Mortgage Help Center

Rent vs. Buy	What's in a Mortgage Payment?	What is Yield Spread Premium (YSP)?
Qualifying For a Loan	Understanding Amortization	Broker vs. Lender
Pre-Qualified vs. Pre-Approved	What's Tax Deductible in the Loan Process?

Rent vs. Buy

If you’re a First Time Homebuyer, you may not be entirely convinced that buying a home is cost effective for you. You may be aware that in addition to your monthly mortgage payments, you will most likely have monthly tax and insurance payments well. And before you know it, the cost of owning a home is a lot more than renting one! But fortunately, the federal government has set up generous tax laws to make homes more affordable for potential homeowners. Though you are required to pay property taxes on your home, these payments are deductible on your personal tax return. Additionally, the interest you pay on your mortgage is tax deductible. With these benefits, home ownership becomes much more affordable! Take a look at the below example which compares the likely housing payments on a $450,000 home, purchased with 10% down, with a rental payment. Also make sure to try out our Rent vs. Buy Calculator.

			Buy		Rent
Monthly Housing Expense (Gross)
Rent/Loan Payment (P&I)			$2,025		$1,600
Property Tax1	+		$470		none
Property Insurance1	+		$75		none
Mortgage Insurance (if applicable)	+		$0		none
Homeowner Association Fees (if any)	+		$0		none
Total Monthly Payment	=		$2,575		$1,600
Income Tax Consideration
Monthly Interest Payment			$2,025		$1,600
Monthly Property Tax1	+		$470		none
Total Deductible Payment	=		$2,495		none
Income Tax Bracket (Fed & State)	x		34%		32%
Potential Monthly Tax Deductible Savings2	=	up to	$848		none
After-Tax Housing Expense (Net)
Total Monthly Payment			$2,575		$1,600
Less Potential Monthly Tax Savings2	-		$848		none
After-Tax Housing Expense	=		$1,727		$1,600

Qualifying For a Loan

A common question most borrowers have is, “how is my loan application evaluated”, or “what is an underwriter looking for?” There are 4 main things an underwriter is evaluating: capital, capacity, character, and collateral. The first 3 relate to the borrower, and the fourth refers to the evaluation of the property. Most of the documentation that must be provided in the loan application is for the verification and validation of these 4 parameters. The following is a discussion of each parameter:

CAPITAL- Capital refers to whether you have enough money for the down payment and closing costs. If it’s a purchase, and you’re putting down 10%, the underwriter will want to know where this money is coming from. For example, do you have this 10% in a bank account, a retirement account, or is it a gift from a relative? Gift money from other is certainly permitted, but there are restrictions with gift money. The underwriter will also want to know if you have enough cash for emergencies. An underwriter will generally require 2 months (sometimes more) of PITI (principal, interest, taxes, and insurance) in a bank account or retirement fund, in case you come upon financially hard times and have trouble paying the mortgage.

CAPACITY-Capacity refers to your ability to repay the debt. Based upon the income indicated on your loan application, the underwriter will calculate your debt-to-income ratio (DTI ratio). The DTI ratio is calculated by adding the minimum monthly payments of all your revolving (ie credit card) and installment (ie car loan) debt, plus your new mortgage payment (including taxes and insurance), and dividing by the monthly income indicated on your loan application. For example, if you have $200 in monthly credit card payments, $400 in monthly card payments, and your new mortgage (principal, interest, taxes, and insurance all included) will be $3000, then the total of your new monthly debts will be $3600. If your monthly income before taxes is $8000, your DTI ratio will be $3600/$8000= 45%. 50% is generally the maximum DTI a lender will allow.

CHARACTER-Whereas capacity refers to your ability to repay the debt, character refers to your past history in paying back your creditors. An underwriter will review your credit report and examine how you’re handling current debt obligations, and how you’ve handled past debt obligations. Particularly, the lender will want to know if you’ve ever been late on a mortgage payment, ever declared bankruptcy, or ever been foreclosed upon. Additionally, the lender will evaluate your tri-merged credit score. When you apply for a credit card or car loan, your credit is pulled from only one of the 3 bureaus (Equifax, Transunion, and Experian ). However, when you apply for a mortgage loan, your credit is pulled from all 3 bureaus; hence the term, tri-merged credit report. Your score can vary widely with each of these bureaus, and the underwriter will only use one of these scores to make an approval decision. Specifically, the underwriter will take the median of the 3 scores, ie the middle score. So if a borrower has scores of 650, 690, and 740 reporting, the lender will use 690.

COLLATERAL-The evaluation of capital, capacity, and character is specific to the borrower. However, since the borrower is pledging his/her property as collateral for the loan, the underwriter wants to know the value of that collateral. To assess this value, a professional, certified appraiser that is a neutral third party to the transaction (ie not an employee of the lender and not a close friend or relative of the borrower) will be sent to the property. The appraiser will determine the fair market value of the property, ie the price that would be agreed upon in a sale between a willing buyer and seller. If the property is a purchase, an appraiser will make sure the sales price is justified. In the event the sales price and appraised value are not the same, the lender will use the lesser of the sales price and appraised value.

Pre-Qualified vs. Pre-Approved

When you begin the process of applying for a loan, you may obtain a pre-qualification and/or a pre-approval. Though the 2 terms sound similar, they are not, and there is a distinct and important difference between them. A pre-qualification is a determination of how much of a mortgage you qualify for based on un-substantiated information. Your credit will not be pulled, and hence your credit report not examined. Income and assets will also not be verified. A pre-qualification is a rough estimate, and a pre-qualification letter is generally unacceptable to a realtor or any other 3rd parties.

However, a pre-approval letter carries far more weight. With a pre-approval, the borrower’s credit report has been pulled and evaluated for credit score, mortgage lates, bankruptcies, etc. Additionally, the GOTeHomeLoans representative has completed a Uniform Residential Loan Application for the borrower, and substantiated the information in that application with various supplement documentation as mentioned above (ie W-2s, bank statements, etc.). When a borrower has been pre-approved, he or she is provided a commitment from the lender based on certain conditions (ie property appraises for appropriate value, 24-mo chain of title is demonstrated, etc). If the borrower is shopping for a home, the realtor will require a pre-approval letter, rather than a pre-qualification letter, before showing properties to the borrower.

What's In a Mortgage Payment?

The monthly payment you make on your home consists not only of your mortgage payment, but “impounds” as well. “Impounds” refer to the pro-rated property taxes and hazard insurance payments you are required to make. You may have heard the industry term “PITI”. This stands for Principal, Interest, Taxes, and Insurance. When an underwriter evaluates whether you can afford your new loan, they account for the fact that your monthly payment consists of PITI, and not just the mortgage payment. So let’s first discuss the property tax component of your monthly payment.

Your property taxes are levied by the county in which the property resides. These taxes are required to be paid twice a year (consult your GOTeHomeLoans representative for the due dates on these property taxes, which vary by state). The annual tax payment is roughly equal to 1.25% of the assessed value of the property. Note we did not say “appraised value”. If you are purchasing a property, the assessed value will equal the appraised value. But if you are refinancing, the assessed value is the value determined by the county assessor’s office. For example, if you are refinancing your home, and the county assessor has determined the property value to be $400,000, but the appraiser the bank sends to your home says the value is $440,000, your property taxes will be based on $400,000. The appraised value is not reported to the county. Per these property taxes, you may pay them on your own twice per year, or you may have your mortgage lender do it for you. When your mortgage lender pays your property taxes, you will be required to make monthly payments to your lender so that they will have the money to pay your taxes. For example, if the assessed value on your home is $400,000, and our property tax rate is 1.25%, your annual tax liability will be $5,000. This equates to $417 per month ($5,000 divided by 12). Thus, each month your lender will require you to pay $417 to your tax impound account, and before the due dates on the property taxes, your lender make the payments for you.

Additionally, your monthly housing payment may consist of insurance impounds. Insurance impounds function the same way as property tax impounds. Your insurance provider (and every lender requires the property be insured for catastrophic damage, ie fire) requires an annual or bi-annual payment on the insurance premium. You may pay this on your own, or have your lender pay for you. If your lender pays for you, you will be required to make monthly payments towards the insurance impound account. A ballpark number to use for calculating your insurance payment is 0.30% of the total loan amount (not the property value). For example, if you are purchasing a property for which you require a $350,00 loan, your annual insurance payment will be in the ballpark of $1,050, or $87.50 per month if you setup an impound account.

Talk to your GOTeHomeLoans representative about whether setting up an impound account is right for you. In some states, such as California, there is no penalty for paying these taxes and insurance on your own. In other states, you will be required to pay approximately 0.25% of the loan amount at closing, in addition to standard closing costs, if you choose to waive impounds.

Understanding "Amortization"

The amortization period refers to the length of time over which the installment payments towards principal are calculated. For example, an amortization period of 30 yrs means that, for purposes of calculating the loan payment, your payment towards principal will be spread out over 30 yrs, with the total amount of principal (ie the loan balance) being paid off at the end of that 30 yr term. Say, for sake of example, you have a $300,000 loan at 0% interest with a 30 yr amortization period. Your required payments towards the $300,000 principal balance would be spread out over 30 yrs, requiring payments of $10,000 per year ($833 per month). Contrarily, if the amortization period was 15 yrs, your payments would be $20,000 per year ($1666 per month), so that at the end of the 15 yr amortization period you’ve paid off the principal (15 yrs X $20,000 per year).

The calculations in our above example were fairly straight-forward since we assumed a 0% interest rate. And we assumed a 0% interest rate for purposes of explanation. But in the real world we pay interest for money borrowed, and the calculation of the monthly payment in this case is a little more complicated. The reason is that the principal payments are not equally spread out over the amortization period. Rather, the principal payments increase over the life of the loan, while the payments towards interest decrease over the life of the loan; all the while, the total monthly mortgage payment remains fixed. Say, for example, you have a $435,000 principal and interest loan (it could be a fixed rate loan or an adjustable rate loan), with a 6.50% interest rate and a 30-yr amortization period (and thus you know the values of the 3 variables identified above). Your monthly payment in Month 1 and Month 12 would be as follows:

	Month 1	Month 12
Principal payment:	$393	$417
Interest payment:	$2,357	$2,333
Total:	$2,750	$2,750

As you can see, the amount of the monthly mortgage payment which is applied towards principal has increased, while the amount applied towards interest has decreased. So how would this look over the 30-yr life of the loan? Let’s take a look at the graph below. Note we have annualized the mortgage payment for better display purposes (total annual mortgage payment is 12 X $2,750= $33,312).

As this graph shows, the mortgage payment remains fixed, while the amount applied towards principal increases over the life of the mortgage. Note too the rate at which the payments towards principal increase, and observe that it’s not until year 20 that the principal payment is more than 50% of the total mortgage payment. It is often a surprise to borrowers that their principal is not being paid down as fast as they thought.

What's Tax Deductible in the Loan Process?

In the "Rent vs. Buy" discussion, the income tax deductibility of monthly interest and property taxes was explained. But besides these tax deductible items, elements of the closing costs are also tax deductible.

Origination fees and points
Loan origination fees and discount points (items #801 and #802 on the settlement statement) qualify as an itemized interest deduction.

Prorated real estate taxes
When buying or selling property, a major tax deduction many real estate buyers and sellers overlook is the prorated property tax they paid at the close of escrow. Even if the other party remitted the payment to the tax collector, but you were charged a prorated portion of the tax bill, be sure to deduct your share on your income tax return.

Deduct prorated mortgage interest in the year of property purchase or sale
Similarly, if you bought a residence and took over an existing mortgage, don’t forget to deduct your prorated interest share for the month of the sale. Your final closing/settlement statement shows your prorated share of the mortgage interest.

Mortgage prepayment penalty
If you paid off an existing mortgage early and were charged a prepayment penalty by the lender, that prepayment penalty qualified as an itemized deduction.

When land rent payments qualify as interest deductions
Million of homes are located on leased land. Internal Revenue Code 163 allows land rent to be deducted like interest when the lease; (a) is for at least 15 years, including renewal periods; (b) is freely assignable; (c) contains a present or future option to buy the land; and (d) is like a security interest, such as a mortgage. Payments to buy the land are not deductible, nor are ground rent payments deductible if you do not have the option to buy the land, such as in a mobile home park.

Home construction loan interest
If you plan to build a new home, or are building one now, don’t forget to deduct the construction loan interest paid. It’s deductible if the construction period does not exceed 24 months before occupancy of your principal residence.

Deduct prepaid property taxes and mortgage interest.
If you prepaid next year's real estate taxes last year, as homeowners do to increase their tax deductions, or if you pay prepay your January mortgage payment in December of the previous year, don’t forget to deduct these extra mortgage interest and property tax payments on your income tax return.

What is Yield Spread Premium (YSP)?

Yield Spread Premium, or YSP, is the mark-up between the wholesale rate and the interest rate. Much like one can buy a piece of equipment wholesale, and sell for a premium, the same applies for mortgage of rates. The loan officer, whether a broker or agent of a retail bank (ie Bank of America, Wells Fargo), acquires the mortgage note at wholesale from the wholesale division of a bank, marks up the rate before selling to the consumer. The wholesale division of the bank pays the loan agent a premium for selling the mortgage note at a higher rate then wholesale. For example, the wholesale rate on a 30-yr fixed note might be 5.50%, and the wholesale division of the bank might offer the agent $4,000 if the note sells for 6.00%, or $6,000 if the note sells for 6.25%. The $4,000 and $6,000 compensations are the Yield Spread Premium. This YSP is often hidden from the borrower- and since it is hidden from the borrower, it opens the opportunity for Yield Spread Premium abuse. For more discussion on this topic, read the Mortgage Professor articles, "Can Mortgage Points Be Negative?" and "Eliminating Yield Spread Premium Abuse".

Broker vs. Lender

This is a great question.....but also a trick question. Typically the question is "should I use a broker or lender", with the assumption that a broker is a "middle-man", and a lender is the true source of the loan.  But it should be clarified that it is the wholesale division of the lender that is the true source of the loan, and consumers deal with the retail division of the lender. One must have a mortgage license to deal with the wholesale division of the lender. The retail division makes its money the same way a broker does- through origination fees, broker/admin fees, and Yield Spread Premium. Thus whether a consumer uses a broker or retail division of a bank, the consumer is still 1-step removed from the "source", so a broker is no more a middleman than the retail division.

It is always wise to shop around for your mortgage, and a retail division of a lender (ie Bank of America) should always be consulted. The advantage to dealing with a retail division of a lender is that a lender will honor a mistake in the customer’s favor made by one of its employees, but it probably won’t honor a mistake made by a mortgage broker. The disadvantage to dealing with a retail outlet of a lender is that only those lender's loan products are available to the consumer, whereas a broker has access to a wide array of loan programs, and knows where to go for a particular scenario. For more discussion on this topic, read the Mortgage Professor article, "Mtg Brokers vs. Lenders: Some Questions".