If you go back fifty years there was only one kind of loan; a thirty year fixed interest loan. As the mortgage business matured and was forced by the federal regulation of the banking system to make changes, new loan “products” came on the market. You will hear terms like “Fannie Mae”, and “Freddie Mac” which you can think of as conduits for loans and money. No need to learn much about them from the homeowners perspective. But this is important – how the world economy looks at our United States economy and more specifically the worth of our home mortgages.
Prior to 1990, a US backed home mortgage was considered one of the safest investments in the world, especially if it was bundled with several hundred others to minimize the risk of carrying a single homeowner. These are called “mortgage backed securities” and are sold on Wall Street. Unfortunately the downturns in 1991-1995 and then again, but worse, in 2007-2010, had a dramatic impact on the world’s perception of our lending practices. It is a miracle that the interest rates on homes managed to stay low in the years 2008 – 2009 because by all rights the global market for those securities should have demanded a higher interest rate. There was a large swing to more “guvy” type loans and this you need to understand. The “guvys” are FHA and VA loans.
Let’s take VA Loans first. These are loans for US military serv ice personnel on active duty or veterans. They are one of the few loan programs GLOBALLY which require no money down. They also require the seller to pay certain of the Veterans closing costs traditionally. With no skin in the game, this raises the potential in a falling market for the veteran buyer to just walk away from the loan and the house. So the VA charges an up front fee (based on how many times the veteran has used this benefit) which they can finance into the loan. So the veteran might buy a $150,000 home and end up with a $153,750 loan. This extra cash, the VA funding fee, goes into a type of insurance pool to cover bad loans.
Next are FHA Loans which are almost as good with their 3.5% down payment. The FHA loan does carry a little bugger called MIP or PMI – mortgage insurance. It serves the same purpose to stand in for the risk associated with a low-down-payment loan. So the same purchase done with an FHA loan starts at $150,000 price with a $5,250 down payment but adds back a $2,533 MIP prepayment to bring the amount owed on move in to $147,283. Then there is also a monthly MIP fee of $68. This monthly amount can eventually be removed as the homeowners equity climbs by paying down the mortgage (which comes naturally as you make regular payments, or in an accelerate fashion by paying additional principal) or an increase in the value of the home because of market conditions. “Equity” is the dollar amount of value owned by you. A home worth $185,000 with a debt of $132,000 has $52,000 in homeowner equity.
Finally there are the traditional Conventional Loans which are offered at anywhere from 15 to 25 percent down in most cases. You can put in more money but we won’t spend much time on this because most first time buyers have modest amounts of savings for their first home. Let’s just say, that if you have more than 25% to put down you deserve the counsel of a good Accountant to help you decide how much, so that you can maximize your tax savings and investment strategy.
SEE CHECKLIST 5 – WHAT AN ACCOUNTANT CAN DO, at the end of the book.
Within each of these large loan arenas – VA, FHA, and Conventional – can be both fixed rate loans, adjustable rate loans, and other, let us call them bizarre, types of loans. Here is one that got a lot of people in deep trouble in the late 2000’s. The negative amortization loan. If the interest rate goes up, you don’t have to increase the monthly payment if you don’t want to. Instead the amount of additional interest cost is added onto the principal you owe on the home. Here is how bad it can be – if interest rates rise at the same time home prices are falling, you can quickly owe a LOT MORE than what you paid for the home, and then much more than what the market says the home is worth.
The most important question to answer is – how long will I own this home. If you intend to sell in three years (don’t ever buy a home because you think prices will rise in a few years and you can take your profit and run) because your company is going to transfer you, then an adjustable loan at a rate significantly below the rate of fixed-interest loans might be just the way to go. But remember, done properly you are going to hang on to
all your real estate. People tend to stay in homes much longer than they think they will. Sometimes decades longer! So when you can, try to stick with a fixed rate loan. Once in awhile the gap between fixed-loan interest rates (higher) and the adjustable-loan interest rates (lower) is so large that it may pay to take an adjustable loan.
The Loan Officer will tell you to “just refinance at the end of the non-adjustable term of the mortgage.” Great idea unless values, your income, or your savings fall. If this appens you may not be able to refinance and then you are stuck with rapidly and steadily accelerating mortgage payments. Welcome to 2009 and the biggest foreclosure period in American history since the Great Depression.
Let us examine the reasons for buying down your interest rate. As mentioned before, investors who buy mortgage backed securities on Wall Street are doing so because of the interest rate they will receive. So if the going rate is 6% and you want a lower rate, you have to pay points to buy the loan interest rate down, let’s say to 5.5%. Maybe that will cost two and a half points. On a $250,000 loan that would be a cost of $6,250. If you save $104 per month in interest costs, it will take just over five years to recoop the cost of the buy down. Again, if you are thinking about selling in three years, that was a bad investment. Or was it? Let’s say you are actually counted as pre-paid interest by the IRS and is deductible. So you would save $1,250 on your taxes for the year in which you close escrow. That brings the payback time down from five years to just over four years. And if that extra $6,250 deduction pops you down into the 15% tax bracket, we are talking even bigger savings. Again, this is worth spending a few minutes with a paid Accountant to figure your best benefits.
So here are some of the adjustable types. Five One ARM – This is a loan that delivers a fixed rate for five years and then starts adjusting annually immediately after that. The joy is a lower starting rate and certainty about payments for five years. The danger is the pent up increases in interest rates over that time could really push interest rates up quickly after the initial period is up.
Two One ARM – Same as the Five One but it only stays fixed for two years.
Negative Amortization Loan - See above
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