Collateral
The second part of figuring out how much you can afford to spend on a home is the collateral pledged for the loan.
For collateral security, lenders care about two things:
- the amount of the down payment
- the professional appraisal of the property value
If you can’t make the loan payments and the lender has to foreclose on the house, they want to make sure that the total of these two amounts (how much money you put down and how much the home is worth) will cover the cost of the loan.
Down payments:
So if you have a 5% down payment, you are borrowing 95% of the home purchase price from the lender. The 95% number is often called the Loan To Value or LTV and is used to evaluate the risk of the loan.
Risk: From the lender’s perspective, the more money you put down when you buy, the more likely you are to keep paying the mortgage even if times get tough: so the less risky the loan.
Over the many years of mortgage lending, lenders discovered that if you didn’t put down much of a down payment, you aren’t losing as much of your own money in a foreclosure and are therefore more likely to walk away from the property if you are having problems making payments.
Avoiding Defaults: Lenders don’t want to foreclose; it is expensive and time consuming, so they’d much rather lend money to people who look like a good risk. That’s why they offer better interest rates and fewer additional costs like mortgage insurance to people who invest at least 20% of the home purchase price, in their own money, at the time of the sale.
The Magic Number: So if you want the cheapest loan, one part of figuring how much you can afford is to look at how much money you have for a down payment (and to cover closing costs [link to CC section]). You will need at least 20% of the purchase price in order to qualify for the lowest-rate loans, and not have to also buy private mortgage insurance (PMI).
No Silver Spoon? Most first-time home buyers don’t have that kind of cash, and there are lots of options if you don’t:
- FHA and VA loans [link to sections]
- Private Mortgage Insurance (PMI)
- Community Programs requiring little or no down payment Secondary Content Box A
- Secondary Loans for the percentage of the down payment not in cash (these are often called 80-10-10s, or 80-15-5s, etc. where 80% is the first mortgage, 15% is the second mortgage, and 5% is the down payment.
- 100% Financing: some lenders offer loans requiring zero down payment. These loans usually have higher interest rates to compensate for the increased risk of foreclosure, but they can be a good solution if you have a stable income but little savings.
Appraisals:
An appraisal is a professional estimate of a property's market value.
More than a “Comp:” A real estate agent can give you an educated opinion of the value of a property based on their experience and what are called “comps,” (recent sales of comparable properties in the neighborhood), but this is a ballpark estimate.
More than a Property Valuation: another way to estimate value is to get a property valuation either online or over the phone. This can be a quick way to get a feel for the amount a property is worth, but like a comp, it is really more of a rough guess than something you can take to the bank.
Official Appraisal: For a professional estimate, the property will be analyzed by an independent, licensed person called an Appraiser. And a lender will require that any property they lend money on has a recent (usually in the last 6 months) appraisal as part of the deal.
Why They Want One: The lender wants to make sure that the property is worth at least as much as they are lending to you to buy it, and if the appraisal doesn’t show at least that amount, it’s very unlikely that they will give you a loan to buy it.
Cost: Appraisals generally cost between $300 and $1,000, and the buyer pays for it, usually as part of the closing costs. Interested in Property Valuation?