Some of the mortgages now available are traditional plans, with interest rates and payments that remain constant throughout the loan and pay off your debt over a long period. Others represent a departure from the older plans: they can involve more risk for the buyer and are frequently tied to changes in the market. But they also can make home buying possible and may offer lower interest rates.
So if you want to purchase a home, you can still find the right mortgage for your needs. But to make sure you understand the choices, you should educate yourself first.
This guide will introduce you to some of the many plans available. Other sources of information include your state, county, or city consumer affairs office; local realtors, home builders, and lenders; bookstores; and the real estate section of your newspaper. You may also want to buy a book of mortgage payment tables to help you calculate whether you can afford a specific loan.
Above all, shop carefully. And, as you read through this booklet, keep in mind the following:
Three important words are: "interest," "principal," and "equity." When you first buy a home you're likely to make a down payment on the property. But, 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, they are 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.
Until recently most mortgages had fixed monthly payments, a fixed interest rate, and full amortization (or transfer of equity) over a period of 20 to 30 years. These features worked in the buyer's favor. Inflation made your payments seem less and your property worth more. So, although the payments seemed hard to meet at first, over time, it became easier.
Many home financing plans are different from traditional mortgages. They may help you buy a home you otherwise couldn't, but they also may 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.
In shopping for financing sources today keep in mind the terms which are keys to the affordability of the home:
For example, suppose you borrow $50,000 at 13 % for 30 years. Your monthly payments on this loan would be $553.10. Over 30 years, your total obligation for principal and interest would never exceed this fixed, predetermined amount.
Fixed rate mortgages are usually available at higher rates than many other types of loans. But, if you can afford the monthly payments, inflation and tax deductions may make a fixed rate mortgage a good financing method, particularly if you are in a high tax bracket and need the interest deductions.
Traditionally both interest rate and monthly payments are fixed for the life of the loan.
Suppose you buy a house for $100,000, and after making a $15,000 down payment, you still need to borrow $85,000. You find a 30-year mortgage for 12%. This means your monthly payments would be $874.32. But, another lender offers you a 15-year plan for a lower rate, 11.5 %. However, under this plan, your payments would be $992.96, $119 higher than the longer-term financing.
In the fifteen-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. So, if you can afford the higher payments, this plan will save you interest and help you build equity and own your home fasten Because you are paying less interest, though, you may also have fewer tax deductions.
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.
If there are no payment or rate caps, interest rate and monthly payments fluctuate according to an index.
Changes in the interest rate are usually governed by a financial index. If the index rises, so may your interest rate. In some plans, if the index falls, so may your rate. Examples of these indexes are the Federal Home Loan Bank Board's national average mortgage rate and the U.S. Treasury bill rate. Generally, the more sensitive the index is to market changes, the more frequently your rate can increase or decrease.
Suppose your interest rate is tied to the Bank Board index. Your mortgage limits rate changes to one per year, although it doesn't limit the amount of the change. For example, assume your starting interest rate is 11% on September 1, 1986. Based on these terms, if the Bank Board index rises 2 percentage points by September 1, 1987, your new rate for the next year will be 13%.
A periodic rate cap limits the amount the rate can increase at any one time. For example, your mortgage could provide that even if the index increases 2 % in one year, your rate can only go up 1%. An aggregate rate cap limits the amount the rate can increase over the entire life of the loan. This means that, for example, even if the index increases 2 % every year, your rate cannot increase more than 5 % over the entire loan.
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 %, it may only decrease 5 %. 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.
Because they limit the lender's return, capped rates may not be available through every lender.
For example, assume your mortgage provides for unlimited changes in your interest rate but your loan has a $50 per year cap on payment increases. You started with a 11% rate on your $75,000 mortgage and a monthly payment of $714.24. Now assume that your index increases 2 percentage points in the first year of your loan. Because of this, your rate increases to 13 %, and your payments in the second year two should rise to $828.33. Because of the payment cap, however, you'll only pay $764.24 per month in the second year.
If the index increases, so does the interest rate. However, monthly payment changes are limited (although the total amount owed may increase).
But remember: if your payment capped loan results in monthly payments that are lower than your interest rate would require, you still owe the difference. Negative ammortization may take place to ensure that the lender eventually receives the full amount. In most payment-capped mortgages, the amount of principal paid off changes when interest rates fluctuate. Suppose you are paying $650 a month with $500 going toward interest, with your rate at 12%. Then your rate increases to 13%. This means your monthly payment should increase to $697.39, but because of a cap, it increases to only $675. Because this change in interest rates increases your debt, the lender may now apply a larger portion of your payment to interest. If rates get very high, even the full amount of your monthly payment ($675) won't be enough to cover the interest owed; the additional amount of interest you owe will be added to the principal. This means you now owe--and eventually will pay--interest on interest.
Another variation is the pledged account buy-down mortgage with an adjustable rate. This plan was introduced by the Federal National Mortgage Association (Fannie Mae), which buys mortgages from lenders and provides a major source of money for future mortgage offerings.
In this plan, a large initial payment is made to the lender at the time the loan is made. The payment can be made by the buyer, the builder, or anyone else willing to subsidize the loan. The payment is placed in an account with the lender where it earns interest. This plan helps lower your interest rate for the first year.
This plan could lower your rate, for example, by 4% in the first year. If you borrowed $50,000 at 13%, for example, this would reduce your rate to 9% and your monthly payments to $402.31, a savings of approximately $151 monthly. Then, for the next 5 years, your interest rate would only increase, for example, by I point each year. After that, your mortgage becomes an adjustable rate mortgage with interest rate and payment changes based upon an index.
This plan may not include any payment or rate caps other than those in the first years. But, there also may not be negative amortization, so possible increases in your total debt may be limited. Because of the buy-down feature, some buyers may be able to qualify for this loan who otherwise would not be eligible for financing.
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.
For example, suppose you borrow $30,000 for 5 years. The interest rate is 13 %, and the monthly payments are only $325. But in this example, the payments cover interest only, and the entire principal is due at maturity -- in 5 years. That means you'll have to make 59 equal monthly payments of $325 each and a final balloon payment of $30,325. If you can't make that final payment, you'll have to refinance (if refinancing is available) or sell the property.
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. Without such a guarantee, you could be forced to start the whole business of shopping for housing money once again, as well as paying closing costs and front end charges a second time.
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.
Fixed interest rate; payments rise gradually for first few years, then level off for duration of 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.
One variation of the GPM is the graduated payment, adjustable rate mortgage. This loan also has graduated payments early in the loan. But, like other adjustable rate loans, it ties your interest rate to changes in an agreed-upon index. If interest rates climb quickly, greater negative amortization occurs during the period when payments are low. If rates continue to climb after that initial period, the payments will, too. This variation adds increased risk for the buyer. But if interest rates decline during the life of the loan, your payments may as well.
The growing equity mortgage (GEM) and the rapid payoff mortgage are among the other plans on the market. 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. For example, the plan might use the U.S. Commerce Department index that measures after-tax, per capita income, and your payments might increase at a specified portion of the change in this index, say 75%.
Suppose you're paying $500 per month. In this example, if the index increases by 8%, you will have to pay 75 % of that, or 6 %, additional. Your payments will increase to $530, and the additional $30 you pay will be used to reduce your principal.
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.
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. Unless you have the cash available, this could force an early sale of the property. Also, if property values do not increase as anticipated, you may still be liable for an additional amount of interest.
There are many variations of this idea, called shared equity plans. Some are offered by lending institutions and others by individuals. For example, suppose you've found a home for $100,000 in a neighborhood where property values are rising. The local savings and loan is charging 12% on home mortgages; assuming you paid $20,000 down and chose a 30-year term, your monthly payments would be $822.89, or about twice what you can afford. But a friend offers to help. Your friend will pay half of each monthly payment, or $420, for 5 years. At the end of that time, you both assume the house will be worth at least $125,000. You can sell it, and your friend can recover his or her share of the monthly payments to date plus half of the appreciation, or $12,500, for a total of $37,700. Or, you can pay your friend that same sum of money and gain increased equity in the house.
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. Before proceeding with this type of plan, check with the Internal Revenue Service to determine the exact requirements.
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.
Some of today's most frequently used indexes are:
Also find out how the index is used. For example, if the index changes monthly, is the lender also changing the rate on your loan monthly? Or, are there limits on the number of times and/or the amount your rate can fluctuate?
Finally, check how much advance warning the lender will give you before your new rate and/or new payments go into effect.
During periods of high rates, most lending institutions are reluctant to permit 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." Read the contract carefully and consider having an attorney or other expert check to determine if the lender has the right to raise your rate in this mortgage.
For example, suppose you want to buy a $150,000 home. The seller owes $70,000 on a 8% mortgage. You assume this mortgage and make a $30,000 down payment. You still need $50,000. So the seller gives you a second mortgage, or take-back, for $50,000 for 5 years at 10% (well below the market rate) with payments of $416.67. However, your payments are for interest only, and in 5 years you will have to pay $50,000. The seller take-back, in other words, may have enabled you to buy the home. But it may also have left you with a sizable balloon payment that must be paid off in the near future.
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 development now enables private sellers to provide this type of financing more frequently. Previously sellers offering take-backs were required to carry the loan to full term before obtaining their equity. However, now, if an institutional lender arranges the loan, uses standardized forms, and meets certain other requirements, the owner take-back can be sold immediately to Fannie Mae. This approach enables the seller to obtain equity promptly and avoid having to collect monthly payments.
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.
Here, taken from a mortgage contract, is a 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 sate and any other remedies permitted by applicable law."
Note the use of the term "without notice" above. If this contract provision is legal in your state, you have waived your right to notice. In other words, you've given up the fight to be notified of some occurrence for example, a missed payment. If you've waived your right to notice of delinquency or default, and you've made a late payment, action may be initiated against you before you've been told; the lender may even start to foreclose.
Know whether your contract waives your right to notice. If so, obtain a clear understanding in advance of what you're giving up. And consider having your attorney check state law to determine if the waiver is legal.
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: "If all or any part of the Property or an interest therein is sold or transferred by Borrower without Lender's prior written consent... 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.
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.
The seller continues to hold title to the property until all payments are made. Thus, you, the buyer, acquire no equity until the contract ends. If you fail to make a payment on time, you could lose a major investment.
These loans are popular because they offer lower payments than market rate loans. Land contracts are also being used to avoid the due on sale clause. The buyer and seller may assert to the lender who provided the original mortgage that the due on sale clause does not apply because the property will not be sold until the end of the contract. Therefore, the low interest rate continues. However, the lender may assert that the contract in fact represents a sale of the property. Consequently, the lender may have the right to accelerate the loan, or call it due, and raise the interest rate to current market levels.
Rate and payments are relatively low for first few years, then jump to reflect full rate in mortgage.
Rate and payments are initially low, then jump and may change throughout loan depending on changes in the index.
There are several things to think about in buy-downs. First, consider what your payments will be after the first few years. If this is a fixed rate loan, the payments in the above example will jump to the rate at which the loan was originally made -- 12 % -- and total more than $770. If this is an adjustable rate loan, and the index to which your rate is tied has risen since you took out the loan, your payments could go up even higher.
Second, check to see whether the subsidy is part of your contract with the lender or with the builder. If it's provided separately by the builder, the lender can still hold you liable for the full interest rate (12 % in the above example), even if the builder backs out of the deal or goes out of business.
Finally, that $150,000 sales price may have been increased to cover the builder's interest subsidy. A comparable home may be selling around the corner for less. At the same time, competition may have encouraged the builder to offer you a genuine savings. It pays to check around.
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.
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.
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.
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.
Suppose you signed an adjustable rate mortgage for $50,000 in 1978. The index established your initial rate at 9.15%. It nearly doubled to 17.39% by 1981. If your monthly payments had kept pace with the index, they would have risen from $408 to $722. But because of a payment cap (see .page 6), they stayed at $408. By 1981 your mortgage had swelled from $50,000 to $58,350, even though you had dutifully paid $408 every month for 48 months. In other words, you paid out $20,000 but you were $8,000 more in debt than you were three years earlier. During the next few years, despite the fact that the index fell gradually, you were still paying off the increases made to your principal from earlier years.
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.