Mortgage 101

The amount of a loan for which you qualify is based on two different calculations. Using what are known as qualification ratios, lenders evaluate your income and long-term debts to determine a "safe" amount for your mortgage payments. A fairly standard ratio is 28/36. Certain mortgage plans sometimes use more liberal ratios-for example, the Fair Housing Authority (FHA) currently uses 29/41.

Here's how it works: With a 28/36 ratio, you are allowed to spend up to 28% of your gross monthly income for mortgage payments.

The lender will then run a different calculation. This one is your loan payment and debt payments combined, which may not exceed 36% of your gross monthly income.

To calculate exactly how much you may borrow, you also need an estimate of interest rates. For example: Suppose you had $1,000 a month for mortgage payment; at 7% that would let you borrow about $160,000 on a 30-year loan. At 6% the loan amount would be nearly $175,000.

As part of this calculation, you also need to estimate and include the property taxes, homeowner's insurance, and homeowner association fees (if applicable) you might need to pay, which are considered part of your monthly expense. Please see our Mortgage Calculators, and click on, "How much will my mortgage payments be?" for estimates of property taxes and homeowner's insurance costs.

Most lenders offer financing programs that allow the borrower to finance up to 100% of the sales price of a new home. However, if no down payment is made, the borrower will be required to pay for private mortgage insurance (PMI), see question ten, below, for further information on PMI. If you can afford to put more money toward a down payment, it will reduce the amount of your monthly mortgage payments. Some loans programs offer 3% down payments if you meet certain income standards.

The lender will want to know how much money you plan to put down and the source of those funds. Sources you may draw upon include savings, stocks and bonds, pension funds, real estate holdings, life insurance policies, mutual funds, and employee savings plans.

You may also use a gift of money from a family member that need not be repaid. If you do this, you will need to present a letter to your lender that states the amount of the gift, is signed by the giver, and is notarized by a third party. A gift letter "form" may be obtained from your lender.

You are also now allowed to withdraw up to $10,000 from both traditional and Roth Individual Retirement Accounts (IRAs) with no early withdrawal penalty, if used towards buying your first home.

Under some mortgage programs, part of your down payment may come from a grant from a nonprofit housing provider in your community. An example would be our City Of Chicago Bond Program.

An Adjustable Rate Mortgage (ARM) is a loan under which the interest rate is periodically adjusted to more closely coincide with current rates. The amounts and times of adjustment are agreed to in the Adjustable Rate Note signed by the homeowner.

Interest rates are usually expressed as an annual percentage of the amount borrowed. You can choose a mortgage with an interest rate that is fixed for the entire term of the loan or one that changes throughout. A fixed-rate loan gives you the security of knowing that your interest rate will never change during the term of the loan. An adjustable-rate mortgage (called an ARM) has an interest rate that will vary during the life of the loan, with the possibility of both increases and decreases to the interest rate and consequently to your mortgage payments.