Choosing the Right Loan
CHOOSING THE RIGHT LOAN
With a variety of different loan programs available, it is important to choose the type of loan that will best suit the buyer’s needs. The determining factors are the length of time the borrower plans to stay in the house and the amount of monthly payment that is affordable.
If the borrower plans to stay in the house for less than 5-7 years, it is reasonable to consider an adjustable rate, balloon, or two-step mortgage. For example, ARM’s traditionally offer lower interest rates than fixed-rate loans during the early years of the loan, a two-step mortgage offers a lower interest rate than a thirty-year mortgage for the first 5-7 years, and a balloon mortgage offers lower interest rates for shorter term financing, usually 5-7 years. Low interest rates make it easier to qualify for these types of mortgages. However, borrowers should not accept an ARM unless they can afford the maximum monthly payment.
The borrower makes monthly payments of interest-only for a fixed period of time, usually 5-7 years. After the end of the term, the borrower must pay the balance in a lump sum or start paying off the loan, in which case the payments increase dramatically. An interest only mortgage might be a good fit for borrowers who have income in the form of infrequent commissions or bonuses, expect a significant increase in earning in future years, or plan to invest the savings between an interest only and an amortizing mortgage, and are confident that the investments will make money.
A temporary buydown offers an initial discounted interest rate which gradually increases to an agreed upon interest rate, usually within 1-3 years. This initial discounted rate allows the borrower to qualify for “more houses”. It provides the advantage of low initial monthly payments for the first years of the loan, when extra money may be needed for furnishings or home improvements. Monthly payments can be reduced during the first few years of a mortgage by making an initial lump sum payment. If the borrower does not have the cash to pay for the buydown, the lender may pay this fee if the borrower agrees to a somewhat higher interest rate. The 2-1 buydown is a very popular loan product. For example, if the interest rate on the note is 8% with a 2-1 buydown mortgage, the initial discounted rate is 6% with a 6% interest rate for the first year, 7% for the second year, and 8% afterwards. A buydown may be used to qualify a borrower who would otherwise not qualify because it results in lower payments.
Graduated payment mortgage (GPM)
Graduated payment mortgages offer low initial payments that gradually increase at predetermined times. Low initial payments allow the borrower to qualify for a larger loan amount. The monthly payments will eventually be higher in order to catch up from the lower initial payments. In fact, there will be negative amortization during the early years of the loan. The mortgage is paid off at an accelerated pace during the later years of the loan. Lenders offer a variety of GPM payment plans, with variations in the rate of payment increases and the number of years over which the payments will increase. The greater the rate of increase or the longer the period of increase, the lower the mortgage payments in the early years.
Adjustable Rate Mortgages
Adjustable rate mortgages (ARMs) have soared in popularity. In 2003, ARMs accounted for as little as 0.5% of all mortgages written, but in the first five months of 20056 alone, accounted for 12.3% of mortgages. Legitimate lenders counsel the borrower on the pros and cons of an ARM. A predatory lender, on the other hand, will often state that continued increases in home equity will offset the loan-to-value ratio.
Some ARMs provide an option to convert to a fixed rate mortgage at designated times, usually during the first 5 years on the adjustment date, an action the borrower can take if interest rates start rising. The new rate is established at the current market rate for fixed rate mortgages. There is usually a nominal fee but little paper work is required. The disadvantage is that the conversion interest rate is typically higher than the market rate at that time.
Another type of convertible mortgage is a fixed rate loan with rate reduction option. If rates have dropped since the time of closing, it allows the borrower, under some prescribed conditions and for a small conversion fee, to adjust the mortgage to current market rates. However, the interest rate or discount points may be somewhat higher.
Fixed period ARM
Fixed period ARM starts out with 3-10 years of fixed payments. At the end of the fixed period, the interest rate will adjust annually. Fixed period ARMs are generally tied to a one year Treasury Securities Index. ARMs with an initial fixed period and lifetime and adjustment caps usually also have a first adjustment cap. The advantage of this type of loan is that the interest rate is lower than a 30 years fixed rate mortgage. Because the lender is not “locked in” for a long time period, the risk is lower, and consequently a lower rate can be changed. The borrower benefits from a fixed rate for a period of time.
Two Step Mortgage
Two step mortgages offer a fixed rate for a time period, usually 5-7 years, after which the interest rate changes to a current market rate. After this one-time adjustment, the mortgage maintains the new fixed rate for the remaining life of the loan.
Option Adjustable Rate Mortgage (Option ARM)
Option ARM loan payments are targeted to those with variable incomes, such as the self-employed and those who receive large year end bonuses, because they allow adjustment of monthly payments. Unfortunately, buyers also use Option ARMs to buy “more house” than they could otherwise afford; in these circumstances, borrowers can default if interest rates rise.