Preparing Yourself to Purchase
   
How Much Can You Afford?
  Understanding how much you can afford is one of the most important rules of home buying. Depending on your individual situation, your budget can affect everything from the neighborhoods where you look, to the size of the house, and even what type of financing you choose.

Bear in mind, however, that lenders will look at more than just your income to determine the size of the loan. Likewise, you may find that there are some creative financing options that can help boost your purchasing power.

Loan prequalification vs. preapproval
One of the best ways to determine your budget is to have your real estate agent or lender prequalify you for a loan. Prequalification is different from preapproval, because it is only an estimate of what you'll be able to afford. On the other hand, preapproval is a more formal process where a lender examines your finances and agrees in advance to loan you money up to a specified amount.

What factors are important to lenders?
Banks and lending institutions will use several criteria to determine how much money they'll agree to lend. These include:

Your gross monthly income
Your credit history
The amount of your outstanding debts
Your savings--or the amount of money you have available for a down payment and closing costs
Your choice of mortgage (i.e. 30-year, FHA, etc.)
Current interest rates

Two important ratios
Lenders also use your financial information to figure out two, very important ratios: the debt-to-income ratio and the housing expense ratio.

Debt-to-income ratio
Many lenders use a rule of thumb that the amount of debt you are paying on each month (car payment, student loan, credit card, etc,) shouldn't exceed more than 36 percent of your gross monthly income. FHA loans are slightly more lenient.

Housing expense ratio
It is generally difficult to obtain a loan if the mortgage payment will be more than 28 to 33 percent of your gross monthly income.

Down payments make a difference
If you can make a large down payment, lenders may be more lenient with their qualifying ratios. For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.

Other ways to improve your purchasing power:

Gifts
If you're having trouble saving money, many lenders will allow you to use gift funds for the down payment and closing costs. However, most lenders require a "gift letter" stating the gift doesn't have to be repaid, and will also require you to pay at least a portion of the down payment with your own cash.

Negotiating Closing Costs
Through negotiation, some sellers may agree to pay all or most of your closing costs (for example, if you agree to meet their full asking price). If you choose to try this, make sure to ask your real estate agent for advice.

Loan Programs
Many local governments have special loan programs designed to help first-time homebuyers. Loans may be available at reduced interest rates, or with little or no down payments. Check with your local housing authority for more information.

Loan Types
Some homebuyers choose Adjustable Rate Mortgages (ARMs) because of low initial interest rates. Others opt for 30-year loans because they have lower monthly payments than 15-year loans. There are significant differences between different loans, so make sure to discuss the pros and cons of different loans with your agent or lender before making a decision.
 

Getting Your Finances in Order
  A crucial step in starting your search for a new home is having a clear idea of your financial situation. By getting a handle on your income, expenses and debts, you'll have a much better idea of what you can afford and how much you'll need to borrow.

For lenders to verify this information, though, they're going to need to look at your financial records. It is also important to remember that you should include records for each person who will be an owner of the house. So before you even visit the bank, make sure you'll be able to provide copies of these important documents:

Paycheck Stubs
Remember that lenders are most interested in your average income. Not only will they want to see this month's paycheck, but also how much you've been making for the past two years. Steady employment is also more attractive to lenders, so if you've been hopping from job to job, be prepared to discuss the reasons why.

Bank Statements
In order to qualify you for a loan, most lenders will also ask you for copies of your bank statements. Ideally, they'd like to see a steady history of savings--or at the very least, that you're not bouncing checks every month.

Tax Records
It's always a good idea to save copies of your tax returns, especially if you're self-employed. If you own your own business, it's important to note that lenders generally
consider your income as the amount you paid taxes on - not the gross income of the business.

Dividends & Investments
Lenders will usually consider long-term investment dividends, as well as your investment portfolio, when evaluating your income.

Alimony/Child Support
If you receive steady payments as part of a divorce settlement or for child support, you can also include this as part of your gross income. Just remember that lenders will want to see a copy of your divorce/court settlement verifying the amount of the payments.

Credit Report
Virtually every lender will want to see a copy of your credit report as part of the loan application process. The report lists all of your long-term debts, as well as your payment history. In general, they will require you to pay for the credit report (approximately $50), but if you have a recent copy, they may accept that instead.
 

Your Credit History
  As part of the loan application process, virtually all lenders will want to see a copy of your credit report. The report will list all your long-term debts (credit cards, mortgage payments, automobile and student loans, etc), as well as your payment history. If you don't have a copy of your credit report, most lenders will generally require you to pay for a copy when they process your loan application.

However, most real estate experts agree that it is a good idea to obtain a copy of your credit report several months before you apply for a loan. This is so you have a chance to resolve any problems with your credit before your bank sees it. U.S. Federal law ensures that you have access to your credit report, which may be obtained from your local credit bureau or any of several national firms that specialize in credit reports.

Late payments
For most people, problems with their credit report are likely related to late payments on a debt. If you were late one month in paying off your credit card, but otherwise have a good payment history, chances are most lenders won't be too concerned. But if you have a history of late payments you'll need to document the reasons why. A slow payment history won't necessarily get you turned down for a loan, but you may have to pay a higher rate of interest or otherwise prove to the lender that you can repay your loan in a timely fashion.

Errors on your credit report
Many people are surprised to learn that credit reports can often contains errors or inaccurate information. If this is the case with your credit report, you'll need to contact the reporting agency or creditor to have the problem resolved. This can sometimes be a slow process, so make sure to give yourself time to clear up the mistake.

Bankruptcies and foreclosures
There's no getting around it, a bankruptcy on your credit report is not a good thing. But that doesn't mean you still can't obtain a loan. Even though a bankruptcy may stay on your credit report for seven to ten years, lenders will often consider the circumstances surrounding a bankruptcy (family illness, injury, etc.). Moreover, if you have reestablished good credit since the bankruptcy, a lender will be more inclined to approve your application.
 

15-Year, 30-Year or Bi-Weekly Mortgage?
  In the past, the 30-year, fixed-rate mortgage was the standard choice for most homebuyers. Today, however, lenders offer a wide array of loan types in varying lengths--including 15, 20, 30 and even 40-year mortgages.

Deciding what length is best for you should be based on several factors including: your purchasing power, your anticipated future income and how disciplined you want to be about paying off the mortgage.

What are the benefits of a shorter loan term?
Some homeowners choose fixed-rate loans that are less than 30 years in order to save money by paying less interest over the life of the loan. For example, a $100,000 loan at 8 percent interest comes with a monthly payment of around $734 (excluding taxes and homeowner's insurance). Over 30 years, this adds up to $264,240. In other words, over the life of the loan you would pay a whopping $164,240 just in interest.

With a 15-year loan, however, the monthly payments on the same loan would be approximately $956--for a total of $172,080. The monthly payments are more than $200 more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $92,000.

What are the advantages to a 30-year loan?
Despite the interest savings of a 15-year loan, they're not for everyone. For one thing, the higher monthly payment might not allow some homeowners to qualify for a house they could otherwise afford with the lower payments of a 30-year mortgage. The lower monthly payment can also provide a greater sense of security in the event your future earning power might decrease.

Furthermore, with a little bit of financial discipline, there are a variety of methods that can help you pay off a 30-year loan faster with only a moderately higher monthly payment. One such choice is the biweekly mortgage payment plan, which is now offered by many lenders for both new and existing loans.

Biweekly mortgages
As the name implies, biweekly mortgage payments are made every two weeks instead of once a month--which over a year works out to the equivalent of making one extra monthly payment (compared to a traditional payment plan). One extra payment a year may not sound like much, but it can really add up over time. In fact, switching from a traditional payment plan to a biweekly mortgage can actually shorten the term of a 30-year loan by several years and save you thousands in interest.

If you're interested in a biweekly payment plan, make sure to check with your lender. In many cases, lenders also offer direct payment services that automatically withdraw funds from your bank account, saving you the trouble of having to write and mail a check every two weeks.

Making extra payments yourself--do it early!
Another way to pay off your loan more quickly is to simply include extra funds with your monthly payment. Most lenders will allow you to make extra payments towards the principal balance of your loan without penalty. This is especially attractive to homebuyers who are concerned about their future earning power, but still want to be aggressive about paying off their loan.

For example, if you had a 30-year loan, you might decide to send the equivalent of one or two extra payments a year (which could shorten the overall length of the loan by many years). But if your financial situation suddenly took a turn for the worse, you could always fall back on the regular monthly payment.

One important note, though, is that if you do decide to send extra funds, make sure to do it EARLY in the life of the loan. This is because most home loans are calculated in such a way that the first few years of payments are almost entirely interest, while the last few years are mostly applied towards the principal balance. Thus, you can get the most bang for your buck by making the extra payments early in the life of the loan.
 

All About Adjustable Rate Mortgages
  Adjustable-rate mortgages (ARMs) differ from fixed-rate mortgages in that the interest rate and monthly payment can change over the life of the loan. ARMs also generally have lower introductory interest rates vs. fixed-rate mortgages. Before deciding on an ARM, key factors to consider include how long you plan to own the property, and how frequently your monthly payment may change.

Why choose an adjustable-rate mortgage?
The low initial interest rates offered by ARMs make them attractive during periods when interest rates are high, or when homeowners only plan to stay in their home for a relatively short period. Similarly, homebuyers may find it easier to qualify for an ARM than a traditional loan. However, ARMs are not for everyone. If you plan to stay in your home long-term or are hesitant about having loan payments that shift from year-to-year, then you may prefer the stability of a fixed-rate mortagage.

Components of adjustable-rate mortgages
Adjustable-rate mortgages have three primary components: an index, margin, and calculated interest rate.

Index
The interest rate for an ARM is based on an index that measures the lender's ability to borrow money. While the specific index used may vary depending on the lender, some
common indexes include U.S. Treasury Bills and the Federal Housing Finance Board's Contract Mortgage Rate. One thing all indexes have in common, however, is that they cannot be controlled by the lender.

Margin
The margin (also called the "spread") is a percentage added to the index in order to cover the lender's administrative costs and profit. Though the index may rise and fall over
the loan.

Calculated interest rate
By adding the index and margin together, you arrive at the calculated interest rate, which is the rate the homeowner pays. It is also the rate to which any future rate adjustments will apply (rather than the "teaser rate," explained below).

Adjustment periods and teaser rates
Because the interest rate for an ARM may change due to economic conditions, a key feature to ask your lender about is the adjustment period--or how often your interest rate may change. Many ARMS have one-year adjustment periods, which means the interest rate and monthly payment is recalculated (based on the index) every year. Depending on the lender, longer adjustment periods are also available.
An ARM can also have an initial adjustment period based on a "teaser rate," which is an artificially low introductory interest rate offered by a lender to attract homebuyers. Usually, teaser rates are good for 6 months or a year, at which point the loan reverts back to the calculated interest rate. Remember, too, that most lenders will not use the teaser rate to qualify you for the loan, but instead use a 7.5% interest rate (or calculated interest rate if it is lower).

Rate caps
To protect homebuyers from dramatic rises in the interest rate, most ARMs have "caps" that govern how much the interest rate may rise between adjustment periods, as well as how much the rate may rise (or fall) over the life of the loan. For example, an ARM may be said to have a 2% periodic cap, and a 6% lifetime cap. This means that the rate can rise no more than 2% during an adjustment period, and no more than 6% over the life of the loan. The lifetime cap almost always applies to the calculated interest rate and not the introductory teaser rate.

Payment caps and negative amortization
Some ARMs also have payment caps. These differ from rate caps by placing a ceiling on how much your payment may rise during an adjustment period. While this may sound like a good thing, it can sometimes lead to real trouble.

For example, if the interest rate rises during an adjustment period, the additional interest due on the loan payment may exceed the amount allowed by the payment cap--leading to negative amortization. This means the balance due on the loan is actually growing, even though the homeowner is still making the minimum monthly payment. Many lenders limit the amount of negative amortization that may occur before the loan must be restructured, but it's always wise to speak with your lender about payment caps and how negative amortization will be handled.
 

Leveraging Your Money
  One of the greatest financial aspects of buying a home is the ability to leverage your money. Simply put, leverage allows you to use a small down payment and financing to purchase a larger investment. For example, if you bought a $125,000 home with 10 percent down, you leveraged the $12,500 down payment to purchase an asset worth 10 times that amount!

Appreciation
The benefits of leverage really become apparent with appreciation, or the rise in value of a property. Using the above example, say you were to live in the house for 5 years, and during that time property values in your area were to rise an average of 2.5 percent a year. Your home would then be worth over $141,000. By putting only 10 percent down, you get to enjoy the appreciation for the full amount!

Paying Yourself
In addition to the 10 percent down, you'll also have to make mortgage payments. But with each payment, a certain amount of money is being used to pay down the principal balance that you owe. This is called building equity. So in the event you sell your house, not only can you realize a profit from your leveraged money, you also have a chance to pay yourself back for the money you've put in over the years. No wonder so many people consider a home an excellent investment!