An Overview of Home Loan Programs
Wade Young | Denver Mortgage Broker | 303.800.3648
Adjustable rate mortgage (ARM)
Piggyback mortgages (no private mortgage insurance)
Commitment period or prepayment penalty
If you'll sleep better knowing that your mortgage payment will never change, then select a fixed rate mortgage. On the other hand, if you are looking to save money, a fixed rate loan might not be your best option.
First I'll point out the obvious thing about fixed rate mortgages, and then I'll address the not-so-obvious. The obvious benefit to a fixed rate loan is that the interest rate never changes. You can borrow money from the bank before your child is born, and when little Johnny becomes the star quarterback for your favorite college team, you’ll still be paying the same interest rate. Your payment will be the same today, next month and for decades to come if you so choose.
What most borrowers do not know is that a long-term fixed rate loan is usually the best financial decision only if you plan to own the home for at least ten years. In today's day and age, most people do not live in the same home for ten years or more. A lot of people move every few years, five years max. Think about your friends and co-workers. Have any of your friends or co-workers lived in the same home for ten, twelve or fifteen years? I doubt it.
Although everything I’ve just said is true, the long-term fixed rate loans still outsell the ARMs and hybrids. The truth is that there is something very comforting about knowing that your house payment is not going to change. There is a large group of homeowners out there who are happy to pay a little extra in terms of interest rate in order to have the peace of mind that comes with the fixed rate note. Below are a few of the most popular long-term fixed rate loans:
30-year fixed rate mortgage
This is the backbone of the industry. When most people think of a mortgage, they think of a 30-year fixed rate mortgage. Why the popularity? Spreading out the principal payments over 30 years results in a relatively low payment…and it’s guaranteed not to change—two very enticing and reassuring positives. What’s the down side? You just asked the bank to commit to an interest rate for 30 years—that’s a long time. If the bank is going to promise you an interest rate for 30 years, regardless of fluctuations in the market, they’re going to charge you for it. The 30-year fixed rate loan is, therefore, one of the priciest loans on the market.
15-year fixed rate mortgage
There is, of course, a way to get a great interest rate and a fixed rate payment. The best way to get a low rate on a fixed loan is to go with a shorter term. Typically, a 15-year mortgage is going to run around ¼ of a percent lower than a 30-year mortgage. Combine that with the fact that you aren’t spreading your payments out over three decades, and the amount of savings you can experience over the life of a loan, rate aside, is pretty phenomenal. The total cost on a 15-year fixed rate mortgage is much less than on the thirty year product. The catch is: your payment is higher. If the 30-year fixed rate mortgage payment was going to cost $1,000 per month, the 15-year fixed rate mortgage will probably cost around $1,400. Paying $400 extra to knock off 15 years of payments is a good deal…as long as you can afford it.
20-year fixed rate mortgage
Another fixed rate loan—and one that doesn’t get its due—is the 20-year fixed rate loan. For a payment of just a little more than a 30-year loan, you can cut 10 years off the life of your loan, not to mention building equity much faster. I’m a big fan of the 20-year mortgage as it gets you roughly two-thirds the benefit of the 15-year mortgage, but with a much smaller bite out of your wallet. Does having your mortgage paid off 10 years sooner than expected sound good? Using the above example wherein the 30-year fixed rate payment was $1,000, a 20 year fixed rate payment would come in around $1,200.
40-year mortgage
Please don't get a 40-year mortgage. The difference in payment between a 30-year fixed rate mortgage and a 40-year fixed rate mortgage is negligible. If you do stay in your home for any time, however, you’ll be building some equity in your 30-year product whereas it takes forever to make any headway on these longer term loans. 50 and 60 year terms are now being offered in California. These people will never own a home because they aren’t building equity.
As I stated earlier, most people don’t stay in a home for more than a handful of years. A lot of people think that the term doesn't matter because the homeowner will be selling or refinancing in a few years anyway. That's not true, however, because the person who chooses shorter term mortgages builds up equity at a faster pace. Will a person who always takes out a 15-year mortgage have a paid for home in 15 years? Most likely, assuming that they don't pull out equity periodically. Will the person who chooses 30, 40, and 50 year mortgages have a paid for home in 15 years? Not likely.
Adjustable rate mortgage (ARM)
Adjustable rate mortgages (ARMs) are also known as variable rate or floating rate mortgages. The payments on an adjustable rate mortgage are subject to changes in interest rates, which means that the mortgage holder's payment can go up or down. The mortgage holder is protected by what are known as "caps." These "caps" prohibit the interest rate from moving beyond a certain point known as the "ceiling." The main purpose of the interest rate adjustment is to bring the interest rate of the mortgage in line with market rates. ARMs usually start with lower interest rates than their fixed rate counterparts, making them attractive to many borrowers. If interest rates remain steady or decline, the borrower will reap a substantial savings. However, if interest rates go up, so do the monthly payments.
Adjustable rate mortgages have three main features: margin, index and caps. These factors can get pretty complex, but I’m going to stick to the basics so you can best understand the concepts.
To compute the interest rate for an ARM, simply add the margin and the index together. The margin is the fixed portion of an adjustable rate loan. A margin is a predetermined number that is always factored into your interest rate. If the index is at 5% initially and the margin is set at 2%, then the interest rate is 7%. If the index goes down to 4.75%, for example, the margin stays the same. The margin will always be 2%, in accordance with the mortgage agreement. If the index goes from 5% to 4.75%, for example, the interest rate becomes 6.75% (4.75% index + 2% margin).
When a borrower pays discount points on an adjustable rate mortgage, they are electing to buy down that margin. A borrower might pay one point to buy down the margin from 2% to 1.75%, for example.
The index is the adjustable portion of the ARM. There are a number of different indexes, and explaining them is the job of economics textbooks. No need to worry, though, as there are a handful of basic indexes that 95% of ARMs are based on, and those are relatively easy to explain. To give a couple of examples, the 11th District Cost of Funds Index is a very popular index. Its popularity is due to its stability. The one year T-Bill, on the other hand, is a very volatile index that fluctuates almost parallel to the overall market. As the T-Bill changes in price with current economic conditions, so will the index.
Caps are the answer to how bad things can get. If you're thinking about choosing an adjustable rate mortgage and you want to know how high your interest rate could go, just look at the caps. Every ARM has caps. These are preset ceilings on how much the interest rate can rise. Most ARMs have the following caps: 1. Annual cap of 2% and 2. Lifetime cap of 6%. With that in mind, if your initial rate (not a teaser rate mind you) was at 6%, your interest rate could only go as high as 8% within the first 12 months, and the rate could never go higher than 12%. Admittedly, reaching the cap limits—or capping out—rarely happens. However, it is possible, so borrowers need to understand how ARMs are calculated.
When a borrower selects an ARM, the borrower is choosing to absorb market rate fluctuations—not the bank. In return for accepting the risk of interest rate fluctuations, ARMs come with lower rates than fixed rate loans. And if the index goes down, the monthly payment goes down. It's important to note that we only hear the stories people tell when their ARM adjusts up. For some reason, people never tell their friends and family when their monthly payment adjusts down. When people think of ARMs, they often think, "Oh, but the payment could go up." Yes, the payment could go up, but it could also go down. That's the benefit to an ARM, along with the lower starting interest rate.
Be very careful to know all the in’s and out’s though, as there is a lot of deceptive advertising in the mortgage business. Teaser rates or "1%" interest rates will never be your real loan rate. Banks simply can't stay in business loaning money at 1%. When a bank or mortgage company tries to entice you with super low rates, realize that they have an agenda. They are willing to price their “milk” cheaper to get you in the door in order to sell you a bunch of groceries at full price. Read more about the 1% loan scam, or click here to read more about deceptive Internet Advertisements.
A hybrid loan gives the borrower the best of both worlds—an interest rate that is fixed for a period of time (say 3, 5, 7 or 10 years) with an adjustable rate following thereafter for the duration of the mortgage. Hybrids haven’t been around as long as fixed rate loans and ARMs. Semi-fixed rate loans came about because of consumer demand. Borrowers wanted to combine the positive features of ARMs (lower starting interest rate) with the positive features of fixed rate loans (stability).
By shortening the term of the fixed rate, the bank has a shorter commitment period. In essence, the bank only has to promise a fixed rate for 3 to 10 years, not 30 years. Because the bank doesn't have to commit to a certain rate for 30 years, they are willing to offer a lower interest rate on semi-fixed rate loans. Here's a question for you: if you plan on moving in 3 to 5 years, why pay for 30-year money? If you plan on moving in a few years, a hybrid loan is definitely a viable option. You'll be long gone before the adjustable rate ever kicks in.
One more thing about semi-fixed rate loans: the longer the fixed rate period, the closer the rate will be to a true fixed rate loan. The savings on a 10-year semi-fixed rate loan might be negligible compared to its 30-year counterpart. However, the savings will be more substantial if you choose a 3 or 5-year hybrid loan.
People who buy hybrid loans are generally focusing on the fixed portion of the product. Most intend to be out of the loan before the adjustable period begins. Realize that after the fixed period ends, you could still be in your home. Also, rates might not be lower if you need to refinance, so there is some risk. Anyone considering a hybrid needs to be comfortable with the fact that they may end up in an adjustable rate mortgage before it’s all over.
One additional difference in the hybrid product is the caps. Whereas adjustable rate mortgages have two caps (an annual or semi-annual) and a lifetime cap, hybrid loans always have three caps. Hybrid loans have an initial rate change cap in addition to annual and lifetime caps. The initial rate change cap limits how much the interest rate can change with the first interest rate change—the point at which the hybrid converts to an adjustable rate mortgage. If you purchased a 5/1 hybrid, you would have a fixed rate mortgage for five years that would convert to an adjustable thereafter, with the interest rate readjusted annually. A 5/1 hybrid is likely to have a 5/2/6 cap (an initial change cap of 5%, a 2% annual cap, and a 6% lifetime cap).
Remember that the bank cannot adjust your rate upwards just because it wants to do so. The adjustable rate is tied to an index, so when the index goes up or down, the rate adjusts accordingly. We haven't seen double-digit interest rates since the 70s, so it's unlikely that you will ever hit the lifetime cap. “Capping out” truly is a rarity. We are talking about your home, however, so you need to be comfortable with the possibilities.
Given my affinity for moving, I have no qualms with taking out a 5/1 hybrid because I am unlikely to stay in a home more than five years. I have lived in five homes in the last ten years, so my average is about two years. Given that all of my moves have been of my own accord, I guess you could say that I enjoy a change of scenery. I also know that if you examine historical interest rates, they don’t move that much. Those two factors combined result in my willingness to take on a little risk in order to have a very competitive interest rate.
Any loan up to $417,000 may be considered a "conforming loan," whereas any loan above $417,000 (Alaska and Hawaii limits are higher) is considered a "jumbo loan." That brings up the obvious question: what is a conforming loan? I'll try not to tell you more than you want to know, so here it goes.
There are two giant quasi-government corporations known as Fannie Mae and Freddie Mac. These two mega corporations buy mortgages from lenders. The lenders do the work to get the home loan done, and afterwards they sell the mortgage to Fannie Mae or Freddie Mac while oftentimes maintaining the servicing of the loan—meaning they still send out statements and provide customer service. Many times the borrower doesn't even know that the mortgage has been sold (if they tossed out the fine-print-looking junk mail that notified them of the change). Fannie Mae and Freddie Mac have their own guidelines that spell out what type of loans they will and won't buy. Mortgages that fit the Fannie Mae and Freddie Mac criteria are known as "conforming loans." To be a "conforming loan," the loan amount must not exceed $417,000. This means that loans over $417,000 (also known as jumbo loans) cannot be sold to Fannie Mae or Freddie Mac. Don't worry, though. There are still plenty of lenders who specialize in jumbo loans.
It's also important to know that jumbo loans often carry a higher interest rate than a conforming loan—usually .25% to .50% higher, although market conditions can sometimes make the figure .75% to even 1% higher. Jumbo loans are a higher risk for lenders. If a borrower defaults on a jumbo loan, it can be more difficult for the lender to unload a luxury property than an average priced home. Also, luxury homes are more susceptible to the highs and lows of market fluctuations, hence the added risk. Sometimes a lender will require two appraisals for a jumbo loan. They require the added comfort of two appraisals because the valuation of some luxury properties is more subjective. They fear that the property might not be easily sold down the road to a different buyer in the event that the first borrower defaults on the loan.
If you are on the conventional/jumbo loan border, dropping your loan amount by just a few thousand can potentially lower your interest rate significantly. If you are buying a home for $450,000, for example, and plan to put $30,000 down, your loan amount will be $420,000. Realize that a loan amount of $417,000 (reducing the loan amount by a mere $3,000) will yield a much lower interest rate on the entire loan. It's worth serious consideration if you can swing the extra down payment.
Piggyback mortgages (no private mortgage insurance)
A piggyback mortgage is a second mortgage that closes at the same time as the first mortgage. It's actually a package of two loans, one on top of the other. And yes, you will write two separate checks each month for the separate loans. A piggyback mortgage is basically a two-tiered loan designed to exploit a loophole, although piggyback loans are completely legal and ethical. The purpose of a piggyback loan is to allow the homeowner to obtain a home loan with less than a 20% down payment while simultaneously avoiding private mortgage insurance (PMI). PMI is an insurance policy paid by the borrower with the lender as the beneficiary—just in case you don’t make your house payments.
In the old days lenders wouldn't make a home loan unless the borrower could put down 20%. That requirement kept a lot of people out of the real estate market. Then a wonderful idea was conceived—private mortgage insurance. A third party known as the private mortgage insurer stepped up to the plate to offer the lender insurance in case the borrower was to default on the loan.
A piggyback loan is designed to get around the need for PMI while still satisfying the lender's need for at least a 20% down payment. The typical piggyback loan is an 80-10-10. The first mortgage is for 80%, accompanied by a 10% second mortgage and a 10% down payment from the borrower. Piggyback loans come in many variations, such as an 80-5-15 or an 80-15-5 or in some cases an 80-20 where no down payment is made. The first mortgage is usually at a standard rate, whereas the second mortgage comes at a higher interest rate because of the added risk. The goal of a piggyback loan is for the total payment of the first and second mortgages combined to be less than the payment for a first mortgage for the full loan amount plus PMI. Basically, a piggyback loan is designed to save the borrower money while working within the boundaries of the law as well as the lender's requirements.
There have been a great number of these adjustable rate mortgages sold over the last few years and the loans have really received a bad rap—deservedly so in many cases. The concept of experiencing negative amortization isn’t necessarily bad. The borrower is in essence borrowing against their home much like a home equity line of credit. The problem stems from people misunderstanding this product.
In a “Pick-a-payment” or “Pay-option ARM” loan, the borrower receives a statement each month with an option as to what their payment will be. Typically, the options are: 1. a minimum payment, 2. a slightly higher interest only payment, 3. 30-year amortized payment, or 4. 15-year amortized payment. The payments grow in amount as you move up the list with the 15-year payment being significantly more than the minimum payment. There are two problems here. First, the minimum payment does not even pay the interest due. The unpaid interest is added to the loan balance. This means that, if the borrower always makes the minimum payment, the loan balance will grow each month. The second problem is that almost everyone taking out this type of loan makes the minimum payment—all the time.
The idea behind this loan was to help a seasonal worker like an asphalt contractor or accountant get through financial droughts with low payments. In the case of the accountant, during part of the year they have a cash-flow feast and can make the larger payments. During the financially dismal part of the year they can make the minimum payments, using the equity in their home to make up the difference rather than credit cards. If the pay-option loan is sold to the person who should get it, it can be a very good thing. If the pay-option loan is presented to anybody who would like to have a really cheap house payment, the results can be disastrous.
For the sake of the savvy investor who is using their funds to get higher returns or the seasonal worker who needs a little help during part of the year, I hope the pay-option ARMS don’t become extinct. For the average person out making a living, these loans should be off-limits. The tendency to rob Peter to pay Paul is simply too high. Many Americans have found themselves years into a loan, owing more than their home is worth. Being upside down is a sad financial situation, so most borrowers should steer clear of negative amortization loans.
Commitment period or prepayment penalty
Many lenders will offer a lower rate if you commit to staying in the loan for a period of time—say three years. Many websites would shame you into thinking that a “prepayment penalty” is sure to have a clause containing handcuffs and solitary confinement. Throwing these terms around as though they are “in the know” makes these companies appear client driven when they are really just using media hype to scare you out of a loan that could save you a lot of money.
The truth is that prepayment penalties aren't nearly as scary as they sound. There are two different types of prepayment penalties: "hard" penalties and "soft" penalties. A "hard" penalty means that the property cannot be sold or refinanced during the commitment period without a hefty penalty being assessed to the borrower. I do not recommend loans with hard prepayment penalties to my clients. On the other hand, a "soft" prepayment penalty allows a borrower to sell the home at any time without penalty, but if the borrower chooses to refinance during the commitment period, the prepayment penalty kicks in. Most prepayment penalty clauses allow the borrower to pay off up to 20% of the loan balance each year. That's a lot of money. 20% on a $250,000 loan amount is $50,000. Most borrowers don't take out a loan only to turn around and pay off more than 20% of the balance in one year.
As long as you aren't expecting a windfall of cash, you probably won't want to pay off more than 20% of your loan balance each year. Remember too that a prepayment penalty clause also has a timeframe—usually 3 years. However, the commitment period can range from 1 to 5 years depending upon the loan program. After the commitment period is over, you are free to refinance the loan. When you get down to it, a prepayment penalty is a clause designed to prevent the borrower from refinancing the loan within the first few years after the loan is originated.
In essence, banks offer loans with a commitment period (also known as a reduced rate option or prepayment penalty) in order to make sure that the borrower doesn't repay the loan too quickly. If the bank is going to give a little on rate, they want you to give a little on time. Prepayment penalties can certainly be ugly if a borrower wasn't told about the penalty. The penalty isn't lightweight—generally five to six months of interest (which may end up being close to five or six months of monthly mortgage payments). But if you know that you are going to keep the same mortgage for a few years and you want to get a lower rate, sometimes letting the bank know you’re “in” for a while will save you money.
People move and/or refinance so often these days that banks have begun to look for ways to make sure that a loan is going to stay in place for a while. If you are willing to assure the bank that you will stay in the loan for a few years, the bank is willing to reward you with a lower rate. If you want the flexibility to refinance at will, even a soft prepayment penalty isn't for you. As with most things in life, there are pros and cons to prepayment penalties. Whether or not to accept a soft prepayment penalty in exchange for a lower interest rate is ultimately up to the borrower.