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A mortgage pre mortem

February 23, 2022

The root of the word mortgage is "mort" which means 'death' (think mortuary or post-mortem). One translation of the word mortgage is "an agreement  until death." Not to be morbid, but before you sign up for one, please consider a pre-mortem. Let's start with 5 obvious factors and some not so obvious implications

1) Home Price
The American dream is available to everyone, but bigger is not always better. There are several hidden costs associated with a larger home even if you can afford the monthly payment. Taxes range from 1-2% and maintenance can cost 0.5-1% each year. A larger home that stretches your budget by $100,000 may only increases your monthly payment by $500, but do not forget to account for a $200 monthly increase in insurance and maintenance. Moreover, coming up with the extra downpayment of $20,000 (20% of $100k) may dampen a rainy day fund or the exciting plans to redecorate a new home. Buying a smaller home and sizing up later is a sound strategy because homes typically appreciate faster than our ability to save for them.

2) Down payment and LTV
While 20% is considered a "typical" downpayment, increasing home prices and cheap loans make lower down payments of 10% or 5% more feasible. In fact, a majority of first time homebuyers purchase a home with 10% down or less. Buyers should we weary of two hidden costs of smaller down payments. First, private mortgage insurance or PMI is added to loans to insure lenders from borrower default. Second, the LTV or loan to value is the opposite of a down payments. 10% down translates to 90% LTV. Higher LTV, all other factors being equal, means higher interest rates for borrowers to reflect a riskier loan.

3) Principal (loan) limits
The principal or size of a loan not only determines your monthly payment, it is also an eligibility criteria for a "conforming" loan. A conforming loan meets meets the size (and credit) limits put forward by the FHFA (federal housing finance agency). Conforming loans follow a strict process after the loan is issued. They are sold to Fannie Mae and Freddie Mac (two government sponsored enterprises), which then package and sell these loans to investors as mortgage backed securities (MBS). These 'MBS' are financial instruments that enable mortgages to be widely available. If a loan is not conforming due to its size, it's called a jumbo and has a different set of lenders. The confirming loan limit in 2022 is 647,200 in most areas and $970,800 in regions like NY and CA to account for a higher cost of living. If you do not qualify for a conforming loan due to size limits, you will need to meet higher qualification requirements and have less options to borrow.

4) Interest Rate and APRs
Lower interest rates are better, period! The best way to get a good deal is to comparison shop using APR across lender, brokers and mortgage marketplaces. Mortgage APR includes all other origination, underwriting and processing fees. The APR offers a fair way to compare loan estimates across lenders. Lenders may sometimes offer lower interest rates with the upfront purchase of points. In most cases, the money is better used towards lowering the principal borrowed.

5) Length of Mortgage
Longer loans have lower monthly payments and higher total interest costs of borrowing. This total cost of borrowing is measured by TIP (total interest percentage). For example, if you pay $200,000 in interest over 30 yrs on a $400,000 loan - your TIP is 50%. Calculating TIP requires multiple steps with a mortgage calculator or a spreadsheet. Loan providers are required by law to provide you with "TIP" in their loan estimate. Comparing TIP with your monthly payments can be used to balance affordability and long term  costs. Since these effects are non-linear, the Altgage Savings calculator can help compute the answer for you.

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