BUYING A HOME
WITH A MORTGAGE LOAN
Keep the decision in your own hands
A practical guide
This brochure has been developed for Armenian households who are thinking of buying a house or apartment of their own to live in, and are considering whether to fi nance it with a long-term loan.
If you are interested in buying a house or apartment, this bro-chure provides you with guidance on:
• how to estimate the total cost of purchasing a home • how to estimate how much you can afford to borrow
• how to choose between the different contract conditions, such as currencies, interest rates, maturities and repayment schemes
The brochure also offers:
• a step-by-step guide to help you make your decision
• a practical checklist of questions to ask lenders before taking out a mortgage loan
• practical tips on other points to bear in mind when buying a home
• a practical checklist of what to consider before deciding on a foreign currency loan
Content
About the brochure
ABOUT THE BROCHURE
Imprint
Published by EFSE Development Facility;
Concept, layout and lithography: IPC with the support of NMC fi nanced by EFSE Development Facility
© 2014 EFSE Development Facility
Disclaimer
Information contained in this document has been checked by EFSE Develop-ment Facility (DF) with due diligence. However, EFSE DF does not assume any liability or guarantee for the timeliness, accuracy, and completeness of the in-formation provided herein. EFSE DF reserves the right to change or amend the information provided at any time and without prior notice. EFSE DF makes no warranties, express or implied, as to the suitability of this document for a parti-cular purpose or application.
This document does not necessarily address every important topic or cover eve-ry aspect of the topics it does address and will not be updated. The information in this document does not constitute investment, legal, tax or any other advice. It has been prepared without regard to the individual fi nancial and other circum-stances of persons who receive it.
Thinking of buying a home ... p. 3 How much can I borrow? ...p.4 How much can I afford to borrow? ...p.6 Should I borrow in foreign currency? ... p.8 Comparing the costs of a mortgage loan ... p.10 Choosing a suitable repayment scheme ... p. 12
Purchasing a home is probably the most important investment most of us will ever make. And very probably we will need to take out a mortgage loan to do so.
Mortgage loans can be used to fi nance the purchase, construc-tion or renovaconstruc-tion of a home, with the house or apartment itself serving as collateral. Typically, mortgage loans carry lower interest rates and have longer terms than most other types of loans. They are offered in local or foreign currency.
Taking out a mortgage loan is not an easy decision and requi-res careful assessment beforehand. It involves a relatively large amount of money and takes a long time to pay back, and for this reason, many people understandably regard mortgage loans as being somewhat risky. After all, if your fi nancial situation worsens during the term of the loan, you may fi nd yourself in a situation where you are no longer able to repay it. However, with careful planning it is possible to mitigate the risks involved. People also tend to be deterred from taking out a mortgage loan by the eligi-bility requirements imposed by lenders, and in particular the need to fi nance part of the investment up front with your own funds. In fact, these requirements exist to protect not only the bank but also you against the risk of excessive indebtedness.
This brochure is designed to help you fi nd answers to some of the key questions you will need to address before taking out a mort-gage loan:
Thinking of buying a home?
Usually people expect the value of real estate to go up, but be aware that the value can also go down.
Good to know…!
How much can I borrow?
How much can I afford to borrow? How should I plan
my budget for the future?
How do I choose a suitable mortgage contract in terms of type of interest rate, effective costs of borrowing,
maturity and repayment scheme?
Mortgage loans typically do not cover the total amount of mo-ney needed to purchase a home. The maximum amount that you will be able to borrow will most likely be a certain percentage of the value of the property you wish to purchase. Lenders call this percentage the “loan-to-value-ratio” (LTV), and they usually set a maximum LTV of 70%.
Let’s have a closer look at what the LTV means in practice: Some banks take the market value of the property as the basis for calculating the LTV, others take the property’s “liquid value”. This is the amount of money you would get for the property if ESTIMATING THE AMOUNT NEEDED
How much can I borrow?
Example:
Market value of the property AMD 20 million
Liquid value AMD 18 million
Maximum loan amount AMD 12.6 million
you had to sell it quickly. Usually the liquid value is around 10% less than the market value as determined by a property appraiser. Suppose the home you want to buy costs AMD 20 million. Here is a calculation of the maximum amount you can borrow, assu-ming that the lender has set a 70% LTV limit after applying a 10% discount on the property’s market value:
In our example the maximum amount you could borrow would be AMD 12.6 million on a home you want to purchase at AMD 20 million. This means that you would have to cover AMD 7.4 million of the purchase price, in other words 37% of the market value, with your own funds.
- 10% x70% (LTV)
Lenders often use the term “down payment” to describe the amount of money you need to provide from your own funds. If the maximum LTV is set at 70%, this would mean a down payment of 30%.
ESTIMATING THE AMOUNT NEEDED
In fact, you will need to have even more than that, because the price of the property itself is not the only cost you will have to co-ver. You will also have to pay for appraisal, notarisation, property registration and bank fees, amounting to up to 3% of the loan amount. And depending on the condition of the home you plan to buy, you will probably need to renovate, and possibly also make structural improvements before moving in, such as upgrading the heating system, renewing the fl oors or replacing some or all of the windows. And of course, you will need to furnish your new home.
So the total cost of buying a home consists of the purchase price plus “closing costs” (the costs associated with completing the purchase, i.e. “closing the deal”) and possibly also “renovation costs” (costs incurred when making necessary upgrades and re-pairs).
As the maximum amount of the mortgage loan you can borrow is restricted to the maximum LTV, and as the total costs of buying a home always exceed the purchase price of the property, you will have to cover a substantial amount of the total costs with your own funds.
If you’re thinking of taking out an additional loan to cover the remaining costs of purchasing a home, you need to bear in mind that the interest rates on other types of loan are gene-rally higher than on mortgage loans, and maturities tend to be shorter. This in turn usually means high monthly instalments which could stretch your monthly repayment capacity to the limit – or even beyond.
Closing costs Renovation costs Mortgage loan BANK Own funds
Total costs
Source of funds
Home purchase price
Attention:
You may be deterred by the amount of your own funds that you will have to put towards fi nancing a home. But fi nding enough money of your own is easier if you start to accumulate savings at an early stage. Long before you actually buy a home, you should start to regularly pay part of your income into a savings account, together with any fi nancial support you may receive from family members.
Current
monthly budget Forecast monthly budget Monthly take-home pay
Food Utilities Transportation Clothing Education
Repairs and maintenance Insurance (car, home, life) Holidays and
entertainment Gifts
Family support Other regular expenses (e.g. credit card or car loan payments, savings plans, etc.)
Medical treatment Total expenses
Monthly available income for mortgage instalment Taking out a mortgage loan usually means taking on a fi nancial
commitment for many years. So you need to bear in mind that something could happen in the future that might change your
fi nancial situation. In other words, even if you can afford to pay the mortgage instalments now, you have to make sure that you will still be able to do so in the future.
Therefore it’s important to choose an instalment amount that gives you space to cope with any fi nancial challenges that might occur during the time that you’re paying back the loan. In order to answer the question “how much can I afford to pay for a mortga-ge instalment?” you can use the table on the right to check your monthly budget.
Take your time to gather the data on your family’s monthly in-come and expenses. Start with your take-home pay, in other words the amount of money that is actually available to you after all taxes, social insurance contributions, etc. have been deducted from your gross salary. Then try to list everything that you spend money on, and don’t forget to include occasional expenses such as birthday presents, wedding gifts, car repairs or medical treat-ment. Write all the numbers down in the “Current” column of the table. Add them up and enter them in the “Total expenses” row. Then subtract your total expenses from your take-home pay. The remaining balance will tell you the amount that is currently available for paying a mortgage instalment each month.
BUDGET PLANNING
How much can I afford to borrow?
Don’t forget that sudden increases in the price of food, trans-port, gas or electricity can put pressure on your budget.
Good to know…
Now, review your budget and try to make a realistic forecast of your income and expenses in the years to come. Consider how your expenses will change in the future if, for example, you start a family, send your children to university, purchase a car or make improvements to your home. Also refl ect on large one-off pay-ments for which you possibly had to take out a loan in the past and would have to do so again in the future. Think conservatively of all the possible ways in which your situation could change while you are still paying back the mortgage loan, consider how those changes would affect your income and expenses, and enter the adjusted fi gures in the “Forecast” column.
Subtract your forecast total monthly expenses from your forecast monthly take-home pay to calculate the amount of money you can realistically afford to pay for a mortgage instalment every month throughout the entire term of the loan.
If you lose your job, become ill or have to make a large one-off payment, such as urgent repairs to your home, it may become diffi cult to pay off your mortgage – unless you are prepared for it. Since you don’t have a crystal ball to see into the future, we strongly recommend that you set aside an “emergency fund” as a risk buffer and enquire about available insurance policies to cover such risks. A rule of thumb is that this emergency fund should cover at least two monthly instalments.
Attention:
If you receive remittances from your family abroad, be aware that they might not be able to keep supporting you if the country they live in goes through a period of economic diffi culties. Because of this risk we recommend that you do not count remittances as part of your regular take-home pay, but rather as additional income which can be used to cover occasional expenses, make unscheduled repayments on your loan or stock up your emer-gency fund.
Good to know…
DT I = Monthly total debt service payments Monthly take-home pay
An additional way of checking whether you can afford a mortgage loan is to calculate your debt-to-income ratio (DTI).
Add up all your monthly payments for all outstanding loans, plus the instalment on the mortgage loan you plan to take out (including principal, interest, fees and insurance) to calculate your monthly total debt service payments. Then divide this by your monthly take-home pay. The maximum acceptable DTI is usually considered to be 45%, which means that total debt service payments should not exceed 45% of your take-home pay. Check: Is your DTI at an acceptable level?
When you have worked out how much you can afford to borrow, it’s time to fi nd out which loan terms suit you best. Let’s have a look at the most important contract terms that lenders may offer to you:
MORTGAGE CONTRACT: FOREIGN CURRENCY RISK
How do I choose a suitable
mortgage contract?
You may be offered the option of taking out a mortgage loan in foreign currency. Here are some facts that you should know about borrowing in foreign currency.
If you take out a mortgage loan in foreign currency, you will have to repay this loan in the same currency, e.g. USD. So you’ll need to consider how much of your future income will be in USD. If you do not have enough USD income, you will have to exchange AMD for USD on the due date at the exchange rate set by your bank as of that date.
This means that you will be exposed to exchange rate fl uctua-tions and have to pay conversion costs: The exchange rate is the price you pay for foreign currency, e.g. the value of 1 USD in AMD terms. It is impossible to foresee the development of an exchange rate. The USD/AMD exchange rate has been rather volatile in recent years.
If you have agreed to pay for your home in USD, you will not only incur costs by converting AMD to USD but you will also run the risk that the exchange rate may change between the time you sign the agreement stating the purchase price con-verted into USD and the date you actually make the payment.
Good to know…
Should I borrow in foreign currency?
AMD/USD exchange rate 2011-2013
410 390 370 350
The development of the exchange rate is infl uenced by many fac-tors that you cannot control, such as infl ation, the government’s monetary policy, Armenia’s economic performance and some-times even speculation. A depreciation of the AMD means that the Armenian currency has lost value against the USD over time, which in turn means that you have to pay a higher amount in AMD for 1 USD than you did, say, a few months ago. Conversely, an appreciation of the AMD would mean that you would have to pay less AMD for 1 USD. Thus, each time you have to pay an ins-talment, the exchange rate may have changed, sometimes in your favour but sometimes to your disadvantage.
The more income in USD you have, the less foreign currency risk you will incur when taking out a mortgage loan in USD. But if you receive most of your disposable income in AMD, it is safer to borrow in AMD.
Good to know…
Imagine you are a newly married couple and you want to purchase a home of your own. You have enough money to make a down payment but you will need to take out a mortgage loan to afford the rest. Now you have to decide whether to borrow in foreign currency or local currency.
You receive all of your income in local currency, about AMD 750,000 per month. If you decide to take out the loan in USD, you will have to repay it in USD. What would happen to your bud-get if things turned bad and the AMD were to depreciate by 20%? Would you still be able to pay the mortgage instalment?
Monthly budget
Monthly budget after 20% AMD
depreciation
Total take-home pay 750,000 AMD 750,000 AMD Total expenses 400,000 AMD 400,000 AMD Available amount 350,000 AMD 350,000 AMD Mortgage instalment in
AMD terms 300,000 AMD 360,000 AMD
Buffer + 50,000 AMD -10,000 AMD
Example:
Calculation:
For example, if you have taken out a mortgage loan in USD and the AMD has depreciated, your mortgage instalment will be more expensive because you will have to convert more AMD into USD to pay for it. The possibility that you will incur additional costs for the payment of your instalment because of exchange rate fl uctua-tions is described as “foreign currency risk”.
To answer this question, you would perform the following calcu-lation:
You will notice that interest rates vary from lender to lender, not only in terms of their level but also in terms of the way they are calculated. Here are some facts that will help you to compare the different interest rates offered.
Lenders might offer you a fi xed rate mortgage, a fl oating rate mortgage or a combination of both. What are the differences? With a fixed rate mortgage, the interest rate remains the same over the life of the loan and is fi xed at the beginning of the con-tract. In contrast, the interest rate on a fl oating rate mortgage may change over time. The floating interest rate consists of a “base interest rate” plus a fi xed additional rate set by the bank. In the case of foreign currency loans, the base or reference interest rate is usually linked to a fl oating international benchmark such as the EURIBOR (for EUR) or the LIBOR (for USD), which chan-ges periodically. On loans in AMD, the fl oating interest rate will depend on the Refi nancing (or “Repo”) Rate which is established by the Central Bank of Armenia at regular intervals. The current reference rates are published in economic newspapers or on va-rious websites. However, many lenders apply a base interest rate that is calculated internally, without any specifi c external referen-ces. This makes it very diffi cult for you to understand and predict the interest rate that a bank intends to charge you.
MORTGAGE CONTRACT: INTEREST RATES AND EFFECTIVE COSTS
Comparing the costs of a mortgage loan
The bank might also offer you a combination of a fixed and a floating rate mortgage. This means that you will pay a fi xed inte-rest rate for the fi rst several years of your mortgage followed by a switch to fl oating interest rates applied during the remaining term of the mortgage loan. At the moment you take out the loan, the fl oating interest rates offered by lenders will most likely be lower than the available interest rates that are fi xed for the entire life of the loan. However, you have to bear in mind that if the base interest rate rises in the future, your fl oating interest rate will also rise, so you may eventually face higher interest costs.
Choosing between fi xed and fl oating interest rates can be dif-fi cult. If you have a fi xed rate mortgage, you will not be harmed by rising interest rates – but you will also not be able to benefi t from decreases in interest rates, as you would with a fl oating rate mort-gage. Generally the initial interest rate on a fl oating rate mortgage is lower than the fi xed interest rate over a comparable term. But bear in mind that your mortgage will span a long period of time. Market conditions can change signifi cantly, impacting the level of the base interest rate. The longer the loan term is, the greater the probability of interest rate cycles with very high and very low rates, and the more diffi cult it will be for you to predict future interest rate developments.
Let’s assume, for example, that you have a fl oating rate mortgage that is conditional on a base rate of 8.75%, and a fi xed additional rate of 3.25%. Hence, the initial effective interest rate amounts to 12%. Let’s assume that there is a 20% increase in that “base interest rate”. How does this impact the effective interest rate of your fl oating rate mortgage compared to a fi xed rate mortgage with the same initial interest rate of, say, 12%?
In Armenia most lenders offer fi xed rate mortgages only through mortgage loan programmes in local currency. Mortgage loans in foreign currency mostly come with a fl oating interest rate or a combination of fi xed and fl oating interest rates. This means that in addition to the foreign exchange rate risk, you will most probably also face the risk of a changing base rate if you decide to take out a loan in foreign currency.
Good to know…
You normally do not have to buy insurance from the lender. Usu-ally, you are free to compare prices offered by other insurers and choose the policy that seems most reasonable.
Good to know…
Attention:
Some lenders offer lower interest rates but charge higher fees than others. This can mean that the actual cost of the loan is substantially higher than it might appear at fi rst glance, pos-sibly offsetting the advantage of lower nominal interest rates. Make sure you understand what type of costs are involved when considering mortgage loans in order to be able to com-pare the total costs of different mortgage loan offers.
Calculation:
Ask the lender how the fl oating interest rate is calculated and make sure you understand the process and the logic behind it. Have a look at the movement of the respective reference rate over the past ten years and ask yourself whether or not you would be comfortable with such a fl uctuation in interest rates and the resul-ting changes in your loan payments. And fi nally, ask yourself how important it is for you to have the security and predictability of a fi xed rate mortgage.
Once you have decided which type of interest rate you would feel more comfortable with, you can start comparing the total costs of taking out a mortgage loan.
Lenders typically quote their nominal annual interest rates. Howe-ver, the nominal interest rate does not include all costs related to a loan, and these additional costs can vary signifi cantly from len-der to lenlen-der. The nominal interest rate plus all other costs related to a loan are considered to be the effective costs of borrowing.
In addition to the nominal interest rate, lenders typically charge the following fees:
• disbursement fee or loan account service fee • account opening fee
• account management fee • cash withdrawal fee • property insurance fee • property evaluation fee • property pledging fee • life insurance fee
In some cases, the fees are paid only once, e.g. at loan disbur-sement, while other fees are payable at regular intervals and are typically included in the monthly repayments on your mortgage loan.
Effective interest rate at loan disbursement
Effective interest rate after 20% increase
in the base rate
Fixed rate
mortgage 12% 12%
50.000 100.000 150.000 200.000 250.000
Interest payment Equal principal payment
0
1 year 2 years 3 years 4 years 5 years 6 years 7 years 8 years 9 years 10 years Most lenders will offer you a mortgage loan with a maturity
bet-ween 10 and 15 years. You can generally choose betbet-ween two different types of repayment schemes: equal payments on loan amount or annuity payments.
With the equal payment on loan amount scheme you pay back an equal and fi xed proportion of the initial loan amount, i.e. the principal, in each period, together with interest payments on the remaining outstanding principal. With annuity payments, in con-trast, the overall monthly payment stays the same over the whole life of the loan, but the relative proportions of principal and in-terest change over time: initially inin-terest will outweigh principal, but as the term progresses, the portion of principal increases and the amount of interest decreases.
To better understand the differences between the two repayment schemes, take a closer look at the graphs below, which are based on the example of an AMD 10 million mortgage loan with a 13% nominal interest rate and a term of 10 years.
MORTGAGE CONTRACT: REPAYMENT SCHEMES
Choosing a suitable repayment scheme
Equal payment on loan amount scheme:
The equal payment on loan amount scheme requires higher monthly payments at the beginning of the loan period, but over time, the interest payments become lower, and this decreases your overall monthly burden. As the principal is paid back faster with the equal payment on loan amount scheme than with annu-ity payments for a given loan term, the total interest amount you pay for the loan is lower.
Annuity payment scheme:
With the annuity payment scheme, the initial monthly burden is lower compared to the equal payment on loan amount scheme. If you have larger expenses at the beginning of the loan period, this might be an advantage.
Interest payment Pincipal payment 20.000 40.000 60.000 80.000 100.000 120.000 140.000 160.000 0
1 year 2 years 3 years 4 years 5 years 6 years 7 years 8 years 9 years 10 years
MORTGAGE CONTRACT: REPAYMENT SCHEMES
To compare the two repayment schemes, you can calculate for yourself the monthly payments due for different loan terms by visiting the website of the National Mortgage Company at
http://www.nmc.am/pages. php?al=calculator&type=credit
and inserting the loan amount, the annual interest rate and the number of monthly instalments. You will fi nd a table that tells you the total instalment due in each period, and the respective proportions of interest and principal included in each payment. If you compare monthly payments and total interest costs for diffe-rent terms, you will gain an understanding of how your fi nancial
planned, or even pay off the debt in full. Such unscheduled repay-ments can, however, come at a cost for you, as the bank might charge you a penalty to compensate for the interest income it forgoes.
By reading this brochure you have learned many important as-pects that you need to consider when taking out a mortgage loan. Let’s have a look at the way these aspects are interrelated and the implications for your decision making.
Decision making step-by-step
HELPFUL HINTS ON DECISION MAKING
Request at least two offers for mortgage loans Make sure you understand the terms and con-ditions offered.
• Choose between a loan in local or foreign currency
• Choose between the type of interest rate (if applicable)
• Choose the repayment scheme
• Compare the total costs related to the loan
yes
no
Check if your future monthly available income is suffi cient to
cover instalments See page 6
Compare the offers and choose the one that best suits your future budget Accumulate more savings Look for a less expensive home
yes
See page 8/9 See page 10/11 See page 12/13Check if your own funds cover at least 30% of the purchase price
and the costs for closing the deal and renovation
no
Find an appropriate property that will meet your needs for the next 15 years.
See page 4
Finally, we believe that your lender should not only offer you loans but should also provide you with useful advice. Make sure you understand the terms and conditions, and all the related risks, before signing the contract. Below you will fi nd a list of important questions that you should ask your lender before taking out a mortgage loan.
Basic terms and conditions
What is the maximum LTV and how is it calculated? What are the available maturities?
Which currencies is the mortgage loan available in? Can you change the currency of the loan during the term of the loan?
Interest rates
Are the interest rates fi
xed or fl oating?
If the interest rate is a combination of
fi xed and
fl oating interest rates, how long will the interest
rate be fi xed?
What is the reference interest rate on which
fl
oa-ting interest rates are based?
How often is the reference interest rate expected to change?
Don’t forget to ask your lender
A PRACTICAL CHECKLIST
Repayment of the loan
Can you choose between an annuity sche-me and an equal paysche-ment schesche-me? What will happen if you are temporarily un-able to repay the loan?
Are early (partial or full) repayments of the mortgage loan possible? Is there a penalty fee?
What is the penalty for late payments?
Costs of the loan
What are the total effective costs of the loan? Which of these costs are included in the monthly instalments (e.g. insurance, fees) and which ones are paid separately? What are the costs of property insurance and life insurance?
How much is the application fee or loan processing fee?
How much is the disbursement fee? What are the costs of appraisal, notarisation and property registration?
Careful planning of your finances and a solid understanding of the implications of long-term borrowing are essential when buying a home with a mortgage loan.
We are confident that the information in this booklet, coupled with the support you receive from your lender, will help you choose a home that suits not only your needs but also your finances!
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