Mortgage Alternatives: How To Choose The Right One
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.
Example: You borrow $50,000 at 8 percent for 30 years. Your monthly payments on this loan would be $366.89. Over 30 years, your total obligation for principal and interest would never exceed this fixed, predetermined amount.
Tip: 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.
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:
- The sales price minus your down payment, i.e., the amount you finance
- The length, or maturity, of the loan
- The size of the monthly payments
- The interest rate or rates
- Whether the payments or rates may change
- How often and how much the payments or rates may change
- Whether there is an opportunity for refinancing the loan when it matures, if necessary
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.
Tip: If you can afford the higher payments, this plan will save you interest and help you build equity and own your home faster. The downside, however, is that you are paying less interest and you may also have fewer tax deductions.
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.
Tip: Whether an ARM mortgage is right for you depends on your financial situation and the terms of the ARM. ARMs carry risks in periods of rising interest rates but can be cheaper over a longer term if interest rates decline. You will be able to answer the question better once you understand more about adjustable-rate mortgages.
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.
Planning Aid: See The Financial Calculator: Which Is Better: Fixed or Adjustable-Rate Mortgage?
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.
Caution: Because adjustable rate loans can have different provisions, evaluate each one carefully.
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.
Caution: Because adjustable rate loans can have different provisions, evaluate each one carefully.
Example: Your mortgage provides that even if the financial index it’s tied to increases 2 percent in one year, your rate can only go up 1 percent. An aggregate rate cap limits the amount the rate can increase over the entire life of the loan. This means that even if the index increases 2 percent every year, your rate cannot increase more than 5 percent 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 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.
Example: 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 an 8 percent rate on your $75,000 mortgage and a monthly payment of $550.33. Now assume that your index increases 2 percentage points in the first year of your loan. Because of this, your rate increases to 10 percent, and your payments in the second year rise to $658.18. Because of the payment cap, however, you’ll only pay $600.33 per month in the second year.
Caution: If your payment-capped loan results in monthly payments that are lower than your interest rate would require, you still owe the difference. Negative amortization 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.
Thus in the above example, your monthly payment should increase to $658.18, but because of a cap, it increases to only $600.33. 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 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.
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.
- Prepayment. Some agreements may require you to pay special fees or penalties if you pay off the ARM early. Many ARMs allow you to pay the loan in full or in part without penalty whenever the rate is adjusted. Prepayment details are sometimes negotiable. If so, you may want to negotiate for no penalty, or for as low a penalty as possible.
- Conversion. Your agreement with the lender can have a clause that lets you convert the ARM to a fixed-rate mortgage at designated times. When you convert, the new rate is generally set at the current market rate for fixed-rate mortgages. The interest rate or up-front fees may be somewhat higher for a convertible ARM. Also, a convertible ARM may require a special fee at the time of 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:
- Rollover mortgages are loans with periodically renegotiated rates. Such loans make monthly payments more predictable because the interest rate is fixed for a longer time.
- Pledged account buy-down mortgage is another variation 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.
Tip: 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 that otherwise would not be eligible for financing.
Shopping for a Mortgage
When shopping for any type of adjustable rate mortgage, always remember to ask about the following:
- The initial interest rate
- How often the rate may change
- How much the rate may change
- The initial monthly payments
- How often payments may change
- How much the payments may change
- The mortgage term
- How often the term may change
- How much the term may change
- The index that rate, payment, or term changes are tied to
- The limits, if any, on negative amortization
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.
Example: You borrow $30,000 for 5 years. The interest rate is 13 percent, 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.
Tip: 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.
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.
Tip: 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.
Growing-Equity Mortgage (GEM)
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.
Example: A GEM uses the U. S. Commerce Department index that measures after-tax, per capita income and your payments increase at a specified portion of the change in this index, say 75 percent. In this example, let’s assume that you’re paying $500 per month for your mortgage. If the index increases by 8 percent, you will have to pay 75 percent of that, or 6 percent, 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.
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.
Tip: 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 housing equity plans in the US. Some are offered by lending institutions and others by individuals.
Example: Suppose you’ve found a home for $100,000 in a neighborhood where property values are rising. If the local savings and loan charges nine percent interest on home mortgages, assuming that you paid $20,000 down and chose a 30-year term, your monthly payments would be $643.70, or about twice what you can afford. But let’s say a friend offers to help and has offered to pay half of each monthly payment, or $321.85 for 5 years. At the end of that time, assuming the value of the house increases to at least $125,000, you would be able to sell it and your friend can recover his or her share of the monthly payments to date–plus half of the appreciation. 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.
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.
Tip: Before proceeding with this type of plan, check with a tax advisor to determine deductibility of interest.
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.
Tip: Read the contract carefully and have an attorney or other expert check to determine if the lender has the right to raise your rate in this mortgage.
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.
Tip: 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.
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.
Caution: 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.
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:
- 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. 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.
- 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, even if the builder backs out of the deal or goes out of business.
- See if the sales price has been increased to cover a 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 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.
Rent with Option to Buy
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.
Tip: In addition to any legal issues, financial considerations also come into play. Therefore, financial guidance is suggested helping before a final decision on the type of mortgage to take.
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.”
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 right 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.
Tip: Know whether your contract waives your right to notice. If so, obtain a clear understanding in advance of what you’re giving up. Try to get the clause removed. Have 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: “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.
Example: Suppose you signed an adjustable rate mortgage for $50,000 in 1996. The index established your initial rate at 9.15 percent. It nearly doubled to 17.39 percent by 1999. If your monthly payments had kept pace with the index, they would have risen from $408 to $722. But because of a payment cap, they stayed at $408. By 1999, 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.