If you were to rate every possible loan program on a scale from
the most conservative to the least conservative, you%rsquo;d have the
30-year and 40-year fixed amortizing loans on the conservative
end and the negative amortization variable-rate loans on the
opposite side. Those are the two extremes.
On the conservative end, you%rsquo;re paying off the loan at a fixed
interest rate. Nothing changes. Your payment is exactly the
same each and every month, for 30 or 40 years. That means you
make the exact same payment today as you will in the year 2036,
or even 2046.
On the aggressive end, you%rsquo;ve got a loan where your payment
isn%rsquo;t even enough to pay the interest on the loan! So the size
of the loan is actually getting bigger each month. To make
matters worse, the underlying interest rate is variable. That
means you can%rsquo;t even plan the extent to which your loan balance
is expected to grow.
We%rsquo;ll take a look at the whole spectrum but first, we need to
examine the interest rate structure. The 30-year fixed mortgage
is one of the most conservative options available. It has the
least amount of risk. Well, for the bank, the opposite is true.
By reducing risk for the borrower, all the market risk is
transferred to the bank. If interest rates sky-rocket, the bank
cannot change the rate on your mortgage. It%rsquo;s fixed. They also
can%rsquo;t “call” the loan because you%rsquo;ve got a full 30 years to pay
it off. So the bank could be making more money but they%rsquo;re stuck
with you and your low fixed-rate mortgage.
That%rsquo;s a risk the bank takes when it gives you a fixed-rate
mortgage. And as a result, the bank charges a premium for 30 or
40-year fixed mortgages. In fact, all other things being equal,
interest rates get higher when you fix them for a longer period
of time. An interest rate that%rsquo;s fixed for 5 years will be
slightly higher than one that%rsquo;s fixed for only 3 years. A
7-year fixed is higher than a 5-year fixed. A 10-year is higher
than a 7. A 15-year is yet higher and a 30-year fixed interest
rate has traditionally been the highest. Of course, recently,
the lending community has come out with the new 40-year
mortgages. When fixed for the full 40 years, the rate is
slightly higher than the 30-year. You pay for the luxury of a
fixed interest rate; the longer it%rsquo;s fixed, the higher the rate
is.
Remember: “all other things being equal.” That%rsquo;s what we%rsquo;re
talking about here. Given the exact same credit, income and
assets; given the exact same closing cost structure; given the
same down payment or equity; the interest rate will be higher
as you fix it for a longer period of time. There%rsquo;s no question
that rates could be higher or lower if other things in the file
are different. For example, if you%rsquo;re comparing a 2-year fixed
Subprime loan to a 5-year fixed A-paper loan, the 5-year fixed
would have a lower rate than the 2-year Subprime but there are
big differences between A-paper and Subprime loans.
The 30-year fixed is, historically, the most conservative
choice. You pay for that security with a slightly higher
interest rate but the risk is extremely low. The new 40-year
mortgage is now increasingly common and by amortizing the loan
balance over a longer period, it allows for slightly lower
payments. Both of these loans have traditionally required
“amortizing” payments; that is, they include both principle and
interest.
Recently, the option of a 10-year Interest Only period has been
introduced. The rate remains fixed for a full 30 years but you
only have to pay interest for the first 10. If you think about
it, there%rsquo;s no reason to have a 40-year loan if you also select
the Interest Only option. If you%rsquo;re only paying interest, the
amortization period become irrelevant. Either way, you%rsquo;re only
paying interest. The difference would show up after the
Interest Only period expires. With a 30-year loan, the
remaining amortization period would be squeezed into the last
20 years. With a 40-year loan, you%rsquo;d still have a full 30 years
to pay the principle down.
Now, how many of us actually plan to spend the next 30 or 40
years in the same house? Perhaps some of us are but the
majority plan to move into a different place sometime before
2036 (30 years from now). The trick is to balance the fixed
period with the length of time you intend to stay in the
property. There%rsquo;s no sense fixing the interest rate for a
period of time when you%rsquo;ll no longer have the mortgage. There%rsquo;s
no sense paying for a luxury you%rsquo;ll never benefit from.
In today%rsquo;s marketplace, you can fix an interest rate for 1
month, 6 months, 1 year, 2 years, 3, 5, 7, 10 years, 15, 20, 30
or even 40 years. So take a minute and think about how long you
intend to stay in your current property. 5 years? Maybe 7? If
that%rsquo;s the case, you should only fix your interest rate for 5
or 7 years; maybe 10, just to be safe. That way, you%rsquo;ll get the
lowest interest rate possible while still getting the security
of a fixed interest rate for the period of time you expect to
keep the mortgage.
Most of these loans =F1 the ones that are only fixed for 3, 5, 7
or 10 years =F1 still have a full 30-year term. The payment is
still calculated as if it was a 30-year amortizing loan. Again,
if you select an Interest Only option, the amortization schedule
becomes irrelevant. It doesn%rsquo;t matter; you%rsquo;re only paying
interest anyway, at least until the fixed period expires. But
for an amortizing loan, the payment is based on a 30-year
amortization period and is completely fixed during the initial
fixed period. After that, the rate changes to an index plus
margin and the loan becomes variable. The margin never changes
but the index can move up or down depending on trading activity
in the bond markets.
In what circumstances should you select an Interest Only
mortgage? Many homeowners today are stretching to make their
monthly mortgage payments. Home prices have risen much faster
than salaries, so it%rsquo;s a bigger strain on homebuyers than it
was years ago. If you select an amortizing mortgage, you%rsquo;re
basically putting yourself into a forced savings program. Any
money you put towards your principle increases your equity. You
get all that money back when you sell the house because your
loan balance will be lower than it would otherwise, leaving you
with more equity. An amortizing mortgage is definitely the
=EBconservative%rsquo; choice.
On the other hand, you can look at an amortization schedule and
see how much of the principle you actually pay down during the
first 5 years of a 30-year mortgage. Not much. If you%rsquo;re only
planning to stay in the property for 5 years, the difference in
your equity is fairly minimal. Meanwhile, paying interest only
would reduce your monthly payment. In California, Interest Only
mortgages are extremely common and they definitely serve a
purpose for those homeowners who are planning to get into a
new, perhaps bigger, property within a few years.
The important thing to remember, obviously, is that your
original principle balance never gets any smaller. In that
sense, you%rsquo;re basically renting the house and banking on
appreciation to build equity. During the past 10 years with
house prices rising between 10 and 20% each year, this strategy
has paid-off handsomely. But what happens when the market starts
going sideways as it is today? What happens if prices remain the
same or even go down a bit?
Also, consider the fact that you%rsquo;ll have to pay 5 or 6% real
estate commissions when you sell. If you put 20% down on a
house and only pay interest for 5 years and if house prices
remain stable, you%rsquo;ll actually lose money on the deal. You%rsquo;ll
start with 20% equity. If you end up paying 5% real estate
commissions, you%rsquo;ll sell the place with only 15% equity
(20%-5%) so you%rsquo;ll have less money after you sell the place
than when you bought it 5 years earlier. And that doesn%rsquo;t
include the closing costs associated with the original
purchase. Those generally run about 2% so you%rsquo;d end up losing
7% of the house%rsquo;s value during the 5-year period.
If the place actually drops in value, the situation gets even
worse. I recently spoke with someone in this situation. He
bought a place 10 months ago and can%rsquo;t keep up with the
mortgage payments. His situation is even worse because he%rsquo;s got
a prepayment penalty in his loan. Meanwhile, his home hasn%rsquo;t
appreciated a cent. Between real estate commissions and the
penalty, he%rsquo;ll be out over $35K if he sold today (he originally
did 100% financing). If he rents it out, he%rsquo;ll still be under
water about $1500 per month. Either way, he%rsquo;s in a bad
situation. You have to be careful. Profit is not guaranteed.
That brings me to the last major loan program; one that is
gaining in popularity. It%rsquo;s a bit scary, actually, because this
last type of mortgage is the least conservative of the bunch.
It%rsquo;s called an Option ARM and it gives the borrower a choice of
4 different payment options each month. They can pay a minimum
payment which is based on an artificial starting interest rate
of just 1%. They can pay the Interest Only payment. They can
pay the 30-year amortized payment or they can pay the 15-year
amortized payment =F1 the highest of the 4.
We%rsquo;ve all heard about these 1% mortgages. They%rsquo;re heavily
promoted and most of the marketing is deceptive. I personally
believe that less than 10% of the people who get into these
loans truly understand what they%rsquo;re getting into. There%rsquo;s no
research to support that =F1 it%rsquo;s only my opinion. Let%rsquo;s take a
closer look and unravel the hype surrounding these loan
products. Believe me; they%rsquo;re not as great as they may appear.
First off, rates have never been 1% and they never will be. 1%
is a marketing label that helps sell loans. They calculate the
payment assuming a 1% start rate, but this minimum payment is
less than the Interest Only payment. You%rsquo;re under water right
from the start. The difference between this minimum payment and
the Interest Only payment is referred to as “deferred interest”
and it gets added to your mortgage balance each month. It%rsquo;s
called Negative Amortization and it erases your equity every
time you make that low minimum payment.
The next thing is that these loan programs are not fixed.
They%rsquo;re variable right from the first month. The minimum
payment structure is indeed fixed for the first 7 years (in
most cases), but that%rsquo;s an artificial payment =F1 a Negative
Amortization payment. Those minimum payments don%rsquo;t reflect the
true interest rate at all. The underlying interest rate on
these loans is variable and can change every month.
Third, the 30-year amortized payment is not fixed either. When
people hear “30-year”, they automatically assume “fixed”.
That%rsquo;s not the case here. There%rsquo;s a big difference between
“amortized” and “fixed”. With a variable interest rate, the
30-year amortized payment changes each month. And these days,
it%rsquo;s probably getting higher, not lower.
We have to admit that there is value in these programs for
people who fully understand them. In an appreciating real
estate market, they can make it easier to maintain an
investment property or provide flexibility for someone with an
uneven income stream. But if the real estate is not
appreciating, these programs erase your equity and destroy
potential profits. So be careful.
About The Author: Patrick Schwerdtfeger is a fully licensed
Mortgage Banker located in Northern California. He is the
creator of “Beyond the Rate” (http://www.beyondtherate.com), a
detailed and candid podcast series providing essential
backstage information for California homeowners.
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