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Thursday, August 24, 2006

Basic Terminology: Interest Only Mortgage

A very common tactic used by homebuyers who want to maximize their borrowing power is the Interest Only (IO) mortgage. As the name suggests the payments on these loans only covers the interest accumulated during the month. The payment does not include any money towards lowering the principal balance of the loan.

The IO term is usually from five to ten years, and then the loan generally converts into a standard principal and interest loan. At the conversion the payments are calculated based on the remaining term. This means that if you get a 30 year IO mortgage, you will have a low payment for the first 5-10 years since you are only paying the interest, but then you have a higher payment than you would for a normal 30 year term since your remaining payments must payoff the full balance in 20-25 years rather than 30. This can come as a big shock since payments can sometimes double or triple.

The smaller payment during the IO portion will improve the borrower's debt to income ratio. In a hot real estate market such as California sometimes this is the only way that people with average incomes can afford average houses. The obvious down side is that if you sell the property during the IO period you haven't gained any equity in the house except for appreciation. If the housing market takes a turn and the house depreciates instead then the borrower ends up owing more than they can sell the house for.

The official suggestion of the Mortgage Insider is to avoid Interest Only mortgages, and instead try to find a 40 or 50 year fixed rate mortgage, or a long term balloon. Lenders are increasingly promoting these options as a way to hedge their risk. Borrowers are more likely to default on a loan where they have little equity in the property, so any loan that builds equity mitigates that risk.

Interest Only loans also have a higher rate than their non-Interest Only counterparts. 0.15% or higher adjustments to the rate are common. So, save yourself the extra interest and earn some equity at the same time with a long term fixed rate loan.

Wednesday, August 23, 2006

Basic Terminology: Balloon Mortgage

One popular type of mortgage product is the Balloon. A balloon mortgage has two numbers associated with it: the balloon term and the loan term. The main idea of a balloon product is that you make payments as if the loan were spread across the entire balloon term, but at the end of the loan term the entire remaining balance is due. A typical sub-prime balloon product would be a 40/30 balloon. The 40 is the balloon term, and the 30 is the loan term.

The advantage of the balloon is that you make a lower payment throughout the balloon term, while the disadvantage is that there is a large balloon payment at the end of the loan. This can be a huge weight hanging over your head for years.

Many lenders that have a huge portfolio of interest only loans are now steering borrowers towards long balloon term products such as the 40/30. The borrower gets the benefit of the lowered payment and can qualify for a higher loan amount, while the lender takes less risk since some equity is being built with every payment. Interest only products don't generate any equity except for the appreciation of the property, and if the property value falls the borrower can easily owe more than the house is worth.

The balloon product can be either fixed rate or adjustable rate. Products such as a 5 year ARM with a 40/30 balloon are now common. This gives the borrower the benefit of both the lower payment of an ARM for the first 5 years plus the lower payment of the balloon. This type of product can be used to leverage a much larger loan amount, but carries double risk. After a few years the adjustable rate can make the payment jump and there is always the balloon payment to be saving towards.

Balloon loans can be a good option for many borrowers, but realize that at the end of the balloon term the loan must either be paid in full or refinanced at the current rates, which could be much higher than when the loan was originated.

Tuesday, August 22, 2006

Basic Terminology: Fixed vs. ARM

There are two main types of mortgage products available: fixed rate and adjustable rate. Fixed rate products have the same interest rate for the entire life of the loan, while adjustable loans have a rate that varies over time.

Fixed products are usually identified by the loan term, such as 30 year fixed, 20 year fixed, 50 year fixed etc. The rate at the time the loan is closed is used to calculate the monthly payment, and both the rate and the payment are fixed from that point on.

Adjustable rate mortgages (ARMs) on the other hand behave like a fixed rate mortgage for some period of time, but after that the rate can change. These products are generally identified by names such as 7/1 ARM, 3/1 ARM, 1 year ARM etc. The first number specifies the the length of the fixed rate period and the second number indicates how often the rate can change after that. In the case of the 7/1 ARM the rate is fixed for the first 7 years, but will adjust once a year from then on. ARMs also have a total loan term, such as 20 or 30 years.

The rate adjustment for most ARMs is based on an index and a margin. The index is a published rate, such as the LIBOR (London Interbank Offered Rate) or the Prime Rate. The margin is the amount added to the index rate to determine the new interest rate for the period. For example, if your loan is tied to the LIBOR index with a margin of 4 you would expect to see your mortgage interest rate at 8% when the LIBOR rate is 4%.

In most cases a rate adjustment on an ARM also triggers a corresponding change in your monthly payment, but not always. Loans that do not include payment changes are referred to as Negative Amortization loans. These are usually a bad idea, since when rates go up your monthly payment is no longer covering the interest on the amount borrowed. Since all accumulated interest must be paid this can lead to a large balance due at the end of the loan term.

Fixed rates are almost always higher than an ARM with the same total term, at least for the introductory period. After that period the ARMs have the potential to adjust upwards, potentially leading to a rate greater than the fixed counterpart. Of course it could also go down, and may do both several times over the life of the loan. The shorter the fixed period the lower the introductory rate will be, with a 3/1 ARM being priced lower than a 7/1 ARM etc.

A good strategy when considering between a fixed rate or adjustable rate mortgage is to think about how long you intend to be in the house. For a starter house that you will only have for a few years until kids come along a 7/1 ARM might be the best option. You will get the benefit of the lower rate and then sell the house before the adjustments kick in. Just make sure you either sell or refinance before the end of the intro period, or you could be stuck with a higher payment.

ARMs are also widely used to help borrowers qualify for a little larger loan. Your debt ratios are calculated based on the first year's monthly payment, so borderline borrowers can choose an ARM with a lower rate that gives them a lower payment and qualify where they otherwise might not. This can be risky though since you may not be able to handle the increase in payments once the intro period is up.