How To Shop For A Mortgage
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, if you know the basic facts about financing a house. That's what this article is designed to give you. Let's start with the questions that are probably uppermost in your mind.
That depends upon your income and the cost of your new house. Lenders use certain guidelines to determine the mortgage amount they will lend any one home buyer. 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 to exceed 29 percent of the home buyer's gross monthly income. With loan guaranteed by the Department of Veteran's Affairs (VA), lenders measure prospective home buyers 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.Your lender will compute these figures for you when you discuss the mortgage you want.
Although you may see many different types advertised, they all belong to two families: 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 article does, however, discuss some new loans who are really "cousins" to each family - convertible mortgages.
You are probably familiar with a fixed-rate mortgage. Your parents more than likely had one, as did their parent 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 offer 20,25, and even 40-year term mortgages as well. 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 home buyers 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.
Some newer mortgages afford home buyers some the best qualities of the fixed-rate and adjustable rate mortgages. One new type of loan, often called a Two-Step 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 home buyers 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 home buyers remain in the home for seven to 10 years before moving. For this type of home buyer, the Two-Step loan presents an excellent way of getting 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 a Lender Buydown, where the home buyer 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 home buyer 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 home buyer 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 type of loan offers homeowners the option of getting a loan, 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 home buyer 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 (CARMs) are another loan product on today's market. It works 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 product developed by the Federal National Mortgage Association (Fannie Mae-FNMA), 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. Home buyers 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 (ARMs) have become one of the most popular and effective tools for helping some prospective home buyers achieve their dream of home ownership. 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.
There are several things to compare when looking at different ARM products. If you are thinking about getting an adjustable rate mortgage, make sure you inform yourself on how they adjust and what it is based on.
One of the best things to use for a good comparison is the start rate. A low start rate is always nice to have. Just make sure you are looking at the whole picture because that nice low rate wonít stay there for very long. They usually adjust every 6 months or every year.
ARMs can be an excellent choice of financing under certain conditions, such as rising income expectations, high interest rates, and short-term home ownership. Because payments and interest rates can increase, either steadily or irregularly, home buyers considering this kind of mortgage need their income to keep up with all possible rate and/or payment changes. Each ARM has four basic components:
It is the index plus the margin that will determine what the interest rate will eventually be.
An ARMís interest rate goes up and down according to a nationally published index. The lender has no control over the index and cannot arbitrarily adjust your rate. Your rate is determined by the index.
The index is what the lender uses as a reference for what it might cost to take in money that it can then lend. Take the CD Index as an example. If a lender is currently paying 5% to depositors for Certificates of Deposit it must then make up that cost when it takes those funds and lends them out.
The index on an adjustable rate mortgage will change during the time that you have the loan. So whatever the index is at when you initially get your loan you can be sure that it will change during the time you have your loan. An index can go up or down depending on the current market conditions. There are several different indexes and they are tied to different market indicators that will change differently.
This ARM index is officially called "The weekly average yield on U.S.
Treasury securities adjusted to a constant maturity of 1 year." It is based on
the interest rate that the government pays on some of its debt. This index is
used on the majority of ARM loans. The Treasury Bill index tends to be fast
moving, which means that when market conditions in interest rates change, they
will react to that change very quickly. This can be a good thing if rates are
going down, and not so good if rates are going up.
|The above graph is a 10-year history of the 1-Year Treasury index for your reference|
Twelve Month Moving Average
|This index is the "Twelve month moving average of the average monthly yield on U.S. Treasury securities (adjusted to a constant maturity of one year.)" Like the Treasury bill index, this index is based on U.S. Treasury securities.
Because the index calculation is an average of an average, it is less volatile.|
|The above graph is a 10-year history of this index for your
|Certificates of Deposit (CD Index)|
|This index is "The weekly average of secondary market interest rates on
6-month negotiable certificates of deposit." They are interest bearing bank
investments that will lock your savings rate in for a specific period of time.
The longer the time you lock your deposit in, the higher the rate being paid on
the certificate. ARM loans tied to this index are usually tied to the average
interest rate banks are paying on 6-month CDís. This index is also quick moving,
but banks typically will adjust interest rates more slowly when rates are going
up in order to avoid paying depositors a higher interest rate. Since this index
is tied to bank CDís you can expect this index to adjust a bit more slowly on
rising interest rates. They also tend to come down quickly when rates decline
because banks do not want to pay higher interest unnecessarily.|
|The above graph is a 10-year history of the 6-Month CD Index for your
Cost of Funds Index
|This index is also known as COFI (pronounced just like a cup of coffee). It
is published monthly by the Federal Home Loan Bank Board. The index shows the
monthly weighted average cost of savings, borrowings, and advances, for member
banks in California, Arizona, and Nevada (the 11th. District).
Because COFI is a moving average of rates that bankers have paid depositors in
recent months it tends to be more stable. This means that the index will
increase more slowly when rates are going up. It will also decrease more slowly
when rates are going down.|
|The above graph is a 10-year history of the Eleventh District Cost of Funds index for your reference:|
|This is the London Interbank Offered Rate index. It is an average of the
interest rates that major international banks charge each other to borrow U.S.
dollars in the London money market. These rates are available in 1, 3, 6, and 12
month terms. The index used, and the source of the index will vary by lender.
Common sources are the Wall Street Journal and Fannie Mae. The interest rate on
many LIBOR indexed ARM loans are adjusted every 6 months. Libor also changes
quite rapidly to adjustments in interest rates.|
The margin is the markup that lenders charge on the money they are lending. It is usually somewhere around 2.50%. The margin does not change during the life of the loan. If your lender offers you various margins, you should consider the lower margin since it will have an impact on how much your rate will increase during the loan term. It is the index plus the margin that gives you the fully indexed rate. This is the rate that your loan should actually be at according to current market conditions. If you have a low start rate, you can be sure it will adjust to the maximum amount it is allowed to at every adjustment period until it reaches the fully indexed rate. Remember though, that the fully indexed rate will change because the index changes, even though the margin does not.
It is important to find out how often the particular ARM loan you are looking at will adjust. Adjustments are usually every 6 or 12 months. If your loan adjusts monthly this should alert you that this loan might have negative amortization. Negative Amortization loans will be discussed later in this chapter.
The lender must inform you before your interest rate is about to adjust. There are usually limits built into the loan as to how much the rate can increase at any one time. These limits are known as periodic rate caps. When shopping for an ARM loan always find out how often the loan will adjust, and what the interest rate caps are.
There are two types of rate caps. There is the periodic adjustment cap and the lifetime cap. The periodic adjustable rate cap limits the maximum rate change, up or down, allowed for each adjustment. If your ARM adjusts every 6 months, the periodic cap is usually 1% (one percentage point above your current rate). If your ARM adjusts every 12 months the periodic cap is usually 2%.
You should never take an ARM without a lifetime cap. This cap limits the maximum amount the interest rate can adjust over the life of the loan. ARM loans usually have a lifetime cap of 5 to 6 % above the start rate of the loan. When deciding on an ARM loan always figure your payment at the maximum rate. This way you will know in advance the very worst-case interest rate for your loan.
Some loans have caps for the amount of your monthly payment. At first this may appear to be beneficial because even though your interest rate might be at the fully indexed level, your payment will only adjust a certain percentage each year. This is a negative amortized loan. With this type of loan you may get a low starting interest rate for the first 3 months and then the loan will go to the fully indexed rate. Even though the rate has adjusted to the fully indexed rate, your monthly payment will increase only once per year. When it does increase, it can only increase by a certain percentage from what it was. This is the payment cap.
When you have a loan where the payment does not adjust to meet the interest rate being charged on the loan, you are not paying off all of the interest each month. What then occurs is the unpaid interest is added on to the balance of your loan. You are not fully paying off your mortgage over the 30 year period as you would in a fully amortized loan over 30 years.
This type of loan does have some benefits. It is usually easier to qualify for and can help out buyers who are having problems qualifying at the standard 30 year fixed rate. It also usually offers the borrower an option on how they wish to pay the loan off each month. They can pay the fully amortized payment, and not allow the loan to go into negative amortization. They can pay the full interest only payment, which does not pay the mortgage down but also does not add to the mortgage balance. They can pay the fully amortized payment for a 15-year loan and pay the balance in full in 15 years. They can also pay the smallest payment allowed which is at the payment cap and allows the loan balance to increase. If your negative amortization loan has this feature, you can usually choose each month which payment option you want to take. This can often make this type of loan very flexible. It is important to remember though, that if you are the type of borrower who will more then likely always pay the minimum due each month, this type of loan is probably not for you.
Before you make your final decision on an ARM loan you should ask yourself the following questions:
An adjustable rate mortgage could very well save you money over a fixed rate mortgage over the life of your loan. Consider if you are financially and emotionally secure enough to handle the maximum possible payments over the life of the loan.
Also consider the length of time you expect to be living in the home. If you donít plan on staying there for a long period of time, (usually more than 5 years) an ARM loan might be a good idea. For the first 2 Ė3 years of an ARM loan you can usually save money over the prevailing 30 year fixed rate.
If you expect to hold on to your home for a longer period of time, a fixed rate loan can be the best way to go.
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 six percentage point cap over the life of the loan. That means a loan with an initial interest rate of 6.25 percent would be able to go no higher than 12.25 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:
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 is 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 or 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.
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 financing by underwriting all or part of the loan.
The advantage of this type of arrangement is the mortgage usually carries a lower interest rate with lower monthly payments. The disadvantage is 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 home buyers 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 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 sell 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.
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 in your local newspaper. Many 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.
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.
When you call around to different mortgage lenders, you might find one lender quoting you an interest rate of 7% for a 30 year fixed rate, while another lender quotes you a rate of 6.75%. If you automatically jump at the lower rate of the two, it could end up costing a lot more money.
Remember, an interest rate quote always goes along with points to be paid on the loan. A lender can quote you varying interest rates, and almost always the lower rate has the higher points.
Points are charged by the lender as a way to pay for the expense and work associated with obtaining you a mortgage loan. When comparing rates it is always important to also calculate the points involved.
One way to do this is to calculate the difference between the payment for the 7% loan and the 6.75% loan. Now you know how much you would save each month if you took the lower interest rate.
Next, compare the points. A point is 1% of the loan amount. So if your loan is $100,000 one point would be $1,000. Letís say the interest rate of 7% is for a one point loan or $1,000. Maybe the points for the 6.75% loan are 1.50% or $1500. You will then be paying $500 more in points for the lower rate. If the difference in payment is $33.23 per month, how long will it take to make up for paying the extra $500? If you divide $500 (the difference in the cost of the points) by $33.23 (the monthly savings) you will get 15.05. It will take 15 months to break even. After 15 months you will actually be saving money. If you plan on keeping this house for a long period of time and staying in this mortgage you will be saving a lot of money over the life of the loan. After the first 15 months you will save $398.76 per year if you take the lower interest rate.
Also consider the tax benefits. Points paid on the purchase of a home are tax deductible. You can claim them as an itemized expense on schedule A of IRS form 1040.
If you have the cash, and will live in the home for a long period of time, you will want the lowest interest rate you can get. Paying the extra points required to get the lower interest rate can be a good idea if you work out the cost and the months of lower payments required to make this cost up.
If you are strapped for cash and can come up with the down payment and minimal closing costs there wonít be a lot of money to pay points. If you plan on living in the home a short period of time, paying less in closing costs and a little more each month makes good sense.
If someone quotes you a no point loan, donít automatically think you are getting a deal. This is also true of a no point Ė no fee loan, where you do not pay any fees at all for the loan. Remember the rates/points tradeoff. You donít get something for nothing. A no point loan may make sense if you have very little funds available for closing costs. You will also find that homeowners who refinance over and over again like to have a no point loan. This way they can refinance into another interest rate whenever rates decline and not be concerned with the added expense of paying points to do this. They still will not be receiving the best rate available, but it can still work to their advantage if they think rates will be going even lower and will want to refinance again, or will not be staying in this home that much longer anyway.
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.
By law, the APR must always be disclosed to you within three days after applying for a loan. The APR is the effective interest rate for loans that are repaid over their full term. The APR calculation assumes you will be keeping your loan for its full term. However, most people sell or refinance their loan within 6 to 12 years. If a $100,000 loan were repaid after 6 years rather then the usual 30, the effective interest rate would be 8.66%; not the 8.32% APR you would be quoted. A fairly accurate way to estimate the APR for comparison is:
Effective interest rate = quoted rate + (number of points / 6) If you plan to stay only 4 to 6 years, divide the points by 4. If you plan to stay for 1 to 3 years, divide the points by the number of years.
While the APR provides you with a common point for comparison, look at the whole product before deciding which mortgage to get. Pick the one with the rate, payment schedule and other terms that suit your situation best.
To compare costs when shopping for loans ask lenders to quote a rate based on the same points (a one-point loan is good for comparison). That way you can generally see which lender has the better rate. Donít forget to compare the APR also, to ensure the lender with the better rate/point quote isnít adding on additional fees. Always ask a lender whose loan you are considering to provide you with an estimated breakdown of closing costs. That way you can compare more accurately.
|at 10%||at 10%||w/5% cap*|
|Monthly Payment||$ 658||$ 806||$ 524|
|Difference from 30 Year Fixed Rate||($91,880)||($29,376)|
Should You Assume Someone Elseís Loan?
It is possible the seller has an assumable mortgage. In that case, there are some questions you need to ask yourself before you assume someone elseís loan: