With dozens of competing lenders and mortgages to choose from, you may think that today's home loan market is terribly confusing. It really isn't though if you know the basic facts about financing a house. That's what this brochure is designed to give you. Let's start with the questions that are probably uppermost in your mind.
How Large a Mortgage Can I get?
That depends upon your income and the cost of your new house. Lenders use certain guidelines to determine the mortgage amount that they will lend any one homebuyer. The two guidelines used are housing expenses and long term debt. Lenders generally say that housing expenses (including mortgage payments, insurance, taxes and special assessments) should not exceed 25 percent to 28 percent of the homeowner's gross monthly income. For Federal Housing Administration (FHA) loans, this figure is not t o exceed 29 percent of the homebuyer's gross monthly income. With loan guaranteed by the Department of Veteran's Affairs (VA), lenders measure prospective homebuyers with "Residual Income," or the monthly income minus expenses. The remainder is then measured against geographical and family size data to qualify the borrower.
Lenders usually define long-term debt as monthly expenses extending more than 10 months into the future. These expenses should not exceed 33 percent to 36 percent of the homeowner's gross monthly income. VA and FHA mortgage lenders define long- term debt as monthly income. Your lender will work out these figures for you when you sit down to discuss the mortgage you want.
What Types Of Loans Are Available
Although you may see many different types advertised, they all belong to just two families: those mortgages that carry fixed interest rates, and those whose rates change during the course of the loan on a periodic schedule mutually agreed upon by you and your lender. This page does, however, discuss some new loans who are really "cousins" to each family-convertible mortgages.
Fixed Rate Mortgages
You are probably familiar with a fixed-rate mortgage. Your parents more than likely had one, as did their patent before them. The major advantage of fixed rate mortgages is that they present predictable housing costs for the life of the loan. Some fixed-rate mortgages you will probably hear about are:
When people thought of a mortgage 10 to 50 years ago, they thought of a 30-year fixed-rate mortgage. This traditional favorite is not the only choice nowadays because volatile financial times created a whole new range of selections. However, the 30-year fixed-rate mortgage may still be the best mortgage for your circumstances. It offers the lowest monthly payments of fixed-rate loans, while providing for a never- changing monthly payment schedule. Some lenders offers 25,20, and even 40-year term mortgages as well. But remember, the longer the term of the loan, the more total interest you will pay.
The 15-year fixed-rate mortgage allows homeowners to own their homes free and clear in half the time and for less than half the total interest costs of the traditional 30-year loan. The loan's term is shortened by the 10 percent to 15 percent higher monthly payments. Some homebuyers prefer this mortgage because it allows them to own their home before their children start college. Others prefer it because they will own their home free and clear before retirement and probable declines in income.
The major disadvantages or the 15-year fixed-rate mortgage are the sometimes higher monthly payments. But if saving on total interest costs and cutting the to free and clear ownership are important to you, the 15-year fixed-rate mortgage is a good option. The bi-weekly mortgage shortens the loan term to 18 to 19 years by requiring a payment for half the monthly amount every two weeks. The bi-weekly payments increase the annual amount paid by about 8 percent and in effect pay 13 monthly payments(26 bi-weekly payments) per year. The shortened loan term decreases the total interest costs substantially. The interest costs for the bi-weekly mortgage are decreased even further, however, by the application of each payment to the principal upon which the interest is calculated every 14 days. By nibbling away at the principal faster, the homeowner saves additional interest. Remember, however, that you trade lower total interest costs for fewer mortgage interest deductions on your federal income tax. Your ability to qualify for this type of loan is based on a 30-year term, and most lenders who offer this mortgage will allow the homebuyer to convert to a more traditional 30-year loan without penalty. Availability is limited on this mortgage, but it can be worth looking for.
Mortgages That Change
Some newer mortgages afford homebuyers some the best qualities of the fixed-rate and adjustable rate mortgages. One new type of loan, often called a Two-Step, Super Seven, or Premier Mortgage, gives homeowners the predictability of a fixed- rate and adjustable rate mortgage for a certain time, most often seven or 10 years, and then the interest rate is adjusted to fit market conditions at that time. The main advantage associated with this type of loan is that homebuyers often get a slightly lower than market rate to begin with. The main disadvantage is that they may see their interest rate go up by as much as six percentage points at the end of the seven-year period. The lender may also reserve the option to call the loan due with 30 days notice at that time, making this loan similar to a balloon mortgage in some cases.
Lenders offer this type of loan in part because research indicates that many homebuyers remain in the home for seven to 10 years before moving. For this type of homebuyer, the Two-Step or Super Seven loan present an excellent way of getting a fixed- rate loan at a better than market price for a fixed-rate loan at a better than market price for a fixed period of time.
Another type of mortgage that is becoming popular is called a Lender Buydown, where the homebuyer gets an initially discounted rate and gradually increases to an agreed-upon fixed rate over a matter of three years. For example: When the market rate is 10 percent, the fixed rate for the mortgage is set at about 10.5 percent, but the homebuyer makes monthly payments based on a first year rate of 8.5 percent. The second year the rate goes up to 9.5 percent, and for the third year through the remaining life of the loan, the rate is calculated at 10.5 percent. A second type of lender buy-down, called a Compressed Buydown, works the same way, but with the interest rate changing every six months instead of on a yearly basis.
The Lender Buydown gives consumers the advantage of lower initial monthly payments for the first two years of the loan when extra money may be needed for furnishings and, secondly, the advantage of knowing that, although the interest rate does change during the first three years of the loan, the interest is fixed from the third year on.
Convertible mortgages offer today's homebuyer the option to change the loan's interest rate after some period of time or some specified movement in interest rates.
Convertible fixed-rate mortgages are often referred to as the Reduction Option Loan (ROLE) or, in some locations, the Reducing Interest Loan (RIL), or Mortgage (RIM). This new type of loan offers homeowners the option of getting a loan that , under the right conditions, can be adjusted to a lower interest rate with a payment of $100 or $200 or so and a small loan amount-based fee, sometimes as little as one-fourth of a percentage point. These conditions usually are a prescribed movement in rates-typically two percent below the initial- during a set time limit-between months 13 and 59, for example.
On a 30-year fixed-rate mortgage with a reduction option, the homebuyer pays an extra one-fourth to three-eighths of a percentage point in the interest rate on the mortgage plus a quarter to three-eighths of 1 percent of the loan amount (points) at the time of closing. This allows the homeowners to adjust the interest rate on the loan without having to go through a refinancing, which could cost up to 5 percent or 6 percent of the loan amount, if the rates are right during the prescribed time limit.
On an $80,000 loan, this means that you could reduce the interest rate on your loan from, say, 10.5 percent to 8.5 percent, and take advantage of the low rates for the rest of the loan term for $150 instead of up to $4,800 , if the rates dropped to that point during your "window of opportunity" - months 13 through 59. Some homeowners may find the ROL a good "insurance policy" against the high costs of refinancing. Others may want the flexibility that refinancing offers - namely the ability to draw on built-up equity- that is not available with ROLs. The decision is up to you.
Convertible Adjustable Rate Mortgages (ARMs) are another new loan product on today's market. It worked like any other ARM, but it offers homeowners a distinct advantage-it allows them to turn their ARM into a fixed-rate mortgage after a set period (usually during the second through fifth years of the loan).
A new product developed by the Federal National Mortgage Association (Fannie Mae), which buys mortgages from lenders, allows the homeowner to convert an ARM to either a 15 or 30 year fixed-rate mortgage for a fee of 1 percent of the original loan plus $250 , as compared to the 3 percent to 6 percent costs of refinancing. Say, for instance, that you got your convertible ARM at an initial interest rate of 10.0 percent, and after a year or so, rates had dropped to 8.0 percent. For the smaller conversion fee, you could adjust your mortgage to either a 15 or 30 year fixed-rate loan at a new rate that would be about one-half percent higher than the going market rate, or 8.5 percent. There are other variations on this loan available from lenders across the country. Homebuyers who want the low initial rate of an ARM, and the option and peace of mind of a fixed mortgage should rates drop, can now have it both ways.
Adjustable Rate Mortgages
Adjustable Rate Mortgages (ARMs) have become on of the most popular and effective tools for helping some prospective homebuyers achieve their dream of homeownership. Developed during a time of high interest rates that kept many people out of the housing market, the ARM offers lower initial rates by sharing the future risk of higher rates between borrower and lender.
ARMs can be an excellent choice of financing under certain conditions, such as rising income expectations, high interest rates, and short-term homeownership. But because payments and interest rates can increase, either steadily or irregularly, homebuyers considering this kind of mortgage need to have the income to keep up with all possible rate and/or payment changes. Each ARM has four basic components:
In addition to the four basic components, an ARM usually contains certain consumer safeguards such as interest rate caps, which limit the amount that the interest rate applied to the payments may move. This prevents the amount of interest the consumer pays from rising higher than perhaps the homeowner can afford. For instance, a typical ARM would have a two percentage point cap over the life of the loan. That means that a loan with an initial interest rate of 9.75 percent would be able to go no higher than 14.75 percent over the life of the loan, and it would be able to move no more than two percentage points per year.
Another safeguard found on some ARMs are monthly payment caps that limit the amount homeowners need to increase their payments at adjustment time. Monthly payment caps can, however, sometimes prevent the monthly payments from increasing enough to keep up with the rise in the interest rate, causing negative amortization-resulting in higher or more payments for the homeowner later on.
Other options you should ask about when shopping for an ARM are:
An Option For Older Homeowners
A relative newcomer in the mortgage market is a Reverse Annuity Mortgage (RAM). For older Americans, especially retirees living on fixed incomes, the equity in their paid-for or almost-paid-for home represents a large but liquid asset. The RAM i s designed to help supplement those homeowners' income.
The lender who will issue a RAM appraises the property and makes the loan based on a percentage of its current value. The homeowner retains ownership, and the property secures the loan. The lender then pays an annuity to the borrower, usually on a monthly basis, up to an amount equal to the equity they have in the home.
The advantage of such a loan for older Americans is that of receiving a monthly tax-free income. Under one plan, this income is available for life or until the house is sold at the homeowner moves. The schedule of payments depends on the value of the home and the ages of the owners. There are risks involved, however. If the homeowner wants to move and buy a new house, there may not be enough equity in the home to permit such a plan. Or the lender may consider only the current market value of the home rather than any future appreciation when deciding on the monthly payments.
The Federal Housing Administration (FHA) and the Veterans Administration (VA) offer a wide range of mortgage choices that may appeal to you. These include 30 and 15 year fixed- rate mortgages, as well as ARMs. Insured by these government agencies, the loans feature low or no down payment terms and are often assumable by future purchasers. VA loans are restricted to individuals qualified by military service or other entitlements, but FHA - insured loans are open to all qualified home purchasers. Note that there are limits to handle moderate-priced homes anywhere in the country. Talk to your lender about FHA/VA possibilities.
Creative Financing or Seller-Assisted Mortgages
This type of financing became popular when interest rates went to very high levels in the early 1980s. Seller-assisted creative financing usually means the seller of the home helps with the financing by underwriting all or part of the loan.
The advantage of this type of arrangement is that the mortgage usually carries a lower interest rate with lower monthly payments. The disadvantage is that the previous homeowner, not an institution, may hold the deed of trust. If the loan terms call for certain payment schedules, the buyer may have to seek new financing. Many homebuyers in recent years have found "creative financing" deals to be fraught with problems and useful only as short-term alternatives to mortgages from traditional lenders.
One type of mortgage you are apt to run into with seller financing is the balloon payment mortgage. Balloons, as they are known, are usually offered as short-term fixed-rate loans. The balloon payment mortgage gets its name from the payment schedule, which involves smaller payments for a certain period of time and one large payment for the entire amount of the outstanding principal. They have terms of 3, 5, and sometimes 15 years, though payments are usually calculated as though it were a 30 year loan. Sometimes a balloon will be offered as a second mortgage where you also assume the homeowner's first mortgage . The major disadvantage with a balloon payment loan is that it may be difficult to save up the money to make the final large payment (often the entire amount of the principal) while paying interest on the loan. Some lenders guarantee refinancing, though the interest rate is usually adjusted when the principal comes due. If you cannot refinance, you may have to the property if you cannot meet the large payment. Balloons are an advantage if you plan on living in an appreciating house for a short period of time and want to pay less while you live there.
How Do You Shop Most Effectively For A Mortgage?
There are several ways. First, talk with your real estate agent or broker. Real estate professionals are normally in the best position to learn about financing opportunities in the marketplace. Lenders regularly call agents to alert them to financing packages. And, of course, agents are highly motivated to obtain financing for their buyers. Without a suitable loan, the sale can't proceed, and agents won't get their sales commission on the house.
Second, look for rate surveys published by your local newspaper. Many American papers now include brief tables on interest rates and mortgage availability in their real estate or business section. They can help guide you to sources you have not thought about.
Third, look in the Yellow Pages under "Mortgages," and shop for quotes by telephone. Call five to 10 different lenders for rates and terms on fixed and adjustable loans.
Finally, if your area is covered by one of the many commercial computerized mortgage shopping services, give it a try. You may find, however, that the computer services have only a selection of local lenders on their listings.
How Do We Evaluate Different Loans?
One important method is by bearing in mind that mortgage packages consist of more than interest rates. They consist of a quoted rate, plus discount points (pre-paid interest assessed by the lender at settlement, or the meeting when the property legally changes hands) and other fees, plus a full range of terms including adjustable versus fixed-rates, low down payment versus high down payment, the presence or absence of prepayment penalties, and many other features noted earlier in this brochure.
One way to evaluate rates, however, is by examining the Annual Percentage Rate (APR). The APR can help you compare different types of mortgages. It indicates the "effective rate of interest" paid per year. The figure includes discount points and other charges and spreads them out over the life of the loan. While the APR provides you with a common point for comparison, look at the whole product before deciding which mortgage to get. Pick the one with the rate, payment schedule and other terms t hat suit your situation best.
Terms You Should Know
* The interest on the ARM used in this example increased 2 percent in the second year (payment = $629), and decreased 1 percent in the third year (payment = $577 for Years 3 through 30). This is a hypothetical situation. Not all ARMs will behave in this manner; some will increase (or decrease) more slowly, some more rapidly. In each case, the monthly payments, interest costs, and the amount you save will differ. For more information about tailoring an ARM to fit your particular circumstances, talk to your lender.