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STEPS TO AVOID MORTGAGE PITFALLS

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July 2003
STEPS TO AVOID MORTGAGE PITFALLS

By GOURANGA C. BANIK, PH.D., P.E. (gbanik62@yahoo.com)

The housing sector has been the pillar of strength for the sluggish U.S. economy, as strong demand for homes has buttressed construction jobs and sales of household goods. Consumers, who account for two-thirds of the U.S. economy, have been tapping into higher home values through "cash-out" refinancing and/or savings from monthly payments for lower interest rates of our existing mortgages. Some of us even already refinanced twice in last one and a half years. The process of buying and owning a home is sometimes difficult and confusing, especially when the buyer is looking for a loan for the first time. Many borrowers fear of making a mistake during their home financial transactions. This fear is real, because buying a home is typically the largest financial transaction the buyers ever undertake. A point here and there or balloon pay-off or an acceleration clause could be the real problems for the borrowers unless they understand the pitfalls in financing home. So during your home buying and/or your refinancing, you might consider the followings to avoid big mistakes:

Don't Borrow too Much which You can't Afford:

Try to borrow what ever you can easily afford. Don't exceed your obligation limits. Consider your present and possible future income before making any decisions regarding your home financing. According to the FNMA /FHLMC underwriting guidelines, you may borrow only 28% of your gross income to pay your mortgage. In today's lending environment, lenders are pushed to lend as much as their underwriting guidelines will allow. Make sure, just because the lender is willing to lend you the money, you can afford it.

Check Your Credit Report In Advance:

How much you can afford, what will be your interest rates and so on depend on your credit score. An error or misreported late payment can have a dramatic impact on your score and reduce your ability to get the mortgage.

So, before going for home buying, it is wise to look at your current credit score and dig-out any anomalies before you plan to buy a home. If your credit score is not good, try to build good credit history by paying regularly which may take a long time. As a Georgia resident, you may get two free copies of your credit history from each of the rating agencies-Equifax, Experian and Transunion. Try to get those free copies every six months to find your current credit and also to find out any errors on the credit reports.

Choose Your Lender Based on Who You Know:

It is always better to get the loan through a loan officer whom you know and/or rely. Before going to look for a home, find the person or mortgage company through which you will borrow your mortgage and if possible prequalify with him. You may ask your friends, relatives and/or neighbors to find a reliable mortgage person. In addition, you may ask your attorney and your CPA, and even talk to your bank as long as they don't have conflict of interest in their referrals. It is always good to get a loan through a mortgage company rather than through your bank, because bank's rate and closing costs are always little higher.

In many cases, your real estate agent might help you to find a good loan officer. But make sure you are making decision about your loan (rate, term and type) based on your need and financial backgrounds, not only on advice of a real state agent. Sometimes, a real estate agent has some personal interest which might contradict with your interests.

Select a Right Type of Loan:

Interest rates are at the bottom since mid sixties. But still a large number of borrowers are taking adjustable rates mortgage (ARM), rather than fixed rates. ARMs are most often based on indexes tied to Treasury Bills that are issued by the U.S. government to pay for the national debt and other expenses. Most 1-Year ARMs are tied to the "Constant Maturity Treasury (CMT)" index which is based on the 1-Year Treasury Bill's activity. Other ARM indexes are based on certificates of deposit (CDs) and the London Inter-Bank Offer Rate (LIBOR) rates, among others. An ARM's initial rate typically is lower than the fixed rate from about a quarter points to two points or more, depending upon the economy. Right now, more than two percentage points separate them.

ARMs come with interest rates that typically adjust up, depending upon current economic trends and the money market index to which it is tied. You know, the economy is in recession in both USA and Europe, but might come back after settling of possible war with Iraq and in that case ARM interest rate will be higher. Since the fixed rates are at the bottom in 40 years, it would be good to take a fixed rate rather than ARM. Some of the borrowers are also taking Home Equity Lines of Credit (HELOC) loans which are also flexible.

ARMs could be a good choice for you if you know your income will rise and at least keep pace with the loan rate's periodic adjustment. If you plan to move in a few years and are not concerned about the possibility of a higher rate, an ARM also could be a good choice. But there are some limitations of HELOC loans. For example, you may need to pay back their loan whenever they want it because of the change of your financial conditions. But you may take a HELOC to pay your higher interest debts like cars and credit cards-interest is tax free and generally close to prime rate as long as your financial conditions are stable.

Shop for Your Loans:

All conforming loans are pretty much the same when it comes to the contract language but not with the same interest rates and settlement costs. So it is always good to ask your lender for a good faith estimate before making any decision. Try to compare apple vs. apple instead of apple vs. orange. But always make decisions based on reliability of your lender, not only just cost. Even if your reliable lender is charging a tiny more, try to work with him/her rather than going for a new lender. Because, you don't know what will happen at the closing table or can they really close the loan for the given quote?

Consider Loan Acceleration:

If you have extra money, try to pay for your principal whenever and whatever you can. One yearly extra payment for 30 years loan reduces the loan period 8 years to 22 years. Similarly, for 15 years loan, one yearly extra payment makes your payment period to 12 years.

Lenders of Bi-Weekly plan claim you can save thousands in interest by paying them a fee of about $400 to accept bi-weekly program. Basically, in this case you are paying 13 monthly payments (26 installments) a year instead of 12. Why would you pay $400 if you can control your financial habits yourself? But if you can't control your financial spending habits and can't pay extra payment on your own, bi-weekly program will force you to pay on time. In that case it is better to take bi-weekly program even if it will cost a little extra money.

Use Home Mortgage Interest Expense as Tax Deductible:

All of the interests on your mortgage debt used for both principal and second residence are tax deductible. But there is a limit of one million dollars on home debt and one hundred thousand dollars on home equity debt. But always there are exceptions depend on individual financial background. It is always good to talk with your accountant/tax professional about interest deduction when you are borrowing and/or taking home equity loan.

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Moneywise is hosted by Rajesh Jyotishi with Shalin Financial Services, Inc. A Registered Investment Advisor. For questions, he can be reached at (770) 451-1932, or email at rajesh@shalinfinancial.com


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