Financial Planning: A Midyear Guide 1987 : part four: Borrowing : Negotiating the Maze of Mortgage Options
Martin Zweben and his wife, Christina, say finding their dream home in Palos Verdes was easy. When the couple saw the handsome ranch-style house and its views of the Pacific, Zweben said, “we fell in love with it instantly.”
But deciding how to finance their purchase wasn’t nearly as simple. “I couldn’t believe how many different kinds of mortgages there are today,” said Zweben, a public relations executive in Santa Monica. “Fixed-rate loans, adjustables, loans you don’t even have to qualify for--it’s enough to drive you nuts.”
Indeed, the wide variety of mortgages today makes choosing the one that’s right for you a difficult task. The recent upturn in interest rates hasn’t helped matters; thousands of home buyers who had planned on getting a fixed-rate loan can no longer qualify because rates have jumped to about 11% today from less than 9% in March.
Some financial experts say the rate run-up has given adjustable-rate mortgages new luster. Many lenders still offer ARMs with introductory rates as low as 7.5% and with caps that prevent them from rising more than five percentage points over the life of the loan.
“If you can get a 7.5% adjustable with a five-point cap, it’ll never go above 12.5%,” says Knight A. Kiplinger, editor-in-chief of Changing Times magazine. “And 12.5% isn’t much higher than the fixed-rate loans some lenders are offering today.”
ARM rates are adjusted periodically based on changes in a given index. In California, the most popular index is the 11th District cost of funds, a composite figure that reflects rates the Federal Home Loan Bank charges lenders for a variety of different loans. Other popular ARMs are linked to the more volatile rate of one-year Treasury securities. Still others are pegged to longer-term Treasuries, the prime rate, or more obscure indexes.
If you think interest rates will head south again--and many economists believe that they will--you’ll want to select an ARM linked to one-year Treasuries because the index reacts more quickly to interest-rate swings. But if you can’t stomach the volatility or fear that rates will move higher, pick an ARM that’s wed to the slower-moving cost-of-funds index or five-year Treasury index.
All lenders slap on a markup, or “spread,” on the index once the introductory period has ended. If the index rate is 8% and the lender’s spread is two percentage points, your new interest rate will be 10%. If a lender wants a spread larger than 2 1/2 points, it’s best to look elsewhere.
In addition to insisting on an ARM that can’t rise more than five or six points over the life of the loan, it’s also important to have a cap on how much your rate can rise each time it’s adjusted. John Cahill, co-owner of the San Francisco-based financial planning firm Carroll/Cahill Associates, says you should shun any loan that can rise more than two points each time it changes. “You could eventually find yourself in a real ‘cash crunch’ if the limit is any higher,” he says.
ARMs often attract first-time home buyers because their low initial rates make it easier to qualify for a loan, Cahill says. Even if you’re not a first-time buyer but plan on moving again relatively soon, an adjustable with a low introductory rate that won’t be changed for two or three years is a better choice than a fixed-rate mortgage because you’ll probably be gone before the rate can ratchet upward, he adds.
Of course, you won’t want an adjustable loan if you can’t sleep at night knowing that your monthly mortgage payment is subject to change. But even if you opt for a fixed-rate loan, you’ll have to choose from a variety of products.
Fixed-rate, 30-year mortgages: These loans are most popular when interest rates are low because borrowers want to “lock in” the attractive rate and like the idea of knowing their payments won’t change. They also require the lowest monthly outlays because you have 30 years to pay the money back.
On the downside, a 30-year repayment plan means it’ll take longer to build equity in your home, and interest payments over the life of the loan will be far higher than if you picked a shorter-term mortgage. You’ll also regret having a fixed-rate loan when mortgage rates are dropping, because the only way you can take advantage of the decline is by spending a lot of money to refinance.
Fixed-rate, 15-year mortgages: These loans have several advantages over their 30-year counterparts. Your overall interest payments will be cut by more than 50% because the repayment period is shorter and rates on 15-year mortgages are a shade below those on 30-year loans.
Even better, you’ll own your home free and clear in half the usual time. “Fifteen-year mortgages can be ideal if you want to pay your home off before you retire, or before your kids trot off to college,” says Ira Cohen, senior vice president at ARCS Mortgage Inc. in Canoga Park.
Of course, reduced interest payments mean fewer tax deductions over the life of the loan. But financial experts point out that the lower individual tax rates brought on by tax reform make deductions worth less, so writeoffs aren’t as important as they used to be.
Some borrowers never ask about 15-year loans because they believe their monthly mortgage payments will be twice that of a 30-year plan. That’s not the case. Principal and interest payments on a 10.75%, $100,000 fixed-rate loan amortized over 30 years would be $933 a month. Payments on a 15-year loan for the same amount, made at the going rate of 10.5%, would be a modest $172 a month more, or about 18%, higher.
The larger monthly payment makes qualifying for a 15-year loan a bit more difficult, and it turns off borrowers on a strained budget. You might also opt for a 30-year mortgage over a 15-year loan if you’re sharp enough to profitably invest the monthly savings elsewhere.
Some lenders have also begun offering 10- and 20-year mortgages. The 10-year mortgages, with rates currently a fraction below rates on 15-year loans, have attracted buyers who have sold a large home and are “trading down” to a smaller house. The 20-year loans lure people who can’t qualify for a 15-year mortgage but don’t want to wait 30 years until they own their house free and clear.
Biweekly mortgages: These loans require that payments be made once every two weeks instead of once a month. Each biweekly payment is about half of what you’d pay on a monthly 30-year schedule. “Since there are 52 weeks in a year, you wind up making the equivalent of 13 monthly mortgage payments in each 12-month span,” says Doug Gallagher, chairman of Miami-based Gallagher Financial Systems. “As a result, the loan is paid off in about 19 years.”
Rates on biweekly mortgages are about the same as those offered on 30-year loans, but the shorter repayment period means lower overall interest payments and a faster buildup of equity.
Biweekly mortgages have been difficult to find in California, but that could soon change. Campbell, Calif.-based Mortgage Loans America recently began marketing fixed and adjustable biweeklies through a statewide network of 1,000 mortgage bankers, and officials at San Francisco-based First Nationwide Bank have indicated that they’ll launch a pilot biweekly program by year-end.
A cautionary note: Some financial experts say the best way to go about paying your home off in fewer than 30 years is to simply make extra payments to the principal when you have some extra cash. By doing so, you won’t be locked into a rigid repayment schedule that will be difficult to meet if you run into cash-flow problems. But other experts say consumers who want to build equity faster need the discipline of a strict repayment plan because they don’t have the willpower to make voluntary payments.
Seven- and 10-year “balloon” mortgages: These types of loans have become easier to obtain in the past three months because lenders can now sell them to the Federal National Mortgage Assn., which packages mortgages for sale to investors.
Balloon mortgages offer some unique advantages. Although the loans must be repaid in seven or 10 years, your payments are amortized using a 30-year schedule. That means low monthly expenses, fairly easy qualifying standards and large deductions for finance charges.
There is, of course, a catch: The entire balance of the loan must be paid in one big balloon payment seven or 10 years from now, so you’ll probably have to sell the property or refinance to meet your obligation. This won’t be a problem if you’re the “typical American” who the Census Bureau says moves once every six years. But it will be a problem if you have to sell your house when the real estate market is soft or refinancing rates are high.
Lenders realize the dangers of balloon mortgages, so most insist that borrowers who choose this type of loan make a down payment of at least 25%. As a result, the loans are unattractive to anyone who can’t tie up a large chunk of cash for several years.
“We think balloon mortgages will primarily attract people who are fairly certain they’ll be in the house for less than seven years,” says George Alexander, Fannie Mae’s director of product and lender marketing. Likely customers include military personnel, corporate transferees and younger couples who will eventually want a larger house to raise a family.
Exotics and hybrids: Hundreds of lenders have begun peddling even more offbeat species of loans. One hot new product is an adjustable-rate loan that can be converted to a fixed-rate when you think mortgages rates have bottomed out. Others tout “no-qualifying” loans for people who have a minimum 20% down payment but might have problems getting a conventional mortgage. Still others are offering so-called growing-equity mortgages, with rates that start out low but rise in tandem with expected increases in your income.
If you’re puzzled by all the choices, there are plenty of people who can help. In fact, it’s a good idea to visit a few lenders and mortgage brokers before you even start your house hunting to see what type of loans are available, how much money you can borrow, and how much up-front cash you’ll need to close the deal. “If you get prequalified, lenders can process your loan faster,” says Dennis Casey, a vice president for San Diego-based Home Federal Savings & Loan. “And you won’t waste time looking at properties you can’t afford.”
