Two Home Loans Go Back to Future

Two cut-rate mortgage ideas that haven’t been seen nationally for nearly two decades have resurfaced and appear to be picking up significant steam.

Both plans allow home buyers to qualify for interest rates below prevailing market levels. Both work especially well for “jumbo” loan borrowers--those seeking mortgages above $227,000--and for buyers who know they’re likely to sell or move in four to five years.

But both require you to strike a bargain of sorts with your lender. You’ve got to give up something to get the discount rate.

The first oldie but goodie making a comeback is the prepayment penalty plan. In exchange for a fixed 30-year interest rate that’s about a quarter percent below the regular rate, you agree not to refinance during the next 60 months. After that, you’re free to do whatever you want.

And during those first 60 months, you’re free to pay off the loan without penalty if you move or sell the house for any reason.

But if you prepay the mortgage balance simply to refinance with another lender, you get hit with a penalty, the size of which varies according to state law.

In California, for example, the prepayment penalty can’t exceed 80% of six months’ interest. In other states, where such prepayment penalties are subject to different statutory restrictions, the penalty may be different or not permitted at all.

What do you get for a quarter-point rate break? On a $300,000, 30-year mortgage at 6 3/4%, you save $50 a month--$600 a year--in principal and interest. If $600 a year is chump change to you, then don’t even think about the prepayment concept.

But if you figure that 30-year fixed mortgage rates are near their three-decade lows and that the odds are good that you won’t be a serious refinance candidate in the next several years, why not save some money?

On the other hand, if you think there’s a chance that mortgage rates will dip below 6% soon, risking a prepayment penalty makes no sense.

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Growing numbers of home buyers apparently think the rate break is worth it. One of the national lenders active in the prepayment-penalty arena--Headlands Mortgage Co. of Larkspur, Calif.--said it is originating more than $100 million a month in jumbo prepayment loans alone.

Peter Paul, president and CEO of Headlands, said, “We don’t try to psychoanalyze our borrowers. If they take [the rate break] and they know they’re going to move some time during the next five years and prepay the loan, that’s fine. We don’t ask that question because you’re allowed to sell without penalty any time.”

Headlands is also involved in the nationwide roll-out of a second oldie but goodie, the graduated payment mortgage, unseen in most places since the early 1980s. Here’s how it works:

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Think of a graduated payment mortgage as a hybrid fixed-adjustable loan with a gradually ascending payment schedule in the early years. You start with a very low rate for the first year, currently 4.89%. That rate is designed to pull in home buyers who couldn’t afford the size loan they need at today’s regular rates.

After one year of payments at the 4.89% start rate, the monthly payment--not the interest rate--in the second year increases by 7.5%. The same payment increase occurs in each of the next four years, and then the loan turns into a standard fixed-rate mortgage.

But you’re not really locked into those graduated increases for any specific number of years. You can bail out--refinance or sell--without penalty any time.

To illustrate one deft use of the loan, say you take out a $250,000 graduated payment mortgage at a 4.89% start rate. Monthly principal and interest come to $1,286.02. That’s $376.48 a month less than the same 30-year loan at a fixed 7%, which is $1,662.50.

At the beginning of the second year, your payment increases by a set amount--a little less than $100 a month--to $1,382.45. You’re still $280 a month cheaper than the 7% alternative. By the third year, you’re paying $1,486. But in the fourth year you get close to the 7% fixed payment--$1,597.60--and in year five you cross the line, with a $1,717 monthly payment.

At this point, you should probably begin looking around for refinancing, unless, of course, interest rates have risen and your graduated payments are lower than what you’d get by refinancing.

One caveat: Your early-year payment savings are financed, in effect, by turning unpaid interest into principal--a process called negative amortization.

When you refinance or sell, you’ll find your loan balance grew by 2% to 3%. But in today’s strong housing appreciation environment, coming up with that extra principal shouldn’t be a major problem.

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Distributed by the Washington Post Writers Group.