightly from lender to lender based on the applicants’ socioeconomic status and the type of loan. 

Credit Score

The first factor–the starting gate if you will–is the applicant’s credit score. An applicant’s credit score, which generally ranges from 300-to 850, reflects an applicant’s creditworthiness. Consequently, the higher the score, the better the applicant looks to a lender. A high score signals that the applicant is more likely to repay.

 For instance, someone with a score of 740 or higher probably has a great history of carrying and repaying debt, while someone with a score between 620 and 740 may have missed payments or have a moderately high debt-to-income ratio. Hence, they may not have built much of a financial history yet, either.

Scores below 620 usually indicate the applicant is high risk and has failed to pay off debts in the past. They may also have an extremely high debt-to-income ratio. As a result, lenders may choose to forgo the risk of lending to these applicants altogether. However, hope is not lost. You may need to consider some other no or low-money-down options.

Or, you could consider putting some effort into raising your credit score.

Employment

The next factor lenders consider is employment. In general, lenders need to know an applicant has a source of income to repay the loan. If you are unemployed, that is a show-stopper. Additionally, if you are newly employed, you lack enough history for a lender to know if you will remain with the company. Longer-term employment, however, screams stability.  

Naturally, having a great credit score and stable employment means nothing if the loan’s monthly repayment plan exceeds your monthly paycheck. Lenders know you have to buy groceries, pay your car note and cell phone bill, buy gas, etc. They also know you will probably pay to eat before paying your mortgage. 

Percentage of Income

Many lenders apply the 28% rule when considering an application. The rule says you shouldn’t spend more than 28% of your monthly gross income on your mortgage payment. That percentage includes property taxes and insurance for the property as well. As that percentage climbs, so does your chance of having the lender reject your applications. 

Loan Down Payment

Depending on the type of loan you seek, lenders also want to see that you have some skin in the game. They want to know that you are invested. Having your money tied up in the house makes it harder for you to walk away from the loan. Obviously, the more you pay, the lesser their risk of recouping their money if your loan goes to foreclosure. Some common loan types you may encounter include the following.  

Photo by Konstantin Evdokimov on Unsplash
Photo by Konstantin Evdokimov on Unsplash

Conventional Loan

These loans typically require a d down payment of 20% if you want to avoid paying for private mortgage insurance (PMI). If you are willing to pay PMI, you could pay as little as 3% at closing. If you have decent credit, this is your most-likely path to a loan–especially if you want to buy an investment property. 

FHA Loan

An FHA loan is tailored to borrowers with lower credit, making it possible to buy a house with a credit score of just 580 and only 3.5% down. An FHA loan is a mortgage insured by the Federal Housing Administration (FHA), which protects mortgage lenders while helping families find homes. If you plan to live in the property, an FHA loan may be a good route to go.

VA Loan

A VA loan helps Servicemembers, Veterans, and eligible surviving spouses become homeowners. If you are eligible, the Department of Veteran Affairs provides a home loan guaranty benefit and other housing-related programs to help you buy, build, repair, retain, or adapt a home for your personal occupancy. They also require No Down Payment, low-interest rates, and no need for PMI. It’s a great deal if you plan to occupy the property you purchase.

Debt-To-Income Ration (DTI)

The last factor is your debt-to-income ratio (DTI). Your DTI considers how much you owe each month to how much you earn. Specifically, it is the percentage of your gross, pre-taxed, monthly income that you must put towards your rent, mortgage, credit cards, or other debt. 

Path to a Conventional Mortgage Loan

The below figure illustrates the path to a conventional loan. Naturally, other loan types will have adjusted values for various factors, as we saw with the money-down requirements.

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What Lenders Don’t Tell You About Mortgage Loans

There are many fees you need to consider when financing a home. Often, lenders don’t disclose these until later in the application process, but they affect your total loan amount and how much you must bring to the table at closing

Because these values can vary, it is a good idea to shop around and compare costs. 

Loan Origination Costs

A loan origination fee is an upfront charge by your lender to process a new loan application. They may also be referred to as points. Lenders use these fees to offset underwriting costs and verify a new borrower.

Origination fees can run between 1-8% of a loan, so to finance $100,000, origination fees can cost between $1,000.00 and $8,0000.00. If you can’t pay this fee out of pocket, lenders are often willing to add it to your loan amount. So, now you must payoff and pay interest on a principal amount of $101,000 to $108,000. 

As an example, a couple of years back, a lender charged me 0.749% of the loan amount (points) for a better interest rate. They also charged me an Administration Fee of $1,095. Instead of opting to have it added to my mortgage, I chose to pay these costs out of pocket at closing. 

The key point is that origination fees are often negotiable, and some lenders will waive them altogether. It is worth shopping around for the best fees when considering lenders. There are also other factors to consider, but I won’t delve into them for brevity. 

Service Costs

To close on a house, many other fees come into play. Most of these will not have great deviations in the area where you purchase a property. So, your lender may not have much control over these. But, it doesn’t hurt to ask around and get an idea of what’s reasonable.  

Many of these fees are for services that ensure the property’s title is free and clear for purchase. Here are some fees I’ve encountered in the Augusta, Georgia, area. 

ServiceAmount
Appraisal Fee$450.00
Credit Report$27.35
Title – Closing Protection Letter$50.00
Title – Courier Messenger Fees$30.00
Title – Lender’s Title Insurance$200.00
Title – Title Binder Commitment$150.00
Title – Settlement Fee$695.00
Title – Examination$195.00
Total (in this specific case)$1,797.35
Service Costs Include in a Mortgage Loan

Other Costs

Your loan must also account for insurance, prepaid fees, taxes, and other government fees at closing. Nevertheless, you have options. For example, you may pay these out of pocket. Otherwise, you can include them in your loan as was the case with your origination costs. 

What you negotiate with your insurance company and what your local government taxes assess will determine most of these costs. 

ServiceAmount
Recording Fees$60.00
State Tax/Stamps$85.00
Transfer Taxes$192.00
Homeowners Insurance*$669.80
Prepaid Interest$141.48
Property Taxes*$595.60
Title-Owner’s Title Insurance (optional)$380.00
Total (in this specific case)$2,123.88
Other Costs of a Mortgage Loan

*Note that property insurance and property taxes are prorated. This means you pay for the portion of the year you have possession of the property. Buy early in the year, and you pay more. However, if you buy later in the year, these charges are less. 

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Conclusion

Loans are a sound way to purchase properties, both for homebuyers and investors. If leveraged properly, loans can also help improve cash flow for investment properties. That said, it pays to shop around for the best interest rates and fees.

By the way, I discuss loans and cash flow in the real estate portion (Chapter 10) of my book.

I’d love to hear from you in the comments. How do you shop for the best lender? Where do you get your loans? Do you have any lessons learned?

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