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If it Sounds too Good to be True ...
The mortgage market has drastically evolved over the last 20 years. Today a borrower has a diversity of products available to him that range from the most conservative, which usually yields the highest monthly payment, to aggressive adjustables that can lower the monthly payments now at the expense of unknown costs in the future. A borrower’s personal financial situation is no longer a barrier to obtaining financing. Mortgage products are designed to fit nearly every need, but will be priced to reflect the qualities, both good and bad, of the individual’s financial situation.
Having a wide range of options to work with certainly is an asset to the borrower. It does, however, require the borrower to develop a working knowledge of the advantages and disadvantages of each type of product and more importantly, requires the borrower to have a complete understanding of his personal needs, goals and acceptable level of risk. Developing a working knowledge of the different product types is the easy part. A competent mortgage broker will be able to explain how each product works as well as the advantages and disadvantages associated with each product type. The hard part is identifying your own individual needs and your personal comfort zone for dealing with risk.
Mortgages are marketed to consumers just like any other product. Bankers and brokers will promote whatever product they feel will attract a consumer’s attention. When rates were dropping several years ago, the promotions were focused on fixed rate mortgages. When the public became accustomed to lower fixed rate mortgages then the focus moved to various types of adjustable rate mortgages, then to interest only mortgages and lately to fixed payment mortgages. All the various promotions have one thing in common. They are designed to feed people what they want to hear. Is security important? Then promote the fixed rate mortgages. The flow of applications begins to slow down and the industry shifts gears. Why pay for the security of a fixed rate mortgage? You’re not going to keep the mortgage more than a few years so the industry moves to promoting the adjustables. Housing prices have
forced buyers to pay more on a monthly basis than they want to. No problem! The industry will show you how to afford more house by moving you into an interest only mortgage. Payments still need to be lowered? We’ll just set your monthly payment as low as you want and increase your mortgage balance each month to make up the shortfall. After all housing prices only go up so why should you care how large your mortgage is? The appreciation of the house will more than cover the higher mortgage.
All these mortgage types have their place. Matching the right product to the needs of a borrower is the goal of your mortgage professional. You, as the borrower, need to do 3 things. Your personal needs and goals have to be explained to your advisor so he will be better equipped to do his job. You also need to find your personal level of risk aversion. The product that best fits your needs and goals may be a product that keeps you up at night making it the wrong product for you. Lastly you need to fully understand what your advisor is telling you. Without a complete understanding of the reasons for his recommendations you can’t make an intelligent decision regarding the recommendations.
A smart consumer doesn’t allow anyone to sell them anything. Applying for the right mortgage is similar to all other major decisions a consumer makes. Listen to and understand the information provided, see how it fits your needs and then make your decision. Don’t let the hype of an advertisement or the fast talk of a salesman decide for you. Don’t forget that doing nothing is also an option. It can easily turn out that the best course of action right now is to do nothing. The effort you put in now might simply confirm that you already have the best mortgage product or this is not the right time for you to buy this particular property.
Keep in mind that there is no absolute right or wrong choice. Some options will prove to be a better choice than others but you will only really know that after years have gone by and you look back to see how good the decision was. You may have thought you were going to buy a house and relocate within 2 years and it turns out that the relocation never takes place. What seemed like a good choice at the time doesn’t seem so now, since your situation has changed. You also need to remember that you are not committed for the rest of your life to whatever decisions you make now. You can always revisit your mortgage and/or housing situation at a later date and make changes as needed. Yes, you will be at the mercy of the marketplace at that time, something you can’t predict. Your personal financial position may be better or worse than it is today and the marketplace may be better or
worse than it is today. You will deal with the conditions at hand when the time comes with the same analysis you are using now. The final point you need to be aware of is that your mortgage professional is human and is subject personal opinions too. His opinions will be part of his recommendations to you. Take the time to see where his is coming from and take note as to whether or not his thinking process is along the same lines as yours. This will make his comments much more valuable to you.
To help you analyze your personal situation and understand your financing options, I’ve put together a list of situations with some of the more common solutions. I’ve also noted the pros and cons of each solution as well as some of my own personal opinions. These examples should help you to be better equipped in deciding which mortgage product is right for you.
I’ve been living in my home for several years and have built up substantial equity. I’ve had some problems paying my bills on time so my credit score is low. I want to use the equity in my home to bring my bills current and lower my monthly payments.
There are two basic ways to use the equity of the house. You can take a second mortgage or you can refinance your existing first. We’ll assume that because of the low credit score, a second mortgage is being offered at a rate that is higher than makes sense to pay and the refinance path is more reasonable. Refinancing into a high interest fixed rate or using some form of adjustable would be the options. The more common recommendation would be to use an adjustable with an initial rate that is fixed for a 2 or 3 year period. The intention is to use that time frame to improve the credit report and then refinance into a new mortgage at the lower rate that the improved credit score deserves. Risk here is that the credit score doesn’t improve (the borrower still pays his bills late) and he is trapped in a mortgage that by design will be adjusting to a higher interest rate making
it even more difficult for the borrower to make ends meet. Maybe the fixed rate would be better. Although the borrower is required to make a higher monthly payment on his mortgage, he isn’t restricted as to how many months he has to improve his credit. If he does it in 24 months, he can refinance at that time. If it takes him 60 months, he can do it then. With this approach, the pressure of time is not an issue and although the monthly payment is higher the trade off of relieving the time constraint may make it a better choice. The real issue for the borrower here is to answer the question, “What caused the credit problem in the first place and is the problem still there?” If the credit issues were due to a one time event, such as a break in employment or an injury, and the borrower is now back at work, then using the equity in the home is a valid approach. If the problem is ongoing say, habitually spending more money than is earned, then using the equity is simply wrong. This
refinance just brings the borrower one step closer to losing his home. Under this scenario the borrower needs to be working with a credit counselor or an accountant to address the cash flow issue first and then approach using the equity in the house. Lenders market to consumers in this situation on a non-stop basis. Just as a drug dealer knows that an addict will always come back for more, so do these lenders know that credit impaired borrowers will always come back for more money. Only after the cause of the problem is addressed will any form of mortgage be helpful.
I’m buying a home for $500,000 and looking to borrow $300,000 and I plan on retiring in 15 years and want my house paid off.
One way of going is to simply apply for a 15 year mortgage. $300,000 @ 5.5% for 15 years will give our borrower a monthly payment of $2,451.25. House is paid off in 15 years and we’ve met the borrower’s goal. An alternative would be to use a 30 year mortgage and invest the difference. $300,000 @ 5.75% (30 year mortgages are slightly more expensive than 15 year mortgages) requires a monthly payment of $1,750.72. This leaves our borrower with an outstanding balance on his mortgage after 15 years of $210,825.40. It also gives him an additional $700.53 a month to use any way he chooses. If he invests $700.53 a month for 15 years @ an average annual yield of 6.0% the balance of the investment would be $203,727.23. If the yield averages 8% then the balance would be $242,410.17 and if it averages 10% $290,348.91. At an average yield of 6.4% the amount available will be exactly
$210,825.40. The advantage of using the 30 year mortgage and investing the difference, consists of the ability of making money on the difference in payment (all you would need to average is greater than a 6.4% average annual rate of return) and gives you the flexibility of having this cash available should an emergency come up. As an added bonus should our borrower change his mind and decide not to pay off the outstanding balance at the end of the 15 years, he doesn’t have to. On the other hand our borrower may just feel better paying off his mortgage in 15 years or he knows he doesn’t have the financial discipline to invest the $700.53 monthly. If that’s the case, then the 15 year mortgage is the right choice for this borrower.
I’m buying a house for $500,000 and looking to borrow $300,000 and plan on moving into a larger house in 3 years.
Under this situation the recommendation would be to utilize a hybrid adjustable. That is, a mortgage that stays fixed for a period of time and then becomes an adjustable (usually with a rate adjustment on an annual basis) for the remaining or the term. The analysis here consists of weighing the overall saving of using the adjustable compared to the probability of actually following through with your plan to trade up to a larger house in 3 years. First, lets see what the savings work out to be under different hybrid adjustables. From the previous example we know that the fixed rate mortgage is going to cost $1,750.72 per month. Using a 3/1 ARM, that is a mortgage that stays fixed for 3 years ands then becomes a 1 year adjustable, the interest rate drops from 5.75% to 5.0%. This brings the monthly payment down to $1,610.46, a savings of $140.26 a month for the first 3 years. If the
house is sold after 3 years there is a total savings of $5,049.18. What happens if your plans change and the house isn’t sold and the borrower now enters the fourth year? Since there is no way of knowing where rates will be 3 years from now and it would be a reasonable assumption that rates will be higher than they are now we will assume that the new interest rate increases the maximum that this mortgage allows. The maximum change typically with 3/1 ARMs is 2.0%. That would bring the interest rate up to 7.0% and increase the payment to $1,967.36. Now the difference between this new payment of $1,967.36 and the fixed rate payment of $1,750.72 is $216.64. So, in the event the borrower held the house for another 12 months he would have given back over half of the savings he accumulated, $2,599.68. Perhaps the 3 year fixed period isn’t long enough and a 5/1 ARM would be safer. Using a 5/1, the rate increases to 5.125% (the longer the fixed rate period, the higher the rate is)
bringing the payment on $300,000 to $1,633.46 and the savings now is $117.26. The 3 year savings has dropped to $4,221.33 but we’ve put off the exposure for a rate change an additional 24 months. The questions this borrower needs to address is how confident is he in his plan to sell in 3 years and where he thinks rates will be in the future. He will also need to consider the interplay of issues. For example, if he thinks rates are going to be substantially higher 3 years from now, will that impact his ability to sell his current home and buy a larger one? And if there is going to be an impact, how severe is it going to be?
My lender has shown me how I can save $66,965.04 in interest on my $300,000 mortgage if I make biweekly payments instead of monthly payments.
Lenders have been offering these programs for several years. You pay them a set up fee and sometimes even a monthly surcharge for the right to prepay your mortgage early on a predetermined schedule. Let’s take a closer look at what really is happening here. The implication from the lender is that by making your monthly payments in half payments you can save a lot of money over the life of the mortgage. What isn’t obvious is that you are actually paying more to the bank on an annual basis. There are 52 weeks in a year. If you are making a payment every 2 weeks you are making 26 payments in a year. Using the same 30 year example we’ve been using, the monthly mortgage payment is $1,750.72. The biweekly payment would then be $875.36. Making this payment 26 times over the year means we’ve given the lender $22,759.36 in the course of a year. Making the regular monthly payment of $1,750.72, we’ve given
the lender $21,008.64. A difference of $1,750.72, exactly one month’s payment. This happens because there are 2 months each year where you are making 3 payments of $875.36. This will have an impact on your personal financial position. There are alternatives that need to be considered here. You could do nothing and stay with your original idea of using a 30 year fixed rate mortgage. Maybe you like the idea of paying the mortgage off early and you should close on a 25 year mortgage instead of a 30 year. The end result will be similar. Or how about just exercising you right to make partial prepayments on you mortgage and make that extra monthly payment at your convenience? Maybe you get an end of year bonus that you would pay towards the mortgage or you want to use you tax refund check. You might want to skip some years and pay more in others. The choice becomes yours. If you have poor savings habits and want a form of forced savings plan then a biweekly program may be the right
choice for you.
I’m taking an Interest Only mortgage so I have lower monthly payments and maximize my tax deduction.
Using an Interest Only (I/O) mortgage does in fact lower your monthly payments and since all the payment is interest you are maximizing you tax benefits. Let’s look at the whole picture. An I/O mortgage has a higher interest rate than one that amortizes (the payment includes interest as well as a contribution to principal so each month you owe less money). Staying with our $300,000 fixed rate mortgage at a rate of 5.75% yields a mortgage payment of $1,750.72. The first monthly payments consists of $1,437.50 in interest charges and $313.22 is paid towards principal. Month two the principal balance is lower by $313.22 so the amount of interest charged reduces slightly leaving a little more money left to pay down principal. This pattern will continue for 360 months, which then leaves a principal balance of $0.00, and the mortgage is paid off. Now lets see what happens in an I/O mortgage. The interest rate
increases to 6.0% and the payment is reduced to $1,500.00 per month. We’ve saved $250.72 in monthly expenses. After 12 months you’ve paid $18,000 in interest charges on the I/O mortgage. With the 30 year mortgage you’ve paid a total of $21,008.64 that breaks down to $17,149.34 in interest and a reduction of the outstanding principal balance of $3,859.30. The actual cost of the I/O mortgage is $850.66 more for the first year than the 30 year mortgage ($18,000 - $17,149.34). One more thing needs to be considered. The I/O mortgage doesn’t stay that way forever. At some point the principal needs to be paid back. Typically the I/O period is for 10 years. At he end of the tenth year the mortgage begins to amortize, not based on 30 years but based on the remaining 20 years. If, for any reason, you have kept this mortgage past the tenth year your monthly payment will increase to $2,149.29. You also need to be mentally prepared to accept the fact that payment after payment is having
no impact to the money you owe to the lender. In the event property values decline over the years that you own this home, you will need to be ready to walk away from the sale of this property with less money than you brought to the table when you purchased it. I/O mortgages carry no risk exposure to rate changes, so they are a more conservative mortgage than an adjustable. Many borrowers, especially first time borrowers, feel uncomfortable seeing the amount they owe not going down as they make payments.
I’m taking a fixed payment mortgage, with a low interest rate, so I can buy a bigger house.
Fixed payment mortgages are being heavily marketed now. Each lender has their own name for this type of mortgage. You’ll see them called “choice”, “option”, “MTA”, “COFI”, “COSI”, etc. There are numerous variations to the mortgage but they all are designed around the same premise. You take a short term adjustable mortgage (usually a monthly adjustable) start it off on an artificially low rate to determine a monthly payment, then instead of limiting the changes on the interest rate (as is the norm) they limit the change of the payment. The payment typically changes on an annual basis and is limited to a 7.5% change. For example, if the first year’s payment is $1,000 then the payment for the second year can be no more than $1,075 ($1,000 + 7.5% of $1,000). Any month that the payment is insufficient to pay the interest due for that month causes the existing principal balance to
increase. A condition known as negative amortization. So if the payment is $1,000 but the interest owed is actually $1,200 the mortgage balance has just increased by $200 and the following month you owe the interest on this new balance. The concept of this type of mortgage is that by having the payment move up incrementally, the payment will eventually catch up to where it needs to be in order to amortize the mortgage over the remaining term that’s left. You don’t have to make this minimum payment - you can pay more if you like. The billing statement that’s issued, gives you choices. You can pay the minimum payment, a payment that covers all the interest owed that month, a payment that amortizes the mortgage on what would have been a 30 year mortgage or any other greater amount you wish. This is the most complicated mortgage offered to the consumer. It affords the maximum buying power, due to the low monthly payment, and the highest risk exposure, due to the short adjustment
term of one month. The borrower needs to be comfortable with the fact that his income may not increase at the same pace as the mortgage payments. He can’t be nervous that his principal balance will at times be increasing instead of decreasing especially in the early years. Should he sell the home in a declining market and his mortgage balance has increased, he will be leaving the closing with less money than he put down on the home originally. It is conceivable that the outstanding mortgage balance could be higher than the sale price and the borrower may have to bring money to the closing to make up the difference. Using a mortgage such as this is not for the faint of heart. Make sure you fully understand all the details of the mortgage, recognize the risk exposure you will be taking and finally make sure this is a comfortable level of risk for you before taking a fixed payment mortgage. Many borrowers are sold on these loans and have no idea what they are getting into until it’s
too late.
When selecting a mortgage, you need to make sure you don’t lose sight of the big picture. In doesn’t matter whether you are purchasing your first home or your third one, or simply refinancing an existing mortgage. You don’t finance a home everyday. The magnitude of the numbers you find yourself dealing with can easily become overwhelming. The above calculations clearly show that the difference in annual interest charges from one product to another on a $300,000 mortgage is small in comparison to the amount of money you are promising to pay back. Yes, there is no reason to pay any more for a mortgage than you have to and I’m not recommending that you do. I do want you to weigh your options carefully and don’t let the marketing hype of the industry sucker you into a product that you are not fully comfortable with. If it sounds too good to be true…
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