HOME BUYERS FAIR : Finance Options : The Menu of Mortgage Possibilities Grows Longer : Home Loans: There are a number of versions of fixed-interest and adjustable-rate loans made available.
Just a decade ago, home buyers had few choices when they went shopping for a loan. Most lenders made only fixed-rate mortgages and many demanded that borrowers make a minimum 20% down payment.
Those days are long gone. Today’s borrowers have dozens of choices, from adjustable-rate mortgages that require 5% down to low-rate seven-year balloon loans.
But while the myriad new mortgage choices gives you an opportunity to tailor a loan to fit your needs, they also make it more difficult to choose the mortgage that’s right for you.
“You’ve got to survey all the different types of loans that are out there today, and see which one best fits your personal financial needs,” said Ira Cohen, senior vice president of Calabasas-based ARCS Mortgage Inc.
“Making a wrong decision now can cost you money later.”
Before you start looking for a mortgage, you need to think about how long you’ll live in the house.
If you’re going to move within two or three years--a good possibility for a first-time buyer hoping to build equity and trade up into a nicer home--it’s almost certain that you’ll do better by choosing an adjustable-rate mortgage instead of one that has a fixed rate.
That’s because you’ll enjoy the smaller monthly payments that the ARM’s low introductory rate will provide, and you’ll be out of the house before the rate has a chance to ratchet up to market levels.
On the other hand, you may want the security that a fixed-rate loan can provide if you’re planning to stay in the home for several years.
“That’s especially true if you’re moving to your retirement spot and will be living on a fixed income,” Cohen said. “Most older people don’t want to worry about their monthly payments fluctuating.”
Until a few months ago, most borrowers were choosing fixed-rate loans over adjustable-rate mortgages because rates on ARMs weren’t much lower than those on fixed loans.
But introductory rates on ARMs have recently dropped, while rates on fixed mortgage loans have risen, giving ARMs some new luster.
“If I was looking for a loan today, I’d seriously consider taking out an ARM instead of a fixed-rate loan,” said John Tuccillo, chief economist of the National Assn. of Realtors.
“If rates went down, so would the monthly payments. Plus, I could always refinance into a fixed-rate mortgage when I think that (fixed) rates have bottomed out.”
Choosing an ARM over a fixed-rate loan can provide other benefits.
First, it’s usually easier to qualify for an adjustable-rate loan than it is to get a fixed-rate mortgage, because an ARM starts out with a below-market rate. The lower the rate, the less you need to earn to qualify for a loan.
“The ARM’s lower rate also allows you to borrow more than you could if you took out a fixed-rate loan,” said Sam Lyons, senior vice president of Great Western Bank. “That means you can buy a bigger or nicer home.”
Rates on ARMs are adjusted periodically based on changes in an index specified by the lender. In California and many other states, the most popular is the 11th District Cost of Funds--a relatively slow-moving index that reflects western-states lenders’ borrowing costs.
Other popular ARMs are linked to the more volatile rate of one-year Treasury securities, the prime rate or more obscure indexes.
If you think interest rates are heading lower--and some of the nation’s top economists think that they will--you’ll want an ARM linked to one-year Treasuries or some other index that reacts quickly to interest-rate changes.
On the other hand, you’ll want to pick an ARM that’s linked to the 11th District Cost of Funds or some other slow-moving index--such as the five-year Treasury index--if you can’t stomach volatile swings in the size of your monthly payments.
On any ARM, you will want to ask want kind of limits, or “caps,” are placed on the loan’s interest rate.
“You’ll want one cap that prevents the loan rate from rising more than five or six percentage points over the life of the loan, and a second cap that prevents it from rising more than one or two points at each adjustment period,” said Lawrence A. Krause, president of a San Francisco-based financial planning firm that bears his name.
For example, an ARM that starts out with an 8% interest rate should have a cap that prevents it from rising above 13% or 14% even if rates skyrocket. A second cap should prevent the rate from rising more than one or two percentage points each time it’s adjusted.
You’ll also want to ask the lender about the ARM’s “margin.”
The margin, or “spread,” is basically a retail markup that the lender will slap on the underlying index in order to make a profit. If the index rate is 8% and the margin is 2 1/2 points, your actual interest rate will be 10 1/2%.
Of course, if you’re worried about future changes in your loan rate, you should shun ARMs and take a fixed-rate mortgage.
Interest rates on fixed mortgage loans have risen gradually over the last few months and now range between 10 1/2% and 11%. But despite the recent run-up, some lenders say fixed-rate loans are still favored by many buyers.
“People who take out fixed-rate loans are looking for security. They like the idea that their monthly payment will never change,” said Cohen at ARCS Mortgage.
“Knowing what your monthly payment will be also makes financial planning easier, because you’ll know exactly how much you’ll have to come up with each month to pay for your housing.”
No matter what type of loan you’re seeking, most experts say it’s a good idea to check out the loan programs offered by at least six financial institutions and mortgage brokers.
The mortgage broker represents several institutions instead of just one--much like an independent insurance agent, who represents many insurers.
Most major newspapers can also give you a general idea of the rates that various lenders are charging. The Times publishes a list of rates offered by more than 30 big Southland financial institutions every Saturday on Page 3 of the Business section.
As you contact various lenders, you will probably find that each one offers a variety of different loans. While most borrowers opt for either a 30-year fixed-rate loan or a 30-year ARM, you might decide that some other type of loan better fits your financial needs.
* Fixed-rate 15-year loans: These have several advantages over their 30-year cousins. Rates on 15-year loans are usually one-quarter to one-half of a percentage point lower than rates on longer-term loans, and the shortened repayment schedule can reduce the interest paid over the life of the mortgage by more than 50%.
Importantly, the monthly payment on a 15-year loan is usually only 20% or so more than the size of the payment on a 30-year mortgage.
“Fifteen-year loans are great for people who want to have their home paid off by the time they retire, or by the time the kids go off to college,” said Cohen at ARCS Mortgage.
* “Two-step” mortgages: These fixed-rate loans start out with a rate that’s about one-half of a percentage point lower than rates on most other fixed-rate loans. After seven years, there’s a one-time adjustment and the new rate applies for the remainder of the loan term.
Although two-step mortgages are relatively new, lenders say most of the loans are being taken out by first-time buyers who like the initial low interest rate but don’t want frequent changes in monthly payments--the type of fluctuations caused by most ARMs.
* Convertible loans: These typically start with a below-market adjustable rate, but you have the opportunity to convert to a fixed rate within a specified period of time--usually between the end of the first year and the start of the sixth.
A convertible can be a good choice if you need a loan now, but you want the option of switching to a fixed interest rate later without paying huge fees to refinance.
On the downside, the conversion rate will likely be about half a point higher than rates on other fixed-rate mortgages at the time.
* Seven- and 10-year balloon mortgages: Usually taken out by people who don’t expect to stay in their homes for long, these loans offer some advantages over other types of mortgages.
Although these loans must be repaid in seven or 10 years, payments are based on a 30-year schedule. That means low monthly expenses, relatively easy qualifying standards and the same amount of tax write-offs available from a 30-year mortgage.
Rates on balloon loans are also typically between one-quarter to one-half point lower than rates on 30-year fixed mortgages, primarily because the shorter repayment term cuts the lender’s risks.
On the downside, you’ll have to make a lump-sum “balloon” payment when the term of the loan is up. That won’t be a problem if you’re planning to move, but you’ll run into trouble if you can’t sell the home in time to pay off the loan or if you’re forced to refinance at a much higher rate than you had been paying.
* Biweekly mortgages: These hard-to-find loans require that payments be made once every two weeks instead of once a month.
Since each biweekly payment is roughly half the amount you’d pay on a monthly basis, you wind up making the equivalent of 13 monthly payments a year instead of 12. As a result, the loan is paid off in about 19 years instead of 30--and the shortened term can save you more than $50,000 in interest over the life of a $100,000-loan.
Still, some experts say that borrowers who want to pay their homes off in fewer than 30 years should shun biweekly mortgages and simply add an extra $50 or so to the monthly payment when they have some extra cash. That way, they won’t be locked into a rigid repayment schedule that will be tough to meet if they run into cash-flow problems.
* Graduated-payment mortgages: These are basically a hybrid of ARMs and fixed-rate loans. They start out with a below-market rate that is increased at specified intervals.
For example, a GPM might start with an 8% rate, move to 9% at the start of the second year, 10% in the third and then settle at 11% for the remainder of the loan term.
“The low initial rate makes it easier to qualify for the loan, and your earnings will presumably rise fast enough to keep up with future rate increases,” Cohen said.
If you’re perplexed 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 to get “prequalified” before you even start your house hunting to see what kind of loans they offer, how much you can borrow and how much up-front cash you’ll need as a down payment.
“Once you’ve been prequalified, you’ll know how big of a loan you can get and you won’t waste time looking at homes that you can’t afford,” said Palma Jarvis, a vice president with HomeFed Bank in San Diego.
