Home Loan Safari Guide: Every Good Hunter Must Understand His Prey

Introduction
If today’s mortgage industry can be characterized by anything other than the slough of middle men, as discussed in my last article, “Mortgage Hot Potato,” it would have to be the diversity and complexity of the home loans themselves. The complexity of modern day loans can be so overwhelming for borrowers that many will just sign their loan documents and hope for the best. Mortgage brokers salivate when they deal with this kind of borrower. These people may as well have a sign on their backs just asking to be fleeced. Some potential buyers may ask a few questions of the broker about the loan terms, forgetting that the broker is a salesman and not a financial advisor. Remember, the broker makes money only when you sign your name to the debt and often times, the more unfavorable the loan terms are for you, the better the paycheck will be for broker. NEVER forget this conflict of interest. With this in mind, it is up to you, the potential borrower, to educate yourself fully and completely about all the mortgage products that are available. This way, when you go to the broker you tell him exactly what you want. Coming to a broker with this confidence, and actually knowing the products available, will let him know that you are not an easy mark. He will still want your business and, realizing you have done your research, he will be much less likely to try and swindle you into a high cost loan. It is for this reason that I create for you this “Home Loan Safari Guide.” Happy hunting.


Every Loan Has a Purpose
People get mortgages for many different reasons, but, as far as the mortgage industry is concerned, there are only three main types of loan purpose: purchase, rate/term refinance, and refinance cash-out. A purchase loan, obviously, is used to purchase a home. A rate/term refinance is a home loan used to pay off a previous loan with the money borrowed at a new rate/term. A refinance cash-out is similar to the rate/term except that the borrower is allowed to extract cash from the equity of his house at the loan’s closing. While there is nothing inherently wrong with any of these loan purposes, all can be obtained at the wrong time, at too high of a cost, or when unnecessary.

When qualifying a borrower, lenders usually use the same qualifying guidelines for both the purchase and the rate/term refinance purposes. Additionally, purchase and rate/term refinance loans usually have identical interest rates. The cash-out refinance, however, is harder to qualify for and usually comes with a higher interest rate. Keep in mind that the fees to close a home loan are usually 2%-4% of the loan amount. This amount is not trivial. If ever you feel uneasy going into a loan and the broker says to you, “Don’t worry, you can just refinance in a couple of years,” then this should be your queue to walk out of the deal. Chronic refinancing does not solve your debt problems; it only makes them worse as the 2%-4% transaction fee often means you owe more on your new loan then on your old one. Brokers love chronic refinacers because it means a reliable source of income for their industry. Another temptation that should be avoided at all costs is the use of home equity from a cash-out refinance to purchase unnecessary luxuries or depreciating assets such as SUVs, fancy vacations, or granite countertops. Instead, use home equity to help a child go to college, to help fund a home business, or for an absolute emergency.

Every Loan Belongs to a Product Line
All loans belong to a product line, and each product line exists to target a different category of borrowers. The product lines each have their own qualification standards and, from the perspective of the broker/lender, some product lines pay higher commissions than others. It is for this reason that many unsuspecting borrowers end up paying much more for their loans than what is justified by their credit risk. It is not usually in the interest of the broker/lender to find the product line most appropriate for the borrower. While the product lines may vary slightly from one lender to the next, the following products are essentially universal: Government, Conforming, Non-conforming, Alt-A, and Sub-prime.

Government loans are loans that are insured by the federal government – either the Federal Housing Administration (FHA loans) or the Veterans Administration (VA loans). Since the government insures these loans, protecting the lenders from default, they are very low cost to the borrower and very safe for the lender. These loans also allow borrowers to make only very small down payments, making them attractive to first-time homebuyers and low-income individuals. Caution: if you can only afford a small down payment, then you should think twice about buying a home in the first place. Ask your broker about one of these loans if you are a first-time homebuyer, a veteran, or have a low income.

Conforming loans – sometimes called “prime loans” – are loans that the banks will eventually sell to either Fannie Mae or Freddie Mac. Both Fannie and Freddie were originally started and funded by the federal government to purchase loans from banks and provide liquidity in the mortgage market. Eventually, the entities grew too huge, so the government converted them into privately owned companies. Even though the government no longer sponsors them, the investing community is convinced that if Fannie or Freddie were to ever face huge financial difficulties, the government would bail them out rather than let them fail. This perceived government backing, valid or not, makes these loans lower cost to borrowers and safer to lenders than any other loan besides the FHA/VA loans. With decent credit and no bankruptcies or foreclosures within the past four to seven years, borrowers should have little trouble getting one of these loans. Currently, the maximum conforming loan amount is $417,000 for single unit residences, with somewhat higher limits for Hawaii, Alaska, and multi-unit properties.

Non-conforming loans (sometimes called “jumbo loans”) are usually loans that meet the same credit requirements as conforming loans but are greater than $417,000 and are thus too large to be eligible for purchase by Fannie Mae and Freddie Mac. Their larger size, coupled with the fact that they cannot be sold to Fannie or Freddie, make these loans more expensive to the buyer and somewhat riskier for the lender. Expect to pay about 1% higher of an interest rate for a non-conforming loan versus a conforming loan. If borrowing more the $417,000, but not much more, consider trying to make a larger down payment or using a small second mortgage so you can get below the conforming loan limit and avoid this more costly loan. Doing so could save you thousands of dollars in interest costs over the life of the loan.

Alt-A loans are one rung up the risk ladder from non-conforming loans. These loans are meant for people who do not meet the credit guidelines of the conforming/non-conforming loans. Often times the borrower will have one or two recent late payments on a credit card, auto loan, or previous mortgage. Borrowers will often have a credit score in the range of 620-680. If an Alt-A loan is the only loan for which you qualify, reconsider your decision to buy a home. These loans are high-cost and if you cannot qualify for a lower cost loan then perhaps you have not developed the financial responsibility required to successfully buy a home and pay it off one day.

Sub-prime loans are the highest-cost of the loan products and they are given to the riskiest borrowers. These borrowers have multiple recent late payments on various lines of credit and generally have credit scores below 620. These loans have been in the news a lot lately and are blamed for the current credit crunch in the mortgage industry. What happened is that once home prices stopped increasing by double digits, more sub-prime borrowers than expected went into default. Suddenly, banks had all this high-risk debt that investors on Wall St. refused to buy. In August of 2007, almost every bank got rid of its sub-prime products, however some banks are still offering them. But honestly, if your credit score is below 620, then you have no business buying a home and you will be paying way too much for it if you do.

***Caution*** Always go into the home-buying process knowing which mortgage products you are eligible for and select the one that is the lowest cost. Sometimes brokers will try to talk borrowers into high-cost loans because of the higher commissions they generate. There have been cases of people that could have received a conforming loan and ended up in a high-cost sub-prime loan because they just didn’t know what was available to them. Do not make the same mistake.

Every Loan Has a Term and an Interest Rate
Loan term refers to how long it will take the borrower to pay off the balance if they were to make the billed payment every month. Over the years, loan terms have been creeping higher and higher. Originally the 15-year loan was standard, while today 30-year terms are the most common. It is also not unusual to see 40-year loans these days. Hopefully, America will not follow the lead of Japan where there are now 100 year loans! Why have loan terms been increasing? The reason is that the average borrower suffers from a condition called payment myopia. What this means is that the borrower equates cost with monthly payment rather than equating cost with total interest paid over the life of the loan. As a loan term increases, the borrower does pay less each month, however the borrower also pays more in total interest over the life of the loan. On top of this, longer loan terms generally come with a slightly higher interest rate. Payment myopia is the mortgage broker’s favorite condition because it allows him to stick the borrower with a higher-cost (high commission for the broker) loan and, at the same time, convince the borrower that he is actually saving money.

The interest rate is the cost of borrowing money. Borrowers can either choose a fixed rate mortgage or an adjustable rate mortgage. Fixed rate loans maintain the same interest for the entire term of the loan. For 99% of borrowers, a fixed rate loan is probably the absolute best loan for them. Since the interest rate is constant, the monthly payment will be the same every single month for the entire loan term. There are no surprises with a fixed rate mortgage, so if you can afford it in the beginning then you should be able to afford it until the end. Fixed rate loans are best when interest rates are low by historical standards, as they are now and have been for the past 7 years. Notice that during this time the media and Alan Greenspan were pushing ARMs big time. Whose interest do they serve?

Adjustable rate mortgages (ARMs) are much more complex than fixed rate mortgages and most borrowers are left very confused by these loans. There are a few things about ARMs that, if everyone were aware of, would alleviate much confusion and could potentially save borrowers thousands of dollars. All ARMs have a fixed rate period at the beginning of the loan. The fixed rate period can be a short as one month or as long as ten years, and during this time the interest rate is set artificially low. Notice that ARMs need to have starting interest rates set artificially low or else nobody would have a reason to choose them over fixed rate mortgages.

Once the introductory fixed rate period expires, an ARM’s interest rate is determined by a formula: interest rate = index + margin. The most common indexes are the LIBOR, MTA, and COFI. An index basically tracks the interest an investor could receive if he invested his money in some low-risk vehicle instead of investing it in mortgages. The margin is usually between 2% and 3.5% and is fixed throughout the life of the loan. The margin is known to the borrower before the loan is signed and is basically a premium the borrower must pay. If this premium were not present then why would the investors choose to fund a risky mortgage over investing somewhere with a much lower risk? While for a fixed rate mortgage you should minimize cost by finding the lowest interest rate, for an ARM, the best way to minimize cost is to find the loan with the lowest margin. You have no control over the direction the index will go, but you can control the margin to some degree since it stays fixed for the life of the loan and is stated before you sign the loan documents.

What’s my advice? Interest rates have been creeping up but they are still near historic lows. If you cannot afford to pay the house off in 30 years then you cannot afford the house. Also, if you cannot afford the only slightly higher payments that come from a fixed rate mortgage, then you cannot afford the house. Getting an ARM right now, or any time in the recent past, is just a bad, bad idea because interest rates have been so low that there is almost no direction they can go other than up. It is almost criminal how many people were duped into ARMs while they could have locked in a fixed rate while rates were the lowest they have been in 50 years.

Conclusion
There are SOOO many more important features of home loans that any complete guide would cover: balloon payments, interest only features, negative amortization, escrow accounts, and more. If you have read this far then I’m not sure you would have read any further if I didn’t cut out a lot of details. However, this guide does cover most of the basics and these basics alone can save people money. I will write other articles that cover the more complex and obscure features of home loans. If there is one thing I want you to take from this guide though, it is that if ever you need to get a fancy loan in order to buy a home, then you are probably getting in over your head. And if you ever sign your name to hundreds of thousands of dollars without understanding EVERYTHING about how the repayment will proceed, then you are probably getting ripped off. The complexity of a home loan seems daunting but just a little research can put your mind at ease and can keep you the hunter instead of the hunted.

Mortgage Hot Potato: How Many Mouths Can One Home Loan Feed?

If you ask the average person “Who holds the mortgage lien over your house?” they are likely to respond with “Countrywide,” “Wells Fargo,” “Goldman Sachs,” “Citi Mortgage,” or some other large bank. Once upon a time, when a person needed a home loan they would go to the bank and, after the borrower made a 20% down payment on the house, and after a careful evaluation of the borrower’s credit risk, the bank would approve and fund the loan. The banks held these loans on their balance sheets as assets and their motivation for extending credit was the interest income the mortgage generated. It was in the best interest of the banks not to lend to people who were too big of a credit risk or to people who could not reasonably afford to pay the loan back, because if the borrower defaulted, then the bank was in a position to lose a lot of money. Furthermore, it was in the interest of the borrower to avoid buying a house that he could not afford because if the bank foreclosed on him, he would lose his 20% down payment. This two species ecosystem may have been a bit boring, but it worked because both the creditor and the debtor had a vested interest in the long term success of the transaction.

But no ecosystem can stay the same forever and in today’s mortgage environment, a whole slew of fierce new beasts exist. They have adapted so well, and the landscape today is so complex, that few people even realize or understand that these creatures are there, or in what ways their presence has changed the game. So, from A to B, just what exactly happens when you borrow money to buy a home and how many mouths do you need to feed along the way?



It all starts with the three headed beast: real estate agents, mortgage brokers, and appraisers. The real estate agent and the mortgage broker are both supposed to work in the best interest of the borrower. The real estate agent is supposed to find the best home for the buyer’s needs at a fair price, while the mortgage broker’s job is to find the buyer an affordable and suitable mortgage product at a fair interest rate. However, both the agent and the broker are paid on commission, which creates a conflict of interest in the buyer-agent and buyer-broker relationships. It is actually in the best interest of the agent for the home to sell for as high of a price as possible, and in the best interest of the broker for the loan to be as large as possible. Since few people have sums of money that are comparable to the cost of a house, the size of the average loan usually goes up when house prices go up, so the interests of the agent/broker are in line with each other. How does the appraiser fit in? The appraiser is supposed to be a neutral party that provides a fair market value for a house. Increasingly, what has been happening is that appraisers, agents, and brokers have been working together, illegally, and manipulating house prices in order to fatten their commission-based paychecks. The agents and brokers put pressure on the appraisers to return an inflated house valuation, and if the numbers come in too low, that appraiser will never get a job from that agent or broker again. So now you’ve essentially paid a premium to the agent, the appraiser, and the broker. The fraud that exists due to the three headed beast goes much, much deeper but will simply need to be addressed in another article.

So what happens after you’ve borrowed too much to pay for a home which is probably worth less than you thought? The actual money for the loan did not come from the broker; it came from the lender for whom the broker works. However, lenders typically have very little money themselves. It is not unusual for a lender to only have enough money to fund a handful of loans. The lenders are not in business to hold your mortgage or to earn revenue from your interest payments. Lenders originate loans in order to sell them off to banks such as Wells Fargo, Bear Stearns, or Countrywide. The money received from the sale of the loans goes toward making new loans and into the lender’s pocket. The business can only survive by continuing to sell loans at a high enough volume to cover its costs and to make enough profit to justify their efforts. Notice that the key to being a profitable lender is high volume; lenders want to originate as many loans as possible so that they can sell as many loans as possible. The lender does not care if the mortgage is suitable or affordable for the borrower because the lender plans on selling the loan within a couple of months anyway. Lenders bear almost no risk in giving out a loan to someone. The only risk the lender faces is the “buyback clause,” which states that the lender must repurchase any loan that they sold to a bank if that loan goes into default within the first 6-12 months of purchase. The only thing the lender and broker need to worry about when giving someone a loan is whether or not that person can make their payments for the first 6-12 months. Notice now that when you get a loan you are also paying a premium to the lender, who must only provide the broker with interest rates high enough so that some bank will be willing to buy the loan from them later on.

Most people think that the banks are the end of the line for a home loan. The truth is that, while banks do keep a small percentage of loans on their portfolios, most home loans are once again sold to other entities. The reason for the confusion about who actually owns the mortgage note is that few in the general public are aware of what are called “mortgage servicing rights.” While the entity that owns the mortgage note ultimately gets the principle and interest, it is the entity that owns the servicing rights who collects the monthly payments from the borrower and forwards it to the note holder. The bank has an interest in keeping the servicing rights of a mortgage because whoever holds servicing rights gets to keep late fees as well as generate revenue by keeping mortgage payments in interest bearing accounts before forwarding these payments to the mortgage note holder. And since the banks too are selling your mortgage, they must only buy loans from lenders that have high enough interest rates so that they themselves can sell the loans off at a competitive price to their buyers. Notice also that, once again, the banks do not care about the long-term suitability or affordability of the loan because they are selling the loan and giving the risk to someone else.

Banks can sell off loans in two different directions. The first is to one of the government sponsored entities (GSEs). For mortgages, these are Fannie Mae, Freddie Mac, and Ginnie Mae. (These GSEs have an interesting history and there is controversy over their existence which may need to be discussed in future articles.) Loans sold to Fannie Mae, and Freddie Mac are called “Conforming Loans” and they currently cannot be larger then $417,000 for single unit residences in the continental US. Also, the borrower must qualify through one of two special underwriting software programs called “Desktop Underwriter” for Fannie Mae and “Loan Prospector” for Freddie Mac. Ginnie Mae purchases FHA and VA loans; special loans set up for low income individuals and veterans. Banks, in general, can only sell their “safe” and “low risk” loans to the GSEs. The loans that are not eligible for purchase by the GSEs are sold to investment banks.

The safe to relatively safe loans that have been sold to a GSE or an investment bank are bundled together and once again sold, this time to Wall St. as a vehicle called a “Mortgage Backed Security” or “MBS.” Basically, the loans are pooled together and chopped up into smaller pieces and sold as bonds. Some loans are just too risky and, if left in the form of an MBS, no one would be willing to take the risk of purchasing them. The investment banks don’t want these loans on their books either and thus was born a highly complex investment vehicle known as a “Collateralized Debt Obligation” or “CDO.” Basically, a CDO is a pool of risky mortgages that are divided into “tranches,” or a hierarchy of risk levels. When an investor purchases a CDO, she selects which tranch she wants to purchase into. The lower tranches have a high yield but are very high-risk, while the high tranches have a low yield and low risk. The people who buy into the top tranches get paid first, then the people in the next tranch, then the next, and so on. The people in the bottom tranch only get paid after everyone above them gets paid. The tranches are designed so that a higher and higher percentage of buyers would need to default in order for people to lose money in the higher tranches. For example: if 10% default, then those in the bottom tranch lose their money but everyone else gets paid; if 20% default, then those in the bottom two tranches lose their money but everyone else gets paid, and so forth.

So the end of the line for a mortgage is not the balance sheet of some large bank – it is in a pool of other mortgages that have all been used, abused, bundled, and chopped up and then sold to Wall St. investors. All MBSs and CDOs receive a credit rating from large ratings agencies such as Moody’s. Unfortunately, over the past few years these ratings agencies have done a terrible job rating these complex investment vehicles. These vehicles are relatively new and the models used to attach credit ratings to them were highly inaccurate because they assumed continued increases in house prices and used recent foreclosure rates which were artificially low because of the recent rise in house prices. Most MBSs and CDOs received “investment-grade” ratings, and with ratings like these, mutual funds, hedge funds, and foreign investors saw no problem in buying this debt.

The key thing to notice in all of this is just how many entities touch a single mortgage before it finds a home for itself. Each of these players takes a cut for themselves and then passes the risk to the next bigger fool willing to buy the debt. The middlemen do not care at all if the loan was ever suitable or affordable; all they care about is the size of the loan and the volume of loans they can sell. In effect, the middlemen are taking a cookie for themselves before passing the jar along and one must realize that whoever held the jar first (the borrower) had to be the one who filled the jar. The borrower pays for this orgy of middlemen through a higher interest rate and through upfront fees known as points. But also, the borrower pays for these middlemen with a higher risk of mortgage default and bankruptcy because all along the way there was no one telling him, “You cannot afford this loan.” Instead, everyone told him “Yes, yes, yes” because anyone in the system who said otherwise would have been less profitable and their business would not have survived the competition. And in a display of slight of hand that would make Lance Burton proud, the middlemen somehow manage to give – no, not give, but sell – the risky debt back to the general public. After all, is it not working Americans trying to save for retirement who put their money into mutual funds? So, in effect, if you bought a house recently and own a mutual fund, odds are you helped fund your own home loan and if you default not only do you lose the home but your mutual fund will go down as well.


The Moral of the Story and What Can Be Done:

Buying a home is probably the biggest financial decision you will ever make. Do not make this decision lightly. Understand that qualifying for a loan DOES NOT mean you can afford a home. Realize that the people you must deal with to buy the home have bills to pay and a family to feed and that their self-interests will not be the same as yours. Fork over the $250/hr to talk to a fee-based financial advisor to find out how much you can afford to pay for a house. Remember that real estate agents and brokers are NOT trained as financial advisors so do not ask for or accept financial advice from them. Also, do not let a real estate agent talk you into paying any more than you are comfortable paying. If something sounds too good to be true then it is too good to be true. Get a rate quote from multiple brokers before you decide who to go with but do it fast as interest rates change every day, sometimes many times a day. Have a lawyer read the loan documents before you sign anything and if a broker pressures you, then walk out. If you believe you were a victim of mortgage fraud then talk to a lawyer. Buying a home can be a great thing, but if something goes wrong it can become a nightmare, so make sure to educate yourself before making any decisions. In the end, you are responsible for your own wellbeing, so do not rely on others assuring you things will be alright. Protect yourself at all times. For absolutely excellent info on purchasing a home and the mortgage industry please read the Mortgage Professor at: http://www.mtgprofessor.com/Default.htm

Introduction

The Guerilla Blog was created to promote education, to create a forum for the exchange of ideas, and to make suggestions for action that can be taken in regards to both personal and global problems that currently exist. Also, it was created to satisfy a restless soul’s desire to stop being quiet, to stop standing idly, and to start doing something about the problems facing humanity.

First and foremost, the mission of this blog is to foster education. The sad truth is that the majority of people in this world do not receive the education that they deserve. Increasingly, education is becoming a privilege for the wealthy. And, increasingly, the people in power are using ignorance to swindle the masses. The “education” people receive in regards to current events from the television/radio/print news media is especially poor, exceptionally biased, and is increasingly acting as a means of control by the powers that be. True education should empower an individual, not leave them in fear or distract them from the truth. On top of this, the education people do receive can often leave them lacking critical real world survival skills. It’s not that English, history, math, and science are not very important, but wouldn’t it be nice if a person could graduate high school knowing how taxes worked, how a car/home loan works, how to shop for insurance and when it is even needed, the true status of global warming and environmental conservation, or how to save for retirement? The current standard education system and mass media fail horribly at addressing and educating people in regards to these and many other issues.

Secondly, this blog seeks to provide a forum for discussion. Whether you agree or disagree with what is said, stand up for what you believe and let it be known. Progress towards truth is only made when all counterpoints are satisfied, so please bring these to light in the comments section. Rational people should never be upset with ideas different from their own. A rational person accepts that his own idea may have been wrong or, after reviewing the facts, uses these facts to try to convince the other person that they themselves are mistaken. Sometimes there will be no absolute truth or correct path and this option must be kept in mind as well. But the biggest obstacles to progress are ignorance, lack of discussion, and stubbornness to accept that our ideas are not always right.

Lastly, this blog urges people to take action. This is a very broad goal. Sometimes the best action is to just educate yourself and those around of important issues so that you and they can avoid becoming victims of ignorance. A lot of times global problems seem so huge that no one person could solve them, but if enough people do their small part the world can change. One letter to a congressman may not change anything, but 1,000 letters could and each of those letters needed to come from one person who had to have faith that they alone could make a difference.

Hopefully the aforementioned goals resonate with you and you continue to read this blog and even contribute to it through comments or by passing it on to friends. The topics to be presented will be very wide-ranging and will include issues relating to economics, math, science, government, politics, arts, literature, philosophy, survival skills, personal finance, the environment, and technology. Occasionally The Guerilla Blog will write a letter to a person in power or of importance and this letter will be posted as well. So read, learn, contribute, and enjoy.