CHAPTER 1
Introduction to Mortgages
There’s a lot more to buying a home than just picking one out and moving in. If you don’t have a wad of cash stuffed in your sofa cushions, chances are you’ll need a mortgage. Mortgage lending has been around for a long, long time, and some things haven’t changed, while other parts of the mortgage process are brand new. Knowing what you’re getting into can help you to make the right decisions.
1.1 HOW HAS THE MORTGAGE MARKET CHANGED SINCE THE LAST EDITION OF MORTGAGES 101?
Wow. A lot, and that’s what we’ll be covering in this new third edition. Yet we appear to have come somewhat full circle dating back to 2004 when the first Mortgages 101 was published. It’s really been interesting to watch, and very much so if you follow the mortgage market like I do.
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If we go back to 2004 and look at the mortgage market then, it was made primarily of two classes of mortgage loans, conventional and government-backed. Conventional loans are those underwritten to standards issued by Fannie Mae and Freddie Mac, while government-backed loans are those carrying a government guarantee and include VA, FHA, and USDA loans. We’ll explore in more detail these two mortgage types in Chapter 7.
Yet the subprime mortgage market was just getting started. Subprime loans, mortgages issued to those with damaged credit, began to enter the mortgage market with swagger. Lenders made a lot of money with subprime loans and soon new lenders entered the market going after the subprime borrower. Within a few years of this overheating subprime market, the foreclosure crisis began and lenders mostly stopped lending—at least those who were still in business.
The second edition of Mortgages 101 exposed these new players in the mortgage market, yet the mortgage landscape has changed dramatically since then. Today, lenders are offering a very tight range of mortgage products. The subprime loan has essentially vanished. And because mortgage lenders have the same basic set of loan programs, they can all make subtle changes in their own internal lending guidelines. Two lenders can offer the very same mortgage but due to the introduction of “overlays” (see Chapter 7) a borrower can be declined at one lender yet approved at another.
This third edition explains how the new lending landscape works and how it should continue to work in the future. The “cowboy” days of mortgage lending have long since ridden off into the sunset.
1.2 WHAT’S THE DIFFERENCE BETWEEN BUYING AND RENTING?
One way you own the roof over your head, and the other way, you don’t. If you’ve always rented or otherwise never owned a home, one of the things you’ll discover is that when things go wrong with your house there’s no landlord to yell at. There’s no superintendent to come fix your leaky faucet. If your hot-water heater is busted, you’re the one who has to make the trip to your appliance store to shell out another thousand bucks or so just so you can take a hot shower in the morning.
When you rent, you can pretty much walk away as long as your lease agreement has been fulfilled. Want a change of scenery? Pack up and move across town. Want a swimming pool and fitness center without the hassles of owning either? Rent. Want new carpet or drapes every year? Rent. Want your utility bills paid? Rent. Free cable? Ditto. You get the point. Renting has its perks. Much less responsibility and no hassles of ownership.
1.3 HOW DO I KNOW IF IT’S BETTER TO BUY A HOME OR CONTINUE RENTING?
Perhaps one of the easiest ways to determine if it’s better to buy or rent is to sit down and calculate the financial advantages of owning versus renting. This is commonly done online with a “rent versus buy” calculator found on the web.
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These calculators compare your current or probable rent situation with a projected home ownership number. They’re easy to find. I ran a Google search for the term “mortgage + calculator” and retrieved more than 56 million websites that had those two terms in combination.
But the kicker is that these calculators rarely will tell you, “No, it’s not a good idea to buy.” That’s because of the tax benefits of home ownership. The interest and property taxes associated with a mortgage are generally tax deductible. You can deduct them from your gross income when you file your taxes. With rent, you can’t.
Yeah, I know. When you’re a renter you don’t pay property taxes or mortgage payments. Instead you give money to someone else for the privilege of living there. But you can’t write off your rent. It’s just that. Rent.
When might a “rent versus buy” calculator suggest it’s better to rent? When you intend to own your next home for only a year or so. Buying a home incurs other expenses, such as money for the down payment, property taxes, and hazard insurance (which is much higher than a renter’s policy). Many apartment complexes pay your electric bills along with water and other utilities. When you own, you pay all these expenses. Owning a home with all its tax benefits doesn’t outweigh the acquisition costs to buy the home if you’re only going to own it for a short period. Short term, rent. Longer term, buy. Are your rent payments the same or less than what a mortgage payment would be? Depending upon where you live, they may be the same. Especially if interest rates are relatively low.
Let’s say you’re renting a nice 3,000-square-foot, three-bedroom home close to schools in a friendly neighborhood. You might be paying $1,800 each month in rent. A similar three-bedroom home might cost $150,000. If you put 5 percent down to buy the home, your monthly house payment, including taxes and insurance, would be close to $800 using a 30-year fixed rate at 4 percent.
If rent payments in the area in which you want to buy are near what a mortgage payment would be, it makes sense to buy. If you can save $1,000 per month and you also get to write off the mortgage interest and property taxes, then it’s truly a no-brainer.
Another reason buying is generally better than renting is simply a matter of appreciation and equity. When you rent and property values increase, your landlord will probably raise your rent again. And, of course, each time you make a rent payment you’re not increasing your equity in anything; you’re just helping your landlord increase his stake in your house or apartment. I’ll give you an example.
Your rent is currently $1,000 per month, and you’re thinking about buying a $150,000 home. If you put 20 percent down and borrow $120,000 at 4.50 percent on a 30-year fixed rate, your principal and interest payment are about $600 a month. Let’s also assume that property values are increasing in your area by about 5 percent per year. What’s the situation after two years?
If you rented, you paid someone else $24,000. But if you owned and itemized your federal income taxes, you likely deducted over $10,600 in mortgage interest on your income taxes. You also paid your loan down by over $4,000 while at the same time increasing your equity position in the house by nearly $20,000.
Now you see why those calculators always tell you to buy a home.
Through all of these calculations, remember the real reason for buying: You buy a home because you want to. Because you like the place. It’s your home. A home is one of the largest single financial commitments someone can make. And while I agree with that statement, let’s not go overboard here. Buy a house because you want to, not because some calculator told you so.
1.4 HOW SHOULD I SEARCH FOR A HOUSE?
That’s easy. Start doing some research on your own on the Internet, even before contacting a real estate agent. If the Internet was invented for any particular industry it has to have been for real estate. Before the World Wide Web was born, one could typically locate houses only in the newspaper on the weekend. If you saw a house that you liked, you’d contact the agent selling the home. Then came the endless cycle of driving around in a real estate agent’s car looking at houses until—finally, finally—you found a home you wanted to buy.
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The Internet has helped agents become more productive by letting consumers do a little shopping first before they get serious enough to use an agent. An agent who advertises a house is called the “listing” agent, because he puts the house for sale on the multiple listing service, or MLS.
The agent will show you the home and ask if you are using another agent. If you aren’t, the agent will ask if you would like to see other homes for sale. You of course say “yes,” and the agent then becomes a “buyer’s” agent as well, helping you find a home to buy and not just listing a house for sale. You give your agent your requirements for your dream home, such as four bedrooms on a cul-de-sac with a swimming pool. Your agent would then scour the MLS to search for such homes. After the search, you’d both get in the agent’s car and go see the homes.
Today, however, there seems to be no end to the ways you can search for homes. Too many, it seems, and it can be a bit overwhelming. But what all of these sites have in common is they access the very same database—the local multiple listing service.
For instance, Redfin, Zillow, and Trulia are all portals where prospective homebuyers can visit online to search for homes. Most people now find interesting homes on their own before even contacting an agent. This way, the agent’s not dragging you all over town to look at homes you’d never buy. Your agent spends more time selling or listing homes and less time driving all over the place.
You can start with www.realtor.com, or get their app for your mobile phone. At this official site of the National Association of Realtors, you can search for homes anywhere in the country or across town. It also has access to every single agent-sponsored multiple listing service database in the country. It is easy to log onto the site, select your desired location, preferences, like four bedrooms in this zip code in this price range with a pool or without, and so on. Many properties offer “virtual” tours showing video of different views of the house. All of the pricing info is there as well so you can see what homes are selling for and what’s generally available.
But don’t get too much further into the process without the help of a real estate agent. In fact, don’t even make contact with any sellers without an agent at your side.
1.4A WHY DO I NEED AN AGENT, ANYWAY?
For one, real estate agents do this full-time; it’s not something an agent does once every seven or eight years or so, typically the life cycle of owning a particular home. Real estate agents know the background of the neighborhood, appreciation, schools, and when homes are overpriced or when a home is a great bargain. Real estate agents are professionals and it doesn’t cost you anything to tap into that knowledge.
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Real estate agents work on a commission. When a homeowner decides it’s time to sell, or is at least thinking about it, they’ll contact a good real estate agent who will then prepare a Comparative Market Analysis, or CMA. The CMA is a report that pulls up recent sales in the area. This provides the agent with the data he or she needs to determine how long it will take to sell the home and how much it will sell for.
In return, the agent charges a commission payable when the home actually closes. The amount of the sales commission varies by locale but a 5 percent or 6 percent commission is common. When the agent who lists the home finds a buyer for that property, the agent gets the entire commission. However, when another real estate agent brings a buyer to the deal, the commission is split between both agents. In essence, it is the property owner who pays your real estate agent—you don’t. Essentially, it’s a free service. Can you think of any other industry where the professional works at no charge to you?
1.4B HOW DO I FIND A GOOD REAL ESTATE AGENT?
Once word gets out that you’re thinking about buying a home, you might soon discover there are more than a few agents who suddenly get wind of your intentions. There are a lot of real estate agents, many of them part-time, while a select few are full-time. You want the full-time agent with lots of experience. Top-notch real estate agents bring in lots of business, both from the buyer’s and seller’s side of the transaction. You want a successful agent, not just a referral from a coworker, family member, or friend.
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Every real estate agent you come across will typically tout how good they are. And that makes a lot of sense because who would advertise they’re not really very good and only work part-time? No one, really. So if every agent is “the best,” how do you sort through all the marketing? It’s really very easy—you look to see how many listings the agent has.
When someone agrees to list a home for sale with an agent, they want the best they can get. That means someone who is experienced with a solid track record. Sure, there are some real estate agents new to the industry who are also very motivated and hungry for business, but you must do everything you can to find the right one to help you find and buy your next home.
Top-level real estate agents have lots of listings. They’ve built a reputation in the community, and with lots of listings that means a lot of other people have chosen that very same agent. If there are three agents you’re considering and two of them have just one active listing while the third has 10, who do you think you should choose? The heavy hitter. The one with the most listings.
1.5 WHEN IS A GOOD TIME TO BUY A HOME?
Have you ever heard a real estate agent say that it’s a bad time to buy? I haven’t. It’s either “The market’s hot, buy now before prices go up even further,” or “It’s a buyer’s market right now, make an offer while the deals are good.” Come on, agents need to make money, too, right? A good time to buy is when you, and only you, decide that it’s right.
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When I moved from San Diego, California, to Austin, Texas, I knew I wanted to live in Austin, but I really had no idea about where to live within the area. Austin’s a great town with a lot going on, but I knew nothing about the area’s traffic, schools, or where the best dry cleaners were. I know that there are plenty of tools out there to help make decisions and there are many relocation experts who can help. But I picked out a house to rent for about a year instead of buying. I wasn’t ready to buy. Why? While I knew Austin, I didn’t know Austin. I couldn’t have known certain things without living there. I also knew that if I bought in Austin, I would most likely soon be moving out of that house to the area where I determined I really wanted to live.
It worked out great. Now when I go to work in the mornings, my commute is quick, the kids are in a blue-ribbon school district, and we’re close to downtown while in a nice, quiet neighborhood. Lucky me, right? Maybe, but I don’t think I would have been so lucky if I had tried to buy a house in a city right off the bat without living there first. Life’s like that.
Sometimes just reading a book about something doesn’t make it feel real. Living it does. Is there something that tells you, “Wham! Buy a house!”? No, of course not. But perhaps one of the best ways to know if it’s a good time to buy or not is the fact that you’re even thinking about it in the first place. It’s a good time to buy if you’re ready, and a bad time to buy if you’re not. Don’t get pushed into home ownership.
Too many people get caught up in real estate valuations, home price cycles, the number of homes listed, buying in the winter instead of the summer, and so on. While these are all useful considerations, they shouldn’t make that much of a difference when all is said and done. Yes, it’s easier to buy in the summer and move if you have kids and you want them to start a brand-new school at the beginning of the new school year. Yes, home prices might be a little softer in the wintertime than in the spring or summer because of seasonal demand. And yes, it might be a good time to buy a home because the market is soft and values will certainly appreciate. But don’t get caught up in all of that. At least not to the point of paralysis. There is no right answer.
Certainly, these things should be taken into consideration at some point, even more so if you’re a real estate investor who studies market trends and buys and sells homes for income. But if you’re just looking for your first home, don’t get bewildered by such facts.
Buy a home because you want to, rather than for an investment. Buy a home that you can call your own. Begin saving for the future by building equity. But buy from the heart while using your head. Don’t buy because some real estate guru told you that you could make millions in real estate. Bookstores and late-night infomercials have enough on real estate investing. If you’re reading this book because you want to become a real estate tycoon, you bought the wrong book.
Renting has definite advantages, too. Renting allows you to be more portable. If you move into an apartment only to discover three months later it was a bad decision, you know that you’ll soon be out of your lease and you can move on. You might even be able to sublet while you move into another space—that is, if your landlord allows you to do so.
When renting, the maintenance costs go to the landlord, not you. If the hot-water heater breaks down, you call the landlord who will dispatch maintenance and either fix the hot-water heater or install a new one. It didn’t cost you anything except maybe a cold shower or two. When you own the home, you also own the water heater and it’s you who bears the cost. You’re the landlord.
1.6 WHAT’S THE DIFFERENCE BETWEEN BEING PREQUALIFIED AND PREAPPROVED?
Before you get into any agent’s car, the first thing you’ll be asked is if you’ve applied for a mortgage and been prequalified or preapproved. Those terms may sound similar, but it’s critical that you know the difference. A prequalification is typically no more than a conversation with a loan officer who asks about your job, how much you make, and what kind of car payments and so on you might have. If the new house payment is below a certain percentage of your gross income and your total debts (for home, car, student loans, etc.) are under yet another certain percentage of your gross monthly income, then voilà, you’re prequalified. It used to be that after such a conversation a loan company would issue a prequalification letter stating that, yes, you can afford the house payments. But that’s pretty much about it.
If all you want to determine is whether a lender thinks you can afford a particular debt load, then that’s probably all you need. But if you’re getting serious about all this and are ready to shop for houses, then a prequalification means little. You need to take the next step, which means getting preapproved.
Preapproval verifies all the information you provided. At this point, your credit report is run not merely to verify the amount of total debt but to check whether your credit is up to par for a particular loan request. Your lender will request credit scores along with your report. Mortgage programs today have minimum credit score requirements. In a preapproval, the income you verbally gave to the loan officer is now verified by a third party by reviewing your paycheck stubs or a recent W-2. Your down payment and closing cost funds are verified by reviewing bank or investment statements showing that your required funds are sitting in the bank somewhere just busting to get out.
This is your preapproval. It’s nothing more than a verified prequalification, but it’s also nothing less than what your real estate agent or home seller wants to see. In fact, in today’s real estate market, real estate agents now know not to even drive someone around to look at homes without a preapproval letter in their client’s possession.
1.7 WHAT IS THE PREAPPROVAL PROCESS?
The “pre” stuff verifies two critical elements in credit approval: your ability and willingness to repay a mortgage. Ability and willingness go hand in hand. While you can make enough money to be able to afford to pay back a loan, if you don’t have the willingness to do so, then it won’t work. And, of course, there are certainly a lot of people out there who may have the willingness to pay someone back, but they just don’t have enough money to do so.
By verifying income and the available assets to close on a house, and then reviewing the credit report, these two initial hurdles are overcome. It’s no big deal, but documenting your prequalification really is your very first step. Let’s examine the process a little more in detail.
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First, here’s what doesn’t happen: Loan applications aren’t sent to some loan committee for review. Loan committees went out with leisure suits. Once upon a time, yes, that’s how it happened. Potential borrowers would apply for a mortgage and extol their financial virtues; a loan committee, usually meeting once per week, would later discuss the positives and negatives of the applications. A host of old men in black suits, smoking cigars and saying things like “harrumph,” would eventually approve or disapprove the loan request.
Today, your loan application is approved or not approved at the very beginning of the process—before it ever gets to an underwriter (the person who physically approves your loan). This process is now fully automated and everything is approved first, before anything is ever verified. It’s different from the old days. It used to be document and verify absolutely everything before any approval whatsoever. You could go three to four weeks without really knowing if you were approved. Today, your loan is approved first, then verified later.
Decades ago, the first thing you did was to gather all your documentation—bank statements, tax returns, and paycheck stubs—whatever you could think of. Then you trotted down to your local mortgage company, bank, or savings and loan and met with a loan officer. You completed the loan application with the loan officer, who then detailed the types of documentation needed. Your credit report was also pulled and reviewed. Your debt ratios were calculated to make certain you weren’t borrowing more than you—in the lender’s eyes—could handle.
If there were any credit problems—say, a late payment on a car last year—the loan officer would ask for an “explanation letter.” The credit report would show whether the problem was a pattern or an isolated instance. The explanation letter was a secondary requirement that had to be in the file. Many times the letter simply said, “I forget why it was late,” and it would still be okay. The explanation didn’t have to convince anyone or be necessarily plausible; it just had to be there.
You’d also have to address any other discrepancies, such as length of time at your current job or a gap of employment. Didn’t work because you broke your leg? Provide some medical bills to prove it. Sudden deposits of money in the account? Prove where you got the funds. You needed to show that you didn’t borrow the money from somewhere else and make sure it wasn’t affecting your debt ratios or perhaps hiding a prior lien on the property.
And that was just from your standpoint. At the same time, an appraisal of the home you were considering buying would be ordered, along with some initial title work. Then a bevy of folks would start mailing stuff to you, explaining this and declaring that, and using words you’ve never heard before. Then about three weeks later, after all of the required documentation had been gathered, and only then, your complete application would be sent to a loan underwriter for approval. By then it’d been nearly a month and the mortgage company still hadn’t looked at your complete application.
Your loan today is electronically submitted to an automated underwriting system. The loan application is electronically submitted to the system, which quickly, as in just a few seconds, issues a response. The response will show whether the loan is eligible for an approval and what items must be provided in order to ensure the final loan is compliant with the guidelines set forth for the loan being applied for.
This process simply means: Verify first, approve last.
1.8 WHAT ARE LOAN CONDITIONS?
When things called “loan conditions” are tagged onto your approval, they mean that your loan is approved “conditionally.” For example: “Your loan is approved with these two conditions: Bring your most recent paycheck to closing and provide me with your complete divorce decree to show that you don’t pay any child support each month,” or “Provide evidence of insurance coverage for the new property.”
If you meet the conditions, then your loan is approved and your loan papers are drawn. In all my years of doing loans, I can recall only a few loans going to underwriting without some sort of condition attached. It’s almost as if underwriters have to put a condition on a loan just to prove that they actually looked at the file.
But this process can really add to the tension of the mortgage approval process. I know that you got prequalified with your loan officer and she kept nodding her head and smiling at you, saying, “Don’t worry, you’ll be fine,” but until you hear that final word, “Congratulations,” you’re still waiting. And waiting.
1.9 WHAT ARE AUTOMATED UNDERWRITING SYSTEMS?
Your loan application is entered into a specialized software program that evaluates your entire application, and within a matter of moments your approval is issued. Sound easy? It is, but that doesn’t mean you don’t have to provide any documentation. You do, but only what the software program says to provide.
Get approved first with an Automated Underwriting System (AUS) before you begin the verification process. Instead of “verify first, approve last,” you will get approved first and verified last.
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If you have excellent credit and a good down payment (anything over 20 percent is generally considered “good”), the approval may only ask for one paycheck stub and last year’s W-2. That’s pretty much about it. Under the old process you would have provided everything under the sun just in case you needed it. In fact, some loan officers used to list the required documentation on the back of their business cards. Some still do. The list of items needed at the time of loan application could be daunting. Paycheck stubs; two years’ worth of W-2s; three months’ worth of bank statements; two years’ worth of tax returns (all schedules); name, phone number, and address of your landlord; a copy of your divorce decree, if applicable; tax returns for your business (for two years, including all schedules); a year-to-date profit and loss statement . . . you get the drill. Now, using an AUS, all the software program does is say, “If you can prove what you said on your loan application, then you can get a mortgage from me.”
1.10 WHO USES AUTOMATED UNDERWRITING SYSTEMS?
Every lender and mortgage broker now uses an AUS. Fannie Mae and Freddie Mac (see Chapter 7) both developed their own AUS to help speed up the home-buying process. These programs tell you exactly what you need to do to get into a home. No more documenting this and tracking down that and waiting for that magic phone call. Your approval is issued first, not last. You only need to supply what the program asked for. Government-backed mortgage loans such as VA, FHA, and USDA loans are also submitted electronically for an AUS decision.
1.11 IF AN AUTOMATED UNDERWRITING SYSTEM APPROVES ME, DOES THAT MEAN I GET THE LOAN?
Not yet. There is still an appraisal to be ordered, an inspection to be performed, a title to be searched, and a review to be done of any claims on the property. That’s just for starters. But in terms of an AUS, there’s still the verification process you need to go through. If you said you made $5,000 per month, then you can bet your lender will want to see a W-2 and a paycheck stub showing your earnings.
In fact, there are actually degrees of approvals using these systems. Loan applicants with little or nothing down and a limited credit history can expect to be asked to provide more documentation than people with a long track record of timely payments and a large down payment. But in any case, you will know ahead of time exactly what to document and what to ignore.
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Remember that lenders expect to get paid back, and so they determine your ability and willingness to do so. Secondly, and just as important, they review their collateral—your future home—by ordering an appraisal and reviewing the chain of title on that home.
Your potential new house and the ground it sits on also have to meet some guidelines. One is its value. Is the home worth what you’re going to pay for it? Is the price based upon similar properties in the same area? Are there any obvious defects in the property, like a foundation problem or leaky roof, that need repair? That affects the value of the home. And while you may be the best borrower in the world with stratospheric credit scores, if the house is a dump needing repair before you can move in, the deal won’t close.
The appraisal reflects the current market value of the home you want to buy. The current market value is, hopefully, the agreed-upon sales price of the home. If you buy a home at $320,000, then an appraisal is performed to justify that value by comparing recent sales of similar homes in your area. Market value is defined by appraisal guidelines, but it is also an art, since no two homes are ever exactly alike.
When an appraisal shows the property value to be lower than the sales price, many times the deal falls through and the buyer begins the search again. This rarely happens, but it’s not unheard of.
Another issue regarding the property is determining whether there are any other claims on that property prior to your buying the home. This is done by reviewing a title report, or a history of all previous ownership claims, liens, and interests. If there’s any interest other than yours showing up on this report, then those issues will have to be resolved.
A title report shows the chain of ownership in the property going all the way back to, well, all the way back to the first person who legally held ownership. Title reports can show owners in a home over several years, each time listing the owner of the property as well as any other party that might lay claim, such as a lender who holds a mortgage on the property. Each time a home is bought and sold, a new name is added to the title. The buyer is listed as the new owner and the seller signs paperwork releasing all claims against the property.
A title report may also show old liens on the property taken out by the homeowner or any judgments that were attached to someone’s home. When a home is transferred from one party to another, all previous owners, liens, and judgments must be released or reassigned before a new loan can be made. Your preapproval only verifies you, not the property.
1.12 WHAT ARE THE BENEFITS OF GETTING PREAPPROVED?
You know before you go. Before you ever start shopping for a home, you should first have your preapproval letter in your hand. Pre-approvals speed up the entire home-buying process. You can shop with confidence, knowing that there are no “kinks” in your application, while your agent can look for homes on your behalf knowing that you’ve already arranged for financing. Even sellers benefit, knowing that they’re selling their home to someone who has already applied for, and been approved for, a mortgage. Still, some consumers don’t get this step done until after they’ve found a home. That’s a mistake for the obvious reasons, but also a mistake for one not-so-obvious reason.
Let’s say there’s a home on the market for $200,000 and there are two exact offers that arrived simultaneously. One buyer hasn’t seen a lender, while the other one has. One borrower hasn’t reviewed his credit report, while the other one has a preapproval letter in hand.
Who do you think will get the house? Still another buyer makes an offer below the asking price but also provides a preapproval letter stating that the loan is ready to close. Do you think a preapproval letter can sweeten an offer? Of course it can. The seller knows there won’t be any hitches and knows that she can move into a new home quickly.
1.13 WHAT ARE ALL THESE TERMS?
Buying a home brings in another tyrant: terminology. You’ll hear terms like PMI, LTV, FICO, title exam, survey, abstract of title, and so on. Sheesh. The glossary at the end of this book is thorough, so if there’s a word you don’t understand, look it up and memorize it. Knowing how to speak mortgage lingo can give you the upper hand when negotiating your mortgage rate. When you hear terms you don’t understand being used rapid-fire during a loan application, it can intimidate you. But understanding the language can empower you.
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A couple has saved up $15,000 to help buy their first house. They go to their bank, sit down with their loan officer, and fill out an application. The husband asks, “I only have $15,000 to put down on a house. How much do I need for everything?” Fair enough question. As the loan officer begins to answer the question, probably taking up about twenty minutes of their time doing so, their eyes glaze over.
Now imagine that same couple walking into another bank one week later and the wife says, “We want to do an 80–15–5 purchase, but are also considering a 90-percent-financed MI. What can you offer us with the least amount of money out of our pocket under your best rate and term on a 30-year conventional?”
First, your loan officer’s chin will drop. But after he is mandibly enabled again, he understands that he’s not dealing with a couple of idiots but with people who may in fact know more about the loan process than the loan officer himself. Knowing how to talk the talk lets everyone in the loan process know that you’re not someone to screw around with, that you’re educated about the process, and that you’ve done more than your share of mortgage homework. Knowing the terminology and knowing who everybody involved in the process is and what they do is also important to you.
1.14 WHO ARE THE KEY PEOPLE IN A TYPICAL LOAN APPROVAL PROCESS?
The key people are the loan officer, loan processor, loan underwriter, inspector, appraiser, closer, and settlement agent.
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Loan Officer. This is the person who helps you complete the mortgage application and acts as a “consultant” when it comes to deciding which program might be best for you. The loan officer is typically your key contact who generally oversees your loan package throughout the process, working up monthly payments, closing costs, and funds required to close. The loan officer might sometimes help the loan processor gather information needed for your file.
Loan Processor. This person assembles your documentation as it comes in for preparation to go either to the underwriter or straight to order your loan papers. You’ll get to know your loan processor fairly well since this person will be collecting your errant paycheck stub or contacting your insurance agent for policy information. Loan officers also keep track of what loan items are in and which items have yet to arrive. Loans don’t get processed for underwriting or closing unless all required documents are in the file.
Loan Underwriter. This person is responsible for ultimately saying “yes” or “no” on a loan file. The underwriter compares loan guidelines with what you have documented in the file. If you say you make $5,000 per month, the loan underwriter verifies that you make that amount by checking your paycheck stubs. Can you afford the house? Are the credit scores in line for a particular program? The underwriter makes sure the loan conforms to loan guidelines. You’ll probably never speak to an underwriter, just to the loan officer and loan processor.
Inspector. This person makes a visual inspection of your home, looking for building defects or pests such as termites. Inspectors can find problems that need repair before the house can close, such as a cracked foundation or a faulty roof. You should get an inspection before you order the appraisal. If the inspection report comes back showing thousands of dollars worth of needed repairs, then there’s no sense in ordering an appraisal if you’re not going to buy the house due to its poor condition. Don’t pay for an appraisal until your home has passed inspection.
Appraiser. This person determines the market value of the home by comparing the sales prices of similar homes in the neighborhood. Appraisers aren’t property inspectors, although they may notice something about the house that would affect value. If they see a crack on an inside wall, they might make note of that crack. If they do, then the lender will want to see if there are any problems with the foundation or investigate further for structural defects. They’ll measure square footage and take pictures of the house, both inside and out.
Closer. In the lender’s department, this person reviews the loan and helps prepare the lender’s closing documents. The closer forwards those documents to your settlement agent’s office, where you will be signing closing papers.
Settlement Agent. This person receives specific instructions from the lender explaining what the lender needs to fund the loan. The settlement agent can be called different things in different parts of the country. In some areas only attorneys can close deals, while in some states an escrow agent holds the closing. The settlement agent watches you sign all of your closing documents and verifies that the sale of the home goes according to state laws and the lender’s requirements. The settlement agent also verifies that you are who you say you are.
1.15 WHAT IS THE 1003?
First, you apply for a loan. You can do that online, you can mail it in, you can do it over the phone, or you can make the application in person—but that’s the very first step. Your loan application is commonly called the 1003 (ten-oh-three), which is in fact Fannie Mae’s form number for a mortgage application. Freddie Mac uses the exact same form (Form 65), but I guess Fannie started first, so that’s what everyone calls it. Again, it’s important that you begin to use some of the lingo. Practice it. Don’t say, “I would like to fill out an application for a home loan.” Instead say, “Do you want me to complete a 1003?”
The 1003 is a big form. Five pages. More if needed. It has somewhere near 350 boxes or spaces that might pertain to you, and it is divided into ten sections. At the very top you’ll see some tiny, tiny writing explaining that Form 1003 should be used with help from the lender (go figure). It also asks whether you’re applying for the loan by yourself or with someone else. You’re supposed to check those boxes if they apply. Oddly enough, even most loan officers forget this part and don’t check either box because the 1003 tells the same story without checking any boxes.
The loan application asks a lot of questions and sometimes uses bizarre language. If you’re not sure what the question is, simply leave it blank and ask the lender later on if it applies. Just because the 1003 has lots of boxes to be filled out doesn’t mean you have to fill in every one of them. You won’t, so don’t be intimidated by the application at the very start. Simply complete the stuff you know about.
1.16 WHAT ARE THE TEN SECTIONS OF THE 1003?
There are ten sections to the 1003:
1. Type of Mortgage and Terms of Loan
2. Property Information and Purpose of Loan
3. Borrower Information
4. Employment Information
5. Monthly Income and Combined Housing Expense Information
6. Assets and Liabilities
7. Details of Transaction
8. Declarations
9. Acknowledgement and Agreement
10. Information for Government Monitoring Purposes
1. Type of Mortgage and Terms of Loan
The very first thing the 1003 asks you is what type of mortgage you’re applying for, be it a conventional, Federal Housing Administration (FHA), Veterans Administration (VA), or other loan. Many consumers won’t know which type they need or if they’re eligible for one or more of these types. That’s okay. If you haven’t decided, just put in the loan type you’re more inclined to choose. If you’re VA eligible, there will be a tad more paperwork for you and the lender to complete with “VA” stamped all over it. There are also two boxes marked “Agency Case Number” and “Lender Case Number.” These boxes are reserved for FHA use and will be filled in by the lender later on. It’s really of no significance to you.
This section also has a place for you to choose a fixed rate, an adjustable rate, the term of the loan (how many months or years), the requested loan amount, and, of course, “other.” This part of the 1003, like the other sections, can be changed throughout the application process, so if you check that you want a fixed rate and change your mind later, you won’t need to complete an entire new application. Just make the changes needed.
2. Property Information and Purpose of Loan
This is the address of the property you want to buy. You can leave it blank if you haven’t found a house yet, or you can put in something like “123 Main Street” just to get an address into the system. This section will also ask you if the property is a single-family house or a multiunit property, like a duplex.
There is an area for the legal description of the property. The borrower or lender typically doesn’t know this information early on, so you’ll probably leave this box blank. A legal description reads something like, “Lot II, Section A, 123 Main Subdivision.” Your lender will get this information from the agent, from the title, or from an attorney involved in the transaction. Some AUS programs require a property address to get a preapproval; if this is your case, use a simple “123 Main Street, Anywhere USA.”
This section also asks if your request is for a refinance loan, a purchase loan, or even a construction loan. Will you live in the property or is it for a rental? Either way, you must explain in this section if the property you’re buying is going to be your primary residence, a vacation or second home, or an investment property.
If you are making an application for a construction loan, there are sections that itemize the land cost and the construction cost, along with final anticipated value. For a refinance, it will ask you when you bought the property, what you paid for it, what existing liens there may be, what improvements you’ve made, and how much they cost.
The final part of this section asks how you’re going to hold title, be it individually or along with someone else, and if you’re going to own the property “fee simple” (which is outright ownership of both the land and the home) or “leasehold” (where you may own the home but the land is being leased).
How can you buy a home on someone else’s land? Leaseholds can work when the lease period is for an extended time, say, 99 years or so. This sounds odd, but it is not as uncommon as you think in areas where Native American tribes may own land that has been developed with houses, shopping malls, and the like. More than likely this option will never be an issue for you.
3. Borrower Information
This section is about you. It gets into the “meat” of the application and identifies who you are by way of your legal name, your Social Security number, and where you live. This is the most personal part of the application since it’s used to check your credit report, address, age, and phone number.
You may be wondering, Who cares how old you are? People have to reach a certain age before they can execute a sales contract. Age information can also help identify a borrower. Someone who is 18 years old shouldn’t have credit lines on her credit report that are 20 years old, for example. Sometimes this question sounds like a loan approval question, but the fact is that it is illegal to discriminate in mortgage lending and it is illegal to discriminate based upon how old you are.
This section also asks how many years of school you’ve had. For the life of me, I’ve never understood why this question is part of a loan application and I’ve never been given any good reason. It seems to be a carryover from older loan applications when this information was used to predict future earnings. An underwriter might let the new law school graduate borrow a little more because of the likelihood that that person will have strong earnings potential. But is a person with a GED somehow less creditworthy than someone with a PhD and an MBA? Hardly. But this box is still there on the loan application, so you can fill in that information if you want to, but it really doesn’t matter one way or the other. It might mean something if you put in just 12 years of school but claim that you’re a doctor or a dentist. Then you will need to further explain how you accomplished such a feat. Otherwise, don’t worry about loans not being approved based upon the number of years you’ve gone to school.
The final section is reserved for the number of your dependents. This box really only applies to VA mortgages that calculate household and residual income numbers, but again it isn’t something that is used to approve or deny your loan request.
If you’ve lived at your current address for less than two years, you’ll also be asked to provide a previous address. But that’s really about it. No pint of blood or firstborn offspring required. Once completed, this section nails down exactly who you are and where you’ve lived.
4. Employment Information
Now that we know who you are, we want to make sure you have a job and see how long you’ve been working and whom you work for, or if you’re self-employed. This section asks for your employer’s name, address, and phone number. Lenders will contact your employer—either by telephone, by letter, or even by email (as long as the email address can be verified)—asking them to verify how long you’ve worked there, what your job description is, and how much money you make.
You’ll notice there are two separate boxes about your length of employment. One box asks for “Years on this job” and the other asks for “Years employed in this line of work/profession.” Lenders look for a minimum of two years in the workforce at the same job as a sign of job stability. They also like to see someone in the same line of work, for the very same reason. If you haven’t been at your current job for two years, don’t worry, as long as you’ve done the same or similar line of work somewhere else.
Have you been laid off because of an economic downturn? Document the dates and reasons for the time not worked. If you’ve been a store manager at your current job for six months, all you need to do is document your previous jobs for at least another 18 months to make up your two-year minimum. There’s another box for previous employers, asking for the same contact information along with how much money you made at your old jobs. Finally, you’ll be asked about your job title and the type of business you’re in and whether you’re self-employed.
5. Monthly Income and Combined Housing Expense Information
Easy enough. Now, how much money do you make and how much are you paying for housing (whether it’s rent, mortgage, or living payment-free)? Your income is divided into six sections plus the now-famous “other.” Here you enter your base salary, commissions or bonuses, income from investments or dividends, overtime earnings, and any rental income you might have from other real estate. Below this section there is an area for you to describe “other” income. This could be anything that’s verifiable, such as child support or alimony payments, note income, or lottery winnings.
Then there is another box for your current house payment or rent. Here you put your rent or mortgage payment, plus any monthly property tax, hazard insurance payment, homeowners association dues, or mortgage insurance payment.
6. Assets and Liabilities
This section covers your bank accounts, investment accounts, IRAs, or whatever other financial assets you might have. Don’t let this section intimidate you. Just because there’s a space for “Life Insurance Net Cash Value” or “Vested Interest in Retirement Fund” doesn’t mean that you have to have either of them to get a home loan. You don’t. You simply need enough money to close the deal.
The very first box describes your first asset involved in the transaction: your “earnest money” or deposit money that you gave along with your sales contract. If you gave $2,000 as earnest money, that’s the first money you’ve put into the deal. Lenders want to know how much you gave as earnest money and who has it. They’ll verify those funds as part of your down payment.
The next four sections are for your bank accounts—checking or savings—and for related account information, such as account numbers and current balances. It’s not necessary to complete every single box or to divulge every single account you might have. Typically lenders only care about having enough money to close your deal and less about what your IRA balance is. The only time other balances come into question is if the lender asks for them as a condition of loan approval. These extra funds are called “reserves.”
Reserves are best described as money left in various accounts after all the dust has settled, including money for your down payment and closing costs. Reserves can sometimes be a multiple of your new house payment, such as “six months’ worth of housing payments,” and they must be in accounts free and clear of your transaction. Reserves can also be used to beef up your application if you’re on the border of obtaining a loan approval. A lender who is a little squishy on a loan may want to see some other aspects of your financial picture before issuing an approval. Reserves are an important criterion for many loans, but it’s up to you to ask the lender if you in fact need to document absolutely everything in your financial portfolio or just enough to close the deal.
This section also asks for other real estate you might own, and there is even an area to list the type and value of your car. I’m serious. Again, this is a holdover from earlier loan applications, but if you leave this section blank, an underwriter might want to know how you get to work and back.
Finally, there’s the question of “other” assets. Historically, they might mean expensive artwork or jewelry, but this, too, is an unnecessary question, so don’t worry about leaving this box blank.
Next to the Assets is the Liabilities section, where you list your monthly bills. This section is only for items that might show up on your credit report, such as a car loan or credit card bill. It doesn’t include such items as your electricity or telephone bills. Don’t worry if you can’t remember the exact balances or minimum monthly payment required, just give your best estimate. Your lender will fill in the application with correct numbers taken from the credit bureau later on. If you owe child support or alimony, there’s a place for that information, too.
7. Details of Transaction
This is the most confusing piece of the application, so much so that most borrowers leave it blank for the lender or loan officer to fill in. In fact, most loan officers don’t fill it in and let their computer program do the work for them. This is an overview of your particular deal, showing the sales price of the home, your down payment amount (if any), your closing costs, and any earnest money held anywhere. It then shows how much money you’re supposed to bring to the closing table.
Note that this is just an overview and not the final word on loan amount and costs, etc. It’s simply a brief snapshot of the transaction. Believe me, you’ll get reams of paper on this topic in other documents.
8. Declarations
These are thirteen statements that you check “yes” or “no.” For example, “Are there any outstanding judgments against you?” and “Are you a party to a lawsuit?” and so on. Here you’ll also declare if you’ve been bankrupt or had a foreclosure in the past seven years.
Actually, there is no such thing as a seven-year requirement for bankruptcies and foreclosures for conventional or government loans anymore; this is another carryover from older application processes. Nowadays, bankruptcies and foreclosures generally affect loan applications only if they’re two to four years old.
9. Acknowledgement and Agreement
This is a long-winded, obviously lawyer-written section where you cross your heart and hope to die that what you put on your application is true, that you agree to have the home secured by a first mortgage or deed of trust, that you won’t use the property for illegal purposes, that you didn’t lie, and so on. You sign your loan application in this section and date it.
10. Information for Government Monitoring Purposes
This is an optional section that asks about your race, your national origin, and whether you are male or female. This information doesn’t make any difference on your loan approval and you don’t have to fill it out if you don’t want to. However, the government requires, through the Home Mortgage Disclosure Act, or HMDA (hum-duh), that when borrowers opt not to complete this information, then the loan officer meeting with the applicants must make a best guess as to “guy or girl” or “black, white, Pacific Islander,” or whatever. It’s one of the ways the federal government can monitor the approval rates for various classes and races of borrowers and see if your bank or lender is discriminating based upon race, color, or creed. After all, how does the government know such things if they’re not told? Or maybe a certain lender isn’t making loans where the community may need them most. For example, the Community Reinvestment Act (CRA) requires lenders to place a certain percentage of their mortgages in specific areas, as required by the federal government.
1.17 WHAT HAPPENS IF THE INFORMATION I PUT ON MY APPLICATION IS WRONG?
One note here, gang. Don’t lie on your application. This is serious stuff, which is why the loan application asks you more than once, in different ways, “You’re telling the truth, right?”
Falsifying your mortgage application for the purposes of buying a home is no fun. It isn’t exactly stealing an extra newspaper from the newsstand. If you get a mortgage under false pretenses, you can go to prison. Prison, folks. This is different from making a mistake on an application, such as claiming to have worked someplace for two and a half years instead of two years and three months. That’s a simple mistake. The more serious issue is willfully falsifying documents in order to obtain a loan, such as lying about where you worked or how much money you made. Your lender will check.
On the flip side is the verification of the application. The lender will verify your information using third-party sources. Your loan officer won’t be able to take your word for it that you have good credit. Instead your credit report will be reviewed. You make how much each month? Yes, you put it on your application and you swore up and down that you didn’t lie about it, but your lender, with your permission, will call or write your employer to verify how much you make.
There are certain types of loans, called “stated loans,” that require less documentation, which means that instead of verifying your income with paycheck stubs and W-2s or contacting your employer, the lender will use whatever you put on your application. If you really, really, really want a house, it can be tempting to falsify your income or your assets in order to qualify, but the problem with that is, if you falsify your income to the point you can’t afford it, you could soon find yourself in foreclosure. When loans go bad, lenders do a little research on their own and compare what you put on your application to what you reported to the IRS. If there’s a big discrepancy, foreclosure won’t be your biggest problem.
So we’ve walked through the application process and at the bottom of the application your loan officer will sign. This is where it starts. Tray tables up, seat belts securely fastened.
1.18 WHAT HAPPENS AFTER I FILL OUT THE 1003?
Lenders follow a strict definition of what is and what is not considered an “application.” By definition, an official loan application has a minimum of six components:
Borrower’s Name
Monthly Income
Social Security Number
Subject Property Address
Estimate of Property Value
Loan Amount
Why these six? Because once the loan application is deemed “official,” it triggers a host of loan disclosures the lender must provide. For example, if you submit an application but haven’t picked out a property, then there is no subject property address, hence no mandated disclosures.
Within three days of an official application, your lender is required by federal mandate to send you a Loan Estimate, a three-page form providing you details about the loan you’ve requested and which includes potential closing costs you will encounter, property taxes and insurance, a monthly payment, interest rate on the loan, as well as the annual percentage rate, or APR.
It’s important to note, these are just estimates. The interest rate listed on the Loan Estimate can change until you lock in your rate. Closing costs may also vary. This document simply provides you with an idea of what you can expect.
Should you decide to move forward, your application will be entered into an AUS for approval. Your approval will come back with your conditions and your loan officer will contact you, telling you what you need to do to complete your approval.
1.19 ARE ONLINE APPLICATIONS THE SAME AS THE FIVE-PAGE 1003?
Essentially, they are the same, but online applications are typically more user-friendly and don’t take as long to complete because they will only ask for the information required to approve your loan. There are fewer boxes to complete. And the online application is also a little faster than a handwritten application.
TELL ME MORE
When you go to a lender’s website to complete an application for a home loan, your file is digitized in a format that everyone in the lending industry can read. Once you complete an online application, your loan officer is sent an email notification that your file is ready.
The loan officer will either click on the link supplied in the email or log onto a website and download all new loan applications. Mortgage companies have different software programs called loan origination systems (LOS) that take your digital loan application and “drop” your information into the proper boxes to form a brand-new loan application on paper. Your file will be stored on the loan officer’s and loan processor’s computer while it is being processed and updated/changed as needed. When the file is ready to be reviewed by the underwriter, it is usually your electronic application (not the “paper file”) that will be sent, again via secure email, to the underwriter for review.
The underwriter will approve the loan, then send the file to the closing department, which will compile your loan documents for you to sign at closing. Your final papers are again sent via email to the person handling your closing, and it’s typically only at this stage that your entire loan application is printed, awaiting your signature.
In fact, your loan will most likely be converted to a digital file even if you completed a handwritten application; loan officers do just that when they enter applications into their LOS. Few lenders these days even accept a “hard” file from a loan officer and ask that the loan officer transmit files to them digitally.
Before files were digitized, a loan officer would keep a copy of the loan papers, a copy would be sent to the underwriter, and a copy would be sent to the lender’s storage office (lenders must keep loan applications at least three years before they destroy them). Meanwhile, the “original” file would be sent to the person handling your closing for your signatures. Now that loan files are digitized, I guess you could say the mortgage industry has become more “green” than it used to be by printing fewer copies!
1.20 WHAT HAPPENS AFTER I MAKE AN OFFER FOR A HOUSE?
Right after your contract is accepted, you will order an inspection of the property. An inspector crawls throughout your house looking for problems in it. Is there termite damage? Is the roof in good shape? Do the faucets leak? Inspectors will even run the dishwasher to make sure it works okay.
TELL ME MORE
Upon a satisfactory inspection report, your lender will order an appraisal. Notice that the inspection and the appraisal are two entirely different things, although some people get them confused. An inspection looks for problems with the house. An appraisal, on the other hand, is a determination of the value of the home based on a comparison of similar homes in your area that have sold recently, typically within the previous 12 months.
While appraisers may indeed note the condition of the house as good or average, they don’t inspect it for defects, as an inspector does.
At the same time, your title is researched and a report is prepared. Your title report reflects all previous owners of the property as well as anyone else who might have had an interest in the home, such as a lender issuing a mortgage or a contractor who placed a lien on the home during a remodeling stage. The purpose of this research is to make sure there are no other previous owners who at some point might lay claim to your property after you close on your house. For example, you don’t want some long-lost heir to the house who fifty years ago never signed anything authorizing transfer of the property. Or what if there is an unsatisfied judgment on record that has never been paid? All previous liens or claims against the property have to be accounted for and properly released. When this is done, the title company will issue a title insurance policy protecting the lender and others against any previous claims, recorded or unrecorded.
Once your appraisal and title work are done, your loan then gets sent to the underwriter, who reviews all the documentation and authorizes your loan papers to be printed. Your papers are sent to the person assigned to hold your closing, at which point you show up, sign, and close your deal.