Spectrum Of Loan Programs

Spectrum Of Loan Programs
If you​ were to​ rate every possible loan program on​ a​ scale from the​ most conservative to​ the​ least conservative,​ you’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’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’ve got a​ loan where your payment isn’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’t even plan the​ extent to​ which your loan balance is​ expected to​ grow.
We’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’s fixed .​
They also can’t call the​ loan because you’ve got a​ full 30 years to​ pay it​ off .​
So the​ bank could be making more money but they’re stuck with you​ and your low fixed-rate mortgage.
That’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’s fixed for 5 years will be slightly higher than one that’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’s fixed,​ the​ higher the​ rate is.
Remember: all other things being equal .​
That’s what we’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’s no question that rates could be higher or​ lower if​ other things in​ the​ file are different .​
For example,​ if​ you’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’s no reason to​ have a​ 40-year loan if​ you​ also select the​ Interest Only option .​
If you’re only paying interest,​ the​ amortization period become irrelevant .​
Either way,​ you’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’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’s no sense fixing the​ interest rate for a​ period of​ time when you’ll no longer have the​ mortgage .​
There’s no sense paying for a​ luxury you’ll never benefit from.
In today’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’s the​ case,​ you​ should only fix your interest rate for 5 or​ 7 years; maybe 10,​ just to​ be safe .​
That way,​ you’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 – the​ ones that are only fixed for 3,​ 5,​ 7 or​ 10 years – 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’t matter; you’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’s a​ bigger strain on​ homebuyers than it​ was years ago .​
If you​ select an​ amortizing mortgage,​ you’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​ ‘conservative’ 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’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’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’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’ll actually lose money on​ the​ deal .​
You’ll start with 20% equity .​
If you​ end up paying 5% real estate commissions,​ you’ll sell the​ place with only 15% equity (20%-5%) so you’ll have less money after you​ sell the​ place than when you​ bought it​ 5 years earlier .​
And that doesn’t include the​ closing costs associated with the​ original purchase .​
Those generally run about 2% so you’d end up losing 7% of​ the​ house’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’t keep up with the​ mortgage payments .​
His situation is​ even worse because he’s got a​ prepayment penalty in​ his loan .​
Meanwhile,​ his home hasn’t appreciated a​ cent .​
Between real estate commissions and the​ penalty,​ he’ll be out over $35K if​ he sold today (he originally did 100% financing) .​
If he rents it​ out,​ he’ll still be under water about $1500 per month .​
Either way,​ he’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’s a​ bit scary,​ actually,​ because this last type of​ mortgage is​ the​ least conservative of​ the​ bunch .​
It’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 – the​ highest of​ the​ 4.
We’ve all heard about these 1% mortgages .​
They’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’re getting into .​
There’s no research to​ support that – it’s only my opinion .​
Let’s take a​ closer look and unravel the​ hype surrounding these loan products .​
Believe me; they’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’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’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’re variable right from the​ first month .​
The minimum payment structure is​ indeed fixed for the​ first 7 years (in most cases),​ but that’s an​ artificial payment – a​ Negative Amortization payment .​
Those minimum payments don’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’s not the​ case here .​
There’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’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.

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