Financing and other mortgage products: What you should know
In recent years there has been an explosion of mortgage “products” available to home buyers. Kelsey Law, LLC can assist you in connecting with a lender who can explain these products and help you find the best possible financing for your purchase.
Each mortgage product is designed to afford some benefit to the appropriate borrowers. Not every mortgage product will meet your needs equally. Therefore, it is important that you consider such questions as:
- How long do you anticipate living in the house?
- Do you expect your income to increase significantly in coming years?
- How large a monthly mortgage payment can you afford?
- How close to retirement are you?
- What other financial obligations do you presently have or do you expect to have?
- What percentage of your wealth or current income do you wish to commit to your home?
The answers to these and other fundamental questions about you and the lifestyle you anticipate will come in handy when selecting the type of mortgage that best meets your needs.
TYPES OF MORTGAGES
Even though there are many variations available, there are basically two types of mortgages: “fixed rate” and “adjustable.”
Fixed Rate Mortgages
As the name suggests, a fixed rate mortgage gives you an interest rate that is fixed for its entire term. The monthly mortgage payments that you will make are determined in advance according to a repayment (amortization) schedule. At the end of this schedule you will have repaid the entire debt, interest and principal. This type of mortgage is popular with borrowers because the interest rate and monthly payment are known in advance. This allows you to manage your finances with more certainty than with other types of mortgages.
Although in most cases the payments are the same for the life of the loan (usually 15 or 30 years), several types of fixed rate mortgages do feature monthly payments that vary.
A second type of fixed rate mortgage does not have payments what vary but features a different schedule of payment. Unlike most mortgages, which have monthly payments, you pay a biweekly mortgage every other week. These payments are half of the size of a comparable monthly payment. Therefore, payments are no more onerous than monthly payments. The principal advantage of a biweekly mortgage is that you will make the equivalent of thirteen payments in a year rather than twelve. This means that you will pay off your mortgage more quickly, and it will cost you less over the life of the loan. The principal disadvantage of this type of mortgage is that the additional payment each year means you will pay out more per year than a monthly mortgage, and unless you have an automatic withdrawal every 2 weeks, you double the chances for a late payment which can adversely affect your credit rating.
Advantages and Disadvantages of Fixed Rate Mortgages
The principal advantage of the fixed rate mortgage is its certainty. You will know what your mortgage payment will be for as long as you have that mortgage. Also, during the early years of the mortgage, when most of your payment is earmarked for interest payment, you will have a significant tax deduction for deferral and most state income taxes.
The major disadvantage of the fixed rate mortgage is that it does not change to meet market conditions. If interest rates drop after you obtain your mortgage, you will have to continue making your payment at the higher than market rate unless you refinance your mortgage. A refinancing is essentially substituting one mortgage for another and requires many of the settlement costs that you paid when you originally purchased your property.
Another disadvantage of a fixed rate mortgage is that it generally had a higher interest rate than adjustable mortgages. This means that your monthly payments will be higher than if you had an adjustable mortgage.
Adjustable Rate Mortgages
The second common type of mortgage is the adjustable rate mortgage. As the name suggests, the interest rate for this type of mortgage adjusts according to the market conditions throughout the term of the mortgage. At certain established points called “anniversary dates,” the interest rate on your mortgage is adjusted to reflect current market conditions. Most often these adjustments are made annually. However they can be made at any time: six months, three years, and five years. The adjustment is made based on the change in a pre-selected index since the last change or anniversary date. The date, and consequently your payments, may move up or down, based on the change to the index. Among the more commonly selected indices are “cost of funds,” “Treasury Bills” and “Prime rate.”
In order to protect you from dramatic changes in the economy, most adjustable rate mortgages have “rate caps.” These caps limit the size of the adjustment that can be made to your rate on any individual adjustment. Typically, rate caps are 1% or 2% per rate change. Most adjustable rate mortgages also have lifetime caps – the maximum increase or decrease that can occur to the rate over the life of the loan. Lifetime rate caps are most often in the 5% to 6% range. If an adjustable rate mortgage does not contain rate caps, you should not accept that mortgage.
How do rate caps work? Suppose you obtained an adjustable rate mortgage with an initial rate of 6%, a 2% annual cap and 5% lifetime cap. At the first change date, your interest rate could go up and down a maximum of 2% to 4% or 8%, based on the change in your index. At no time during the life of the loan could your minimum interest rate fall below 1% or maximum interest rate go above 11%, regardless of what happens to the index used for your mortgages because of the lifetime cap is 5%. Most adjustable rate mortgages have a “floor”, a rate below which the loan will not adjust. Unfortunately, the “floor” on many loans is the same as the initial rate resulting in no downward adjustment.
Advantages and Disadvantages of Adjustable Rate Mortgages
Adjustable rate mortgages will generally have lower initial interest rates than fixed rate mortgages because they are tied to general economic conditions during their entire term. This means that you will have lower income requirements and lower initial costs. A second advantage of the adjustable rate is that it may be assumable. With the lenders consent, this means if you wish to sell your home, the person buying your home can essentially take over your mortgage and save the costs of obtaining his or her own mortgage. This may make your home easier to sell. Also, if interest rates decline while you hold an adjustable rate mortgage, you will get the benefit of a lower rate without the expense of refinancing your mortgage.
The principal disadvantage of the adjustable rate mortgage is its lack of certainty and what that can mean for you. With an adjustable, while you obtain the benefit of lower payments if your index moved down, you will have the burden of higher payments if rates go up. If you do not plan to be in this particular home for very long, anticipate income increases, plan on refinancing in the not-too-distant future or obtain a very attractive interest rate, you may decide that the benefit of lower initial payments offsets the risk of higher payments.
Interest ONLY Mortgages
Interest only mortgages are mortgages in which your monthly payments only apply to the interest part of your home loan for a fixed period. Loan terms will often be 5, 7 or 10 years and upon expiration of the specific term, your loan can become a fixed rate or adjustable mortgage amortized over a traditional 15 to 30 years.
These loans have the advantage of lower monthly payments and payments are fully deductible during the term of the loan. Money that is saved not having to pay principal can be used to invest or can be used to pay toward debt-consolidation.
However, before considering such option, consult with your tax advisor regarding your particular situation.
Reverse Equity Mortgages
A Reverse Equity Mortgage is a loan against the equity in a property that gives tax-free cash advances, but requires no payments during the term of the loan. Since there are no monthly payments during the life of the loan, the balance grows larger and the equity gets smaller.
To qualify, you must be at least 62 years old and own your home. The amount of benefit that you will qualify for will depend on your age at the time you apply for the loan. As a general rule, the older you are and the greater your equity, that larger the Reverse Equity Mortgage benefit will be.
Borrowers who pay off a mortgage in the first few years, either to refinance or upon subsequent sale of the home are often surprised to learn that they must pay additional sums under mortgage language called a prepayment penalty.
Pre-payment penalties are increasingly common and should be avoided whenever possible – especially when interest rates are falling or when it is likely the home will be sold within the first few years of the mortgage.
Lenders say they offer prepayment clauses in return for lower rates, which they say can range from one-eight to one quarter of a percentage point. Some lenders will waive the prepayment penalty if the mortgage is refinanced with the same lender or if the home is sold and new mortgage is obtained with the original lender.
CHOOSING A MORTGAGE LENDER
One of the first things you should do is to select a mortgage lender. You should feel comfortable enough with your lender to ask all the appropriate questions. A mortgage lender may be a bank, savings and loan, credit union, mortgage banker or mortgage broker. While most mortgage documents are similar, there can be substantial differences in costs and procedures among mortgage lenders. Here are some questions you may ask each mortgage lender you are considering. Comparing their answers may help you decide which lender is best for you.
- What is the current interest rate for the type of mortgage that you are interested in?
- How long will that quoted rate be held?
- When is the rate fixed? (Time of application, commitment or closing?)
- How many points are required? (A point is equal to 1% of the mortgage amount
and is paid at closing.)
- Can you pay more or fewer points to affect the interest rate on your mortgage? (Generally, the more points you pay, the lower the rate; the fewer points, the higher the rate.)
- What is the application fee and what services does it cover? (Normally appraisal and credit reports.)
- What other services will the lender require and what are their estimated costs? Pest inspection? Title insurance? Homeowner’s insurance? Document preparation fee? Closing or escrow fee?
- Will private mortgage insurance be required? (If your down payment is more than 20% of the purchase price of the home, it is generally not required.)
- Will you have to escrow for taxes and insurance or can you pay your own?
(While most lenders will want to escrow for taxes and insurance to make sure that they are paid, it may be less costly for you to pay your own obligations.)
- How long will it take for the lender to process your application?
- Will the lender give an unconditional loan commitment upon approving your application?
- After receiving a commitment, how long will you have to wait to close the loan?
- Is the lender TRID compliant?
In selecting a lender, you may wish to ask for recommendations from Kelsey Law, LLC or the real estate sales person who has been showing you properties. You should compare the types and costs of mortgages offered by at least a few different lenders before making a decision.
HOW MUCH OF A LOAN CAN YOU OBTAIN?
Both you and the lender want to be sure that you will be able to afford the loan you obtain. To determine this, most lenders use one of two ratios. The first is called “total debt ratio” (TDR). This determines the relationship between your income and all of your installment debts, such as car loan, credit card balances and student loans. Although there may be some variation in the acceptable limits, most lenders at the time this was printed would not allow you to have a TDR, including your mortgage payments, of more than 38%. For example, this would mean that if your family income was $50,000.00 your total debt payments for the year could not exceed $19,000.00.
A second ratio that is used is called “housing debt ratio.” This is calculated by comparing your family income to your mortgage payment (principal and interest), real estate taxes and homeowner’s insurance. Most lenders do not approve loans if your housing related payments will exceed 32% of your family income.
It is always a good idea to have at least a rough idea how large a loan you will be able to obtain. Most real estate sales persons and many lenders will be glad to “pre-qualify” you for a mortgage at no charge. This means that they will calculate what they believe you can afford. Be sure that you are under no obligation and will not be charged for pre-qualifying. You may wish to have several sales persons or lenders pre-qualify you to make sure that you are looking at homes you can afford.
It is important to remember that the maximum mortgage amount that you can obtain will depend on the type of mortgage you obtain (fixed rate versus adjustable) and the terms of the mortgage (amount of down payment, term of the mortgage and size of the mortgage).
In deciding how you wish to finance the purchase of your home, you must carefully consider how your lifestyle and plans correspond with each type of mortgage available in your area. No single type of mortgage is best for everyone. Your Kelsey Law can help you weigh the alternatives and advise you as to the meaning of the mortgage’s terms.