IntroductionIf 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.
