A brief course on lending

The world of lending can be confusing and daunting. For many folks, so is buying a home. There are a lot of myths about the homebuying process — 83% of homeowners say they were surprised by at least some aspect of buying a home.

A major piece of homeownership is getting a mortgage, which is a loan for buying a house or other property. With some input from Gordon Rice, who has spent 30 years in the banking industry as a lender and is now director of lending services at Neighborhood Housing Services of Chicago, we've put together this guide to how lending fits into becoming a homeowner.

"We want to make sure that our homeowners in Chicago and Cook County are taken care of, whether it's through us or somebody else," Rice said. "We want to make sure that we are addressing the needs of our community, and we get people into homes that are looking for that in this chapter of their life."

For many Americans, a home is the biggest purchase they'll ever make. The payment, however, is not all upfront. Prospective homeowners take out a mortgage to make that purchase, which breaks the payment into increments over many years. One of the first steps in the process a homebuyer should take is determining a budget: how much they can put toward a down payment and how much they can realistically pay every month.

The connection between home ownership and lending doesn't stop at a mortgage. Owning a home also gives borrowers increased leverage when asking the bank for a personal loan. This is just one way homeownership can facilitate long-term stability.

What is a mortgage?

A mortgage is a loan from a bank or other lending institution used to purchase property. Once the borrower pays off the mortgage, plus interest, they own the home outright. There are several types of mortgages for people in different financial situations and stages of life.

In general, mortgages are made up of four parts: principal, interest, taxes and insurance.

The principal is the amount of money borrowed to buy a house. Keep in mind, more money paid upfront on the down payment means a smaller principal.

Interest is the cost of borrowing that money — it generally appears as a percentage of the total amount borrowed. Sometimes, a higher credit score can lead to a lower interest rate.

In Chicago, all homeowners must pay a property tax, with some exemptions available. The statewide average is 2.07% of the total value of a property. Property taxes in Cook County are paid over two installments each year.

Homeowners insurance protects the homeowner from all sorts of things, like damage to their house or theft. Home insurance isn't required by law, but lenders typically require it as a condition of a mortgage. Mortgage insurance, on the other hand, is usually only necessary for borrowers who put a down payment of less than 20% on their home.

Generally, homeowners insurance and mortgage insurance are paid annually. But, many mortgage agreements allow borrowers to pay insurance and taxes a bit at a time, as if it were a monthly bill. Those payments are saved in an escrow account until the actual bill is due. This system helps borrowers to not fall behind on payments.

Why do I need to get preapproved?

"A lot of people start looking, they don't get the preapproval letter ahead of time," Rice said. And unbeknownst to them, they fall in love with the property that weekend. A lot of times if there's multiple people that want to buy the same property, [so] having a preapproval will expedite that process. [Preapproval] shows that they're a legit buying customer, they've already been given their amount of what they can afford."

When you apply for an actual mortgage, Rice added, you will do so with the same lending institution that gave you a preapproval letter or contract.

How do I decide which lender to work with?

When shopping around for a mortgage, it's important to determine which lender offers the best terms. Rice recommends working with a reputable company, maybe someone a friend or family member had a good experience with. Borrowers should avoid loan officers who work on a commission basis, Rice said, because they may not have your best interests at heart.

"All my loan originators are not on a commission basis. They're salaried. So, their job is to go ahead and not show any favors to anybody, there's no extra commission to be made outside of just trying to help the homeowner get into the best possible situation for them," he said.

Types of mortgages and loans

"A" Loan: A term to describe loans with the best possible terms, conditions and interest rate. Borrowers must demonstrate strong credit to be considered for an A loan.

Adjustable-Rate Mortgage (ARM): The interest rate on an ARM will fluctuate based on market conditions. ARM rates usually start low, but once the rate increases, monthly payments will increase, too. When the rate decreases, so will monthly payments. These mortgages are also known as variable-rate loans.

"B" or "C" Loan: used to describe loans or mortgages with less-than-ideal terms and conditions, such as high interest rates and fees. Borrowers with little to no credit history or a history of bad credit are unlikely to get an A loan, but may qualify for a B/C loan. These can generally be classified as subprime loans.

FHA Loan: a mortgage insured by the government and issued by a bank or other lender. This loan type is intended for low- or middle-income earners who may not get approved for a commercial mortgage. FHA loans require a minimum 580 credit score and a 3.5% down payment, but they tend to come with higher interest rates than conventional mortgages and require borrowers to purchase mortgage insurance.

Fixed-Rate Mortgage: A mortgage with a stable interest rate that does not change. Monthly principal and interest rate payments will stay the same for the life of the loan.

VA loan: a home loan backed by the Department of Veteran Affairs for U.S. veterans. These loans have a low down payment or none at all — nearly 90% of all VA-backed home loans are made without a down payment.

USDA Loans: United States Department of Agriculture (USDA) Rural Housing Service Loans are available in designated rural areas for low- and moderate-income buyers and are insured by the federal government.

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Some other terms to know when it comes to getting a mortgage

Automated Underwriting System (AUS): When a potential borrower applies for a loan or loan preapproval, the loan officer will run their application through an AUS. The computer program looks at information like income, debt-to-income ratio, employment history, credit history, public records, cash reserves and liquid assets to determine whether to approve the borrower for the loan. While automated underwriting is quicker than manual underwriting, the latter can be a good option for individuals with bad credit histories or complicated financials, whom an automated system may be quick to deny.

Commitment Letter: a formal document that serves as proof a borrower is preapproved for a loan. The letter states what amount the borrower is preapproved for, but the letter is not binding. It is often dependent on listed factors, like a second credit check closer to closing and a home inspection. Usually, real estate agents and home sellers won't consider an offer from a prospective buyer without a commitment letter.

Compensating Factors: elements of a borrower's financial profile that allow lenders to be more forgiving in other areas where the borrower's qualifications aren't as stellar. An example of a compensating factor could be significant additional income, like yearly bonuses or seasonal work, to compensate for lower regular income. Another example is mortgage insurance, which can act as a compensating factor for borrowers with low credit scores.

Debt-to-income (DTI) ratio: a calculation comparing debt to income. The amount of a borrower's monthly debts divided by their gross monthly income (including their housing payment) equals the debt-to income ratio. It is a major factor used by lenders to determine how much to loan a borrower.

Derogatory Information: negative information on a borrower's credit report that can be used to turn down a mortgage application. Examples include serious loan delinquency or frequent late payments.

Four C's of Lending: The four major factors lenders consider when determining whether to approve someone for a loan.

* Capacity: whether the borrower will be able to pay back the loan. This includes income, savings, debt-to-income ratio, existing debt and other financial commitments.

* Capital: any readily available money, savings and investments for a downpayment and other fees associated with the homebuying process.

* Credit: credit score history and other records of paying bills on time.

* Collateral: Lenders will consider the value of the property the borrower is getting a mortgage for, as that property will act as security against the loan. (If the borrower doesn't pay back the mortgage, the lender could take possession of the property.)

Loan Officer: the person who takes applications for loans offered by a bank or lending service. The loan officer can answer questions, provide written information explaining loan details, and help borrowers fill out a loan application.

Subprime Loan: credit and loan products — including mortgages — which have less strict approval terms and conditions compared to a typical loan. However, as a compensating factor for the higher risk, subprime products charge consumers higher interest rates and fees. Many subprime loans are considered to be predatory because they do not appropriately take into account whether the borrower will be able to pay back the loan.

Truth-in-Lending Act: A law that protects consumers against inaccurate and unfair credit billing and credit card practices. This act means lenders must always inform borrowers of all the terms and conditions of their loan.

Wait, how do I get a mortgage?

Once you decide you're ready to seriously begin your home buying search, a major step is to get preapproved for a loan. (Earlier steps include building credit and saving for a downpayment. For our glossary on that, check out last month's guide). Below are the six steps of the mortgage process.

Research

How much do you have saved for a downpayment? How much can you realistically spend per month?

Preapproval

Preapproval is an offer from a lender to loan a certain amount — a.k.a. the mortgage amount they will approve you for. This is based on information including a credit check, pay stubs, bank statements, tax returns, ID and social security card. You should get preapproved before finding a house you want to buy. You should also visit different banks and credit unions to see what your loan options are and get the best deal.

"I usually ask [new clients] to either go through the homebuyer education seminar process or preferably, in our lending group, we want to get you preapproved," Rice said. "So then, when a property is attractive to the homeowner and a future homebuyer, with a realtor, they can go ahead and make that offer if they feel that's the property they want to purchase."

Loan

Once you find a home and put in an offer, then you can go through the loan application process. This will be similar to preapproval, but now you know exactly how much to ask the lender for.

Loan processing

A loan processor will verify your credit and other financial and work history. They will also order an appraisal of the property you're looking to buy, which will determine the value of the home.

Underwriting

An underwriter will look at the four Cs of lending, determine your risk level and decide whether to approve you for the mortgage. They may also ask for additional documentation.

Approval and Closing

Once you've been approved, it's almost time to celebrate! You will still have to sign final documents and pay closing costs.

"Don't run out and buy a car or take on any debt until you close on your loan because it will be found out and it will be added to your debt ratios," Rice said.

Celebrate!

You are now a homeowner! You have taken a big step in securing a stable future and creating generational wealth for yourself and your family.

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