Buyers face a big challenge in choosing a mortgage, but you can help them get off to a good start. How do you know which mortgage option is best for a particular buyer? Even if economic experts could agree about what will happen to interest rates during the next year, you still shouldn’t choose a type of mortgage for a buyer. What you should do is stay as informed as possible about mortgage options. Then you can give buyers information that will help them make informed decisions. This section discusses some of the mortgage instruments currently used, as well as some of the features of those mortgages.
The most popular and traditional mortgage is the fixed-rate, which involves making regular payments based on a fixed interest rate. Unless interest rates exceed “comfortable” levels (typically about 10 percent), buyers are likely to choose this type of mortgage. According to the Federal National Mortgage Association (Fannie Mae), first time buyers often choose fixed-rate mortgages because they want the security of stable and affordable payments. Also according to Fannie Mae, financially motivate buyers may choose fixed-rate mortgages because they want low monthly payments throughout the loan term.
For instance, because homes in some areas may appreciate more slowly than those in other areas, some people prefer to make low monthly payments so that they can put the money they save into other investments that bring greater returns. Also, buyers can reap the greatest cumulative tax deductions available over the loan term.
Generally, lenders require 20 percent down payments on conventional fixed-rate mortgages, but with Federal Housing Administration (FHA) insurance, only 5 percent is required.
Also, private mortgage insurance (PMI) can help buyers purchase a home with only a 10 percent down payment. As the name implies, buyers purchase PMI through private companies but lenders typically acquire the insurance for the buyers. First-year premiums are usually between .35 and 1.65 percent of the total loan amount, and depending on policy requirements, buyers must pay the premiums either in advance or monthly.
A twist on the 30-year fixed-rate mortgage is the shorter-term fixed-rate mortgage, with either a 10- or 15-year loan term. These shorter terms require larger monthly payments than a 30-year term, but the benefits that often attract buyers include the lower interest rates, faster equity buildup, and a substantial interest savings over 30-year mortgages.
With biweekly fixed-rate mortgages, payments are about one-half those of monthly fixed-rate mortgages with the same amortization schedule, and they`re drafted automatically from the borrower`s bank account every other week. Borrowers make the equivalent of 13 monthly payments in just 12 months, and as a result, they save on interest and their equity builds faster. Biweeklies amortize every two weeks rather than monthly, and loan amortization terms of 10,15,20, and 30 years are available.
Adjustable-rate mortgages (ARMS) are a little riskier than fixed-term mortgages. In exchange for lower initial interest rates, borrowers take the risk that if lending rates rise, their payments will also rise.
With ARMs, rates are adjusted during the term of the loan according to changes in market interest rates. Borrowers typically choose a six-month or one- or three-year ARM, and as the names imply, the rate remains stable for the first six months, year, or three years. (There are, of course, other kinds of ARMs, which are also classified according to the frequency of their payment adjustments.) A per adjustment cap and a lifetime cap on the level to which the interest rate may be adjusted can help reduce some of the risk, and these are available on some ARMs, as are 15- and 30-year loan terms, and options to convert to fixed-rate mortgages.
Why do some borrowers opt for ARMs? Those who expect to move within a few years will often choose an ARM because of the low initial interest rates and then resell the home before the rates are adjusted. Borrowers refinancing their current mortgages may also choose ARMs if the lower initial interest rates can make up for the transaction costs of refinancing.
Remember, though, lenders use different indexes on which to peg their ARMs. The index used will determine the payments during the loan term. For example, cost-of-funds indexes are tied to the interest rates on savings accounts. Many lenders, however, now use the one-year U.S. Treasury securities index or the 11th-district cost of funds index to adjust their ARMs.
Also, treatment of closing points can be different with ARMs. A few lenders allow buyers to spread the cost of closing points in equal monthly installments over the first two years of the loan. Buyers should check the deductibility of these payments with their tax adviser.
With most loans, the payments cover the principal and interest, and the borrower will have repaid the loan by the end of the loan term. But some borrowers are taking more risks by using negative amortization loans. In those cases, monthly payments fall short of what the borrowers must pay to cover both the principal and the interest of the loan, and at the end of the year, the borrowers actually owe more than they owed before they make 12 payments. Why would a borrower do this? Lower monthly payments are available with negative amortization loans, and most often, borrowers who take this risk are buying in markets with extremely high prices. Many gamble that their home will appreciate enough to cover the difference between their payments and the new loan amount.
Taking Known Risks
Some borrowers are willing to take risks if they know the risks in advance. With graduated payment mortgages (GPMs) or growing equity mortgages (GEMs), payments increase during the loan term. Borrowers can plan for the larger payments because they know exactly how much the payments will increase. The difference between GPMs and GEMs is the treatment of the amortization schedule. GEMs are calculated on 30-year fixed terms, even though payments increase during the loan term. As a result, a 30-year loan is often paid within 15 to 20 years. With GPMs, the increase payments are scheduled within the 30-year term, and the “overpayments” are applied directly to the loan principal. The FHA offers five different types of GPMs, and the Veterans Administration (VA) offers its own GPM and GEM plans.
Let the VA Take Risks
Except for its GPMs and GEMs, loans guaranteed by the VA require no down payment, and a builder or seller may pay closing costs for the buyer.
The VA also offers veterans a buyer-down purchase plan in which the seller pays the lender to lower the borrower`s interest rate either temporarily or permanently. In permanent buy-downs, sellers will typically offer to make the interest rate 1 percent below the maximum rate set by the VA for the entire 15- or 30-year loan term. With temporary plans, the 3 2 1 option is common. The interest rate is reduced 3 percent during the first year, 2 percent during the second year, and 1 percent during the third year. Then payments increase to normal levels for 30-year terms. Finally, to increase the options when a borrower decides to resell, no VA loans have due-on-sale clauses. Thus, another buyer may assume the veteran`s loan at the original interest rate, or the veteran may incorporate a second mortgage, a wraparound, a contract for deed, or a lease purchase without the original lender`s approval.
Let the FHA Take Risks
Not only does the FHA insure loans for lenders but also its insurance makes it possible for buyers to purchase a home with a small down payment. Under the FHA`s 203b plan, virtually any U.S. resident 18 years or older can purchase a home with a 15- or 30-year fixed-rate loan and a 3 percent down payment on the first $25,000 of value and closing cost and 5 percent on the remainder. Another FHA option is the shared equity mortgage (SEM), whereby a marginal buyer can pair up with a relative or investor to purchase a home. With an SEM, loans often go as high as 97 percent of the home`s value. Each investor owns a percentage of the home, and monthly payments are based on those percentages.
If buyers are considering a home with an assumable mortgage at a fair interest rate or if the sellers have already paid their mortgage, remember to consider seller financing. With seller financing the seller determines the sales price and then acts much like a lender. He determines the amount of down payment necessary and the other terms of sale.
Seller financing becomes more common when interest rates are high and buying a home is out of reach for many who could otherwise afford it. But regardless of interest rates, this option helps qualify people to buy who might not be able to qualify for a loan through a lending institution or who may have the income to afford monthly payments but not the cash for a down payment. With seller financing, borrowers whom lenders might consider marginally qualified not only may qualify to buy but also may save money because closing costs are often nonexistent or less expensive than with lender financing. Why would a seller take the risk? Often, seller financing produces returns that are substantially higher than those of most other investments. Also, seller financing is treated as an installment sale for tax purposes. Finally, if the buyer defaults, the seller can take the property back under the contract or, if absolutely necessary, he can foreclose on the property.
A seller can also offer a wraparound mortgage to a buyer who already owns a home. With this option, the seller makes a money advance to cover or “wrap” the balance due on the old mortgage and the amount on the new loan at an interest rate below market levels. The term of the wrap is the time left on the old mortgage. So with the seller`s help, the buyer`s monthly payment is substantially less than for a new first mortgage at the higher interest rate.
Helping Find the Right Option
Maybe some of the buyers you`re working with want to purchase a home, but they want low monthly payments so that they can save for their children`s college education. Or maybe some of your prospects haven`t saved enough money to afford a down payment on the home they`re interested in, but they want to invest in a home rather than pay rent each month.
Today’s buyers have many financing options, and the challenge for them is to find the option that best suits their special circumstances. Your knowledge about their options can help ensure that their first step is the right one.