In This Chapter

Mortgages come in an infinite variety of shapes and sizes. As a mortgage broker, you’ll need to explain the advantages and disadvantages of each type of loan so that your client can make an informed decision about what works best for him. On the other hand, avoid information overload. That’s where, in your zeal to present options, you overwhelm the borrower with so many choices he doesn’t have a clue where to begin to make a decision.

A big part of your job as a mortgage broker is as an educator. You’ll need to explain the underlying premise of each of these types of loans: fixed rate, adjustable rate, and hybrid. Then you can offer the details that differ from lender to lender.

Your role is not to make the decision for your client. But out of 50 different loan products, you need to make an assessment of what you think would work best, present the choices to him, and explain your reasoning. He’s counting on you to be the expert on financing. I mentally run through the various loan products and present my clients with five or six that might work for them. Generally I’ll suggest a couple of loans from each type of mortgage. I can always offer more, but I haven’t scared the client off with my initial presentation.

In this chapter, we’ll get down to the nitty-gritty of loan products currently available on the market. I’m offering an overview of the most popular options, with the understanding that there are variations that crop up constantly. But if you have a firm understanding of these basic types of loans, you’ll see that the variations don’t fundamentally change how the mortgage works.

When you present your client with alternative loan products, you need to present the full picture. The client may be tempted to reach for the loan with the lowest interest rate. But you know that the number may not be an accurate representation of the loan. For example, a 30-year mortgage with an interest rate of 8.0 percent and four points would have an APR of 8.44 percent, while a mortgage with an interest rate of 8.25 percent and only one point would have an APR of 8.36 percent.

In order to accurately compare the true cost of each loan, you need to provide the APR, the interest rate when it is calculated to include other costs of the credit. But not all lenders use the same formula to determine the APR. Some APRs are based on the loan amount, interest rate, and points, but others may include other costs including mortgage insurance, application fee, closing fee, title fee, and other costs. Make sure you are comparing similarly defined APRs when discussing loan costs.

You need to list the components of each loan product and how that impacts the short-term and long-term payments. Only then can the client make an informed decision.

There has to be a bit of a risk taker in the client who opts for an adjustable rate mortgage. In most cases it’s not a big threat, but clients must accept that risk is the underlying premise of an ARM. With a fixed rate mortgage, the client’s payment is the same for the first month and, 15 or 30 years later, for the last payment. In contrast, the interest rate of an ARM is periodically subject to change. How much of a change and how often is part of the loan specifics.

Let’s define a few terms important to understanding how adjustable rate mortgages work.

Momentarily ignore the initial rate of the ARM. The lender can set that at whatever level he chooses. And almost always, that initial rate is lower than a fixed rate mortgage. It’s one of the selling points of an ARM.

If this is a three-year ARM, at the end of three years the ARM’s interest rate is subject to change. What do they base the new rate on? An index rate.

Lenders use different indexes as the bases for their interest rates. Some choose a Treasury Rate Index (one-, three-, or five-year T-bills); others use the Cost of Funds Index (the average cost of money to the San Francisco Federal Reserve); the London International Bank Offering Rate (LIBOR); while still others use their own cost of funds as an index, CDs index, PRIME rate, and others. The name of the index the lender uses is part of the loan papers.

That’s part one of the ARM interest rate. The second part is the margin.

Lenders then add to the index a certain number of percentage points—called the margin. The number of points varies from lender to lender, but is usually constant over the life of the loan. For example, the lender uses the One-Year Treasury Bill as the index, and let’s assume it’s at 7 percent. The lender then uses a 2 percent margin. That would make the interest rate 9 percent (7 percent index + 2 percent margin = 9 percent interest rate). Buyers can often buy down the margin. Like points, this is a good investment if the buyer plans to hold on to the property for the long term. It’s paying money now to save money over the life of the loan.

Two lenders can use the same index, but use different margins resulting in different rates.

The period between one rate change and the next is called the adjustment period.

Since the ARM interest rate is subject to change, lenders build in certain protections that limit some of the risks of an adjustable mortgage.

Almost all ARMs have a rate ceiling, also referred to as a lifetime cap. This is the highest interest rate that a borrower can receive under an adjustable rate mortgage over the life of the note. It is usually a specified number of percentage points above the initial interest rate.

Many ARMs also have periodic caps. This limits how much the interest rate can increase from one adjustment period to the next.

Monthly ARMs have payment caps that limit the increase of the monthly payment at the time of adjustment, usually to a percentage of the previous payment.

Here’s an example:

How does it work? These calculations are simplified for the sake of illustrating how points and caps work. Actual payment figures would include amortization of the mortgage, taxes, insurance, and so on.

Some ARMs permit rate increase carryovers so even if there is no change in the index rate at the time of adjustment, if the increase at the previous adjustment was limited by the periodic cap and did not cover the actual index increase, it carries over to the next adjustment period.

For example, using the same loan described here:

Initial Rate: 5.75 percent

First Adjustment: LIBOR increases 1 percent, loan interest rate is 6.75 percent.

Second Adjustment: LIBOR increases by 3 percent, but with periodic cap, loan’s interest rate can only increase by 2 percent, so loan rate is now 8.75 percent with one point carryover.

Third Adjustment: LIBOR has 0 percent increase. But the extra point that wasn’t included in the second adjustment carries over and the loan rate is 9.75 percent.

Bottom Line: The loan rate can increase at any scheduled adjustment date when the index plus the margin is higher than the rate currently being paid before the adjustment.

As borrowers look for financing solutions to help with cash flow problems, interest only ARMs have grown in popularity. They meet the needs of the borrower who has limited funds at the onset of the loan, but anticipates an increase in his earnings. For example, a 5-year ARM, interest only option, has a fixed interest rate for the first five years of the loan. Years 6 through 30, the interest rate is adjusted every year to the sum of the LIBOR index plus a margin rounded to the nearest one eighth of one percentage point (.125 percent). The margin doesn’t change throughout the term of the loan. During the first five years of the loan, the borrower is offered an interest only payment option or an interest and principal payment option. For those who pay the interest only, the principal is obviously not reduced during that period. Years 6 through 30 require a principal and interest payment, but obviously the payments are significantly higher if no principal has been reduced for the first five years.

This option appeals to the borrower with limited funds, but a strong certainty that his income is going to increase enough during the life of the loan to pay the interest and principal. For example, the borrower who has just finished school and is beginning his career.

Most mortgages are designed to amortize: through monthly payments, the borrower reduces his debt to a zero balance by the end of the loan. In order to do that, the monthly payments are divided between paying down the interest and the principal. In the beginning of the loan, most of the payment goes towards interest.

The problem with payment caps is, while they limit sticker shock from skyrocketing interest rates, they can lead to negative amortization. The payments don’t cover the rising interest rate, so the difference is added to the loan balance. The borrower could end up owing more than the market value of the home. Most loan papers limit the amount of negative amortization to 110 to 125 percent of the original loan amount. If the loan balance exceeds this amount, the borrower is required to accelerate principal payments until it reaches the recommended loan to value.

If home values are increasing, then by selling the home, or refinancing, the borrower can repay the now larger debt. If home values have fallen, then the borrower is in trouble. The borrower can avoid negative amortization if he pays the additional interest owed monthly.

Negative amortization sounds scary—and for some homebuyers it’s a tragedy. But again, for some clients, it may be the right choice. It’s made for the buyer who is banking on the property appreciating in value, wants to minimize his monthly payments and the amount of money he puts down, and wants the interest deductions. Again, you need to understand your client’s financial circumstances and plans and then you can help him choose the right loan product.

Here’s a simplified example.

1/1 ARM loan with an initial rate of 5.75 percent, 2 percent rate cap, and 7½ percent payment cap.

Year One

Loan Amount: $65,000 @ 5.75 percent

Monthly Payment—$379

Of the $4548 paid, $3715 is for interest and $833 is for principal.

Year Two

Loan Amount: $64,167 @ 7.75%

Monthly Payment—$459

Of the $5508 paid, $4,952 is for interest and $556 is for principal.

But there is a 7½ percent payment cap. Monthly payment is $407.43 ($379 × .075) = $28.43 + $379 = $407.43 × 12 = $4,889.16.

Since interest for that year is actually $4,952, that results in a shortfall of $62.84. The borrower begins year three of the loan having not paid down the principal at all and the shortfall is added to the principal, which is now $64,229.84.

Negative amortization also occurs with option ARMs, also known as payment-option adjustables. This form of financing gives borrowers the option of several different monthly payment plans ranging from full amortization of interest and principal to minimum payments as low as 1 percent. Borrowers who opt for the minimum payment plan that doesn’t even cover the interest due may quickly find themselves in deeper debt, the result of negative amortization.

This kind of loan may appeal to:

Most option ARMs have built-in periodic conversion or reset rules that adjust the monthly payments at fixed points in time. The sticker shock that comes as the borrower transitions from minimal payments to dramatically higher ones (sometimes 70 to 90 percent) can be overwhelming. The borrower is forced to find a cheaper alternative, find the cash, or default. If the borrower has limited equity in the house, which is likely since these loans generally appeal to those with inadequate cash reserves, and if housing values have decreased since the purchase, the owner is left with a mortgage that even the sale of the house won’t pay off.

Industry leaders are tightening the reins on these option loans because of fears of a rising tide of defaults. This isn’t acceptable to bond investors (in the secondary mortgage market) who have purchased option ARM pooled mortgages. Your client may still need and want an option ARM.

Like any loan, you should advise him to consider:

ARMs come in many configurations. Some permit the borrower to pay off the loan in full without any prepayment penalty whenever the loan rate is adjusted. Others charge a fee. Still others permit the borrower to negotiate to eliminate or reduce the fee. You want to review with your client the specifics of the loan he is considering.

There can be a soft prepayment clause, which permits prepayment without penalty, or a hard prepayment clause, which requires the borrower to pay a penalty for prepaying the mortgage. Check the laws of your state because some have restrictions on prepayment penalties.

Some ARMs permit the borrower to convert his ARM to a fixed-rate mortgage at designated times. The new rate is generally tied to the current market rate for fixed-rate mortgages. There may be a fee for the conversion. The interest rate and upfront fees may be higher for convertible ARMs. Again, as the mortgage broker, you want to review each of the loan’s requirements with your client.

Adjustable rate mortgages generally offer lower interest rates, at least for the initial period, than fixed rate mortgages. But ask your clients the following questions before they elect an ARM:

That last question, length of ownership, is critical. Especially for clients who anticipate remaining in the house for a relatively short term, rising interest rates may not be a problem. If your client opts for a 7/1 ARM that has a lower initial interest rate than a fixed mortgage, if he plans to sell the home before the adjustment period, he may not care if interest rates rise.

ARMs make sense for the client who doesn’t mind a certain level of risk, needs (or wants) a lower interest rate for cash flow purposes, anticipates his income rising so is confident he can cover any increase in interest rates, or needs a larger loan.

Electing an adjustable rate mortgage with a lower interest rate may qualify the borrower for a bigger loan. Lenders sometimes grant a larger loan based on current income and the first year’s payments rather than on the payment schedule if there is an increase in interest rates.

Even negative amortization may be an acceptable risk for some clients. In a rapidly appreciating market, the borrower may be able to cover the increased loan balance because the value of his house has appreciated as well.

Make sure your client understands all the provisions of his loan, what each of the caps mean (and their consequences), and what his payment schedule will be.

The fixed rate mortgage is the traditional home loan. The borrower is guaranteed that the interest rate will not change during the entire life of the loan. That can be good news if interest rates are low and the borrower can lock in a good rate. It can be less appealing if rates are high and the borrower is looking at 15 or 30 years of a high rate even if at some point interest rates fall.

Fixed rate mortgages generally run for either 15 or 30 years. Here are the pros and cons of each option.

The advantages of a 15-year fixed rate mortgage:

The disadvantages of a 15-year fixed rate mortgage:

The advantages of a 30-year fixed rate mortgage:

The disadvantages of a 30-year fixed rate mortgage:

Let’s compare the costs of the same loan under a 15-year plan and under a 30-year payoff:

There really is no “right” decision on whether to choose a 15- or 30-year fixed rate mortgage. Your client needs to determine what works best in the short and long term. While he undoubtedly would save money in the long run by opting for the 15-year loan, he may find himself cash strapped by undertaking such a large monthly payment.

Ask your client to review his current and foreseeable monthly obligations.

A good alternative, if he has any doubts about assuming the larger monthly payment, is to choose a 30-year mortgage, but increase the amount he pays each month. He can double up payments and the additional checks will go directly to principal. That way he reduces the amount of interest he pays, but isn’t contractually obligated to make the higher payments every month.

This loan is a combination of a fixed loan and an ARM. It starts out as a fixed rate loan, but morphs into an ARM. It generally carries a lower interest rate than a fixed rate loan, and less risk than a 1-year ARM.

Hybrids are available in varying time lengths. For example: 3/1, 5/1, 7/1, and 10/1.

Here’s how it works. The 3/1 hybrid is a 30-year loan, with a fixed rate for the first 3 years. At that point, the interest rate and payment rate changes once a year for the life of the loan. Initially, the rate is less than for a fixed rate loan.

The other combinations work similarly, but a 3/1 will have a lower initial rate than a 10/1 because the higher the delayed adjustment period, the higher the initial rate.

There are 15-year hybrid loans with the same characteristics as the 30-year versions, but a shorter loan term.

There are hybrids that have longer adjustment periods. For example, there is the 3/3, which means that after the initial period of three years, the interest rate and payment rate change once every three years.

The popularity of this new mortgage is the result of several trends.

Hybrids are likely to get more popular now that Fannie Mae has standardized terms for the 5/1 hybrids that it pools for mortgages. This will expand the money from the bond market for hybrids. Lenders are likely to push these loans harder and may lower initial rates even more to attract customers.

Fannie Mae’s standard for a 5/1 is:

With a 30/5/1, the difference of 1 percent between a 4.75 initial rate for the first 5 years of the hybrid versus 5.75 percent for a fixed rate mortgage means a savings of $8,940.

As with any loan, there are advantages and disadvantages of taking a hybrid mortgage.

On the plus side:

On the negative side:

The Least You Need to Know