When a home buyer is considering
which type of loan program to use to finance a home purchase, a number of
personal factors need to be considered and planned. The buyer needs to understand
the relationship between interest rates and points, the leng th of time he/she
plans to stay in the home, as well as his/her own preference of a loan type.
If a buyer doesn't take the time to consider these factors, he/she could be
spending more money than necessary when financing a home. In order to demons
trate the importance of this step, we will once again refer to our hypothetical
buyer -- Mortimer Gage.
When we last left Mortimer
Gage, he and his wife were learning about how to prequalify for a mortgage
loan, and were trying to find ways to increase their borrowing power. Mortimer
was so excited about his dream home, he couldn't wait to talk about it at
his wife's family reunion. Since Mortimer and his wife are celebrating their
search for a house, they decided to assume the "Lones" tradition and host
the "Lones" family reunion.
At the reunion, Mortimer
started talking to his father-in-law, Homer. Homer, being a retired loan officer,
had much advice to offer Mortimer. He told Mort that when a home buyer is
considering which type of loan to use to finance the purchase; he n eeds to
consider other factors as well. Homer also stated that the buyer should understand
the relationship between the interest rate and points (a point is one percent
of the loan amount). Homer is absolutely right! If a buyer wants a lower inter
est rate on a loan, more points must be paid. If a buyer wants to pay less
points, he/she must settle for a higher interest rate. If you want to apply
this relationship to your personal situation use this simple equation: 1.25
points = .25% (of in terest rate) for example: 7.75% interest rate with 0
points could be lowered to 7.50% interest rate with 1.25 points or 7.25% interest
rate with 2.5 points.
Mr. Homer Lones is a man
that cares about his family very much. So Homer asked Mort what his future
plans were for his daughter and their careers. Mort told his father-in-law
that there was a good chance that he could get transferred in the future,
so he might have to move in a few years. Homer told Mort that if he only tends
to stay in the home for a few years, he may want to consider a lower interest
rate program, such as an Adjustable Rate Mortgage (ARM), or a balloon (2-step)
mortgage. He also told Mortimer to consider a higher interest rate with lower
points. Mortimer couldn't believe his ears. His initial response "Why would
I want to pay a higher interest rate?" is a common response to this suggestion.
The purpose of paying points
(a point is 1% of the loan amount) is to lower the interest rate on the loan.
A lower interest rate means lower monthly payments. Over time, the savings
from the these lower monthly payments will pay for the extra point s paid
for at the closing. In most cases, it will take several years for the points
on a loan to pay for itself. If a buyer sells the house within 5 years, the
buyer could be losing part of the points that were paid up-front (in which
case the buye r would be better off paying the higher interest rate).
Homer also mentioned to Mortimer
that he should consider what he feels comfortable with in choosing a loan
program. If a buyer wants the security of no risk in rising interest rates,
the buyer should select a 15 or 30 year fixed rate loan. If a buyer wants
a home but can't afford the payments associated with a higher interest rate
(but is willing to accept the risk of future interest rates rising), the buyer
should consider adjustable rate or graduated equity/payment or balloon programs.
The ARM will usually offer the lowest starting interest rate but can be the
most volatile over time. The GEM or GPM offers the security of knowing the
amount of each of your monthly payments along with having low initial monthly
payments. However, the en ding interest rate is substantially higher than
a thirty year program. Balloon mortgages have the higher interest rate of
these three categories but is still less than a thirty year program for the
initial five or seven years. This advice caused Mortimer to have second thoughts
about his loan arrangement. But before he made any final decisions, he asked
Homer to write out the different loan programs available (with a brief description).
The list reads as follows:
15 & 30 year fixed conventional (conforming or jumbo) fixed - Mortgage payments
(principal & interest) are the same for the life of the loan.
conventional - Mortgage loan
is not insured by the Federal Housing Authority (FHA) or guaranteed by the
Veterans Administration (VA), although Private Mortgage Insurance (PMI) is
required by the lender when buyer's down payment is less than 20%. conforming
- Loan amount is below $203,150. JUMBO - Loan amount is above $203,150.
FHA & VA.
FHA - Loan insured by the Federal Housing Administration (Limits on loan amount
vary between counties, call local lender for loan limits) VA - Loan is guaranteed
by the Veterans Administration (Borrower must be a veteran of U.S. Armed Services)
*These loans are backed by Government Agencies and insure the lender against
borrower default. Since these loans usually require little or no down payment
(0% - VA loans, 3-5% - FHA loans). They make housing available to buyers that
could normally not afford a substantial down payment.
Balloon Programs: 5,7,10
year Balloon:
Loan payments are calculated based on a fixed rate schedule (usually a 30
year fixed rate program) these payments are paid monthly for a specified term
(5,7,10 years). At the end of the term, balance must be paid in full "balloon
payment" (immediately).
5/25 & 7/23 (2-step) Balloon:
These are balloon programs that have the option (at the end of their term)
to convert to a fixed rate program for the remainder of the loan's life.
Adjustable Rate Programs:
Adjustable Rate Mortgage (ARM)
These are loan programs that offer a lower interest rate than fixed rate loans
(for the beginning period of the loan). The interest rate on the loan remains
fixed for a set period of time. Once this period is reached, the interest
rate will be adjusted, based on a selected economic index (eg. T-bill rates,
cost of funds) for another set period of time. This process repeats itself
throughout the life of the loan. * There are multiple varieties of Adjustable
Rate Mortgages. We advise buyers to discuss these different programs with
their lenders.
Graduated Payment Mortgage
(GPM):
Loan payments are smaller at the beginning of the loan. Payments rise on a
fixed schedule or a predetermined number of years. (usually 5, but sometimes
10) The first few years of payments are applied to interest payment only.
Due to the fact that the loan principal balance can actually increase under
this program, negative amortization may occur. It is recommended that buyers
consult their lenders if considering this program.
Growing Equity Mortgage (GEM):
Each year payments are increased by a predetermined percentage (typically
7 1/2%) This increase is applied directly to the repayment of the principal
of the loan.
After seeing this list, Mortimer
decided to sit down and put some serious thought into a decision on what type
of loan he and his wife should use. Mortimer's father in law, Homer has lived
in the same house for 30 years, and likes a fixed mortgage p ayment every
month. A traditional 30 year fixed loan is appropriate for Homer. Mortimer,
on the other hand, only plans to stay in the house for a few years, and doesn't
mind taking the risk of rising interest rates. Mortimer decided that he wants
t o use a (2-step) balloon program to finance the purchase of a home. He will
benefit from the lower starting interest rate. If for some reason he does
not want to relocate, Mortimer can always convert the loan when the balloon
payment comes due.
In our next issue, we will
take a look back in time when Mortimer was looking for his dream house. We
will show how Mortimer selected a Real Estate Agent and learned how to find
the right property and negotiate a contract.
Go
to Part 3: Finding and Securing the Right Property
