If you've been thinking about buying a home, you may wonder how to select the right financing for your budget and needs. This Financial Guide explains the basics of most of the mortgage loans that are available today.
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If you've been thinking about buying a home, you may be wondering how to select the best way to finance your purchase. With so many choices available--from traditional fixed rate loans to adjustable rate loans and reverse mortgages--it's more important than ever to educate yourself in order to find the right mortgage for your needs.
Many people prefer a traditional or a fixed-rate mortgage with fixed monthly payments, a fixed interest rate, and full amortization (or transfer of equity) over a period of 20 to 30 years. Because the interest rate is fixed, monthly payments that remain constant over the life of the loan and there is a maximum (and known) amount on the total amount of principal and interest that you pay during the loan. Traditionally, these mortgages have been long-term. As the loan is repaid, ownership shifts gradually from lender to buyer. These features work in the buyer's favor because inflation makes your payments seem less and your property worth more. So, although the payments seem hard to meet, at first, that monthly payment becomes easier over time.
On the other hand, many home financing plans today differ materially from traditional mortgages. They may help you buy a home you couldn't otherwise afford, but they may also involve greater risks for buyers. For example, the interest rate and monthly payments may change during the loan to reflect what the market will bear. Or the interest rate may fluctuate while the payments stay the same, and the amount of principal paid off may vary. The latter approach allows the lender to credit a greater portion of the payment to interest when rates are high.
Some plans also offer below-market interest rates, but they may not help you build up equity.
When shopping for financing sources today, keep the following in mind:
These concepts will be discussed in greater detail as we explore the different types of non-traditional financing.
The 15-year mortgage is a variation of the fixed-rate mortgage that is becoming increasingly popular. This mortgage has an interest rate and monthly payments that are constant throughout the loan. But, unlike other plans, this loan is fully paid off in only 15 years. And, it is usually available at a slightly lower interest rate than a longer-term loan. But it also requires higher payments.
In the 15-year mortgage, you pay off the loan balance faster than a long-term loan. Because of this, a smaller proportion of each of your monthly payments goes to interest.
Adjustable-Rate Mortgage (ARM)
If you see an ad for a low-rate mortgage, it might be for an adjustable rate mortgage (ARM). These loans may have low rates for a short time, maybe only for the first year. After that, the rates can be adjusted on a regular basis. This means that the interest rate and the amount of the monthly payment can go up or down.
With an adjustable-rate mortgage, your future monthly payment is uncertain. Some types of ARMs put a ceiling on your payment increase or rate increase from one period to the next. Virtually all must put a ceiling on interest-rate increases over the life of the loan.
Today, many loans have interest rates (and monthly payments) that can change from time to time. To compare one ARM with another or with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps, negative amortization, and convertibility. You need to consider the maximum amount your monthly payment could increase.
Most important, you need to compare what might happen to your mortgage costs with your future ability to pay.
Interest Rate Variation. Adjustable rate mortgages have an interest rate that increases or decreases over the life of the loan based upon market conditions. Some lenders refer to adjustable rates as flexible or variable.
In most adjustable rate loans, your starting rate, or "initial interest rate," will be lower than the rate offered on a standard fixed rate mortgage. This is because your long-term risk is higher your rate can increase with the market so the lender offers an inducement to take this plan.
Changes in the interest rate are usually governed by a financial index. If the index rises, so may your interest rate. If it falls, your interest rate also falls.
Rate Caps. To build predictability into your adjustable rate loan, some lenders include provisions for rate caps that limit the amount of any interest rate change. These provisions limit the amount of your risk. A periodic rate cap limits the amount the rate can increase at any one time. Because they limit the lender's return, capped rates may not be available through every lender.
Many flexible rate mortgages offer the possibility of rates that may go down as well as up. In some loans, if the rate can only increase 5 percent, it may only decrease 5 percent. If no limit is placed on how high the rate can go, there may be a provision that also allows your rate to go down along with the index.
If the interest rate on your adjustable rate loan increases and your loan has a payment cap, your monthly payments may not rise, or they may increase by less than changes in the index would require.
Negative Amortization. If your ARM contains a payment cap be sure to find out about "negative amortization." Negative amortization means the mortgage balance is increasing and occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage.
Because payment caps limit only the amount of payment increases, and not interest-rate increases, payments sometimes do not cover all of the interest due on your loan. This means that the interest shortage in your payment is automatically added to your debt, and interest may be charged on that amount. You might, therefore, owe the lender more, later in the loan term than you did at the start. However, an increase in the value of your home may make up for the increase in what you owe.
Prepayment and Conversion
If you get an ARM and your financial circumstances change, you may decide that you don't want to risk any further changes in the interest rate and payment amount. When you are considering an ARM, ask for information about prepayment and conversion.
Variations of Adjustable Rate Mortgages. Another variation of the adjustable rate mortgage is to fix the interest rate for a period of time, 3 to 5 years, for example, with the understanding that the interest rate will then be renegotiated. These variations are:
Shopping for a Mortgage
When shopping for any type of adjustable rate mortgage, always remember to ask about the following:
Balloon mortgages have a series of equal monthly payments and a large final payment. Although there usually is a fixed interest rate, the equal payments may be for interest only. The unpaid balance, frequently the principal or the original amount you borrowed, comes due in a short period, usually 3 to 5 years.
Some lenders guarantee refinancing when the balloon payment is due, although they do not guarantee a certain interest rate. The rate could be higher than your current rate. Other lenders do not offer automatic refinancing.
A balloon note may also be offered by a private seller who is continuing to carry the mortgage he or she took out when purchasing the home. It can be used as a second mortgage where you also assume the seller's first mortgage.
Graduated Payment Mortgage
Graduated payment mortgages (GPM) are designed for home buyers who expect to be able to make larger monthly payments in the near future. During the early years of the loan, payments are relatively low. They are structured to rise at a set rate over a set period, say 5 or 10 years. Then they remain constant for the duration of the loan.
Even though the payments change, the interest rate is usually fixed. So during the early years, your payments are lower than the amount dictated by the interest rate. During the later years, the difference is made up by higher payments. At the end of the loan, you will have paid off your entire debt.
The growing equity mortgage (GEM) is tailored for first-time home buyers or young families whose incomes are likely to rise. These mortgages combine a fixed interest rate with a changing monthly payment. The interest rate is usually a few percentage points below market. Although the mortgage term may run for 30 years, the loan will frequently be paid off in less than 15 years because payment increases are applied entirely to the principal.
Monthly payment changes are based on an agreed-upon schedule of increases or an index.
With this approach, your income must be able to keep pace with the increased payments. The plan does not offer long-term tax deductions. However, it can permit you to pay off your loan and acquire equity rapidly.
Shared Appreciation Mortgage (SAM)
In the shared appreciation mortgage (SAM), you make monthly payments at a relatively low-interest rate. You also agree to share with the lender a sizable percent (usually 30 to 50 percent) of the appreciation in your home's value when you sell or transfer the home or after a specified number of years.
Because of the shared appreciation feature, monthly payments in this plan are lower than in many other plans. However, you may be liable for the dollar amount of the property's appreciation even if you do not wish to sell the property at the agreed-upon date.
There are many variations of this idea, called housing equity plans in the US. Some are offered by lending institutions and others by individuals.
Another variation may give your partner tax advantages during the first years of the mortgage, after which the partnership is dissolved. You can buy out your partner or find a new one. Your partner helps make the purchase possible by putting up a sizable down payment and/ or helping make the monthly payments. In return, your partner may be able to deduct a certain amount from his or her taxable income.
Shared appreciation and shared equity mortgages were partly inspired by rising interest rates and partly by the notion that housing values would continue to grow over the years to come. If property values fall, these plans may not be available.
An assumable mortgage is a mortgage that can be passed on to a new owner at the previous owner's interest rate.
During periods of high rates, most lending institutions are reluctant to permit mortgage assumptions, preferring to write a new mortgage at the market rate. Some buyers and sellers are still using assumable mortgages, however. This has recently resulted in many lenders calling in the loans under "due on sale" clauses. Because these clauses have increasingly been upheld in court, many mortgages are no longer legally assumable. Be especially careful, therefore, if you are considering a mortgage represented as assumable.
Seller "Take-Back" Mortgages
This mortgage, provided by the seller, is frequently a second trust and is combined with an assumed mortgage. The second trust (or second mortgage) provides financing in addition to the first assumed mortgage, using the same property as collateral. (In the event of default, the second mortgage is satisfied after the first).
Seller take-backs frequently involve payments for interest only, with the principal due at maturity. Some private sellers are also offering first trusts as take-backs. In this approach, the seller finances the major portion of the loan and takes back a mortgage on the property.
Another variation on the second mortgage is the wraparound. Wraparounds may cause problems if the original lender or the holder of the original mortgage is not aware of the new mortgage. Upon discovering this arrangement, some lenders or holders may have the right to insist that the old mortgage be paid off immediately.
Borrowed from commercial real estate, this plan enables you to pay below-market interest rates. The land contract or installment sale agreement as it is also known permits the seller to hold onto his or her original below-market rate mortgage while "selling" the home on an installment basis. The installment payments are for a short term and may be for interest only. At the end of the contract the unpaid balance, frequently the full purchase price, must still be paid.
A buy-down is a subsidy of the mortgage interest rate that helps you meet the payments during the first few years of the loan. There are several things to think about in buy-downs:
There are also plans called consumer buy-downs. In these loans, the buyer makes a sizable down payment, and the interest rate granted is below market. In other words, in exchange for a large payment at the beginning of the loan, you may qualify for a lower rate on the amount borrowed. Frequently this type of mortgage has a shorter term than those written at current market rates.
In a climate of changing interest rates, some buyers and sellers are attracted to a rent-with-option-to-buy arrangement. In this plan, you rent property and pay a premium for the right to purchase the property within a limited time period at a specific price. In some arrangements, you may apply part of the rental payments to the purchase price.
This approach enables you to lock in the purchase price. You can also use this method to buy time in the hope that interest rates will decrease. From the seller's perspective, this plan may provide the buyer time to obtain sufficient cash or acceptable financing to proceed with a purchase that may not be possible otherwise.
If you already own your home and need to obtain cash, you might consider the reverse annuity mortgage (RAM) or equity conversion. In this plan, you obtain a loan in the form of monthly payments over an extended period of time, using your property as collateral. When the loan comes due, you repay both the principal and interest.
A RAM is not a mortgage in the conventional sense. You can't obtain a RAM until you have paid off your original mortgage. Suppose you own your home and you need a source of money. You could draw up a contract with a lender that enables you to borrow a given amount each month until you've reached a maximum of, for example, $10,000. At the end of the term, you must repay the loan. But remember, if you do not have the cash available to repay the loan plus interest, you will have to sell the property or take out a new loan.
Before going ahead with a creative home loan, have a lawyer or other expert help you interpret the fine print. You should consider some of the situations you could face when paying off your loan or selling your property. And make sure you understand the terms of your agreement such as acceleration clauses, due on sale clauses, and waivers.
An acceleration clause allows the lender to speed up the rate at which your loan comes due. Suppose you've missed a payment, and your contract gives the lender the right to "accelerate" the loan when a payment is missed. This means that the lender now has the power to force you to repay the entire loan immediately.
Sample acceleration clause: "In the event any installment of this note is not paid when due, time being of the essence, and such installment remains unpaid for thirty (30) days, the Holder of this Note may, at its option, without notice or demand, declare the entire principal sum then unpaid, together with secured interest and late charges thereon, immediately due and payable. The lender may without further notice or demand invoke the power of sale and any other remedies permitted by applicable law."
A due on sale clause gives the lender the right to require immediate repayment of the balance you owe if the property changes hands. Here's an example of a due on sale clause: "All or any part of the Property or an interest therein is sold or transferred by Borrower without Lender's prior written consent...or, "Lender may, at Lender's option, declare all the sums secured by this Mortgage to be immediately due and payable."
Due on sale clauses have been included in many mortgage contracts for years. They are being enforced by lenders increasingly when buyers try to assume sellers' existing low rate mortgages. In these cases, the courts have frequently upheld the lender's right to raise the interest rate to the prevailing market level. So be especially careful when considering an "assumable mortgage." If your agreement has a due on sale provision, the assumption may not be legal, and you could be liable for thousands of additional dollars.
To buy or sell a home today, it's important to know the vocabulary. Understanding terms like amortization or appreciation can save you time and money; it can also prevent you from obtaining a mortgage ill-suited to your needs.
When you first buy a home you're likely to make a down payment on the property. However, because you financed the purchase, you are now in debt and the lender owns most of the property's value. In traditional mortgages, the monthly payments on the loan are weighted. During the first years, the monthly payment is largely interest; in time, more of each payment is credited to the loan itself, or the principal.
Gradually, as you pay off principal, you build up equity or ownership. Your equity also increases if the value of the home increases. This process of gradually obtaining equity and reducing debt through payments of principal and interest is called amortization.
Repaying debt gradually through payments of principal and interest is called amortization. Today's economic climate has given rise to a reverse process called negative amortization. This means that you are losing, not gaining, value, or equity because your monthly payments may be too low to cover the interest rate agreed upon in the mortgage contract. Instead of paying the full interest costs now, you'll pay them later, either in larger payments or in more payments. You will also be paying interest on that interest.
In other words, the lender postpones collection of the money you owe by increasing the size of your debt. In extreme cases, you may even lose the equity you purchased with your down payment, leaving you in worse financial shape a few years after you purchase your home than when you bought it.
Certain loans, such as graduated payment mortgages, are structured so that you regain the lost ground with payments that eventually rise high enough to fully pay off your debt. And you may also be able to pay off the extra costs if your home is gaining rapidly in value or if your income is rising fast enough to meet the increased obligation. But if it isn't, you may realize a loss if, for example, you sign a below-market adjustable rate mortgage in January and try to sell the home in August when interest rates are higher. You could end up owing more than you'd make on the sale.