Although interest rates continue to be astonishingly low, the conservative 30-year fixed rate loan seems to be going the way of the Brontosaurus. According to the folks at Cohn’s Loans in North Berkeley, roughly two thirds of buyers are choosing alternatives to the 30-year fixed loans. Buyers are attracted to the low rates and flexible programs offered by adjustable rate mortgages (ARMs). This low cost financing gives consumers greater buying power.
Given the price of housing in Berkeley, buyers--especially first time buyers--are searching for ways to finance nearly all of their home purchase price. An entry level home or condo can easily cost over $400,000. A buyer may need 10 percent down, $40,000, plus closing costs of up to $15,000, for a total of $55,000. On top of that, once a buyer has jumped over this hurdle she is still faced with a monthly payment based on 90 percent or more of the purchase price. Today’s ARMs provide lower payment options that get buyers through the front door, but with a plethora of these programs to choose from it is easy to get lost.
Mortgage lending, like most investing, is a game of trying to maximize returns and minimize risks. In making their investment decisions, lenders juggle numerous variables to reflect their own investment goals as well as the risk each borrower represents. The higher the risk a consumer’s profile suggests, the higher the interest rate the lender will demand. Just because your friend got an impressively low rate, doesn’t mean that you will qualify for that same rate.
The following is a summary of two of the most popular loan programs buyers are choosing today:
Short-term, fixed-rate Adjustable-Rate Mortgages (ARM): These loans are typically fixed at a low rate for three, five, seven or 10 years and then they adjust annually (or monthly) for the remaining life of the loan. The rates adjust based on a set margin over a moving interest index. The longer the fixed term, the higher the rate. These are fully amortizing loans, meaning that each payment is comprised of a portion of interest and principal.
Ideal Borrower: This is the perfect loan for someone who wants a home but is planning on selling before the loan starts to adjust. If you anticipate a job relocation or a sudden change in family size this is a great loan option because it temporarily fixes your finance costs.
Risks: Remember that the adjustable part of this loan exposes you to interest rate risks. Your rate is fixed for the first few years and then it adjusts to reflect changes in market rates. Make sure that your loan will adjust reasonably if you end up staying in your house longer than anticipated. The margin is a fixed amount that will be added to an index rate, which is variable, the adjustable part of the loan. Make sure the index on which your loan rate is based moves slowly. Research the history of the index so you don’t end up with one that tends toward sharp upward shifts. A prepayment penalty is often an option that will buy your rate down, but don’t get one unless you know you are definitely going to sit tight for a couple of years. Prepayment penalties are usually in effect for two to three years and typically cost two percent of the principle. This is a big chunk of change.
Short-term, fixed-rate, interest-only ARMs: These loans are similar to the amortizing ARM described above, only they don’t amortize. That means you don’t pay down any of the principle. You may choose to increase your payment to pay down principle, but if you choose only to pay the interest the balance of the loan never decreases. You borrow $300,000 and after years of paying only interest you would still owe $300,000. Therefore the only equity you will have in your house is the initial down payment plus that gained from improvements and/or market appreciation. The difference in an interest-only payment is hefty. For example, if you have a loan amount of $300,000 and an interest rate of five percent, your fully amortizing payment would be $1,610, but your interest-only payment would be $1,250. The difference of $360 per month can make it or break it for many people.
Ideal Borrowers: People with fluctuating incomes, who can afford to increase payments to pay down principle in some months, but need the security of making a lower payment in other months. Also, people who are planning on making home improvements and choose to leverage extra cash by making home improvements rather than spending it paying down the principle.
Risks: The same risks apply as for the amortizing program. The difference here is that if you don’t increase your payments to pay down principle you will not build the certain equity that an amortizing program provides.
When shopping for ARMs always compare the following details:
• Initial fixed rate: For example five percent.
• Initial fixed period: For example five years.
• Index: For example the COFI (Cost of Funds Index)
• Margin: For example 2.25 percent in addition to the index rate.
• Cap Rate: For example 9.5 percent (this is the shocking amount the adjusting rate can never exceed)
• Prepayment Penalty: For example two percent of balance if paid off within a certain number of years
• Loan Origination Fee: Zero to two percent of the loan amount (aka “points”). The higher this fee the lower the rate—the more you pay now the less you’ll pay in the long run.
• Lender Fees: For example $500 for processing and $200 for document preparation.
When choosing a loan program it is very important to shop for the program that will suit your needs and your plans. The services provided by a trustworthy loan broker are valuable because brokers work with multiple lenders and have market and program knowledge that is not generally available to the layman. Ask your friends and your real estate agent for referrals, and make sure you compare cashews to cashews. ]
Heather Sittig is a local real estate agent.