By Lynnette Khalfani-Cox, The Money Coach®
Getting a home loan can be a confusing process. You have to decide whether to get a fixed rate mortgage or an adjustable rate loan. You’ll want to shop around and qualify for the best loan rates and terms. And when you’re signing on the dotted line for one of the biggest purchases of your life, you naturally want to fully understand everything. So one way to make the home loan process easier is to understand some important lingo you might hear from experts in the mortgage industry.
Here are four confusing mortgage terms made simple.
- DTI or Debt-To-Income Ratio
When a lender mentions your debt-to-income ratio, or DTI, he or she is talking about how much debt you owe compared to how much your gross monthly pre-tax income is. This is an important consideration because if you’re approved for a mortgage, the lender wants to be sure you’ll be able to repay that obligation. This is why lenders make a careful review of your existing debts before saying “Yes” to a loan application.
But not all of your monthly financial obligations are considered when calculating your monthly debt-to-income ratio. For example, your utility bills, the money you spend eating out, or the cash you dole out for daycare expenses is not included in your DTI. Instead, the lender will look at the traditional credit obligations that are reflected on your credit reports – such as your credit card payments, auto and student loans, and alimony or child support — along with any current mortgage/housing payment you’re making.
To compute your DTI, your monthly debts are divided by your monthly gross pre-tax income. For example, if your total monthly credit obligations are $2,000 a month and your gross pay is $5,000 a month, you have a 40% DTI ($2,000 / $5,000 = .40). Debt-to-income ratios can vary by loan type, such as if you’re purchasing a home versus refinancing a home loan. Additionally, every lender has its own DTI guidelines. But most lenders will require that your monthly expenses not exceed roughly 36% to 43% of your monthly income, meaning your DTI typically needs to be lower than 43%.
- Discount Points
A discount point is simply a fee you can pay to lower the interest rate on a home loan. An easy way to understand points is to know that one point is equal to one percent of a home loan.So if you obtained a $300,000 home loan, paying one point on that loan would mean paying $3,000. Why would you want to do this? To lower your long-term borrowing costs. Assume that paying a point lowers your interest rate by 1/4th of a percent, which cuts your mortgage payment by $100 a month. If so, paying $3,000 in points means that in 30 months (2.5 years) you would have recouped your money. As long as you plan to live in the house for 2.5 years, paying the point was worth it. In fact, the longer you plan to live in a house the more worthwhile it becomes to pay mortgage points and save money over the long haul.
Another common phrase in the mortgage industry is LTV, which stands for “Loan-to-Value,” also sometimes called “Loan to Value Ratio.” Loan-to-Value ratio describes the size of a home loan, compared to the dollar value of the same home, expressed in percentage terms, such as 80% or 90%. It might sound kind of complicated at first. But once you get the concept of LTV, and understand that it’s tied to various factors, LTV is actually quite simple.
Here’s an explanation of how LTV works. Let’s say you agree to buy a home in the community of your choice for $350,000. During the mortgage process, your lender will order an appraisal on the property – assessing the size and quality of the bedrooms, bathrooms, kitchen and so on, and comparing your prospective home to other similar, recently sold neighboring homes. Once an appraisal report indicates that your home is, indeed, worth the price you’ve agreed to pay, your lender is satisfied that the “value” of your home is properly established at $350,000. This covers the “V” in “LTV.”
Now it’s time to consider the “L” part, or the “Loan” in “Loan-to-Value.” The size of your mortgage loan is always dependent upon your down payment. So assume you have been saving money for a while and have amassed $35,000 that you can put toward the purchase of the property. That’s a 10% down payment, or 10% of the home’s price. But in order for you to complete your home purchase and gain full ownership of the home, the seller will need to get 100% of the purchase price. This is how a mortgage helps. When you make a 10% down payment, your home loan covers the remaining 90% of the funds due to the seller. In this example, since the agreed upon price and value of the home is $350,000, your lender will subtract your down payment funds ($35,000) in order to arrive at the loan amount you require. Ultimately, your home loan would be $315,000 ($350,000 – $35,000 = $315,000). Also, your Loan-to-Value would be 90% since your home loan of $315,000 represents 90% of the value of the home.
If you had even more money saved — say, $70,000 — then you’d have a 20% down payment and you’d only need to borrow $280,000 to buy that $350,000 home. Under these circumstances, your loan to value ratio drops to 80%. In other words, the bigger your down payment, the smaller your loan-to-value ratio.
We all know that coming up with a huge down payment is often the hardest obstacle to overcome for would-be homeowners. Which leads us to Private Mortgage Insurance, or PMI. Anytime you put down less than 20% on a home, you typically have to pay for mortgage insurance. This is an insurance policy that you buy to protect your lender against the risk of you not paying your home loan, and defaulting on your mortgage. With conventional loans, mortgage insurance is called PMI, or Private Mortgage Insurance.
With federally backed loans, like those insured by the Federal Home Administration (FHA), you pay a monthly fee called MIP, or mortgage insurance premium. The advantage of an FHA loan is that it allows you to purchase a house with a down payment as low 3.5%, making it far more feasible to buy the home of your dreams. But the FHA doesn’t actually lend you money. Instead, it “guarantees” your mortgage by promising your lender — like a credit union or bank – that should you default on your home loan, the FHA will step in, pay off the mortgage, and take over the house. Because of this willingness by the FHA to back home loans, lenders are willing to make mortgages to those with relatively modest down payments. That’s good news to anyone who can’t afford a large down payment, even if you have to pay mortgage insurance. It’s worth noting that mortgage insurance is also issued the U.S. Department of Agriculture’s Rural Housing Service (for USDA loans), and the Department of Veterans Affairs (for VA loans).
Finally, for 2018, mortgage insurance paid is fully tax deductible as long as your adjusted gross income (AGI) is $100,000 or less. If your AGI is more than $100,000 up to $109,000, your deduction is reduced. But once your adjusted gross income exceeds $109,000, you get no deduction for paying mortgage insurance premiums.1
Check with a SchoolsFirst loan consultant for options to reduce or eliminate PMI even with a low down payment.
Federally insured by NCUA.
- Please consult a qualified tax professional for tax advice on your specific situation.
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