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You
may jump to each loan type by clicking on the headings below,
but I would strongly suggest simply reading straight thru the
first time. It will be more understandable if you learn the loan
types concept by concept as some loans are combinations of different
concepts. I have included visual aids to make it simpler. The
concepts presented here apply equally to all types of loans.
FIXED
______Bi-Weekly
WARNING
BUYDOWN
INTEREST RATE BUYDOWN
TEMPORARY BUYDOWN
GRADUATED PAYMENT MORTGAGE
TWO STEP OR BALLOON
ARM
INTEREST ONLY
AMALGAM
When
you understand how each Loan type works you will find there is
no ONE SPECIAL loan type that is inherently better than the rest.
The best loan for you will depend upon your situation. Which means
the better you understand the concepts the better choices you
can make.
For
example, the best loan for someone who intends to live in a home
for the rest of their life would be different than the best loan
for someone who intends to live in the property for 5 years or
less.
Most
people automatically opt for a 30 or 15 year fixed rate loan because
they feel safer with them. When you learn that according to Fannie
Mae and Freddie Mac the average loan only lasts 5 years you begin
to realize there may be other options that could save you $$$$.
If
you will take the time to learn how each basic loan type works
you will be able to figure out any loan you hear about. For marketing
purposes loans on the street may have different names than the
concepts listed below, but no matter what they are called, they
are all simply variations on these basic themes.
FIXED
- This is the traditional
loan.
Although
15 and 30 year terms are the standard, 10 - 20, 25 & 40
year terms are available.
With
a fixed rate loan, the interest rate as well as the principal
& interest payments are established at the inception of the
loan and do not change at any time during the life of the loan.
ON
ALL LOAN TYPES your TOTAL payments will change over time because
your tax and insurance costs will change over time.
(ALL
ILLUSTRATIONS REFLECT HOW FINANCING
AFFECTS THE MONTHLY P&I PAYMENTS)
A
loan of this type gives the borrower the most protection but
carries the most risk for the lender.
How
come it's risky for the lender? From the Lender's viewpoint
they feel they are "stuck" with your initial interest
rate for the life of the loan (30 years?) knowing full well
that at some point in time the Going interest rate will
be higher than the Note rate. The bean counters say the
Lender is losing money when this happens.
Because
of this risk factor a fixed rate loan may carry a slightly
higher interest rate than a variable rate loan. Even so, this
is the loan type you grew up with and is still by far the preferred
loan type.
Actually,
the term of the loan (15 or 30 years) is a misnomer.
The
15 or 30 years term refers to the MAXIMUM amount of time allowed
to pay the loan back.
Since
interest is calculated on the unpaid balance and not rolled
into the loan, the term of the loan and the interest paid will
change to match your repayment method. This means you can change
the term of the loan by simply modifying your payment amounts.
If you pay extra, whether it is in the form of a little each
month or an extra payment or two a year, a 30 year note can
become a 22, 18, 15 or any term you desire. Knowing this, most
people start with a 30 year note instead of a 15 year note because
it allows them to qualify for a larger loan amount.
Along
these lines, a common occurrence is for a Borrower to occasionally
make an extra payment. If you were to pay ONE extra P&I payment
a year you would cut almost 9 years off your 30 year note and
almost 4.5 years on a 15 year note.
An
extra payment a year is the basic concept behind a Bi-weekly
loan. A Bi-weekly loan doesn't have 2 payments a
month as most people think, but instead has payments every other
week which means some months will
have 3 payments. The advantage comes from the
fact that you are paying 13 payments a year instead of 12. (just
like the one extra payment a year in the scenario above)
BTW
- A 20 year amortization seems to be the best balance between
reasonable payments and the term.
A
WARNING ABOUT Bi-Weekly PROGRAMS
Bi-Weekly
programs are a payment schedule and not a loan type.
It is a FREE service from your lender and you do
not need to pay a third party to be able to make your
payments this way. You can request to be
placed on a bi-weekly plan at any time OR for maximum
flexibility you can just make an extra P&I payment
anytime during the year at your convenience to get the
same effect.
There
are several aftermarket "services" (be very
proud of me, I used a nice word here instead of the
word I would like to use) who take advantage of people
by implying you must use their service to get a bi-weekly
payment plan or that their plan is better than the Lenders.
These
third party programs charge an upfront fee of $275 to
$1,000 AND a monthly fee of $3.95 to $10 (they
have to make money their somehow). This, of course negates
most of the advantages of making an extra payment per
year. There are no charges to
have your Lender set up the Bi-Weekly plan. And you
can do this at any time, on the first payment or the
251st payment. You can even go bi-weekly for a
while and then cancel it if you don't like it.
BUT
THE BIGGEST PROBLEM with a 3rd party Bi-Weekly plan
is the fact that they have your mortgage payment money!!
Your payment IS NOT applied directly to your mortgage
when you make a payment. As a matter of fact your lender
does not receive their money until sometime around your
actual due date (YOU HOPE!)
Usually
these companies will try to alleviate your fears by
telling you your money is put in a "trust"
account at a big lender and you will be drawing interest
on that account, but who knows where the money actually
goes. There have been many cases where your monthly
payments are never made or were made sporadically.
How THEY PAY your
payment is how the credit bureau reports your creditworthiness.
Once
again let me state that the Bi-weekly payment program
is FREE from your lender!!
As
an aside, all the bi-weekly programs I am aware of must
be set up to automatically debit your payment from your
checking account. In the event there is not enough money
in the account to make the payment when it is due, there
are usually penalties in excess of what a traditional
late payment fee would be so be sure our income stream
can accomodate this type of payment plan before you
enroll.
Let
me say this again, payments are made every 2 weeks,
NOT TWICE A MONTH! This
means some months you will make 3 payments.
If
your paycheck is automatically deposited in your account
and you normally keep a very healthy reserve in your
checking account then a Bi-weekly plan can work to your
advantage. OR you can just make one extra P&I payment
a year on your own when you get your bonus and accomplish
the same thing.
Although
it is technically not required, on any extra principle
you send I would send instructions on the check or on
an accompanying letter that states this amount is to
be applied towards the principle. Without the note I
have heard a tale or two of the Lender, being very helpful
and returning your check because it doesn't match your
payment amount.
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BUYDOWN
- There are two different ways to Buydown a loan.
You
may buydown the INTEREST RATE OR
buydown the PAYMENT.
Make
sure you understand this distinction because buying the INTEREST
RATE down lasts for the life of the loan while buying the PAYMENT
down lasts for a limited period of time. Obviously buying the
interest rate down for the life of the loan has to cost more.
The
main reason for a Buydown is to allow a buyer to qualify for
a larger loan. But Buyers like it because it also minimizes
payment shock.
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INTEREST
RATE BUYDOWN or permanent buydown-
EXTRA discount points are paid to lower the interest rate to below
the market rate which helps the buyer qualify for more house.
(see also Reading and Controlling Rates)
EXAMPLE:
$90,000 loan at 11.5% = $891.18 P&I payment
An EXTRA 4 points are paid which
reduces the interest rate to 10.5%.
$90,000
loan at 10.5% = $823.23 payment
$891 payment ÷ 28% qualifying ratio = $3182
minimum monthly income needed to qualify at 11.5%
VS.
$823 payment ÷ 28% qualifying ratio = only $2939
income needed to qualify at 10.5%
$3182
- $2939 = $243 difference
For
Qualifying purposes this means the payment drop is the equivalent
of the borrower getting a raise of $243 mo.
Looks
good, but IS IT WORTH IT? (this same question holds
true on a refi) "I don't know" is the only answer I can give
without additional data.
If
this is the only way a person can qualify for the home, then
the answer has to be a resounding Yes. But if qualification
isn't the issue the only sure way to know the correct answer
is for me to ask another question "How long do you intend to
live in the house?"
Divide the monthly payment savings into the cost of the points
to determine how many months until you reach the break even
point. If you intend to live there much past the break even
point then it would be worth it.
EXAMPLE:
$90,000
X 4% = $3600 cost of points
$891.18 (monthly payment @ 11.5%)
minus
$823.23(monthly payment @ 10.5%)
equals $67.95 a month
savings
$3600
COST ÷ $67.95 SAVINGS = 52.98 MONTHS to recapture your
money
If
the buyer is going to live there less than 53 months they
would be better off to pay the higher interest rate.
Many
times 4 points wouldn't drop the interest rate a full percent
so in many cases the comparison is even worse. The text books
say it will take 8 points to drop the rate 1%. In real life
the amount varies according to the market.
IN
MOST CASES THE BORROWER WOULD BE MUCH BETTER OFF TO PAY THE
HIGHER INTEREST RATE.
There
is one factor that has been left out of this calculation - the
4-8 points are tax deductible in the year in which they are
paid. But even after working hundreds of these we have found
that tax benefits do not change the equation much. Time is still
the main factor.
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TEMPORARY
OR PAYMENT BUYDOWN - Instead of paying EXTRA points,
the Temporary Buydown uses the buydown money to reduce the monthly
payments for A L IMITED TIME PERIOD. Consequently you initially
get a much greater payment reduction and a much greater qualifying
benefit. Basically you are subsidizing your house payment by prepaying
a portion of your monthly payment up front. In the example below
you are buying your PAYMENT down for 3 years.
$800
you OWE minus the $600 you
are PAYing leaves a $200
per month difference.
You
would pay the normal points + the difference between what
you OWE and what you are supposed to PAY.
In
this case it would be $200 X 12 months
$2400 per year x 3 years = $7,200 BUYDOWN
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GRADUATED
PAYMENT MORTGAGE (GPM ) A more cost effective way to
buy a loan down to increase qualifying levels and to eliminate
some of the payment shock is to graduate the payments. This graudually
increases your monthly payments and decreases the initial costs.
Year 1 = $200 difference X 12 = $2400
($800 - $600 = $200)
Year
2 = $125 difference X 12 = $1500
($800 - $675 = $125)
Year
3 = $ 75 difference X 12 = $900
($800 - $725 = $75)
$2400
+ $1500 + $900 = $4,800 buydown
fee instead of the $7,200 in the level 3 year buydown above
How
do you arrive at your various monthly payments? You can't simply
say "I want my payment to be $. . .", instead your
payments are calculated based upon set interest rate reductions.
These
Buydowns are known by the interest rate reductions used to figure
the payment changes. e.g. a 3 - 2 - 1 buydown has a 3% lower
rate the first year, a 2% lower rate the 2nd year, and 1% lower
rate the third year. Years 4 thru 30 would be at the note rate.
If
you had a note rate of 10.5% a 3 - 2 - 1 buydown would give
you payment rates of
(10.5%
- 3% =) 7.5% the first year,
(10.5%
- 2% =) 8.5% the second year,
(10.5%
- 1% =) 9.5% the third year and 10.5% for all years
thereafter.
A
2 - 1 buydown would only have a 2 year payment drop and therefore
would cost less to buy down. A 2% reduction in the first year's
payment rate and a 1% reduction the next year.
This
Buydown fee could be paid at closing or it can be paid in the
form of a slightly higher interest rate later to minimize your
out of pocket expense.
If
you choose to pay the fee by taking a higher rate later it means
your final rate might be 11% instead of the note rate of 10.5%
we used above. Some of these loans qualify the borrower at the
first year payment others, because it is a given that the payment
will rise, qualify the borrower at the 2nd year payment.
In
most instances you no longer see the mechanics of the Buydown
or the GPM, you are simply presented with a set of payment rates,
but this is how they arrived at those figures. Once again, how
long do you intend to live in the house determines whether this
is a good loan type. To compare loan types simply figure
out what total payments would be over the same time period for
the 2 or more loan types you are considering and see which one
costs you the least. You might want to see which one will
have the lowest loan balance at the end of that period as well.
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BALLOON
or TWO STEP -
these loans are designed to take the low initial interest
rates of Buydowns and incorporate them with the safety factors
of a Fixed rate mortgage.
Let's
first look at the rationale behind this loan type before we
go into the details. This will answer most of your questions
about is it safe?
The
most common 2 STEP/Balloon notes offered are based upon FNMA/FHLMC
guidelines.
In the 70's FNMA noticed that over 90% of their loans were paid
off by the 7th year (now over 95% are paid of in just under
5 years). They also noticed that according to historical data
there was a very good probability that every 5-7 years financial
cycles would repeat themselves. Kind of like El Nino.
In
other words, if you took a loan out today, and were at the bottom
of a rate cycle, in 5-7 years you should also be at or near
the bottom of the next rate cycle no matter what happened to
rates in between. They put these two facts together and came
up with 5/25 & 7/23 loans.
In
these loan types the initial rate is fixed at a below market
rate for 5 or 7 years and then makes ONE adjustment to the then
current 30 year FIXED rate. eg. on the 5/25 you would have one
payment and note rate for the first 5 years and another for
the remaining 25 years. Keep in mind the historical perspectives
that were applied in the development of this loan. I had one
of these and started out with a 7.5% interest rate and it adjusted
to 8% 7 years later so I know first hand that it can work.
These
loans have CAPs or limits to the amount of adjustment allowed
just like an ARM.
In
the example above the 30 year Fixed was offered at 8%, but a
2 Step was offered at 7.5%. In a worst case scenario at the
time of adjustment the rate would rise to above 8% (ceiling)
and in the best case it would fall below the initial 7.5% (floor).
In theory the rate would continue for the balance of the loan
at or very near the start rate.
2
steps and Balloons differ slightly. The 2 STEP
uses a different INDEX, and therefore has slightly higher rates
than the Balloon, it also usually has a 6% CAP but it converts
to a FIXED automatically.
The
Balloon has a 5% CAP but the Borrower must
take the initiative to exercise their option to convert to a
fixed rate when the the 5-7 years is up.
There are 3 conditions to the conversion:
1.
Buyer must still live in the property
2. Have no 30 day lates in the last 12 months.
3. No 2nd liens. (can be waived if the 2nd lien company will
subordinate their loan to the new loan*)
*a
2nd lien simply means it was the 2nd loan filed. Due to
the fact that the existing 2nd lien will have been filed
prior to the renewal of the note the new permanent note
would automatically become a 2nd lien otherwise.
Both
the 2 Step & the Balloon have a small charge for re-recording
papers, usually around $250, but no new title policy or other
refinance closing costs are required.
As
I mentioned before the new note will continue at the new rate
for the period of time necessary to amortize the loan in a total
of 30 years or in other words 23 or 25 more years.
Non-Conforming
loans (loans above $417,000 as of 5/08) sometimes do not
have the same conversion option. The buyer may have to pay off
the loan or refinance it and bear the full closing costs. If
you had to refi, the new rate would be the then current market
rate.
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ARM
or ADJUSTABLE RATES
-
Instead
of the lender being stuck with the initial interest rate for the
life of the loan, the ARM allows the lender to change the loan
interest rate periodically to more closely match the going rate.
This means they will sometimes offer you a more attractive starting
rate because they have less long term risk. There are risks involved
with this loan type, but there can also be great REWARDS
Most
ARM borrowers are optimists, they are sure the economy will
improve and rates will drop.
They don't focus on the aspect that ARM rates might rise, but
on the fact that it is possible for them to drop. ARM's aren't
used much at this moment except for people buying Jumbo properties.
That is not to say that an ARM is not a good loan, people just
usually prefer the surety of the fixed rate.
You
can always tell when the investors feel that long term rates
are due to rise because you will see a proliferation of ARM
programs. We have recently seen a great number of ARM programs
introduced. This means everyone expects rates to start rising.
That isn't all bad because more homes are bought when rates
are on the rise than when rates fall.
Why?
Rates rise when the economy is improving which means people
have more disposable income and greater confidence in the future.
If you will look at interest rates in a historical context you
will find the last 8 years or so have been extremely stable.
The rate changes have been more like the 50's than the 70's.
Just
a note on election years, more times than not, rates tend to
rise during election years because there is so much muck being
stirred up and the financial world is not sure how to forecast.
The Chinese curse of "May you live in interesting times"
is truly a curse when it comes to forecasting interest rates.
Look
at the chart below and you will see that you will need to learn
a different vocabulary to talk "ARM".
The
INDEX could technically anything that can be graphed.
Your interest rate will be based upon an INDEX.
Although financial indices are used, the INDEX could be the
frequency of red cars traveling on the freeway between the hours
of 8-10 a.m. The important things to you are 1) the Index be
out of the control of the financial institution and 2) that
you have access to the past history of the movements of the
index.
For
instance you wouldn't want an index that is the Cost Of Funds
Index (COFI) for that particular institution because then they
would have no incentive to control their costs. They'd be guaranteed
a profit no matter how inefficiently they operated.
The
difference between the INDEX and the % RATE is called the MARGIN
It is easier to understand if you will think of
it as the profit margin. Typically it will be quoted like this:
2.75% margin on the T Bill index. In this case your rate will
be 2.75% above the T Bill rate on any given day. This makes
it easy to keep track of proper rate movements.
The
bigger the margin the faster your rates can rise.
We see 3 major Indexes - T Bills, Cost of Funds
(COFI), and LIBOR (London Interbank, something, something).
COFI
is usually the most stable but also the most expensive. T Bills
are the most common and usually are safer. The LIBOR, being
an international index, has ups and downs that don't necessarily
to correspond to the American based indexes, which can be advantageous
at times.
In
the example above the payment INTEREST RATE is indicated in
dark blue, but the actual PAYMENTS
are indicated in red.
As
you can see the payments fluctuate as the INDEX changes. Theoretically
your interest rate could change daily or even hourly, but practically
they use set periodic intervals to change your interest &/or
payment rate. A Monthly ARM would change payments every month.
A 1 year ARM every year, 3 year, 5 year, etc. etc.
Most
loans (but not all) fix the payment AND the interest rate at
the same time.
Look
back to the example and you can see what could happen if you
got a loan that fixed the payment but NOT the rate. Anytime
the % rate line is above the payment
line you would be accruing Negative Amortization which
means your loan balance would be going UP not down. Anytime
the payment line is above the %
rate line you would be accruing extra Positive Amortization
which means your loan balance is going down more than normal.
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both the payment and interest rate are fixed you basically
have a series of short notes that adjust interest rates
at the beginning of each note and there is NO
POTENTIAL for Negative Amortization.
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To
eliminate some of the fear of payment changes, most ARM loans
have CAPS or limits on how far and how fast your rate can change.
A
typical cap is 2/6. This limits your rate movements to no more
than 2% in a given year and no more than 6% over the life of
the loan. The caveat is to determine
2% or 6% above what!
Many
times the 2% is self evident because it will be based upon the
initial payment, but on "B" loans quite often the payment is
fixed for only 6 months and then rises dramatically. Your 2%
cap usually is based upon this new higher interest rate. This
means you could have a 4%, 5% or even greater increase the first
year.
The
6% lifetime cap is rarely based upon your first payment period
but instead on FIAR (Fully Indexed Accrual Rate) or in other
words what the rate should be right now.
The reason for this is that many ARMs start at
an artificially low rate so payment increases are almost
guaranteed for the first 2 - 3 years. After that period
movements are dependent upon the market. So your ceiling really
could be 7-8-9% above your start rate. I hope you are working
with an honest mortgage lender who'll explain things like this
to you.
Many
people hope that by getting an ARM that has a lower initial
rate they can qualify for a higher loan amount, but that is
rarely true. Most ARMS qualify you
at the FIAR rate.
Why?
Because most of your loan life will be at a higher interest
rate and because payment rates are sure to rise often in the
first few years. Even so, FIAR is usually slightly lower than
a Fixed rate so there are some qualifying benefits, just not
as much as you might hope for.
Some
ARMs are CONVERTABLE, which means they allow you to convert
to a fixed rate loan later.
Usually you are able to convert anytime between
the 2nd and 5th year anniversary. But don't get your hopes
up! Unfortunately, you don't get to convert at your present
ARM interest rate, you must convert to the then going FIXED
rate 60 day pricing + .375% (not the cheaper 15 day price or
the rates being quoted at that time.). YOU
DO NOT GET TO CONVERT TO YOUR CURRENT ARM RATE!
Plus
you will have to pay extra for this conversion privilege either
in the form of a higher interest rate on the initial ARM loan
and/or possibly a conversion fee. Because of this high conversion
interest rate fewer than 7% of ARM borrowers ever convert. So
why pay a penalty interest rate!! Get the cheaper non-convertable
ARM if you are of such a mind.
INTEREST
ONLY LOANS- Sounds almost too good to be true doesn't it?
An
Interest Only loan allows you to pay back your loan for a given
period (3-5-7-10 years) at a payment rate that covers just the
interest accruing. YOU ARE NOT PAYING ANYTHING TOWARDS
PRINCIPLE SO YOUR LOAN BALANCE IS NOT GOING DOWN AND YOU ARE NOT
ACCRUING EQUITY EXCEPT BY VIRTUE OF ANY PROPERTY VALUE INCREASES.
Think of Mighty Mouse, Pauline Pureheart and Oilcan Harry the
unscrupulous lender in the History section!
Given
that most of a payment of any type of loan is mostly interest
in the first years it would not appear that paying only Interest
would lower your payment enough to make the risk worthwhile BUT
they usually couple an Interest Only loan with an ARM or other
low starting rate loan type. So the Teaser interest rate is really
what makes most of the payment difference, not the Interest Only
aspect.
Here's
the caveat, keep in mind that these loans are tied to ARMs so
once the Interest Only period is over your payments have to increase
significantly so that your loan will fully amortize over
the remaining time left on the loan. Your payment will be
higher than normal if for no other reason than you have to catch
up because ofthe time period when you weren't making full payments.
PLUS
the loan converts to some type of ARM which means you could have
a significant payment increase &/or multiple payment increases.
So how long are you going to live in the house? If you intend
to live there less than the Interest Only period &/or you
are buying the house well under market or the house is in an area
that will have guaranteed great value increases
then this could be a loan for you. You can always Refinance into
another loan type at the end of the Interest Only period, but
remember there are costs associated with a refinance so this could
negate any perceived advantages. The lost costs on a refinance
could equal $4,000 or more - Whoops, there went your savings!
AMALGAM
- Now if someone were to come out with the Super Duper Deluxe
Qualifier Equity Builder loan (SDDQEB) you would know enough to
figure out if it is good for you.
If
the stupendous new SDDQEB loan has fixed payments for the first
3 years with a start rate of 5.5% and .5% payment caps at which
time it will float the rate for 5 years and then do a one time
rate adjustment with a ± 4% cap and fix for the life of
the loan. You can look at this and determine it is really a GPM
loan that converts to an ARM and then converts again like a 2
Step.
It
would graph something like this:
Now
that wasn't too hard was it?
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