Real Estate Financing and Investing/Classification of Mortgages
In no area of real estate terminology is there more diverse classification of terms than with real estate mortgages. The following classification is offered as an aid in explaining the more common typed of mortgages used in financing real estate.
- 1 Method of Payment
- 2 Time Period
- 3 Priority Senior Instruments (First Mortgages)
- 4 Junior Instruments (Second Mortgages)
- 5 Types of Property Pledged
- 6 Flexible Financing Techniques
- 6.1 Graduated Payment Mortgages (GPM)
- 6.2 Flexible Loan Insurance Program (FLIP)
- 6.3 Reverse Annuity Mortgage (RAM)
- 6.4 Adjustable Rate Mortgages (ARM)
- 6.5 Renegotiated Rate Mortgages (RRM)
- 6.6 Shared Appreciation Mortgage (SAM)
- 6.7 Deferred Interest Mortgage
- 6.8 Participation Mortgage
- 6.9 Sale Leaseback
- 7 Help Buyers Compare Mortgage Options
Method of Payment
Straight Term Mortgages
Prior to the Great Depression of the 1930s, the straight term or term mortgage was the common means of financing residential real estate. Under this method of payment, interest only is paid periodically (monthly, quarterly, annually) and the initial amount borrowed, the principal, is not paid until the last day of the loan period. Typically, term mortgages covered short periods of time three to five years and there was normally little intent by either the borrower to repay the principal or the lender to demand payment of the principal.
The original amount borrowed was either extended for another term at an agreed upon interest rate or the borrower would negotiate with a new lender and pay off the old loan. However, as a result of financial conditions during the Depression and the National Housing Act of 1934, which among other things established the Federal Housing Administration, term mortgages became less popular. Borrowers during the Depression were unable to pay the principal when it became due. Because of the tightness in the money supply, lenders were unable to roll these loans over, and thus had to foreclose. Over a million families lost their homes during this time. The failure of the money market led to the creation of the Federal Housing Administration and increased usage of the amortized mortgage. Today, term mortgages are generally used only in the financing of land and construction.
Fully Amortized Mortgages
Unlike the term mortgage where none of the principal is repaid during the life of the mortgage, a fully amortized mortgage requires periodic (typically monthly) payment of both interest and principal. The first part of the payment covers interest on the outstanding debt as of the payment date, and the remainder of the payment reduces the outstanding debt. At the maturity date, the balance has been reduced to zero. The initial payments will consist of more interest than principal reduction; however, the percentage of the periodic payment reducing the subsequent payment is made.
Fully-amortized mortgages are currently the normal means of securing permanent financing. The maturity date is usually much longer than with a term mortgage. For residential property, this type of mortgage usually covers 20 to 40 years and for commercial property the time period is 10 to 15 years.
Partially amortized mortgage also require periodic repayment of principal. However, unlike the fully amortized mortgage, the principal has been only partially reduced. The remaining balance is referred to as a balloon payment.
As a result of higher interest rates and inflation during the early part of this decade, this type of mortgage has become more common in residential financing. Today, some lenders make loans based on, for example, a 30 year amortization schedule but with a five year term. Thus, at the end of five years, the outstanding balance is due.
Besides paying interest and principal each period, a borrower can also be required to pay a certain percentage of annual property taxes and property insurance. For a residential mortgage this means one twelfth of the property taxes and one twelfth of the property insurance each month. The advantage to the borrower is that a budget mortgage allows the spreading out of these annual expenses into 12 equal payments. For the lender, who normally places these funds into an impound or reserve account, the advantage is the assurance that these expenses will be paid when due.
These are also referred to as interim financing. A construction mortgage provides the funds necessary for the building or construction of a real estate project. The project can be a residential subdivision, a shopping center, an industrial park or any other type of property requiring financing during the time required to complete construction. Normally, the full amount to be loaned is committed by the lender, but the actual disbursement of the loan is dependent upon the progress of the construction. Funds are sometimes distributed to the borrower in a series of draws, depending upon the work required by the lender. Another method used is for the developer to submit all bills to the lender, who in turn pays the bills. In either case, interest is paid on what has been distributed and not on the total amount to be borrowed.
Typically, the interest rate charged is tied to the lender`s prime rate, which is the interest rate charged to the lender`s AAA customers. In addition to interest, the borrower is normally charged a 1% or 2% origination fee. Since construction mortgages are considered high risk loans, a lender often requires a standby or take out commitment from a permanent lender. A standby or take out commitment means that another lender will provide permanent financing when a certain event, generally the completion of the project, occurs. This assures the construction lender that permanent financing will be available to repay the construction loan if the project is completed and other conditions are met. Sometimes, permanent lenders require a certain percentage of a project to be rented before the financing is provided.
The permanent loan is used to repay the construction loan. Whereas a construction loan is typically short term in most economies, permanent financing normally covers 10 years or more. Permanent financing will either be fully or partially amortized through periodic mortgage payments.
Since the payment will be paid from the income generated from the project, the lender can make the amount borrowed contingent upon a certain amount of the available space being leased prior to closing the loan transaction. For instance, the developer of a shopping center might be able to borrow $2,000,000 if 80% of the available space is leased. This could result in a gap in the capital needed for financing.
Gap financing often covers a shorter period of time than permanent financing and usually at a substantially higher interest rate. First of all, it is a junior mortgage, which means the lender does not have the same lien position as the permanent lender; second, there is more risk involved. Normally, different types of financing are used. For instance, a commercial bank might provide the construction financing and a real estate investment trust the gap financing. Quite often all of this is arranged through a mortgage broker. Gap financing may also be needed if the conditions set by the permanent lender have not been met and the construction financing has expired. In this case, the gap financing would be senior financing.
Priority Senior Instruments (First Mortgages)
To hold the first mortgage on real estate means that the lender`s rights are superior to the rights of subsequent lenders. This means less risk to the lender, which normally results in a lower interest rate charged to the borrower than charged on second or junior mortgages. Certain lenders only make first mortgages due to regulatory requirements; others limit mortgages to these senior instruments due to company policy.
The majority of permanent residential financing provided in this country is through the fully amortized conventional mortgage. The term "conventional" refers to a mortgage that is not FHA insured or VA guaranteed. Since there is not third party to insure or guarantee the mortgage, the lender assumes full risk of default by the borrower. A lender`s decision to make a conventional loan is usually dependent upon: (1) the value of the property being used to secure the debt and (2) the credit and income position of the borrower. As more and more conventional loans have been made, the loan to value ratio (relationship between amount borrowed and the appraised value of the property) has continued to increase, even though most lenders still limit the amount they will lend to no more than 80% of value unless private mortgage insurance is carried.
This down payment requirement is higher than with either FHA or VA loans. As the market price of residential real estate has continued to increase, more cash down payment has been required of the borrower, and thus many people have been eliminated from financing with a conventional mortgage. With both insured and guaranteed mortgages, people have been able to purchase real estate with a smaller cash down payment.
Federal Housing Administration Insured Mortgages (FHA)
In 1934, Congress passed the National Housing Act, thus establishing the Federal Housing Administration (FHA) which immediately resulted in more construction jobs for the unemployed. This in turn helped to stimulate the depressed economy. In order to provide the means by which these new homes could be purchased, FHA (www.fha-home-loans.com/) established an insurance program to safeguard the lender against the risk of nonpayment by people purchasing these homes. The result was that the majority of homes financed were FHA insured. Even though the percentage of homes insured under FHA coverage has continued to decrease, the standards and requirements under FHA programs have been credited with influencing lending policies and techniques in financing residential real estate.
Under an FHA insured mortgage, both the property and the borrower must meet certain minimum standards. The borrower is charged an insurance fee of one half percent on the unpaid balance and can, under certain conditions, receive up to 97% financing on the appraised value of the property.
If a purchaser using FHA financing is paying more than the appraised value, the difference between the appraised value and the sales price must come from the purchaser`s assets. Borrowers are not permitted to obtain second mortgages to use as down payments. Also, FHA sets limits as to the maximum loan origination fee charged by the lender. The subject property must be appraised prior to the loan being made; this fee is normally absorbed by the mortgagor. FHA insures these loans for up to 30 years. Thus, the low closing costs, the relatively low down payment and the long amortization period permitted under FHA have all aided in providing residential financing for millions of people who otherwise would not have been able to purchase a home. On a conventional mortgage, the interest rate is determined by the lender rather than by the Secretary of Housing and Urban Development.
This rate is periodically raised or lowered to reflect changes in the cost of money, although historically, interest rates on FHA mortgages have been slightly below conventional mortgage interest rates. In addition, borrowers financing with FHA coverage may be charged discount points since points can be paid by either the buyer or the seller. In recent years, FHA has expanded its operation; currently, the agency administers a number of programs dealing with housing. The basic home mortgage program is normally referred to as 203(b), and the program which provides insured mortgages for low or moderate income families is referred to as 221 (d)(2).
Veterans Administration Loan Guaranty Program (VA)
Included in the Servicemen`s Readjustment Act of 1944 were provisions covering the compensation to lenders for losses they might sustain in providing financing to approved veterans. The maximum guaranteed amount, which has periodically been increased, is set by the VA (www.va.gov/ and www.homeloans.va.gov/faqelig.htm) as is the maximum interest rate charged by lenders. There are no provisions on the upper limits of the loan to value ratio, which means that it is quite common for an approved veteran to receive 100% VA financing. It should be noted that some lenders set limits on how much they will finance using VA financing. VA guarantees loans up to 30 years.
To qualify for VA financing the veteran applies for a certificate of eligibility. The property as well as the borrower must qualify. If the property is approved a certificate of reasonable value is issued. As is true with FHA, junior financing is essentially prohibited under VA. (Junior financing is rare and its terms keep it rare.) Coverage also extends to the financing of mobile homes, condominiums and nonreal estate purchases such as farm equipment and business loans. A VA loan is assumable; however, unless released by the lender, the veteran who borrowed the funds initially remains liable to the lender. Lenders cannot insert prepayment penalties under either VA or FHA loans. A mortgage without a prepayment penalty is commonly referred to as an open mortgage while one that cannot be prepaid is a closed mortgage. VA limits the points charged to the buyer to one point. Any other points must be paid by the seller.
California Farm and Home Purchase Program (CAL VET)
The Cal Vet (www.cdva.ca.gov/calvet/) began in 1921 as a program to assist California veterans in acquiring suitable farm or home property at low financing cost. It is a complete financing program within the Cal Vet office. The funds for financing come from the authorized sale of state general obligation bonds approved by the voters, and most recently from the sale of revenue bonds authorized by the legislature. The department purchases the property from the seller, and then sells to the qualified veteran on a land contract. The veteran holds equitable title, while the department holds legal title.
To be eligible, veterans must use their benefits within 30 years of their date of release from active military duty. No time limit is placed on those who were wounded, disabled, or prisoners of war. Nearly any veteran wanting to buy a home in California is eligible. They currently have funds for all qualified wartime era veterans, regardless of when they served in the military. They also have funds available for peacetime veterans who meet the criteria for Revenue Bond funds (first-time homebuyers or purchasers in targeted areas who meet income and purchase price limitations). There are no residency restrictions. Veterans are eligible regardless of where they entered service. Only one loan may be active at any time; however, a second loan is possible if the veteran served during multiple war periods.
The loan includes single family homes, condominiums, town houses, and mobile home on land owned by the borrower.
Insured Conventional Loan
An insured conventional loan is one which is insured by a private (nongovernmental) insurance company. The establishment of FHA insured loans and VA guaranteed loans resulted in higher loan to value ratios and longer amortization periods than lenders were willing to offer under conventional financing. As the costs of housing continued to increase year after year, some means of providing protection against loss of high loan to value conventional mortgages was needed. Thus, in 1957, the Mortgage Guaranty Insurance Corporation (MGIC) or "Magic" as it is normally referred to, established a private mortgage insurance program (PMI) for approved lenders.
MGIC offered the lender quicker service and less red tape than FHA. Today private mortgage insurance companies insure more loans than both FHA and VA. Unlike FHA, which insures the whole loan, PMI insures only the top 20 or 25% of the loan, and the insurer normally relies on the lender to appraise the property. While the majority of PMI loans are for 90% loan to value, coverage does extend to a maximum of 95%. On a 90% loan, the borrower is normally charged one half of 1% at closing and one fourth of 1% of the outstanding balance each year thereafter. With a 95% loan, the rate is normally 1% of the loan at closing plus 1/4% of the outstanding balance each year the insurance is carried. Since only the top portion of the loan is covered, once the loan to value drops below a certain percentage, the lender may terminate the coverage, and thus, the insurance premium is no longer charged to the customer. In case of default, the insurance company can either pay off the loan or let the lender foreclose and pay the loss up to the amount of the insurance coverage.
Junior Instruments (Second Mortgages)
A junior mortgage is one which has a lower priority or lien position than a first mortgage. A third or even a fourth mortgage is also classified as a junior mortgage. What established a mortgage as being a junior mortgage is that it was recorded after the first mortgage was recorded and thus its lien position is inferior to the first mortgage.
Purchase Money Mortgages (PMM)
The term purchase money mortgage has a dual meaning in real estate financing. All mortgage loans for real estate purchases are designated purchase money mortgages by lenders, and thus all the different types of mortgages explained could be classified as purchase money mortgages. The second meaning of the term explains what happens when the buyer does not have the necessary cash and the seller agrees to take back a part of the selling price in the form of a purchase money mortgage. Such a mortgage is ordinarily subordinated to take a second lien position since the primary lender will require a first lien position before making the loan. For the purchaser, this means less cash and possibly an interest rate on the PMM less than if those same dollars were borrowed from a primary lender. The seller can possibly induce a sale not otherwise possible by agreeing to take back a purchase money mortgage. The seller is protected in that a PMM places a lien on the property the same as any other second mortgage.
Home Improvement Loans
In recent years, one result of increased housing costs and higher market prices has been the relatively fast equity build up for owners of real estate. To an owner, this equity can become a source of capital that can be drawn out of the home for home improvements, personal or business reasons. Numerous commercial banks and finance companies make short term (three to five years) junior mortgages based on a percentage of the homeowner`s equity. Since they are junior mortgages, such loans normally carry an interest rate three or four percentage points above that charged on senior instruments.
Wrap Around Mortgages
As its name implies, a wrap around mortgage (or deed of trust) is a junior mortgage that wraps around an existing first mortgage. It is also called all inclusive trust deed (AITD). This method of obtaining additional capital is often used with commercial property where there is substantial equity in the property and where the existing first mortgage has an attractive low interest rate. By obtaining a wrap around, the borrower receives dollars based on the difference between current market value of the property and the outstanding balance on the first mortgage. The borrower amortizes the wrap around mortgage which now includes the balance of the first mortgage, and the wrap around lender forwards the necessary periodic debt service to the holder of the first mortgage. Thus, the borrower reduces the equity and at the same time obtains an interest rate lower than would be possible through a normal second mortgage. The lender receives the leverage resulting from an interest rate on the wrap around greater than the interest paid to the holder of the first mortgage.
The sale price is $300,000. There is a mortgage balance of $200,000 payable at 9% interest. The buyer will pay $30,000 cash down and agrees to pay the balance at 11%. By using the wrap around mortgage, the seller can have the buyer agree to a mortgage of $270,000 at 11%; the buyer makes the applicable monthly payment to the seller. The seller, in turn, continues to make payments on the underlying first mortgage which was written at 9%. This means that the seller, in his or her role as a mortgagee, now earns 11% on $70,000 (the difference between the new mortgage of $270,000 and the existing mortgage of $200,000) and 2% on the existing $200,000 loan.
The seller grants a deed to the buyer in the regular way. Note that for this method to work, the original lender must be agreeable to the seller transferring title.
Types of Property Pledged
Quite often the sale of real property includes certain items and equipment as part of the sales price. Rather than acquiring separate mortgages on each of these items, the buyer can, through the use of a package mortgage, finance both the real property and the personal property. In residential real estate, a builder might include a stove, refrigerator, dishwasher or air conditioning in the sales price. For commercial real estate, certain equipment or furniture is often included in the sales price. The advantage to the purchaser is that these items can be financed over a much longer period and at a much lower interest rate than if a separate financial instrument was used. For the builder or seller, these items often serve as inducements used in financing the sale.
A blanket mortgage is often used by a developer to cover more than one parcel of land under the same mortgage. For example, a developer buys a large tract of land and plans to subdivide the land into 100 lots and then build homes on the lots. Rather than going to the expense and time of obtaining 100 separate mortgages, one blanket mortgage covering all the lots is obtained. Since the developer will probably be developing a few lots at a time, the mortgage will include a partial release clause which means that as the debt is paid, individual lots will be released from the mortgage. Thus, the developer can pay off part of the mortgage, have a certain number of lots released, build on the lots and then sell them free and clear from the lien that still exists on the unreleased lots.
Mobile Home Loans
Certain lenders, although not all, make loans on mobile homes. Typically, the amount financed is far much less than the average residential loan, and the amortization period is much shorter, perhaps seven to 10 years, even though longer terms are available under both FHA and VA financing. The amortization period is usually shorter since, unlike a permanent home, a mobile home normally depreciates in value, and thus, the lender wants to be repaid over a shorter period of time. A fear of some lenders is that since mobile homes are not permanently affixed to the land, the security for the loan, the mobile home, can be moved by a dishonest borrower, thus, not all lenders make mobile home loans.
Also referred to as an installment sales contract, a land contract involves the seller`s accepting a down payment on a parcel of land and a series of periodic payments of principal and interest. However, unlike other types of financing, title to the property does not pass until the last payment has been received. Although called a land contract, this means of financing can also be used to purchase improved land. Rules relating to land contracts differ from state to state. For instance, some states require that title be passed when a certain percentage of the loan has been paid by the borrower.
Lease hold Mortgages
Sale leaseback are used by owners of commercial property as a means of raising capital. The process involves the simultaneous selling and leasing back of the property usually through a net lease. The advantages to the seller include the freeing of capital previously tied up in the project and the inclusion of the rental payment as a legitimate operating expense for income tax purposes. For the investor, the rental payment represents a return on investment and any depreciation for tax purposes or increases in value due to market conditions accrue to the investor.
Land Leases (Ground Leases)
A ground lease is ordinarily a long term lease for a parcel of unimproved land. The tenant pays what is known as a ground rental and pays all taxes and other charges associated with ownership. The landlord receives a net amount which may have an escalation clause to periodically adjust the ground rental so that the property reflects the changing values of the land.
Normally, a ground lease contains a subordination clause. A subordination clause is an agreement that the first lien holder will agree to take a junior position to another lien holder. Without a subordination clause, it may be more difficult to construct improvements on the land. A lender, without a subordination agreement by the leasor of the land, will only consider the value of the leasehold in making a loan, while with a subordination will consider the full value of the property.
In certain parts of the country, most notably Baltimore, Maryland, the land under residential real estate is leased through a long term lease agreement whereby the owner of the land receives periodic rent for the use of the land. Such an agreement covers an extended period of time, possibly 99 years, renewal at the lessee`s option and results in a lower purchase price of the home, since the land is not owned in fee simple. Thus , less money has to be borrowed. The owner of the ground rent has a superior lien position to that of the lender, and therefore the lender normally requires the borrower to include the ground rent as part of the monthly debt service. State status regulate land leases.
Flexible Financing Techniques
As conditions and needs change, new and more flexible financing techniques have been introduced by lenders. The switch from term mortgages to fully amortized mortgages and the increase in the loan to value ratio are examples of such action. While no one is sure as to exactly what lies ahead, a number of different types of financing techniques are currently being used.
Graduated Payment Mortgages (GPM)
Under the fully amortized mortgage, each month`s payment is exactly the same. The obvious advantage is that when securing a mortgage the borrower is assured of a level or constant mortgage payment. However, for some purchasers the required monthly payment is so high that a lender will not make the loan simply because the borrower`s income is insufficient. With a GPM, monthly mortgage payments start at an amount less than would be required under a level annuity payment and increase periodically over the life of the mortgage. Therefore, the borrower can finance a larger purchase than if the monthly payment were level throughout the life of the mortgage. FHA has a number of GPM programs currently available.
Flexible Loan Insurance Program (FLIP)
This is a graduated payment mortgage developed to overcome the negative amortization aspects of the GPM. The key to the FLIP mortgage is the use of the buyer`s down payment. Instead of being used as a down payment, the cash is deposited in a pledged, interest bearing savings account where it serves as both a cash collateral for the lender and as a source of supplemental payments for the borrower during the first few years of the loan.
During the early years of the mortgage, each month the lender withdraws predetermined amounts from the savings account and adds them to the borrower`s reduced payment to make a full normal mortgage payment. The supplemental payment decreases each month and vanishes at the end of a predetermined period (usually five years). By using this type of program, a borrower is likely to qualify for a larger loan than with a conventional fully amortized mortgage.
Reverse Annuity Mortgage (RAM)
Reverse mortgages are a way for seniors to enjoy their retirement as well as cope with inflation and what comes with it. The reverse mortgage enables older homeowners to convert part of the equity in their homes into income without having to sell, give up title or make monthly payments. Homeowners must be 62 or older to be eligible. In a reverse mortgage, the lender pays the homeowner - the opposite of a traditional mortgage where the homeowner pays the lender. The homeowner has the option to receive monthly payments, a lump sum payout, a line of credit or any combination.
Adjustable Rate Mortgages (ARM)
It is also known as variable rate mortgages (VRM). Under ARM, the interest rate charged by the lender can vary according to some reference index not controlled by the lender, such as the Cost of Living Index, the San Francisco District 12 Cost of Funds, the 1 year United States T Bill, and the London Interbank Offered Rate (LIBOR). For the lender, this means that as the cost of money increases, the interest being charged on the existing mortgage can be increased, thus maintaining the gap between the cost of money and return. Either the monthly payment, the maturity date or both can be changed to reflect the difference in interest rates. In addition, the mortgage usually stipulates a maximum annual charge and a maximum total increase in the interest the lender may charge. Under current regulations established by the FHLBB, the interest rate may not be raised more than 2.5% points above the initial rate. The rate can be changed each 6 month, with no more than 1/2 of 1% change each 6 months.
The 11th District Index, which is probably the most widely used benchmark for ARMs is computed by the Federal Home Loan Bank of San Francisco. It reflects the cost of deposits at savings and loans in California, Arizona and Nevada. Most ARMs written in California in recent years are tied to this index.
Renegotiated Rate Mortgages (RRM)
The renegotiated rate mortgages, also known as the rollover mortgages, helps the lender to avoid being locked in to an interest rate that is below the cost of money. Here, at intervals such as 3 to 5 years, the loan is renewed at the going rate; the borrower is guaranteed at least a 30 year term and can pay off the loan without penalty at any time. If rates go up, so would payments if the loan was renewed, but the borrower could shop around to get the best deal.
A shared appreciation mortgage is a type of equity participation loan in that in exchange for charging a below market interest rate, the lender receives a predetermined percentage of any increase in value of the property over a specified period of time. For the lender, the money received from the appreciation of the property increases the effective yield on the investment. The borrower ,by agreeing to share the interest rate, in turn reduces the monthly mortgage payment. A SAM is normally written so that at the end of the shared appreciation period, the property will be appraised and the amount due to the lender through appreciation is due at that time.
Deferred Interest Mortgage
This financing technique is aimed at those people who only plan to live in a house for a short period of time. Under this mortgage, a lower interest rate and thus a lower monthly mortgage payment is charged. Upon the selling of the house, the lender receives the deferred interest plus a fee for postponing the interest that would normally have been paid each month.
This term, when used to classify types of mortgages, has numerous meanings. One common type of participation mortgage is when more than one mortgagee lends on a real estate project, such as with a large commercial project. A second type of participation mortgage involves more than one borrower being responsible for a mortgage, such as with a cooperative apartment. Finally, a participation mortgage also represents an agreement between a mortgagee and a mortgagor which provides for the lender having a certain percentage ownership in the project once the lender makes the loan.
A sale leaseback is a situation in which an owner of property sells the property to an investor and then leases the property back, usually for a twenty or 30 year term.
Jay sells a property to Laura for $500,000 and agrees to lease it at a net rental to give her a 10% return on her investment. Jay will receive $500,000 in cash and will keep the property, pay Laura a net amount of $50,000 each year. At the end of the term, the property will revert to Laura.
Help Buyers Compare Mortgage Options
Buyers face a big challenge in choosing a mortgage, but you can help them get off to a good start. How do you know which mortgage option is best for a particular buyer? Even if economic experts could agree about what will happen to interest rates during the next year, you still shouldn't choose a type of mortgage for a buyer. What you should do is stay as informed as possible about mortgage options. Then you can give buyers information that will help them make informed decisions. This section discusses some of the mortgage instruments currently used, as well as some of the features of those mortgages.
The most popular and traditional mortgage is the fixed-rate, which involves making regular payments based on a fixed interest rate. Unless interest rates exceed "comfortable" levels (typically about 10 percent), buyers are likely to choose this type of mortgage. According to the Federal National Mortgage Association (Fannie Mae), first time buyers often choose fixed-rate mortgages because they want the security of stable and affordable payments. Also according to Fannie Mae, financially motivate buyers may choose fixed-rate mortgages because they want low monthly payments throughout the loan term.
For instance, because homes in some areas may appreciate more slowly than those in other areas, some people prefer to make low monthly payments so that they can put the money they save into other investments that bring greater returns. Also, buyers can reap the greatest cumulative tax deductions available over the loan term.
Generally, lenders require 20 percent down payments on conventional fixed-rate mortgages, but with Federal Housing Administration (FHA) insurance, only 5 percent is required.
Also, private mortgage insurance (PMI) can help buyers purchase a home with only a 10 percent down payment. As the name implies, buyers purchase PMI through private companies but lenders typically acquire the insurance for the buyers. First-year premiums are usually between .35 and 1.65 percent of the total loan amount, and depending on policy requirements, buyers must pay the premiums either in advance or monthly.
A twist on the 30-year fixed-rate mortgage is the shorter-term fixed-rate mortgage, with either a 10- or 15-year loan term. These shorter terms require larger monthly payments than a 30-year term, but the benefits that often attract buyers include the lower interest rates, faster equity buildup, and a substantial interest savings over 30-year mortgages.
With biweekly fixed-rate mortgages, payments are about one-half those of monthly fixed-rate mortgages with the same amortization schedule, and they`re drafted automatically from the borrower`s bank account every other week. Borrowers make the equivalent of 13 monthly payments in just 12 months, and as a result, they save on interest and their equity builds faster. Biweeklies amortize every two weeks rather than monthly, and loan amortization terms of 10,15,20, and 30 years are available.
Adjustable-rate mortgages (ARMS) are a little riskier than fixed-term mortgages. In exchange for lower initial interest rates, borrowers take the risk that if lending rates rise, their payments will also rise.
With ARMs, rates are adjusted during the term of the loan according to changes in market interest rates. Borrowers typically choose a six-month or one- or three-year ARM, and as the names imply, the rate remains stable for the first six months, year, or three years. (There are, of course, other kinds of ARMs, which are also classified according to the frequency of their payment adjustments.) A per adjustment cap and a lifetime cap on the level to which the interest rate may be adjusted can help reduce some of the risk, and these are available on some ARMs, as are 15- and 30-year loan terms, and options to convert to fixed-rate mortgages.
Why do some borrowers opt for ARMs? Those who expect to move within a few years will often choose an ARM because of the low initial interest rates and then resell the home before the rates are adjusted. Borrowers refinancing their current mortgages may also choose ARMs if the lower initial interest rates can make up for the transaction costs of refinancing.
Remember, though, lenders use different indexes on which to peg their ARMs. The index used will determine the payments during the loan term. For example, cost-of-funds indexes are tied to the interest rates on savings accounts. Many lenders, however, now use the one-year U.S. Treasury securities index or the 11th-district cost of funds index to adjust their ARMs.
Also, treatment of closing points can be different with ARMs. A few lenders allow buyers to spread the cost of closing points in equal monthly installments over the first two years of the loan. Buyers should check the deductibility of these payments with their tax adviser.
With most loans, the payments cover the principal and interest, and the borrower will have repaid the loan by the end of the loan term. But some borrowers are taking more risks by using negative amortization loans. In those cases, monthly payments fall short of what the borrowers must pay to cover both the principal and the interest of the loan, and at the end of the year, the borrowers actually owe more than they owed before they make 12 payments. Why would a borrower do this? Lower monthly payments are available with negative amortization loans, and most often, borrowers who take this risk are buying in markets with extremely high prices. Many gamble that their home will appreciate enough to cover the difference between their payments and the new loan amount.
Taking Known Risks
Some borrowers are willing to take risks if they know the risks in advance. With graduated payment mortgages (GPMs) or growing equity mortgages (GEMs), payments increase during the loan term. Borrowers can plan for the larger payments because they know exactly how much the payments will increase. The difference between GPMs and GEMs is the treatment of the amortization schedule. GEMs are calculated on 30-year fixed terms, even though payments increase during the loan term. As a result, a 30-year loan is often paid within 15 to 20 years. With GPMs, the increase payments are scheduled within the 30-year term, and the "overpayments" are applied directly to the loan principal. The FHA offers five different types of GPMs, and the Veterans Administration (VA) offers its own GPM and GEM plans.
Let the VA Take Risks
Except for its GPMs and GEMs, loans guaranteed by the VA require no down payment, and a builder or seller may pay closing costs for the buyer.
The VA also offers veterans a buyer-down purchase plan in which the seller pays the lender to lower the borrower`s interest rate either temporarily or permanently. In permanent buy-downs, sellers will typically offer to make the interest rate 1 percent below the maximum rate set by the VA for the entire 15- or 30-year loan term. With temporary plans, the 3 2 1 option is common. The interest rate is reduced 3 percent during the first year, 2 percent during the second year, and 1 percent during the third year. Then payments increase to normal levels for 30-year terms. Finally, to increase the options when a borrower decides to resell, no VA loans have due-on-sale clauses. Thus, another buyer may assume the veteran`s loan at the original interest rate, or the veteran may incorporate a second mortgage, a wraparound, a contract for deed, or a lease purchase without the original lender`s approval.
Let the FHA Take Risks
Not only does the FHA insure loans for lenders but also its insurance makes it possible for buyers to purchase a home with a small down payment. Under the FHA`s 203b plan, virtually any U.S. resident 18 years or older can purchase a home with a 15- or 30-year fixed-rate loan and a 3 percent down payment on the first $25,000 of value and closing cost and 5 percent on the remainder. Another FHA option is the shared equity mortgage (SEM), whereby a marginal buyer can pair up with a relative or investor to purchase a home. With an SEM, loans often go as high as 97 percent of the home`s value. Each investor owns a percentage of the home, and monthly payments are based on those percentages.
If buyers are considering a home with an assumable mortgage at a fair interest rate or if the sellers have already paid their mortgage, remember to consider seller financing. With seller financing the seller determines the sales price and then acts much like a lender. He determines the amount of down payment necessary and the other terms of sale.
Seller financing becomes more common when interest rates are high and buying a home is out of reach for many who could otherwise afford it. But regardless of interest rates, this option helps qualify people to buy who might not be able to qualify for a loan through a lending institution or who may have the income to afford monthly payments but not the cash for a down payment. With seller financing, borrowers whom lenders might consider marginally qualified not only may qualify to buy but also may save money because closing costs are often nonexistent or less expensive than with lender financing. Why would a seller take the risk? Often, seller financing produces returns that are substantially higher than those of most other investments. Also, seller financing is treated as an installment sale for tax purposes. Finally, if the buyer defaults, the seller can take the property back under the contract or, if absolutely necessary, he can foreclose on the property.
A seller can also offer a wraparound mortgage to a buyer who already owns a home. With this option, the seller makes a money advance to cover or "wrap" the balance due on the old mortgage and the amount on the new loan at an interest rate below market levels. The term of the wrap is the time left on the old mortgage. So with the seller`s help, the buyer`s monthly payment is substantially less than for a new first mortgage at the higher interest rate.
Helping Find the Right Option
Maybe some of the buyers you`re working with want to purchase a home, but they want low monthly payments so that they can save for their children`s college education. Or maybe some of your prospects haven`t saved enough money to afford a down payment on the home they`re interested in, but they want to invest in a home rather than pay rent each month.
Today's buyers have many financing options, and the challenge for them is to find the option that best suits their special circumstances. Your knowledge about their options can help ensure that their first step is the right one.