Mortgage

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Usually when people talk about getting out of debt, they aren't considering a home mortgage. The idea is that if you didn't have a mortgage you'd need to rent so you'd be spending the money anyway. Also when you rent you do not build up any equity and for many people, their home is the biggest portion of their net worth. Normally over time, home prices go up at least keeping pace with inflation, so a lot of people see a home mortgage as a necessary and prudent investment.

A mortgage on a reasonable sized home falls into a different class of debt that high interest credit card debt and other "bad" debt. However, it is still something you should consider very carefully. House prices do not always go up. When you buy a house on credit, you may find yourself in a situation where the house is later worth less than what you owe on it.

For example, if you purchase a house for $100,000, the first few years very little of your payment goes toward the principle. So after two years, you may still owe $96,000 on the house. If your job forces you to move, you will not really make any money on the house. In fact, it is likely you will lose money because of the fees and realtor commission.

Worse still, if the housing prices go down, your house may be worth significantly less. If a couple large employers go out of business or lay off a number of workers, there could be many houses on the market as people look to relocate to different areas of the country where jobs are available.

Even though you paid $100,000 for your house, it may only be worth $75,000. That means if you sell it, you will be required to come up with the difference between the selling price and what you owe on the house. In this example that would be $21,000. People in this situation often find they can't sell their houses because they can't come up with the cash to complete the transaction.

When you look at taking on a mortgage, be sure to consider that house prices don't always go up. Be sure to think ahead about how you will handle selling in a down market. This might mean you buy a much smaller house than what the bank says you can afford. With a cheaper house you can retain money in savings to pay the difference if it becomes necessary. Also with a cheaper house you can pay off the principle more rapidly in order to get more equity--money you don't have to repay when you sell your house.

It is also important to take a good look at the true cost of renting. When you factor in property taxes and other expenses, renting may be a good solution. This is especially true if you are unsure how stable your income may be.

There is nothing wrong with taking out a mortgage for a home, but it is important to understand the risks that go along with borrowing large sums of money.

Is a Mortgage Debt?[edit]

Usually when people talk about becoming debt free, home mortgages are considered to be in a different category. That is because traditionally, home mortgages have been very safe good investments. You can usually sell your house for more than you paid for it, so banks charge minimal interest. As a result many people make money when they sell their house over what they would have had they rented a place.

It is important to understand that house prices don't always go up. Also you may need to sell your house for a very low price if you need to sell the house and move quickly because of a job change or other reasons.

Right now there are sections of the country where houses are going for half of what they were just a few years ago. The problem is that for many of these home owners, they can't sell their house because it they don't have enough money to pay off what would remain on the loan once they sold. To make matters worse, many of the places where this is happening are in areas that have lost a lot of jobs recently, so there is a glut of houses being sold. As more people put their houses up for sale the home values continue to drop.

If you want to be debt free, you need to make sure you are careful about how you approach purchasing a house. Ideally you want to buy a house when everyone else is selling. You should also be careful not to over extend yourself. Don't try to get the biggest house possible. If you end up in a situation where you have to move, you may end up paying on the home mortgage for a few years before you are able to sell it so you want to make sure you can afford another place if necessary.

People usually consider renting to be a waste of money, but this isn't always the case. In some areas rentals include things like water and heat which can cost you hundreds of dollars per year if you are paying for them in a house. Also keep in mind that the upkeep you have to pay for on a house is usually quite substantial compared to what you would pay on a rental.

Cash Out[edit]

During the height of the housing bubble it was common to use a mortgage to get cash out of the equity of a property when it was being purchased. For example, if a house was being purchased for $100,000 but an appraiser said it was worth $125,000, the buyer could take a loan out for more than the purchase price. So in this example they could take a loan out for $125,000, pay $100,000 for the property and be left with $25,000 to do repairs or pocket.

While this might work fine in theory it turns out there is a lot of variability in the way houses are appraised. In many cases loans were being made for $125,000 on property that couldn't even sell for $100,000. To make matters worse some lenders would even loan 125% of the properties appraised value. So in this example, the health selling for $100,000 could qualify the buyer for a loan of over $150,000. It's easy to see how banks started getting in trouble when they were forced to foreclose on property that at best was worth only two thirds of what they had loaned on it. In many cases the property was being purchased for more than it was actually worth due to speculation or localized housing bubbles.

Due to new rules and banks being more careful, it is a lot more difficult to get cash out at closing days. Most banks will only loan you money for the lower of the appraised value or the purchase price. So if you have a house that appraises at $125,000, but your purchase price is $100,000 the bank will only loan you $100,000. In the past this wasn't a big deal because you could simply refinance and pull cash out of the value of the house. But the new rules have also changed that. Once you purchase the property you can't refinance and use the appraised value for at least six months. If you try to refinance before the six-month waiting period, you must use the original purchase price. This obviously prevents you from pulling out any value in the form of home equity unless it was actual cash you put down a purchase.

Qualifying for a Mortgage[edit]

There are a number of factors banks consider when determining whether or not they will loan you money for a mortgage. Here are some of them.

Credit score[edit]

Lenders will pull your credit score as one of the first steps in the loan approval process. Your credit score tells the bank how well you have made payments to other people in the past. Your credit score takes a number of items into consideration including your past credit history and any problems you've had paying past bills.

No credit history can sometimes be a negative just like a bad credit history. Some individuals have found that paying for everything in cash makes it harder for them to get a mortgage because banks don't have any proof that they have been able to make timely payments on debt in the past.

Also be aware that when a company checks your credit, it lowers your score for a while. This is done to reflect the risk that someone trying to get credit in a bunch of different places may be about to get a bunch of loans for various things and may represent a greater risk than someone who is simply trying to buy a house.

Income stability[edit]

Your employment history is important to a bank. They may be less likely to loan you money for a mortgage if you have just recently started your own business or a new job. If you are thinking about changing jobs, don't do it right before applying for a mortgage if you can help it.

If you are self employed be prepared to offer extensive paperwork showing your income and the viability of your business and past history. Some banks even want to talk to some of your customers to make sure you have a business that will continue to make money.

Debt ratio[edit]

Banks will look closely at your debt ratio to determine how much they can loan you. Generally this involves making sure that no more than about 38% of your income is going to pay for debt. So if you make $1000 per month, banks don't want to see your total payments (including the new mortgage) coming to more than $380.

Keep in mind that when the bank pulls your credit statement, they will see any outstanding amounts on credit cards. The minimum payment will be factored into this debt ratio. So even if you pay your credit card off at the end of each month, the amount they are willing to loan you will take these debts into account. Make sure you don't put a large purchase on your card right before they pull your credit.

The debt ratio calculation tends to favor people with no existing debt. For example, if you make $2000 per month and have no other debt, banks will be comfortable giving you a loan with a $760 per month payment. However, if you make $4000 per month and already have payments of $2000, they probably won't loan you any money at all because you already have committed 50% of your income to other things. Even though, you still have $2000 of income that isn't going to debt just like the person who only makes $2000 per month.

While this seems odd, banks realize that people who have a lot of debt already and are trying to get a house are probably dealing with consumer debt and people with consumer debt are likely to acquire more. They don't want the money that should be going to your mortgage to end up going to pay off a television and new stereo.

Collateral[edit]

When a bank is getting ready to loan you money on a house, one of the most important things they look at is whether or not they can turn around and sell your house if you default on the mortgage. This is where the appraisal comes in, but not only does the bank consider the value of your house today, they also want to try to project the future.

If you are trying to buy a house in an area where the home prices are declining, banks may not be willing to loan you as much money because they figure that the value may continue to decline and want to make sure that there is enough cushion between what they loan you and the value the house may drop to.

Debt Consolidation Mortgage[edit]

Many debt consolidation loans moves involve taking out a second mortgage or rolling debt into a new mortgage on your house. This is because mortgage debt is secured debt and therefore lower interest rates are available that are not available for unsecured debt. Unfortunately this type of approach means that creditors who had very little recourse against you if you went bankrupt can now take your house. Debt consolidation may be a good move for some people, but make sure you understand all the issues before using a mortgage on your home as the means of consolidation.