VA Loan

Posted on July 16, 2011 by descriptions

The Department of Veterans Affairs (VA) loan program began after World War II to help veterans buy homes. While the FHA insures a lender against loss, the VA guarantees a lender against loss. The difference between insurance and a guarantee does not affect the borrower. These are differences in the procedures that a lender must follow to be reimbursed for a loss. (The following is the procedural difference as explained by HUD.)

• VA—When a delinquency is reported to VA, and no realistic alternative to foreclosure is developed by the loan holder or through VA’s supplemental servicing of the loan, VA determines, through an economic analysis, whether VA will (a) authorize the holder to convey the property, securing the VA Loan to the Secretary of Veterans Affairs following termination or (b) pay the loan guaranty amount to the holder. The decision as to disposition of properties securing defaulted VA Loans is made on a case-by-case basis, using the procedures set forth in 38 U.S.C. Section 3732(c), as amended.

• FHA—Upon default, the lender—depending upon the circumstances—may (a) assign the mortgage to FHA, (b) acquire (through foreclosure or deed in lieu of foreclosure) and convey title to FHA, or (c) work with the borrower to sell the property before the foreclosure sale. The lender will receive insurance benefits equal to the unpaid principal balance of the loan, plus approved expenses.

The original program had two main goals. First was to make it easy for veterans to buy a home by not requiring a down payment. Second was to protect veterans from overpayment. In order to accomplish this, the rules were that the buyer could pay no more than the appraised value of the property. The appraisal, called a certificate of reasonable value (CRV) was done by a VA-approved appraiser.

There was also a maximum interest rate that could be charged, as well as a restriction on points. Today, the no down payment benefit still exists. The other protections have been eliminated.

How do I find out if I am eligible for a VA mortgage?

Loans guaranteed by the VA require military service for eligibility. A certificate of eligibility is issued to the veteran. If you have served in the military or were activated from the National Guard, you may be eligible. Type “VA loans” into your search engine or go to www.va.gov, click on “Benefits,” and then click on “Home Loans,” for complete information.

Although you can contact the VA directly to determine eligibility, the VA recommends that you first contact a lender. Most lenders now have access to a database that will enable them to determine whether you are eligible. A second reason to see a lender first is the same as for any loan that you plan to get; you can be prequalified or preapproved.

You will have a good idea of the price range that is realistic for your new home. Call your local VA office for a list of lenders in your area. It is important to note that spouses of deceased veterans may be eligible. There are also special programs for disabled veterans and direct loans to Native Americans for certain tribal lands.

Can VA loans only be used to buy a home?

No. In addition to the veteran status necessary to be eligible, the website provides information on using eligibility more than once, the types of properties that can be purchased, assuming a VA loan, and the various types of loans that are offered. Any of the following reasons are acceptable as an eligible loan purpose for a VA loan:

• to buy a home;
• to buy a townhouse or condominium unit in a project that has been approved by the VA;
• to build a home;
• to repair, alter, or improve a home;
• to simultaneously purchase and improve a home;
• to improve a home through the installment of a solar heating or cooling system, or other energy efficient improvements;
• to refinance an existing home loan;
• to refinance an existing VA loan to reduce the interest rate and add energy efficient improvements;
• to buy a manufactured (mobile) home or lot;
• to buy and improve a lot on which to place a manufactured home that you already own and occupy; and,• to refinance a manufactured home loan in order to acquire a lot.

The VA-guaranteed loan has many of the same benefits and drawbacks as the FHA-insured loan. Down payment requirements are significantly lower than conventional financing, and closing costs may be less. Even though VA loans have no maximum loan cap, they currently top out at about $240,000 because of the inability to sell higher-amount mortgages in the secondary market.

You will find two charts taken from the Government National Mortgage Association (Ginnie Mae) website on the following pages. The first shows a purchase price of $200,000, with $25,000 available for a down payment. The second shows the same purchase with no money available for a down payment. You can see that only the VA loan works with no down payment, and then only if the seller pays all the buyer’s costs.

You will also find a third chart on page 112, which is taken from the VA website and further compares down payments of different types of loans. This table shows that while a home buyer can qualify for about the same house price with either an FHA or a conventional loan, the down payment requirements are very different. In summary, the VA loan is an excellent loan if the seller is having a problem selling the property. The requirements to qualify for a VA loan—except for eligibility—are more liberal than for a conventional loan. No down payment and allowing the seller to pay closing costs enable the veteran to buy the property when a nonveteran would not qualify.

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FHA Loan

Posted on July 16, 2011 by descriptions

The FHA does not make loans, but rather insures the lender against loss that may occur if the property is foreclosed upon and the sale does not cover the amount owed. The FHA insures lenders against loss from making loans that have a higher risk of default than the lender would accept without the insurance. For purposes of simplicity and because of its common terminology, these FHA-insured loans are referred to as FHA loans.

Advantage of an FHA Loan

The major advantage to the borrower has changed in recent years. At one time, the low down payment was the major advantage. Now, the major advantage in qualifying for a loan is that FHA standards for approving a borrower for loans requiring little or no down payment are more liberal than those of conventional lenders.

When qualifying a borrower’s income, FHA allows coborrowers who do not occupy the property to have their income count in the qualification process. FHA also allows gifts for closing costs that conventional lenders would not.

Disadvantages of an FHA Loan

There are three major disadvantages of FHA loans. First, there is a mortgage limit that excludes many homes. The lending limit is set by area, with higher limits in states with higher home costs. As of October 2007, the lowest maximum limit was $200,160. The highest was $362,790. Although this covers many homes, it obviously also excludes many. You must remember that the purpose of these loans is to allow low-income borrowers a chance at home ownership. Low-income borrowers buy the least expensive homes. They may cost less because of size, location, need for repair, or a combination of these factors.

The second disadvantage is that selling a home to a buyer using an FHA-insured loan may cost the seller more money than if the buyer used conventional financing. The seller may be asked to pay points, which is allowed under FHA rules. This does not happen with conventional financing. This was a more serious problem when the buyer was allowed by law to pay only one point. The FHA buyer may now pay all the points. The time involved to close is longer than with conventional loans. Even with automated underwriting and more authority given to lenders to qualify borrowers, it still could take forty-five days to process an FHA loan. Sellers will tend to accept a buyer who will finance conventionally over an FHA buyer.

The third disadvantage to FHA loans is the mortgage insurance premium (MIP). This is the FHA equivalent of the conventional loan’s private mortgage insurance (PMI). The cost for MIP is higher than PMI. FHA-insured loans work best for low-priced homes when the buyer cannot get conventional financing. When there are many buyers and few homes for sale (a seller’s market), fewer homes are sold through the FHA. When there are few buyers and many homes for sale (a buyer’s market), more FHA financing is used. The advice is simple. If you can qualify for a conventional loan at a standard rate, you are better off getting a conventional loan than getting an FHA loan. If you must pay a substandard (higher) interest rate, higher points, and so on because of credit or income problems, FHA may be your answer to home ownership.

Major FHA Programs

There are four major FHA programs of which you should be aware.

1. 203(b). This is the original program, which has been used since the Great Depression. It is aimed at borrowers who would not qualify for conventional financing because of credit, income, or cash requirements. The borrower must intend to use the home as his or her primary residence. It requires a 3% down payment and allows closing costs and mortgage insurance to be financed. It covers one- to four-family homes.

2. 203(k). This program is for the rehabilitation of property. The main goal is to revitalize neighborhoods that have properties in need of rehabilitation. It is very broad, covering property that has one to four family units, condominiums, and even property that is partly commercial. It also covers complete demolition and rebuilding, as well as moving a building onto the land after demolition. (There are requirements for keeping the original foundation.) The difference from conventional financing is that one loan can cover the purchase price and rehabilitation costs, based on the estimated value of the property after the work is completed. As with all FHA loans, qualifying is easier than for a conventional loan.

3. 234(c). The purpose of this program is to help tenants buy units when their apartments are converted to condominiums. It can also be used by developers to convert apartments to condominiums. Qualifications similar to 203(b) are required.

4. 251. This is the FHA adjustable rate mortgage program. It can be used in conjunction with the three programs previously described. The index used is the Constant Maturity Treasury (CMT). The adjustment is yearly with a 1% cap, and the lifetime cap is 5%.

There are several other programs designed to help specific groups, such as loans for Native Americans, the Good Neighbor Program designed to help people with certain jobs (such as teachers, police officers, and firefighters), graduated payment mortgages, disaster relief loans, the Home Equity Conversion Mortgage (reverse Mortgage for Seniors), etc.

Fortunately, FHA has an excellent website that not only explains each loan, but also helps you find an approved lender in your area. Visit the site at www.fha.gov or type “FHA” into any search engine. For an even broader site, the U.S. Department of Housing and Urban Development (HUD) can be accessed at www.hud.gov or by typing “HUD” into any search engine. This will also give you access to HUD homes for sale.

Another important section of the HUD website gives advice if you are facing foreclosure. FHA can provide counseling as well as possible help in refinancing. I say “possible” because FHA has been given expanded authority to help homeowners facing foreclosure. The program or programs may be clearer by the time you read this.

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Government Loans

Posted on July 16, 2011 by descriptions

There are two types of government mortgage loans that must be addressed—FHA loans and VA loans. Farm loans are not discussed, as they are specialized, and if you are looking to finance the purchase of a farm, you should seek advice from a local bank near the farm. The government mortgage loans are not really loans from the government. Instead, a government agency insures or guarantees a loan made by a private lender. These are loans insured by the Federal
Housing Administration (FHA) or guaranteed by the Department of Veterans Affairs (VA).

The purpose of these governmental programs is to facilitate home ownership for those moderate- or low-income families who do not have the ability—usually the down payment—to qualify for a conventional loan. The insurance or guarantee takes away the lenders’ risk of loss, allowing them to make loans with as little as 3% down for FHA-insured loans and zero down for VA guaranteed loans.

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Prepayment In Mortgage

Posted on July 16, 2011 by descriptions

Prepayment of your mortgage loan has two purposes:

1. shortening the term; and,
2. allowing you to pay less interest.

The way prepayment was traditionally made was by paying the exact amount of principal for your next payment along with your current payment. If you had 300 payments left on your loan, your current payment would bring you down to 299. If you paid payment 300 plus the principal reduction amount on payment 299 at the same time, you would then have 298 payments remaining.

This was an easy way to figure out how much to pay and how many months you would have to pay to pay off the loan. The greatest advantage in prepaying your loan was during the early years of your loan. This was when the amount going to principal was lowest and the interest amount was highest. If your payment was $1,000 per month early in your loan, perhaps only $100 was going to principal and $900 to interest on your current payment. Your next payment might have $110 going to principal. By prepaying the $110, you saved $890 in interest.

Late in your loan the opposite would be true—$900 would go to principal and $100 to interest. You would have to make a very large additional principal payment to save a small amount of interest. It simply is not a good option.

What changes in the industry affect prepayment today?

There are two major changes that affect prepayment today. The first is the computer. In the past, the reason you were required to pay the exact amount of principal as a prepayment was that someone had to do the math by hand. Unless you used this easy method, it was very time-consuming for the lender to redo your whole amortization schedule. Now, the computer refigures the amortization schedule in seconds, making the specific amount of the prepayment immaterial.

The second change makes prepayment even more important for some loans. In the old days, you had to put 20% of the loan amount as a down payment and there was no PMI. Today, loans with greater than 80% loan-to-value ratios are common and PMI is required. Prepaying a loan down to 80% not only saves interest, but also allows you to stop paying PMI. If you are paying PMI and have some money available at the end of the month, making additional principal payments is an excellent investment. Unfortunately, most borrowers who do not have 20% to put down at the beginning do not have extra money with which to make prepayments in the early years of the loan. However, there are other, more sophisticated methods to eliminating PMI.

Example 1: You originally obtained a 90% loan and you have paid it down to 85%. Your income has increased, so you now have a few hundred dollars that you could put into prepayments. Your home may also have increased in value. You should be able to get an equity line of credit at the prime rate or slightly lower. You could use the line of credit to pay your loan down to 80% and eliminate the PMI. Then you would use the extra money you have to make payments on the line of
credit loan.

Example 2: You have purchased a home for $200,000 and put 10% down. Your monthly payment on your $180,000, thirtyyear loan at 6% interest is $1,079.19 (rounded to $1,080). You have paid down your loan to $170,000 by making required payments, but still need to reduce it by another $10,000 to eliminate the PMI.

If you were to get a home equity line of credit (HELOC) for $10,000 and use the money to pay down your first mortgage, you could eliminate the PMI and save the interest that you would have paid to reduce the loan by making required monthly payments. By making the required payments, you would reduce your loan balance to $160,000 in thirty-nine months and pay over $32,000 in interest for that period. In addition, you would pay a PMI premium of approximately $75 per month, or $2,925, for a total cost to you of approximately $35,000. A reasonable interest rate for an equity line of credit would be less than the interest on your first mortgage loan.

A reasonable interest rate on an equity line of credit would be the prime rate to 1% below the prime rate. Let us split the difference and say 8%. Your monthly payment on a $10,000 loan at 8% for five years would be $202.76 ($203). Since you eliminated the $75 per month PMI, your out-of-pocket payment would be $128. If you made only the monthly payment required to amortize the loan, your total cost would be roughly $12,180 ($203 x 60). Of that, $2,166 would be interest.

Note: Even though the above numbers may seem outdated, I have not revised them. They were valid only a few months ago and I want you to understand how quickly things change. Rates can go up just as fast. You can see the obvious advantages, but there are also risks. First, by getting an additional loan, you are taking on an additional required payment. If you have future financial difficulties, this could become a burden. Second, the equity line of credit may only be available with an adjustable rate. This could raise your payment amount if rates increase and lessen the advantage. Both risks seem manageable and well worth taking to realize the savings. The last consideration for our example is what else you could do with the extra money each month. There is no safe investment in today’s market that equals a rate of return even close to prepaying your mortgage loan, especially if you eliminate the PMI payment.

Note: By the time you read this, PMI may be tax deductible. Check with your tax adviser. Another possibility is to borrow against your 401(k). However, this is usually not a good idea for several reasons.

• You are borrowing from yourself. The money you borrow will not be earning retirement income for you. Since many employer-sponsored retirement plans have employer contributions, this could be a significant loss.

• If you leave your job, you will have to pay back the loan in full. This could cause you to stay with your current employer and pass up a better opportunity.

• Under current law, you will have five years to pay back the loan. If you fail to do so, you will incur a penalty of 10% of the amount owed, plus you will have to pay income tax on that amount.

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Jumbo Loans

Posted on July 16, 2011 by descriptions

As the name implies, a jumbo loan is a loan for a large amount of money. A loan is a jumbo loan if it exceeds the maximum amount of Fannie Mae and Freddie Mac programs. Because exceeding the loan amount allowed by Fannie Mae and Freddie Mac guidelines means that the loan does not conform to the guidelines, the jumbo loan is also called a nonconforming loan. There is no single standard amount that defines a loan as jumbo, since Fannie Mae and Freddie Mac change their maximums yearly based on changes of real estate prices. As of April 2008, the highest allowable amount for a single-family property mortgage loan in the continental United States was $729,750. Anything above that amount was considered jumbo. This amount will change as real estate prices rise or fall.

Loan programs for jumbo mortgage loans are as varied as smaller loans. There are fixed rate, adjustable, and hybrid jumbos. The loanto-value ratio can be anywhere up to 100%. The term is also the same as smaller mortgage loans, the most common being fifteen and thirty years. A jumbo loan can be used to purchase or refinance a primary residence, vacation home, or investment property. The strength of the borrower will determine the interest rate, just as with smaller loans. For equally qualified borrowers, the jumbo loan will have a higher rate—usually between .125% and .75%—than a conforming loan, depending on the size of the down payment and the lender’s profit requirements.

Although the exact number varies with the lender, some lenders are using the terms good credit and excellent credit in their underwriting for jumbo loans. Excellent credit may get the borrower a lower interest rate or require less documentation than good credit. Generally, good credit would range from a FICO score of 650 to 700, and excellent credit would be above 700. If you are thinking of buying a home that will require a jumbo mortgage, you are faced with the same challenges that you would face for a smaller loan. Research to find the right lender offering the right program for you must be done for any mortgage loan.

Can I avoid having to get a jumbo loan?

Yes. A big disadvantage to the jumbo loan is that even a slightly higher interest rate over a conforming loan is magnified because of the large amount of money being borrowed. There is a way around this if you need a loan slightly higher than the maximum conforming limits. Many lenders now offer a conforming loan for the maximum allowed and a second mortgage loan for the balance needed. Since you are saving interest on the higher-amount first mortgage, you can afford to pay a higher rate on the second and still come out ahead.

Example: Since conforming loan maximums change with the real estate market and region, suppose $450,000 is the conforming loan limit. You need to borrow $460,000. Instead of paying the higher interest of a jumbo loan, you get a second loan for $10,000. Since the higher interest of the jumbo loan would be paid on $460,000, the savings are considerable. You could pay over 15% interest on the second (although you should not have to) and still come out ahead, using a difference between the rates of a jumbo and conforming loan of only .25%, with interest on the conforming loan at 7% .

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Hybrid Mortgages

Posted on July 16, 2011 by descriptions

Hybrid mortgages fall between a fixed rate and an adjustable rate loan. Lenders realized that there was a market for borrowers who wanted the lower cost of an adjustable loan but were afraid of a possible interest rate increase within a short time. The lenders also realized that some interest rate adjustment was better than none at all.

The hybrid mortgage loan begins with a fixed rate for a set time. The most common fixed periods are three, five, seven, and ten years. At the end of the fixed term, the loan adjusts to the agreed-upon index rate plus the margin. Further adjustment is most commonly annually, although the adjustment period may be every three, or even every five, years. The loans are categorized by their overall term, then fixed term, then adjustment period. A thirty-year loan with a three-year fixed term and a one-year adjustment period would be expressed as a 30/3/1 loan. A fifteen-year loan with a fiveyear fixed term and an adjustment period every three years would be expressed as a 15/5/3 loan.

At the end of the fixed interest period, the loan is recalculated to reflect the new interest rate. If you borrowed $100,000 on a 30/3/1 loan, for example, the loan would be recalculated at the end of three years. Your payment would be based on the new interest rate (index rate plus margin), term remaining (twenty-seven years), and the principal balance ($100,000, less the amount of principal paid during the first three years). Each succeeding year would have an interest rate adjustment based on a change in the index rate, with a resulting payment adjustment.

What are the advantages of a hybrid mortgage?

• The fixed interest rate period is at a lower rate than a fixed rate loan for the entire term. If you expect to sell your home during the fixed rate period, it equates to getting a fixed rate loan at a lower rate.

• The risk of a higher rate is postponed for three to ten years rather than three months to one year with a standard adjustable rate mortgage. This gives you time to increase your income or savings should the new rate require a substantially higher payment.

• Many hybrid loans are assumable, which may be an advantage if you sell the property.

What are the disadvantages of a hybrid mortgage?

• The initial interest rate on a hybrid loan is higher than on an adjustable rate loan.

• The new rate at the end of the fixed rate period may cause a significant increase in the monthly payment.

• Once the interest rate begins to adjust, it could be more costly than a fixed rate loan would have been.

What factors do I need to consider before deciding whether or not to get a hybrid mortgage?

As with most mortgage loans, there are several factors to consider.

• Interest rate. Is the lower rate for the hybrid enough to make it worthwhile compared to a fixed rate loan? If you plan to stay in the home for the foreseeable future, you may want to compare the hybrid to a shorter-term fixed rate loan that has a lower interest rate.

• Loan costs. A lower interest rate does little good if you are being charged points and other fees that eat up the savings. Comparing several lenders’ programs will help you determine the standard costs.

• Index. As you know from Chapter 9, there are leading and lagging indexes. If you are concerned about rate increases, find a lender using a lagging index, such as COFI.

• Margin. The lender’s profit will be the fixed part of your interest rate once the loan adjusts. Margins can range from .5% to 4% or higher. Get several quotes from lenders. There may be substantial differences in margin amounts, which can also be negotiated.

• Prepayment penalty. If you plan to pay off the loan before adjustment begins, a prepayment penalty may eliminate any savings from a lower interest rate.

• Caps. There are three caps to protect you from fast-rising interest rates.

1. First is the lifetime cap. A 5% loan with a 5% lifetime cap means that you will never pay more than 10% interest.
2. Second is the interest rate adjustment cap. How much can the rate adjust during any one adjustment period? This is extremely important. It is your security that you can count on a maximum that the rate can adjust and plan for this increase in a rising interest rate market.
3. The third cap is the payment cap. Will any interest rate adjustment be fully reflected in your monthly payment? If the answer is yes, you should figure out what your monthly payment will be if the interest rate adjusts to the highest rate allowed. If the answer is no, will you be able to extend the term of your loan or will you have a balloon payment?

Finally, you must look at the worst possible adjustment. For example, your fixed rate is 5% for three years. There is a 5% cap. The worst that could happen is that three years from now, your interest rate will be 10%. If you owe $240,000 when the loan becomes adjustable, that is a $12,000 per year increase in interest.

Will your payment increase by $1,000 per month? Refinancing will not be a good option, since prevailing rates for a new loan will be in the same 10% range. Since fast-rising interest rates usually drive down property values, you may not be able to get out from under your mortgage by selling your home. Of course, you can what if yourself out of buying a home. If the only way you can qualify for any home is through a hybrid, the gamble is probably worth it. If the hybrid is the only way to buy your dream home, maybe you should look again at the lowerpriced adequate home that you could keep if the worst happens to interest rates.

You can plan to minimize a larger increase in interest rates, but the problem is it requires discipline that most people do not have. If you can take the amount of money you save every month with your lower-interest hybrid loan and put it into some sort of interestbearing account, you can create a cushion for yourself for when the loan switches from fixed to adjustable.

Example: By getting the hybrid at a lower interest rate, you save $100 per month over a fixed rate mortgage. Your loan will begin to adjust after five years. Each month, you put this $100 savings into an interest-bearing account. At the end of five years, you will have $6,000, plus the amount of interest you have accumulated. This can be used to pay the monthly increase in your payment or give you some time to find a buyer if you cannot afford the higher payment.

The higher your loan, the greater the savings. On a $200,000 loan, a 1% difference in interest would save you $2,000 per year. You would have $10,000 at the end of five years, plus the interest you made on the savings. It may put a strain on your budget, but it might also avoid disaster if the worst happens. Of course, if interest rates do not increase, having an extra $10,000 in the bank cannot hurt.

Were the 2007–08 housing problems caused by hybrids?

Much has been written about the subprime mortgage , but the hybrid mortgage is the real problem. Borrowers signed up for hybrid loans that adjusted to high margin loans after a few years. The payment adjustment was too much for the borrowers to be able to pay. This is true of many borrowers with good credit histories as well as the subprime borrowers (those with poor credit histories).

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Adjustable Rate Mortgage

Posted on July 16, 2011 by descriptions

The adjustable rate mortgage (ARM) is the favorite of most lenders. From the lender’s point of view, it is the mortgage that is fair to all parties—it changes to reflect current market conditions. As interest rates rise and fall, the interest rate of your mortgage follows suit. To understand ARMs, you must understand the language used with them. The interest rate of the loan is tied to an index.

What is an index?

An index is an interest rate that is publicly published, such as the interest paid on a government bill or note, the cost of funds for a Federal Reserve Bank district, the prime rate, and so on. The interest rate on your loan may be higher than the index rate. For example, it could be 2% over the rate of the index used. You may have heard phrases such as 2% over prime, which means the lender is using the prime rate index and charging 2% more for the loan. The amount over the index rate is called the margin. Your protection against skyrocketing interest rates is called a ceiling, or more commonly, a cap. For example, if your original interest rate is 5% and your cap is 5%, your rate can never go higher than 10%. You should also have a cap on an adjustment. This means that your rate cannot be raised by, for example, more than 1% per year (or whatever period is used for adjustments).

Which indexes are most often used?

One of the most important features of an adjustable rate mortgage is the index to which it is tied. If you plan to keep your loan for more than five years, it may be the most important feature, as all indexes do not react equally to rate changes. There are two basic types of indexes. They are classified as leading and lagging. As the names imply, leading indexes react quickly to economic changes and are highly volatile. Lagging indexes adjust more slowly and do not reach the highs and lows of the leading indexes. Some of the indexes used to determine adjustable mortgage rates include the following.

• Constant Maturity Treasury (CMT)
• Treasury Bill (T-Bill)
• 12-Month Treasury Average (MTA)
• Cost of Deposit Index (CODI)
• 11th District Cost of Funds Index (COFI)
• Cost of Savings Index (COSI)
• London Interbank Offered Rate (LIBOR)
• Certificates of Deposit (CD) Indexes
• Prime Rate

To use an extreme historical example, in May 1981, the prime rate soared to 20.50%. The cost of funds index had also risen, but only to 11.43%. By May 1986, the prime rate had fallen to 8.25%, a 12.25% drop. The cost of funds index had also fallen, but only to 8.44%, a 2.99% drop. A mortgage lender’s success is largely dependent on interest rate trends, especially if making portfolio loans. A lender selling loans to secondary lenders will not worry about rate changes five years from now. The lender making a portfolio loan will usually want to use a leading index. If rates rise, the increase is reflected quickly in the loan rate. If rates fall, it is less likely that the borrower will refinance and the lender will lose the loan entirely.

Which index is right for me?

Your decision depends primarily on the length of time that you intend to keep the loan. If you are planning to keep the loan for five years or less, you are probably better off getting the lowest interest rate available, even if it is tied to a leading index. Your protection is the cap on adjustments. The risk of the loan adjusting dramatically and unexpectedly in a five-year period is usually outweighed by the lower interest rate being offered. The longer you keep the loan, the greater the risk.

This is especially true if the trend appears to be toward higher rates. The advice is simple. If you plan to keep your loan for an indefinite period over five years and you believe interest rates will rise, get a fixed interest rate loan. If you only qualify for an adjustable rate loan, get one that uses a lagging index. The lagging index is most often the best for the borrower under any interest rate trend. If rates rise, they rise more slowly. If rates fall, you can refinance. Something to remember when trying to estimate how long you will keep your mortgage: If your plan is to sell your property in a few years and buy a more expensive home, rising rates may prevent this by making the payments on the more expensive home beyond your reach. Also, refinancing may not be an option if rates rise, since you will have to pay the prevailing higher rate at the time you try to refinance. Planning to keep your mortgage for only a few years because that is how long you usually stay in one place before your job requires you to move is a much better reason.

The following is a list of the most often used indexes and a short explanation of each. When you are offered an adjustable rate mortgage, ask your lender which index is being used and how it has reacted to economic changes over the last few years compared to other indexes. You can also do your own research by typing “mortgage indexes” into a search engine. There are several good websites that will list current index rates, as well as supply historical data.

• Constant Maturity Treasury (CMT). These indexes are the weekly or monthly average yields on U.S. Treasury securities, and are based on closing market bids for actively traded Treasury securities. They are quick-reacting leading indexes. As of October 2007, the rate ranged from 4.11% on the oneyear security to 4.24% on the five-year security. Checking the current rate may give you an indication of the direction in which rates are moving and the speed at which rates can change.

• London Interbank Offered Rate (LIBOR). This index is based on the average interest rate of deposits of euros traded among banks in London. The LIBOR is also considered a leading index, adjusting quickly to world economic changes. As of April 2008, the LIBOR index was 2.72%.

• 11th District Cost of Funds Index (COFI). This index is based more on interest paid on savings and checking accounts. As you know, the interest paid by savings institutions on these accounts rises at a slower rate than loan rates. The 11th District encompasses the savings institutions (savings and loan associations and savings banks) headquartered in Arizona, California, and Nevada. This rate is more commonly used in the Western states, but it is not confined to use there. It is a lagging index that moves at a much slower rate than either the CMT or LIBOR, and rarely reaches their extremes.

• Prime Rate. The prime rate has historically been the rate banks charge their best customers for short-term loans. It is now also being used as a common index for equity lines of credit. Some lenders are offering rates below prime for equity lines with low loan-to-value ratios for customers with high credit scores. The prime rate will move on Federal Reserve Board interest rate hikes, and generally reflects the Fed’s view of the strength of the economy and the threat of inflation. In times of high inflation, the prime rate can rise quickly.

There are several other indexes that are not as commonly used. If you are getting an adjustable rate mortgage loan, be sure to question the lender about the index being used and its volatility. What is a margin? A margin is the difference between the index interest rate and the rate charged to the borrower. The lender has no control over the index rate, but complete control of the margin. One lender could set the interest rate at 2% over COFI, while another could charge 4% over COFI. Shopping for a lender that uses the index most suitable to your situation and the lowest margin is crucial to getting the best adjustable loan.

What is a start rate?

Many adjustable rate loans offer a start rate. This is a very low rate that lasts for only a short time (usually three to six months) before your actual interest rate begins. Start rates are not only confusing and misleading, but they also are, in many instances, scams. A lender offering a start rate as low as 2% cannot get the money to lend to you at that rate. This means that the lender is taking a loss for the first few months of your loan. Lenders are not in business to lose money.

A start rate is similar to a retail store offering a specific item at a cost so low that they lose money selling it. This is called a loss leader. The idea is that when you come to the store to buy the item, you will buy other items that are profitable. The difference between the loss leader and the start rate is that you can buy only the loss leader item and leave the store. You cannot get the start rate only. You have to take the profitable part of the loan, as well. There are several advantages of a low start rate for the lender, especially the less-than-honest lender. First, it is a wonderful advertising gimmick. The naïve borrower hears only the words 2% mortgage loan. This is exactly the type of borrower that this lender wants—someone who can be sold a very profitable loan.

Another advantage is that the lender can qualify the borrower at the start rate. This is good for getting the loan, but puts many borrowers in over their heads when the true payments have to be made. To prevent this, lenders often connect the payment increase to the start-rate payment. When the interest rate jumps to the real rate, the payment does not increase to cover it, also putting the borrower in a poorer financial position.

Since the borrower is not paying enough interest to reduce the principal balance, the interest owed but not paid is added to the principal. This creates negative amortization. Now the borrower is no longer reducing the term of the loan. Since the principal balance is increasing, the borrower is now paying compound interest. At some point in time, the loan must be repaid. This can be done by an increase in the monthly payments necessary to amortize the loan, creating an extreme burden on the borrower, or by a balloon payment that would necessitate refinancing. This may not be possible, since much more money is owed than was originally borrowed. Even if it all works out because the borrower is becoming financially stronger and home prices are increasing, there was a major risk and major expense over a more sensible loan.

There can be a good use of a start rate to qualify a buyer if the start rate is closer to the real rate and the payment adjustment enables the borrower to at least pay the interest once the loan adjusts to the permanent rate formula. Then the payment can gradually adjust to an amount that pays on the principal.

How can I best understand adjustable rate mortgages?

The best way to understand an adjustable rate mortgage is to look at a specific example and then, using made-up numbers, examine some variations.Every six months, you must look at the current rate of the index. The interest rate rises or falls by the same amount as the rise or fall of the index rate, up to the cap of 1% per six-month period. This is where the first problem arises. If the interest rate goes up, does your monthly payment also go up? The answer is a definite maybe.

Depending on the terms of your specific loan, you may have an increase in your monthly payment that fully reflects the increased interest, partially reflects the increased interest, or does not change at all. If you owe $300,000, a 1% rise in interest is $3,000 per year. That is $250 per month. This may strain your budget. If your payment increases by less than $250, you are not paying down your loan as quickly as you might have anticipated. If your payment does not increase at all, you could quickly be paying interest only or less (negative amortization). You can voluntarily increase your monthly payments to avoid this, but can you really afford it?

You can easily see that timing is critical for an adjustable loan. If interest rates are at historic highs when you get your loan, your rate will probably adjust downward. An added bonus is that falling interest rates usually cause an increase in property values. If you use an adjustable loan when rates are at historic lows, you will probably see your rate go up. One problem is that rising interest rates usually cause property values to stabilize or fall. In an extreme case, you would no longer be able to afford to make your increased monthly payment, and falling property prices would make you unable to sell.

The logical question is, “Why would anyone want an adjustable loan when interest rates are low?” The major reason is that it is the only way for them to qualify for a loan. The formula used to qualify a buyer for a loan considers the beginning monthly payment, not the possible future monthly payments. It is similar to the interestonly loan situation with the balloon payment. If it is the only way to home ownership, you take the risk. A more sound reason would be that your job requires you to move every few years. You will pay lower interest and fees for the adjustable loan and you will probably sell before the rates change too much.

What is a flexible payment adjustable rate mortgage?

A lender may suggest a flexible payment adjustable rate mortgage, which limits the payment increase in order to ease the borrower’s fears. The flexible payment aspect of the loan looks like a solution to the problem.

The typical loan of this type will call for a payment adjustment of no more than 7.5% per year, based on the start rate payment. However, there are two problems with this loan for the borrower. First, the increased payment will usually not be enough to cover interest only (negative amortization). This is especially true in a market in which the index rate is rising. Remember, the margin is part of the interest rate. A high margin will cause negative amortization even if the index rate is stable or falls slightly. In flexible payment adjustable rate mortgages, there is a clause that states that if the negative amortization reaches a certain level—usually no more than 125% of the original loan amount—the payment will be adjusted to amortize the loan, superseding the payment cap. Since you owe more than you originally borrowed and have less time to pay it off, the payment will be even higher than if you originally agreed to fully amortize the loan over the original loan term.

What is recasting and how will it affect my mortgage?

The second problem is that the loan will be recast periodically, commonly every five years. Recasting means that the payment is adjusted to fully amortize the loan in the remaining time of the term. This recasting clause also supersedes the yearly payment cap and adjusts the payment to whatever is necessary to pay off the loan in the remaining term. What is the answer? It is the same old story of common sense. If the start rate and initial monthly payment are far below prevailing rates and the payment amount necessary to amortize the loan amount in the agreed-upon term, be careful. You know how much you are borrowing. You know the real interest rate that you will have to pay (the index plus the margin). You know how many years you have to pay it off (the term).

What does common sense tell you?

The less you pay in the early years of the loan, the more you will have to pay later. It also tells you that the smaller the payment, the less will go to principal. This means that you will pay much more interest than in the price of the early smaller payments. Studies done on these loans show increases in the monthly payment well over 100%, even if the index rises only slightly. The higher the margin and the lower the start rate, the greater the payment increase. It has been suggestedthat lenders should be required to raise the start rate based on their margins. A lender with a 4% margin would be required to have a higher start rate compared to a lender with a 2% margin.

This would narrow the gap between the initial required payment and the adjusted payment if maximum negative amortization occurs, or when the loan is recast. However, there is currently no law or regulation requiring lenders to do this. Again, the time element is very important. If your income does not allow for a standard payment interest rates are high and are expected to fall, housing prices are on the rise, and you plan to sell the home within five years, this may be a great loan. Unfortunately, most of these ifs are unpredictable.

The smarter way is to work out a somewhat pessimistic scenario of the possibilities. If you believe you can survive the worst case and the only loan that will allow you to buy the house is one with a low start rate and high margin, you are at least making an informed decision.

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Private Mortgage Insurance

Posted on July 12, 2011 by descriptions

Lenders want to make loans at the lowest risk possible. With a 20% down payment, most lenders are comfortable with the risk level of the loan. To cover risks with down payments of less than 20%, private mortgage insurance was developed. Private mortgage insurance (PMI) insures the lender in the event that the foreclosure of a mortgage results in a sale that nets less than the balance owed on the loan. The cost of the insurance is paid by the borrower. For a loan with a down payment of less than 20%, you will have, as part of your monthly mortgage payment, an additional payment for PMI. The insurance does not cover the entire loan amount—only a small percentage. So, if you have only 10% to put down, the lender requires you to buy PMI to cover the other 10%. If the lender takes a loss, the insurer will cover that loss up to 10% of the amount of the loan.

Theoretically, the lender’s risk is the same as if it made an 80% loan. As a practical matter, though, the lender’s risk is greater, since borrowers who put 10% down are more likely to default than borrowers who put 20% down. The more you put down, the better chance you will get the most favorable interest rate for a loan and have to pay less in PMI.

The rates you will pay for PMI vary, based on the percent covered and the borrower’s credit score. Borrowers who put down 5% pay more than those who put down 15%. This makes sense because more insurance is required. It also makes sense that a higher down payment means a lower risk of default. The lender may have a choice of how much insurance it requires.

The lender may buy insurance to cover 30% of the loan, rather than 20%. This will cost more. If you are getting PMI, ask if the lender is getting the minimum insurance. If you have good credit and good income-to-debt ratios, you should question why the extra insurance is necessary. At the time you apply for the loan, you also want to ask about cancellation of the PMI. Once you have paid on the loan to a point that PMI should no longer be required, you should stop paying for it or get a refund if you paid the total up-front. Laws now require a lender to cancel PMI when the loan-to-value ratio reaches 78% of the value of the property at the time when the loan was made if cancellation is not requested by the borrower, and at 80% if the borrower makes a request. Ask about cancellation before taking a loan and always contact your lender when the loan-to-value ratio reaches 80% to have it canceled.

Many people hate having to pay PMI. There are ways to avoid PMI using different types of loans that will be discussed later. One way to increase your down payment and lower or eliminate PMI is through a gift.

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Mortgage Payment Plans

Posted on July 12, 2011 by descriptions

Before you can make any meaningful comparison of the types of loans available, you must compare the required monthly payments. There are loans where the monthly payment is the primary feature of the loan. When you apply for one of these loans, you are looking at the monthly payment as the reason for taking this loan over a loan with similar or the same interest rate, term, etc.

Without taking into consideration additions to your monthly payment amount, such as for PMI and funds in escrow for taxes and insurance, your monthly payment is made up of two components—principal and interest. Principal is the amount of money that you borrowed or owe on the loan at any given time. Interest is most easily understood as the rent you are paying for the use of the principal. As

you pay down the principal amount, you pay less interest.

In a standard loan, called an interest included, level payment loan, your payment is the same each month. However, how the money is allocated between principal and interest changes.

 

Example: If your loan is for $100,000 and your payment is $1,000 per month, very little of your first payment will go toward principal. This is because you are paying interest on $100,000 dollars. If, of your $1,000 payment, $100 goes toward principal reduction and $900 is interest, you will have a slightly higher amount going toward principal reduction and less to interest on your next payment. This is because your first payment reduced your principal balance (the amount you owe) by $100. With your second payment, you are paying interest on $99,900 instead of $100,000.

As you keep making payments and reducing the principal amount of your loan, the allocation of the monthly payment will continue to change. When you reduce your principal balance by half, for example, more of your payment will be going to principal than to interest. When you get close to paying off your loan, almost all your payment will go to principal.

Other payment plans exist that differ from the standard plan and can be of benefit to some borrowers. One plan, which concerns only the payment aspect of the loan, can be used with any type of principal reduction loan. This is the biweekly payment plan. A second is a specific type of loan that has payment amounts as its main feature. It is the graduated payment mortgage. The third is the interest-only mortgage, which features the lowest possible payment over the life of the loan. The final one is a cross between interest only and full amortization. This is the balloon payment mortgage.

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Mortgage Industry

Posted on July 12, 2011 by descriptions

There is a long list of the types of lenders that make loans using a mortgage for security. They include government agencies, lending institutions (such as banks and mortgage bankers), credit unions, finance companies, mortgage brokers that arrange loans, insurance companies, and even individuals.

There are two types of lenders. The first type of lender is the primary lender, which is the type you will deal with. This may be a local bank or other financial institution that meets with you and originates your loan. After your transaction is completed, your primary lender can either keep the loan or sell it on the secondary market. If your lender keeps the loan, it is called a portfolio loan.

The second type of lender is one that buys loans made by primary or retail lenders, and does not deal directly with the public. Entities that buy existing loans in the secondary mortgage market may be pension funds, for example, or even primary lenders that have money but cannot originate enough loans. The largest buyers are government agencies or quasigovernment agencies—private companies originally created by Congress.

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