Buying Your First Property: Understanding Your Loan
Updated: Apr 30, 2019
When it comes to buying property, most of us don't have hundreds of thousands of dollars laying around to go buy one in cash. The reality is, that most of us will have to take out a loan in the beginning... which can actually make a lot of sense. However, taking out a loan and leveraging your capital can only make sense if you understand the what you're doing. With dozens of different loan programs, and hundreds of acronyms, there is a steep learning curve to develop. Today, we're going to cover some of the basic loan programs and acronyms, to make sure that when you first talk to your loan officer, you'll be speaking fluently.
Though there really are dozens and dozens of different loan programs out there, the market is really dominated by four major types, and unless you're a full time real estate investor, these are likely the loan programs you're going to be dealing with.
Federal Housing Administration Loan (FHA): An FHA loan is probably the one that you've heard of the most. This is a loan that can be used to purchase your first home, or multi family property for very little down... as long as you plan to live in it for at least a year. The Federal Housing Administration subsidizes your loan, allowing lenders to loan you more money, without the need for larger down payments. You can purchase a Single Family property for nothing down, or a multi family property for 3.5% down.
Use: Owner Occupied (1 Year)
Down Payment: 0% - 3.5%
Types: 1-4 Unit Properties
Rent: 2-4 Unit Properties can be rented as long as you occupy one unit.
Minimum Credit Score: 580+ (Sometimes lower with larger down payments.)
United States Department of Agriculture Loan (USDA): USDA is an awesome loan program that applies to only certain rural areas. The intent of these loans is to develop, and increase the population of rural areas within the United States. Now, when you hear the word rural, you may be thinking farmland, but you may be surprised! There are many cities that qualify for USDA loans, and you may not even know it! USDA loans have lower PMI than FHA loans do, and they are generally easier to get too! However, the residences can generally not be rented, and cannot be used to purchase multi family property.
Use: Owner Occupied
Down Payment: 0%
Types: Single Family
Rent: Generally Not
Minimum Credit Score: 640+
Veterans Affairs Loan (VA): VA loans are some of the best loans in the world, however, they are exclusively available only to those who served in the United States Military in some capacity. The department of Veterans Affairs truly allows you to get the best of both worlds. Not only can you purchase both Single Family and Multi Family properties, you can also buy both for $0 down out of pocket. To make things even better, VA loans are completely exempt from having to pay PMI! A seriously awesome loan.
Use: Owner Occupied
Down Payment: 0%
Types: 1-4 Unit Properties
PMI: 0% <----
Minimum Credit Score: 620+
Now that we are familiar with some of the most common loan programs, you'll need to understand some basic terms/concepts. Let's jump in!
Private Mortgage Insurance (PMI): Private mortgage insurance is something that almost nobody knows about when they buy their first property, and always shows up as a surprise when you see your monthly payment.
PMI is something that lenders will require you to have anytime you take out a government backed loan in which you put less than 20% down in cash. This insurance you take out, is essentially insuring the lender, and making sure that if you don't pay your mortgage and the lender loses money foreclosing on you, that the insurance is going to make them whole.
The bright side is that carrying PMI on your loan allows you access to programs that will allow you to put less than 5% down... often even 0% down. Saving your cash for other things you may need.
Annual Percentage Rate (APR): Almost everyone knows what an interest rate is. It's the percentage of money that a lender makes annually for extending you a loan. What most people learn the hard way however, is that the interest rate, is not the only cost of borrowing money.
Lenders will often try to get you in the door by advertising low interest rates, but what they don't tell you, is that they may be charging high fees. An APR essentially calculates all the fees, interest, and other back end cost associated with your loan, and converts it into a percentage that you pay each year... showing you a more accurate representation of how much the loan is REALLY going to cost you each year.
Principal, Interest, Taxes, & Insurance (PITI): When you are trying to calculate what your payment is going to be each month, often times you may only be seeing your principal and interest (P&I) payment, and not your (PITI) payment.
PITI calculates for your total payment, after adding your property taxes, and your insurance to your payment each month.
Adjustable Rate Mortgage (ARM): This is a less common type of loan, where the interest rate is not fixed for the full life of the loan. The rate will normally be fixed for 5-7 years, and then adjust up or down, based on current market interest rates.
Amortization (Am): Now, this is a tricky one to explain. An amortization is essentially a written out debt schedule. In a standard mortgage, the amortization will match the term of the loan, making it easy... but not always.
If you take out a thirty year mortgage, with a thirty year amortization, the day you make your last payment, is the day you will own your house free and clear. However, the amortization doesn't always match up like this. In order to keep payments lower, sometimes the amortization can exceed the term of the loan. For example, what if you have a thirty year amortization, but only a 10 year term? You are paying your loan off as if you have thirty years to do so, but the entire balance is due in 10 years. This will mean that at the end of your loan, you will still owe a large balance, which you will either need to refinance, pay off, or sell to get out of.
Loan to Value (LTV): The loan to value ratio is the algorithm by which lenders determine how much money they are willing to lend to you based on the property that you want to purchase. Many lenders will require at least an 80% LTV. What that means is that they will fund, or loan you, up to 80% of the value of the property that you are purchasing. Requiring you to come up with the difference in cash, as a down payment. If a lender is willing to lend 95% LTV, then you need to come up with 5%, and so on. Generally this term is actually widely misused, as lenders will often determine the value of the property based on the amount that you have agreed to purchase it for, and not what it is worth. What if you are buying it significantly under market value? This practice of determining value based on purchase price is more accurately referred to as Loan to Cost (LTC).
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