Your Mortgage : ‘Balloons,’ Leasebacks and Paying Points : Loans: Readers ask about the pluses and minuses of different types of financing and why lenders charge ‘points’ upfront.
Readers have started off the new year by asking about offbeat loans, sale/leasebacks and lenders’ alleged “gouging” of the public.
Jeff Jackson of San Diego says he’s been shopping for a loan of about $150,000 recently to buy a condominium.
Several lenders have said they would give him a standard 30-year, fixed-rate loan at about 9 3/4%, but a few have offered him five-year and seven-year “balloon” mortgages with a rate that’s between one-half and three-quarters of a point lower.
“Could you please discuss the advantages and disadvantages of balloon loans?,” Jackson writes. “Picking a balloon loan would save me more than $50 a month in interest charges, but I don’t really understand what would happen when the five years or seven years are up.”
Balloon mortgages have only recently become widely available. They get their name because the final payment on the loan is the loan’s total outstanding balance--a sum that can be 50 or even more than 100 times larger than the previous monthly payments.
In other words, the final payment “balloons.”
Different lenders offer different types of balloons. One of the most common types is the “30-due-in-7” mortgage, nicknamed a “30/7.”
Let’s say Jackson takes out a typical 30/7 for $150,000. Although the entire amount must be paid back in seven years, his monthly payments will be based on a 30-year payback schedule. That keeps his payments relatively low and writeoffs for mortgage-interest charges high.
Even better, the rate on the 30/7 loan will be about a half-point lower than the rate that Jackson would get if he took out a standard 30-year loan. That’s because the lender knows that the short, seven-year payback schedule lessens the chance that it will lose money if rates skyrocket in the future.
Countrywide Funding Corp., a big mortgage banking company headquartered in Pasadena, was recently quoting a 9 1/4% rate on 30/7s, compared to a 9 3/4% rate on standard 30-year loans.
If Jackson opted for the 30/7, his monthly payments for principal and interest would be $1,234--about $55 less than he’d pay for the standard loan. He’d also save about $1,500 in upfront costs because most lenders charge fewer points on 30/7 loans.
At the end of seven years, the 30/7 will have saved Jackson more than $4,600 on his monthly mortgage payments.
The trouble is, Jackson would then have to pay off the loan, which likely means that he’ll either have to sell the property or spend a lot of money to refinance. Since neither alternative is very appealing, five-year and seven-year balloon loans are most popular with home buyers who plan to move before the balloon payment comes due.
Sue Grannis, a Countrywide vice president, points out that her institution and some others allow borrowers to extend some types of balloon loans to avoid having to move or refinance if certain conditions are met.
If you’re thinking of taking out such a mortgage, it’s a wise idea to see if the lender offers an extension option--and what conditions must be met to exercise it.
As an alternative to a balloon loan, Jackson might also consider the “two-step” mortgages that many lenders recently began offering. They provide a below-market rate for the first seven years, and then there’s a one-time adjustment to market levels at the start of the eighth year.
The biggest advantage that two-step mortgages have over balloon mortgages is that two-step borrowers don’t have to worry much about what will happen when the first seven years are up. They won’t be forced to move or refinance; they’ll simply have to endure a one-time adjustment to the interest rate on their loan.
Perhaps the biggest drawback to choosing a two-step over a balloon loan is that introductory rates on two-steps typically aren’t as low as rates on balloons.
Sara Klein, who reads this column in the Orlando Sentinel, says she and her husband have been shopping around for a “reverse mortgage” to supplement their monthly retirement income.
“All the reverse loans we’ve looked at are very expensive,” she complains. “You had mentioned that one alternative would be to do a sale/leaseback with our children. Can you give us more information on how that would work?”
Sale/leasebacks are fairly easy to understand. Let’s say that the Kleins agree to sell their house to their son. As part of the deal, the couple would simultaneously sign a lease that will require the son to let them rent the house back from him for as long as they wish.
The son would make a down payment and then go to a bank or S&L; to get a loan to finance the rest of the purchase.
The Kleins would get to keep all the sale proceeds and would probably also be eligible for the one-time exclusion that allows people 55 or older to keep up to $125,000 in resale profits tax-free. They’d also have the comfort of knowing they can stay in the home for as long as they wish.
The son, meantime, would collect monthly rent checks from his parents and be eligible to take the tax deductions that all landlords enjoy. He would also get the house when the Kleins either move out or die.
Sale/leasebacks entail some complex tax and legal issues for both parents and their children. So, it’s important to talk with a knowledgeable attorney and tax expert before entering one.
The nonprofit National Center for Home Equity Conversion offers a guide to sale/leasebacks and a model agreement that can be used to fashion a contract. It’s available for $39 from the group’s headquarters at 1210 E. College Drive, suite 300, Marshall, Minn., 56258.
Barbara Hall of Los Angeles recently bought a home with a 30-year loan of about $175,000. When she got her federal truth-in-lending disclosure, she learned that she’ll pay more than $300,000 in interest over the life of the loan--not to mention the $175,000 she originally borrowed.
Her question is one that has undoubtedly crossed the minds of many borrowers before: “Considering the fact that the lender is going to make so much money off me in the coming years, why did they also have to charge me two points in order to take the loan out?
“I think that America’s home buyers are getting ripped off!”
A point is an upfront charge of 1% of the total loan amount. So if Hall borrowed $175,000 and paid two points, she paid a total of $3,500 in points ($175,000 x .02).
We asked Jack Barcal, a financing expert and associate professor of accounting at USC, why lenders charge upfront points even though they stand to make thousands of dollars in interest earnings over the life of a typical loan.
“I suppose lenders could justify charging points because they’ve got to spend a lot of time checking out a borrower’s references and credit rating, processing paper work and the like,” Barcal said.
“And if a borrower defaults or pays the loan off early, the points that were paid upfront will compensate the lender for some of the interest income it could have earned if the borrower had kept the loan for its entire term.
“But the truth is, lenders charge points as a simple matter of economics,” Barcal said. “It’s just a way for them to make more money.”
Letters and questions may be sent to Myers at the Real Estate section, Los Angeles Times, Times Mirror Square, Los Angeles 90053. Questions cannot be answered individually. AVERAGE RATES FOR RESIDENTIAL MORTGAGES Average rates for residential mortgages as of Jan. 11, 1991
Survey Conventional Mortgages Adjustable Mortgages Area 15 Year 30 Year Composite 1 Year Composite National 9.41% 9.74% 9.59% 7.76% 8.06% California 9.66 9.96 9.82 8.11 8.15 Connecticut 9.44 9.76 9.63 7.82 8.03 Wash. D.C. 9.25 9.59 9.44 7.31 7.62 Florida 9.33 9.73 9.54 7.69 8.04 Mass. 9.50 9.85 9.69 7.72 8.09 New Jersey 9.47 9.77 9.64 7.74 8.22 N.Y. Metro 9.53 9.84 9.71 7.84 8.19 New York 9.64 9.94 9.81 7.93 8.23 N.Y. Co-ops 9.85 10.14 10.07 8.22 8.64 Pa. 9.12 9.50 9.32 7.48 7.63 Texas 9.19 9.54 9.38 7.72 7.82
SOURCE: HSH Associates, Butler, N.J.
