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Home Mortgage Basics

Home Mortgage Basics

While your student debt burden may seem eye-popping, there is one other form of debt that may eclipse it: your home mortgage. Home mortgage loans may offer fixed interest rates (principal and interest payments remain the same) or variable interest rates (payments change over time, depending on some underlying economy-wide interest rate benchmark). Typical fixed terms are 15 and 30 years (correpesponding to 180 or 360 fixed monthly payments, respectively). Variable rate loans often offer initially low "teaser" rates which adjust upward after a couple of years. These can be dangerous if there is a possiblity you'll be unable to afford the higher interest rates. In contrast, fixed rate loans offer comforting certainty, and are wise choices while rates remain low.

Traditionally, lenders ask homebuyers to put down an upfront payment equivalent to 20% of the purchase price, and will provide a loan for the remaining 80%. Borrowers whose downpayment is less than 20% are generally required to buy Private Mortgage Insurance (PMI), ranging from 0.5 percent to 2.25 percent of the original loan amount. Some lenders offer doctors zero-money-down loans, which means you don't have to provide a downpayment at all and they waive the PMI requirement.

Just because you’re given the opportunity to buy a home with zero money down, doesn’t mean you should take it. Lenders don’t make these offers as a favor to you—they make the offers because they stand to profit. And real estate agents may encourage you to take a zero-down loan as a path to buying a larger, more expensive home than you'd normally be able to afford because the more expensive purchase gives them a higher commission payment. But the larger home without a downpayment could leave you overextended financially because your monthly payments will be larger than those on a less expensive home with a downpayment. 

When deciding whether to approve a loan lenders consider the applicant's annual income, credit score, existing debts, as well as several measures including:

  • Loan-to-value ratio. If your down-payment is the standard twenty percent of the home’s value your loan-to-value ratio is eighty percent. If you default, the property value can decline by twenty percent and the lender can still recover its full loan amount by seizing your property and selling it. A low loan-to-value ratio is viewed more favorably by lenders because they have a larger buffer and face less risk. They may reward you for a larger down payment by offering a lower interest rate on your loan. 
  • Leverage ratio. Your leverage ratio is the ratio of your debts to assets. Generally, the higher the ratio, the riskier the borrower. Borrowers with high leverage typically find it harder to qualify for a loan or may be required to pay a higher interest rate. Highly leveraged applicants may be denied credit.
  • Debt-to-income ratio. This measure aims to quantify your ability to service debt. Generally, a person with a low ratio of debt to income can handle higher debt levels. A person with a high ratio is riskier. The latter may be charged higher rates, subject to stricter borrowing limits, or denied credit altogether.

More information regarding mortgage loans and the decison to buy vs. rent, along with links to various calculators, may be found in the Mortgage Debt section of e-book 1. 

One rule of thumb is that a household should not spend more than 30% of monthly income on housing. Of course, where you live has a big impact on this rule’s relevance. If you live in New York City or San Francisco you may have to spend more than 40% of income on housing, whereas in a rural setting you may spend less than 20%.

Buy a home with a mortgage that fits into your household budget comfortably and allows you to meet your other financial needs, including paying back student debt and investing for retirement.

If you qualify for Veterans Affairs (VA) benefits, there may be other lending or housing programs available to you. Check the government website at https://www.va.gov/.