A few words about the procedure of getting a mortgage. I have noticed, that a lot of people, especially first home buyers, find themselves pretty much at a loss as to where to start, where to look and who to turn to, if you want to buy a home.

Certain details may fluctuate in our turbulent times, but the big conceptual steps remain the same, for they are not based on the whims of the market, but rather on common sense developed from them. Let’s take a walk, step by step.

Step One: first of all, you have to estimate how much of a home you can afford. Our Affordability Calculator can be of great help here. You can fiddle with parameters like Down Payment or Interest Rate to find out the maximum rate you can agree to and the most sensible amount to put down. In real life, however, you have to be prepared for other influential factors to pop up, your credit score being probably the strongest. Generally speaking, the affordability estimate you are making in the very beginning reflects only your personal financial capability; the credit score is important at a later stage, when a lender decides on the terms of your mortgage. I am drawing your attention to the score now only to point out, that if your score is far from perfect, the ideal combination of, say, the interest rate and the down payment you have calculated for yourself, may not be possible in real life. The low credit score puts you in no position to wish a lot from the lender, you will rather have to agree to whatever the lender offers to you. It should not stop you from shopping around for a better deal, though. On the contrary – the lower the score, the harder you have to look for both conventional and non-conventional offers. Even a minor difference in the initial conditions may make a big difference in the long run.

If you do not trust your own judgment, ask a realtor or a lender to make pre-qualification calculations for you. At this stage, it can be any realtor or lender, as a request of pre-qualification imposes no commitment obligations either on you or the other party.

Step Two: the pre-qualification estimate in place, you can start getting real. The following step involves actually two parallel processes: looking for a dream home and getting pre-approved. If you are looking for a home yourself, pre-approval is recommended, if a realtor is looking for a home for you, an official pre-approval by a lender may be required, as the realtor needs to make sure he is not wasting his time by looking at properties you cannot afford. Pre-approval is based on a complex analysis of information about your income, credit history and assets. You have to be very thorough working through the checklist of documents you have to provide, otherwise the process may take a very long time. The lender verifies the information, checks on your credit score and pre-approves you for a mortgage loan of a certain type and amount. He will probably also provide you with information about the possible price of the loan, the interest rate, other options, but nothing is fixed yet as the property to be mortgaged is unknown. As the lender will make an inquiry about your credit history, your credit score may get affected. The effect inquiries have on the credit score is explained in my article.

At this point it is still not critical which lender you choose. The pre-approval issued is only a pre-approval, not an obligation to stick to the partnership. For either part, by the way. A pre-approval describes your situation of a certain period of time. Even though officially it will probably be valid for 45 days, you cannot expect the lender to stick to his initial opinion if your circumstances, or the market, change dramatically. Same as you should not consider yourself obliged to deal with the lender only because he pre-approved you. However, if your situation has not changed by the time of the actual purchase, the approval with the same lender will very likely be streamlined as the lender should already have most of the necessary documents.

Lenders do pre-approvals in the hope, that you will borrow from them when you are ready to buy. For you, an up-to-date pre-approval means that if you find a property you really want to buy, you will have certain advantages over your non pre-approved shopping competitors: the advantage of time – pre-approval makes the entire loan approval process more efficient; the advantage of means – pre-approval indicates to the seller that you are a trustworthy capable buyer.

Step Three: the search is over – you have found your dream home! Now you need to make a written Offer to Purchase, and as soon as it is accepted, the process of approval can be started. Approval is a lot like pre-approval regarding the things you need to do, which is basically providing all the necessary documents as accurately and soon as possible. However, approval implies an a lot higher probability of closing a mortgage with this particular lender. It is almost an obligation. The property is known, the terms and the type of the mortgage are discussed and agreed upon. In fact, the only reason for a lender to back off at this stage is the borrower’s failure to meet some of the qualification requirements. If you had been pre-approved, even by another lender, for the mortgage type you are seeking now, failure to comply is not very likely to occur, unless your circumstances or the market have changed a lot since.

The most important thing to always bear in mind here is – by default, approval does not lock the points and the interest rate on a mortgage! Points and rates may be quoted, but you should not assume that they are already applied to your mortgage. They are not until you lock them! Rates change all the time and lenders’ quotes get reset every day, or sometimes twice a day to match the market. There is always some time gap between the approval and the closing. During this time, the rate will continue to fluctuate. Even if the general tendency of the period around seems to show the decline in mortgage interest rates, it is impossible to predict how long the trend will continue. When it finally comes to closing you may have to face an interest rate considerably higher than you counted upon in the first place. It’s a gamble on the one hand and the lender’s interest on the other. Even if the rates do go down, the lender will try to impose the highest rate possible under the circumstances on you anyway, knowing you don’t have very much room for maneuvers left now that the process has gone so far. The bottom line: if you are satisfied with the points and interest rate quoted on the day you are approved – lock them. It will still take a couple of days, during which all you can do is count on the lender’s honesty, but then you can relax and be sure of what exactly mortgage you have. For another 30 days, or other period, as agreed and paid for. Locking is a commitment. Once you’ve locked the points and the rate, you are expected to stick with the lender. However, lenders regard this situation potentially unfavorable for themselves and require a payment to compensate for the losses if the borrower backs off before closing. The payment usually locks the points and the rate for 30 days, during which some borrowers continue to shop for an alternative mortgage with other lenders, and, believe it or not, sometimes find it more profitable to switch to another lender anyway.

A payment as such is not enough to lock the rate and the points. Locking requires additional documents, too, as the lender makes sure he is not getting himself into trouble with this commitment. I would say, the documents are even more important than the money. Some lenders require the credit report, appraisal, a purchase agreement etc., i.e. documents from a more advanced stage of the mortgage process, to make sure that the borrower stays all the way to the closing. If you intend to lock, which I recommend you do, it is advisable to find out about the locking requirements and conditions well in advance.

When the home mortgage loan is approved, a closing date will be set up and the lender will be able to review the closing with you.

Points are quite a useful tool helping a borrower to lower the interest rate on his mortgage loan. The price of one point equals to 1% of the amount you borrow. If you pay this 1% amount in cash at the loan origination, the interest rate of your loan will drop by usually 0.25 percentage points. Each new discount point bought lowers the loan interest rate by another 0.25 percentage points. Thus, a 7% original rate can be reduced to 6.5% by buying 2 points. Sometimes the 0.25 percentage points off the rate become pricier if you go for more than 2 discount points. The lender may require that you buy, say, 3.5 discount points to reduce a 7% rate to 6.25%.

You cannot buy your interest rate totally out, though. Usually lenders offer several combinations of the rate and points for you to choose from.  If you see a 7% and 2 points offer in an ad, it is not very likely to be the only option available. All you have to do is ask.

Even though the idea of discount points looks rather attractive, I find it important to draw your attention to a number of subtle matters involved, and help you avoid any financial losses that may occur if the points get to be applied inappropriately.

As I have mentioned before, points have to be paid for in cash. If you are low on cash at the time of the loan origination, do not buy points, first make sure you have enough cash for an at least 20% down payment. Avoiding PMI is a lot more important!

The calculator can help you estimate whether points can be any use for you at all. Even though they do reduce the rate, the price of this reduction is pretty high. The points are not cheap and you have to make sure they are worth the money. The key to this estimation is the break-even period – a period of time by the end of which the amount you have paid for the points and as monthly payments becomes equal to the amount you would have paid as monthly payments if you had not bought any points. This is the break-even point. Only after this moment the points will start to really save you some money. The length of the break-even period usually varies around 3-4 years, which brings us to the bottom line of the paragraph – buying points only makes sense if you are sure that you will keep this particular mortgage longer than that. Long-term Fixed Rate Mortgages potentially have the best return on points.

Points bought for a short term Fixed Rate Mortgage may yield some return, too, depending on how long you stick to it. Buying points for an Adjustable Rate Mortgage is usually a less wise choice. The rate you buy down will hold only during the initial period, i.e. until the first rate adjustment. The advantage that you do get, though, is that the lower initial rate determines a lower maximum rate, if the overall maximum rate cap of your Adjustable Rate Mortgage is a value relative to the initial rate, as opposed to an absolute one. And for that matter, there’s been a word around of lower point prices on short initial rate period Adjustable Rate Mortgages. The break-even rule holds for Adjustable Rate Mortgages, too, but it is harder to estimate, because of the changing indexes and rates.

The usually painful question of taxes proves to be quite significant and still painful in regard to points, the effect they have on the interest rate, and consequently, the amounts paid towards interest. Interest payments, as well as point payments, made in a given year are deductible in that year. On a purchase transaction, points are deductible in the year of purchase, but on a refinancing, points must be deducted over the life of the loan. There are other regulations about the deductibility of points that are explained on the IRS web-page. However, each case is unique and requires special attention, consideration and professional advice.

One general rule holds, though: the lower the interest rate > the smaller the amount of money paid as interest > the lower the amount you can deduct from taxes.

Now, the last, but not the least – negative points (also called “rebates”). This is the way points work the other way around: the lender pays some of the closing costs for you in exchange for a higher interest rate on your loan you have to accept. Negative points can become your (rather expensive though) way out of a situation, when you cannot afford paying all the mortgage closing costs yourself. It is, I’d say, quite a desperate and costly measure. I wouldn’t recommend resorting to it, unless it is really necessary. If you got yourself into a mortgage with negative points, try to get rid of it as soon as possible. Do not wait until the overcharged interest rate depletes your funds.

And always remember – you are not obliged to buy any points. They are just an option provided for your convenience if you want it that way. Nobody can make you buy any points if you don’t feel like doing so.