How To Get The Best Real Estate Loan

Getting Started

When should I start thinking about financing my new home?
For best results, start planning your financial strategy when you first decide that you want to buy a home. You will need to do some or all of the following:

  • Get your financial house in order.
  • Determine how much you can afford to pay for a home.
  • Get pre-approved for your loan.

What do you mean, "Get your financial house in order"?

Lenders will evaluate your ability to pay back your loan based upon information you give them on your loan application. The lender will verify each financial fact on your application, and will be looking for any "red flags" which might affect your ability to repay the loan.

Everything you put on your loan application should be truthful and as accurate as possible. However, there are actions that you can legitimately take to present your financial picture in the best possible light.

Pay off or pay down any credit card debt as much as possible. Credit card debt reduces the amount you can borrow for your home purchase. If you owe $2,000 on your credit card, the lender will assume you have a monthly debt payment of 5% of that amount, or $100 per month payment. Minimize the use of your credit card. Pay off auto and other debt which has over 9 monthly payments left. Note: auto debt with less than 9 payments remaining will usually be excluded from your debt calculation.

First-time buyers: If you expect to receive a family gift or loan as part of your down payment, be sure it is clear whether the money received from family members is a gift or a loan. If it is a gift, lenders will usually require a "gift letter" from the donor. Lenders will be checking your bank balance for the last three months, and will notice any large increases in your balance during that three month period.

Start saving even more for your down payment. Remember, there are almost always significant "closing costs" which must be paid at close of escrow, in addition to the down payment. Estimate closing costs at 3% of the purchase price.

Don't change your line of work. Lenders expect bread winners to be in their jobs at least two years. Change to a job in the same line of work is OK, but this is not the time to make a shift to a different line of work. Do not go from a salaried position to a "self-employed" status! Income figures from self-employment are often averaged over the last two years.

Hold off on large purchases (autos, appliances. etc.) which may increase your debt or reduce your cash reserves. Postpone these purchases until you have moved into your new home.

What is the typical down payment for purchasing a home?

In a typical transaction, the buyer will put 20% down, and borrow 80% of the selling price. For example, for a home costing $300,000:

Down Payment   $60,000   20%

Loan   $240,000   80%

Total   $300,000   100%

Can I buy a home for less than 20% down?
Yes. Many lenders will lend up to 95% of the purchase price. Some government sponsored programs will allow loans up to 95% of the purchase price.

How can I estimate my monthly payments?
The monthly payment on the loan will vary, depending upon the interest rate, and the length of the loan. (Most loans are for 30 years, but 15 years is another option.) The following chart shows the monthly payment required per $1,000 loan, assuming a 30 year loan. To estimate your payments, select the interest rate closest to the rate you expect to pay, and multiply by the number of thousands you are borrowing. (In the above example, if the interest rate was 7%, the monthly principal and interest payment for a $240,000 loan would be 240 times $6.65, or $1,596 per month.)

Monthly Cost of $1000 loan, 30 year term

Interest Rate6%6.5%[7%]7.5% 8%8.5%9%
Monthly Payment6.006.32[6.65]6.997.347.698.05

If you want to calculate your payment exactly, see Useful Links for our favorite on-line calculators.

How can I estimate my total monthly housing cost?
Your total monthly housing cost consists of your Principal, Interest, Taxes, and Insurance (PITI). An estimate, based upon the above example, is calculated as follows:

Principal and Interest (the "PI") (240 times $6.65)   $1,596
Taxes: Estimate at .1% of the selling price per month*   $300
Insurance: Estimate at .02% of the selling price, per month   $60
Total    $1,956

* In California, property taxes are calculated at 1% of the purchase price. There are often additional taxes and fees, such as special school taxes, bonds, etc. A reasonable estimate is 1.2% of the purchase price per year, or .1% of the purchase price per month. In other states, the formula will differ.

Note: In the above example, the taxes and insurance are 18.4% of the total cost. These two items are estimated at 20% of the total monthly housing cost on our "Affordability Worksheet" discussed below.

As a rule of thumb, your "PITI" should not exceed 33% of your gross monthly income. (More on ratios later.)

How can I estimate the price range of a home that I can afford?
Use our Affordability Worksheet. We suggest you print out a copy of our Affordability Worksheet, to make it easy to fill in your own financial data. See also our links page for an on-line affordability calculator.

Note that figures for the following example are included on the Affordability Worksheet, within [square brackets].
Gross annual income: $66,000
Monthly long term obligations: $400
Interest Rate: 7%
Down Payment: 20%
Taxes and insurance are estimated at 20% of the allowable housing cost.

What does it mean to be "pre-qualified" or "pre-approved" for a loan?
In both cases, the borrower provides the lender with the appropriate financial information, and asks the lender to evaluate the borrower's financial situation before an offer is made upon a specific house. The advantages:

You will know how much you can afford to pay for your new home.

Sellers will regard your offer highly, since there is evidence that you will be able to get the required loan.

When pre-qualified, the lender gives you a letter stating that (in his opinion, assuming all verifications are satisfactory) you are qualified to borrow a specified amount.

When pre-approved, the lender actually takes an application, verifies all data, and commits to loan a specified amount, subject to a satisfactory appraisal of the property.

Note: In order to be a successful buyer in today's market, it is imperative that buyers become pre-approved for their loan before making an offer on a house.

The Loan Processing Procedure

When do I need to decide on the type of financing?
The Deposit Receipt (Purchase Contract), which represents the terms of purchase of your home, will list the amount to be financed, estimated interest rates and term.

What are the steps in processing a loan?
You will apply for a loan by completing a loan application with a mortgage broker or loan company. There will be a non-refundable loan application fee, usually around $200 to $400.

A mortgage broker represents several lenders, and will submit your application to the lender he believes most appropriate for your situation. Representatives for banks and other lending institutions usually represent only one institution, and will submit your application to that institution. There are advantages to each type.

The lender will verify your statements of assets, liabilities, employment, and salary. The subject property will be appraised. The purpose of these investigations is (1) to assure that you have the income to repay the loan as scheduled, and (2) in the event that you default on the loan, the property is valuable enough to pay off the loan upon its sale.

How long does it take to process a loan?
Usually about 20 to 30 days, although it can take as few as 10 days, or as long as 45 days for some transactions. The actual time depends upon how quickly the lender can process the application, get the appraisal, and obtain verification of employment and bank balances.

What documents will I have to supply?
Be prepared to provide verification of income (pay stub and recent tax returns), a schedule of your assets (bank account numbers, securities, other real estate, etc.), and a list of your liabilities (credit card statements, auto loans, child support, student loans, and any other debt). If you are self-employed, you may need to supply financial statements or tax returns for your business.

Many lenders sell the loans to investors. The standardized analysis of your application is required so that your loan will be acceptable to investors.

What might delay approval of my loan?
Pay careful attention to your lender's request for information. Be sure you understand all the requests. (It often seems as if the lender needs "just one more document"!)

If you have had credit problems, be prepared to explain exactly what happened, and why a lender should not be fearful of a reoccurrence. If you have had a foreclosure, or been through bankruptcy, the lender will probably want 20% down, re-established credit with a clear credit history for at least two years from the date of discharge of bankruptcy; a salaried income is preferred over self-employed status.

What are "closing costs" and how much are they?
Closing cost are any fees paid by the buyer at the close of escrow. These fees may include "points" on the new loan, escrow fees, recording fees, title insurance, notary fees, and any other costs of processing your loan. In addition, you will be asked to prepay interest charges to cover the partial month in which you close escrow, and the first year's premium of your fire insurance policy. (Buyers often prefer to close near the end of the month to minimize prepaid interest charges.) "Impounds" covering the prepayment of a pro-rata share of your property taxes, property insurance, and mortgage insurance (if any) may also be included. Closing costs will vary by area.

When must my down payment and closing costs be paid into escrow?
Ask your title or escrow officer. In California, funds must be held by the escrow holder at least 24 hours before closing. Often buyers have their savings in a money market account, operating out of state. Funds can be wired to the escrow holder directly. To assure that your purchase will close on time, we recommend that you gather all funds required for closing your escrow into a local bank two weeks ahead of time. Failure to have all cash readily available at the time of closing is a common cause of late closing and can cause chaos!

When do my mortgage payments start? Usually about 30 days or more after closing. The date is often the first day of the first month falling at least 30 days from close of escrow. The actual date of your first payment will be included in your closing documents.

Types of Loans

Borrowers will be faced with a large variety of available loans. We have described below the major considerations in selecting your loan. The fundamental purpose of this section is to help you select the best loan for you. Your objectives: select a loan that will allow you to purchase your selected home with payments that you can afford, with the minimum total loan cost.

What is the difference between "fixed" and "adjustable" (or "variable") rate loans?
A fixed rate loan has an interest rate that is fixed (remains constant) for the term (duration) of the loan. Payments are also fixed (remain the same) for the term of the loan.

An adjustable rate loan has an interest rate that changes periodically in relation to an index. Payments may increase or decrease from time to time, according to a formula.

What are the advantages of fixed rate loans?
Since the monthly payments stay the same for the entire term of the loan, your payments are stable and predictable. However, the initial rates tend to be higher on a fixed rate mortgage than on a adjustable rate loans.

Fixed rate loans may be preferred by buyers with fixed incomes, or incomes which are not expected to increase materially in the future.

What are the characteristics of adjustable rate mortgages (ARM)?
The initial rate of an adjustable loan is usually substantially less than a fixed rate loan. This difference is due the fact that the borrower is assuming the risk of a future rise in interest rates. If interest rates rise, then the rate charged for an adjustable rate loan will also rise, and could ultimately exceed the rate for the fixed rate loan.

The interest on an adjustable rate mortgage is linked to a financial index, such as a Treasury security, so the monthly payment can vary up or down over the life of the loan. Some adjustable rate mortgages have a "cap" or maximum increase on the interest rate, to protect the borrower.

The lower initial payments make it easier for buyers to qualify for an adjustable rate loan. Some loans may be converted to a fixed rate loan within a specific period of time.

Here are some of the commonly used terms relating to ARMs:

Adjustment Period: The length of time between interest rate changes on an ARM. For example, a loan with an adjustment period of 6 months would be called a 6-month ARM, which means the interest rate can change twice a year.

Annual Percentage Rate (APR): The total finance charge (interest, loan fees, points) expressed as a percentage of the loan amount.

Cap: The limit on how much an interest rate or monthly payment can change, either at each adjustment or over the life of the mortgage.

Index: A measure of interest rate changes used to determine changes in an ARM's interest rate over the term of the loan such as the 11th District Cost of Funds, 1 year Treasury Bill rate, or the 6 month Treasury Bill rate. (Note: The 11th District Cost of Funds may be found in the Wall Street Journal, Section C, "ARM indexes", each Monday. Treasury rates are published daily in the Wall Street Journal, Section C, "Treasury/Agency Issues.")

Margin: The number of percentage points a lender adds to the index to calculate the ARM interest rate at each adjustment. (The margin represents the amount to cover the lender's overhead and profit.)

How many years will it take to pay off a real estate loan?

The most frequent number of years, or "term" of a loan, is thirty years.

Fifteen year loans are also usually available. If you can afford a somewhat higher monthly payment, then you should consider the fifteen year loan. The interest rate is often .5% less than the thirty year note, plus you save fifteen years of payments! Forty year term is sometimes available.

What are "Points"?
Points are a fee paid to obtain a loan, or to lower the interest rate charged. Each point is equal to one percent (1%) of the loan amount. (e.g. 3 points on $100,000 would equal $3,000.) On a purchase, points are prepaid interest.

"No point" loans have no initial points; usually the interest rate will be somewhat higher than a loan with points, and may have a pre-payment penalty.

I've seen rate sheets showing various combinations of fixed and adjustable, points, and rates. How do I decide what's best for me?
Loan programs can be confusing. Important factors are how long you expect to live in this house; your prospects for future income; your acceptance and ability to pay higher monthly payments if interest rates rise in the future. Here are some guidelines to help you choose the best loan for you:

If you have a fixed income, and would worry about possible payment increases, use a fixed rate.

If you think you may need to move in 2-5 years, the lower rates of an adjustable loan would be attractive. Also consider the no-point adjustable.

If the loan will be paid off soon (e.g., you will be receiving an inheritance or proceeds from sale of other property), select no-points adjustable. (Watch out for a pre-payment penalty.)

If you expect increases in income, and need to buy as much house as possible now, select the adjustable loan; consider no-point.

If you can afford to pay a larger payment each month, consider a 15 year loan instead of a 30 year loan.

I've heard about ratios. What should they be?
A buyer's ability to afford the payments on a loan is usually judged on three ratios. The allowable percentages may vary between lenders; the following ratio values are typical of most lenders. All ratios are calculated on the basis of gross monthly pre-tax income and monthly payments.

Loan Payment ratio: (principal + interest) divided by gross monthly income. Maximum ratio value = 28%

Housing expense ratio (PITI): (principal + interest + taxes + insurance) divided by gross monthly income. Maximum ratio value = 33%

Housing expense + Other monthly debt payments ratio: (PITI + monthly payment on all long term debts) divided by gross monthly income. Maximum ratio value = 36% to 38%. Note: When lenders have plenty of money to loan, a total ratio of 45% is not unusual for a solid buyer.

Disclaimer: The above information has been compiled from sources deemed reliable, but cannot be guaranteed, and should be independently verified. This summary of loan information is designed for educational purposes, to help you understand the workings of real estate lending. Remember, each lender may have different policies, may have higher or lower allowable ratios, and different procedures. If you have tax or legal questions, see your accountant or attorney. We hope this section helps you ask the right questions of your loan agent, so that you can obtain the loan best suited to your personal circumstances.