Choosing a Home Mortgage
You’ve decided to buy a house! Congratulations! Your next decision, which you should have already considered in depth, is how to pay for it.
Ideally, you’ve just won the lottery! Or you recently inherited mucho money. Perhaps you are an incredible saver and have stockpiled funds for several years. It’s possible you’re over 59 and a half and have oodles of cash and no worries about paying the income tax on funds from your retirement account. Maybe you are uber talented and got a sign-on bonus for your dream job at a generous, thriving company and that is plenty to buy 123 Elm Street!
But, probably not … I am such a dreamer!
Most people need to obtain mortgage financing to purchase a home. So let’s discuss some of the options available to you.
The thirty year fixed rate conventional conforming loan is still the most popular home loan. According to US News, “It accounted for 85 percent of the home-purchase loan market in 2012, according to Freddie Mac, and 90 percent in the first half of 2013.” Thirty year fixed rate loans are simple – everyone knows that, right? Here is the formula used to compute your payments on a $50,000 mortgage loan, at 5 percent interest, for 30 years, making 12 payments a year (one a month): Monthly Payments = L[c(1 + c)^n]/[(1 + c)^n - 1], where L stands for "loan," C stands for "per payment interest," and N is the "payment number." Monthly Payments = 50,000 [0.004 (1+0.004)^360]/[ (1 + 0.004)^360 - 1] Monthly Payments = $268.41 Woo Hoo! Easy peasy!
Fortunately, you don’t need a PhD in math to compute your monthly home loan payments. Your mortgage loan officer will do that do you or you can use any number of internet sites which provide a “mortgage calculator”. Here’s one called – what?!? – Mortgage Calculator!
A 30 year fixed rate mortgage will not change over the life of the loan; it is predictable, so you will experience no surprises, hence the common nickname – the ‘vanilla’ loan. However, if you include payment of your taxes and home owners insurance with the mortgage payment, those can (and, sadly, often do) rise over the life of your loan and either event will raise your monthly payment based on the increase of either or both.
If you pay your taxes and insurance with your monthly mortgage payment, the company which holds your mortgage will keep an escrow account. That’s means that while you pay them monthly, they typically pay your taxes (as required by law and your location) quarterly or semi –annually, etc. Lenders are typically allowed to maintain a cushion equal to one-sixth of the total amount of items paid out on a yearly basis. In other words, to ensure that lenders will have sufficient funds to timely pay the real estate taxes (and/or the insurance), the law allows them to maintain a cushion of two months per year.
We currently have a mortgage being serviced by the world’s worst company. In the past 5 years, we have had to pay additional funds to escrow (because our taxes and/or insurance allegedly went “up”) so our lender could maintain its 2 month cushion. OR we’ve (three times) gotten a check because they “accidentally” took too much as an escrow cushion. A few months ago, we got a letter stating our mortgage company needed a check for $1200 (or our monthly payment would rise accordingly) ON THE SAME DAY we received a check FROM them for $1500! All righty then. As I’m fairly sure the owners of our mortgage company will not be in business much longer, you probably will not have these issues.
Also of note about a thirty year fixed rate loan, most Americans tend to move or refinance every 5 to 10 years. So you may be paying more for a fixed rate mortgage than you could be paying if you opted for an adjustable rate loan or a loan with a shorter tem (like a 15 year fixed). The longer the term of your home loan, the more interest you will pay. But the shorter the term of your loan, the higher the monthly payment may be, even though the interest rate is lower.
For example, if the current rate for a thirty year fixed rate loan is 4.25% with zero points (these will be covered in the Part II), then a 15 year fixed may be 3.375%. But monthly principal and interest payments on a $100,000 loan at that rate for 30 years -- with zero points and no MI, more on that later, too – is $492. The payment on the 15 year loan is $709, but you will be paying off principal more quickly and less interest overall, of course. You can use a mortgage amortization calculation to tell you just how much interest you will pay over the life of any loan. The ‘pro’ of this is that mortgage interest is (still, for today) a tax deduction! The ‘con’ of this is, err, the total amount of your payments while you pay off the loan – lots ‘o money. Little known fact – if you personally opt to make additional payments to principal each month (above and beyond what your payment requires), you will pay off your home loan much more quickly and pay significantly less interest over the remaining life of the loan.
These self-chosen options are not to be confused with a “Bi-Weekly” mortgage. If you opt for one of those, you make payments toward the principal and interest every two weeks instead of once monthly. These payments are exactly half of what you are required to pay for the month. Some people prefer this arrangement based on how they receive income and budget their funds. But be aware that paying twice a month is not an option when a Bi-Weekly loan is chosen; it is required. The key difference between a biweekly mortgage payment plan and a traditional mortgage payment plan is that instead of making 12 full payments each year, you make 26 half payments--the equivalent of 13 full payments-- each year. On biweekly mortgage payment plans, some months will, therefore, require 3 payments, or 1 and one half traditional payments, because they are due every two weeks. If you get paid every two weeks, this may be no problem. But if you get paid once or twice a month, it may require some “juggling” and budgeting finesse to easily accommodate this. And if you’re finically savvy and successfully “juggling” already, you may want to consider an ARM loan or at least something a tad bit ‘tastier’ than vanilla.
Do You Have a Plan?
Most lenders offer loans with a short fixed term that usually changes to an adjustable rate mortgage after that term. That short term where the rate is fixed is typically 3, 5 or 10 years. These types of loans might be perfect if you know you will be moving again in 3, 5 or 10 years. The initial fixed rate is typically much lower than a 30 year fixed rate. For example, back to the 30 year at 4.25%, a corresponding 5/1 might be 3% or 3.25%. The trick here is avoiding the ‘end’ of the fixed rate period (i.e. not selling/moving/refinancing). Several things may happen then. Typically, your loan converts to an ARM loan with fluctuating interest rates. But is the interest rate based on LIBOR or T-Bill? Is it adjustable monthly or annually? Or is it a balloon payment after the fixed rate term that you can negotiate into something else the lender offers (like an ARM). Be sure to examine the fine print, ask your Loan Officer many questions, request and view an amortization schedule, and plan accordingly.
ARM Your Weapons
Just as there are numerous arms in society – skinny, fat, long short, black, white, freckled, muscular, hairy (all right, you get the point) there are also many Adjustable Rate Mortgages. Since I am limited to 1500 words here, I can only skim on the very fun aspects of ARM loans. Back in the “glory days” of mortgage lending – pre-2006 -- we had weekly classes on ARM loans – LIBOR vs. T-Bill vs. COFI, adjustable monthly versus daily versus annually. What exciting opportunities we had to identify and best meet the needs of our clients! So, okay, some lenders and Loan Officers pretty much met their own needs and sold what was best/most profitable for them. Those days are gone; just ask the CFPB!
So, in summary, an adjustable-rate mortgage (ARM) is a home loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The most common indices for determining the interest rates are the rates on 1-year constant-maturity Treasury securities (T-Bill), the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Payments made by the borrower may change over time with the changing interest rate. And there are various kinds of ARM loans also, including the interest-only mortgage and the negative amortization mortgage. You will not choose either of those two today unless you are the director of a hedge fund and need a huge tax write off.
Here is an ARM acronym cheat sheet you can use to ask your lender intelligent questions if you are interested in obtaining an ARM loan, courtesy of Wikipedia. Woo hoo!
- Initial interest rate. This is the "teaser" interest rate that is fixed for the initial period of time.
- The adjustment period. This is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated.
- The index rate. Most lenders tie ARM interest rates changes to changes in an index rate; as mentioned above.
- The margin. This is the number of percentage points that lenders add to the index rate to determine the ARM's interest rate.
- Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
- Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan. They reduce the interest rate below the prevailing rate (the index plus the margin).
- Negative amortization. This means the mortgage balance is increasing. This occurs whenever the monthly mortgage payments are not large enough to pay all the interest due on the mortgage. This may be caused when the payment cap contained in the ARM is low enough such that the principal plus interest payment is greater than the payment cap.
- Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
- Prepayment. Some agreements may require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.
Please note: I have a dozen or more former mortgage coworkers who opted for ARM loans in the early 2000’s. They have been dancing the happy jig for many years because the interest rates have actually dropped (yes, that may be possible!) or moved very, very little upward since the initial rate of almost nothing in the days the loans were originated. Also, ARM loans (and some others) used to often be “assumable” – meaning the buyer of your house would sometimes qualify to “take over” your mortgage when s/he bought your house – back in the glory days again. J
I have exceeded my word count limitation and probably your interest level, so this topic is to be continued ……. But until then, let me leave you with this (and an apology because of it … ) Did you hear about Robin Hood's house? It has a little John.