The hybrid ARMS - those are the loans that fix the interest
rates for an initial period of time and then turn into adjustable
rate loans for the remainder of the term - have been versatile
loan products to help clients save money.
When I discuss loan programs with clients, I usually will
give them an idea of their choices by showing them a
spectrum of typical mortgage products.
These include the following:
30-year fixed rate loan - most stable, highest rate
15-year fixed rate loan - retires loan quicker, higher payments
10-year hybrid ARM - targeted to cover a period of ownership
7-year hybrid ARM - targeted to cover a period of ownership
5-year hybrid ARM - targeted to cover a period of ownership
3-year hybrid ARM - targeted to cover a period of ownership
1 year adjustable rate loan - useful for short-term strategies
Semi-annual adjustable rate loan - useful for short-term strategies
Monthly adjustable rate loan - lowest payments, allows for
negative amortization
Some clients will prefer the 30-year fixed rate loan because they
will be guaranteed that there will be no surprises in that loan. If
they can afford the payments today, they should be able to
continue to afford the payments in the future.
The 15-year fixed rate loan has appeal to those clients who want
to have their loan paid in full, usually to coincide with a retirement
strategy. The interest rate on the 15-year loan is generally a little
less than the rate offered on a 30-year loan.
The 1-year and semi-annual adjustable rate loans are usually of
interest to borrowers who have a very short term strategy in owning
the home. They enjoy the benefit of the lower interest rate that
the adjustable rate loan offers initially, and plan to dispose of the
property before the loan has an opportunity to adjust to any large
degree. Because these loans offer interest rate caps per adjustment
period, they can forecast what their worst-case scenario would be in
the near future.
The monthly adjustable rate loan is also known as the deferred
interest option loan, or the negative amortization loan. This program
allows a borrower to make a minimum payment that is actually less
than the interest owing at the time. If the borrower pays the
minimum payment, the unpaid interest gets added to the principal
balance of the loan and the loan gets larger each month. This loan
can be the right mortgage vehicle in certain circumstances, but
the client deserves to fully understand how this loan works so that
there are no surprises. In a future issue, I will feature this loan.
The 10-year, 7-year, 5-year and 3-year hybrid ARM loans serve a
very useful purpose for a majority of borrowers. The longer that a
lender is asked to guarantee an interest rate, the rate is usually
higher. So, a 30-year loan carries a higher interest rate than a
15-year loan, which in turn is higher than the 10-year hybrid
ARM, the 7-year hybrid ARM, the 5-year hybrid ARM, and the
3-year hybrid ARM.
The key to a suitable recommendation for a client is to determine
how long they intend to own the home. If they intend to own the
home for 5 years, it would not be wise to recommend the 3-year
hybrid ARM, because they would face an adjustment to the
interest rate before they planned on moving. In this case the 5-year,
7-year, or 10-year hybrid ARMS would be worthy of consideration
to protect the borrower with a guaranteed interest rate for the
period of time they intend to own the home, and to give them
additional protection in the event that their time frame slipped
from their initial plan.
The hybrids function like this:
The term of the loan is typically 30 years, with the initial interest
rate guaranteed for a specified period of time - 10, 7, 5 or 3 years.
When the loan reaches the end of that guaranteed period of time -
let's use the 5 -year as our example - the loan ceases its fixed rate
period and turns into an annual adjustable rate loan. So, beginning
after the 60th month, the new interest rate is calculated by using an
index that is specified in the loan documents and determining the
index value at that point in time, and adding to it a "margin" that is
also specified in the loan documents that can best be thought of
as the lender's profit margin.
Many of these loans use the 1-year LIBOR index and have a margin
of say, 2.75%. Using today's rates as an example, a borrower could
expect their new interest rate to be 4.893% for the LIBOR value plus
2.75% margin, giving the borrower a new rate of 7.643% for the next
year. The payments would be calculated on the remaining balance
at the end of the 5 years over a 25-year period (the remaining term
of the loan) at an interest rate of 7.643%.
At the end of that year, the lender would do a new calculation using
the same formula but setting the payments over a 24-year period.
There are additional features of these loans to be considered. Many
programs will allow for interest-only payments which allows the
borrower to make the lowest possible payment and it keeps their
principal balance on the loan level. Many lenders will also allow
for slightly lower interest rates or fees if the borrower will accept a
prepayment fee for the first year or 3 years.
Since these loans have been introduced, many borrowers have
chosen them as their preferred mortgage product. As always,
make sure that the details and the answers to your "What if..."
questions are fully explained to you so that you can make an
informed decision.
Wednesday, September 26, 2007
Wednesday, September 12, 2007
Learning From Others-A Cautionary Tale
Over this last weekend, I did a fund-raising charity ride for the
benefit of United Cerebral Palsy in San Diego. At dinner on
Saturday I was talking with another rider and when she
found out that I was a mortgage broker, she asked me a
number of questions and I learned about her current predicament.
She had worked through another mortgage originator previously.
She has had her existing loan for about a year and a half. She
discovered, too late, that it was one that allowed for deferred
interest or "negative amortization". This loan was a refinance
due to a divorce situation, so she pulled cash out of the prop-
erty to pay off her former spouse.
At that time, she financed 90% of the value of the home, and
she was qualified based on the "stated income" program.
She had a strong credit history and credit score, but limited
savings or retirement funds, so she needed every advantage
to qualify for the new loan and keep her condominium for
herself and her two children.
And, in the "Add Insult to Injury" Department, she also has
a prepayment penalty on the loan that was not made clear
to her.
She could be the Poster Girl for the current excesses that
have taken place in liberal underwriting and approvals, and
also how misplaced trust in financial advisors can create
bigger problems.
Let's look closely at some of these details.
First, she was emotionally attached to wanting to keep her
condominium for comfort and security and that framed her
decision-making at every turn. She never seriously considered
selling the home and splitting the proceeds with her former
spouse because she didn't want to rent or downsize to a
smaller place.
Second, the low payments that the deferred interest option
loan offered were very attractive to her, and were affordable.
Although she seemed to recall having some of the conse-
quences of that loan explained to her, she never thoroughly
understood how it worked.
When she got the loan, the amount of interest deferral was
modest, but as interest rates have increased over the last
year and a half, she is looking at her loan balance increasing
significantly each month.
The loan allows for the principal balance to increase no higher
than 110% of the original loan amount. When the loan began
the projection was that it would not happen for many years,
but with the higher interest deferral she may be facing signi-
ficantly higher payments within the next year.
Third, she obtained her loan, and bought out her ex-husband
near the top of the real estate market. Property values have
dropped, and combined with her loan balance increasing, her
equity is being squeezed very close to nothing.
Fourth, by relying on the "stated income" qualifying feature,
she allowed herself to be put into a situation that could become
increasingly unaffordable. I did not get all the details of what
she really made versus what was represented on her loan
submission, but she may have been optimistic about having
additional income that did not come to fruition.
Lastly, the prepayment penalty handcuffs her to the existing
loan unless she wants to pay thousands of dollars to get out
of it. Of course, she does not have the equity in the property
or the cash in reserves to absorb this kind of expense.
What can we learn from her ordeal?
A. Seek out many solutions to the problem and don't rule out
any of them until you have a chance to assess the merits
of all of them.
There is a saying that when your only tool is a hammer,
you treat everything like a nail. But be cautious that the
person from whom you are seeking advice is helping you
brainstorm solutions to your problem and not just promoting
their product.
In too many cases, if you speak with a real estate agent,
they will want you to list the house with them. If you speak
with a mortgage originator, they want to sell you a new loan.
But there are quality professionals in both industries that will
give you honest advice and resources to explore to make sure
that you are well-cared for.
B. Thoroughly understand why the proposal that is being
offered is good for you, and take the time to understand the
details.
I know that the mortgage business can be confusing, and some
originators are not that great on explaining the features without
using verbal shorthand, but you have to insist that they keep
explaining it until you understand it properly. If they are unable
to communicate to you effectively, you should find someone
who can. The consequences of misunderstandings or failure
to disclose pertinent terms to you are just too expensive in
both dollars and emotional distress.
C. Forecast what the "worst-case scenario" is, especially if
you are considering an adjustable rate loan. We can make
projections based on reasonable assumptions but insist on
knowing how the loan performs if everything goes crazy.
That is the only way that you can satisfy yourself that you
have a plan that can work for you no matter what.
I know that I keep repeating this, but it is important that you
find the right people to counsel you, and who are truly looking
out for you best interests.
If she comes to me to help brainstorm a solution to her
problem, I will do my best to help her, irrespective of whether
it creates a new loan for me or not.
When you come to me for help, advice, or mortgage services
you can be confident that I will do the same for you.
benefit of United Cerebral Palsy in San Diego. At dinner on
Saturday I was talking with another rider and when she
found out that I was a mortgage broker, she asked me a
number of questions and I learned about her current predicament.
She had worked through another mortgage originator previously.
She has had her existing loan for about a year and a half. She
discovered, too late, that it was one that allowed for deferred
interest or "negative amortization". This loan was a refinance
due to a divorce situation, so she pulled cash out of the prop-
erty to pay off her former spouse.
At that time, she financed 90% of the value of the home, and
she was qualified based on the "stated income" program.
She had a strong credit history and credit score, but limited
savings or retirement funds, so she needed every advantage
to qualify for the new loan and keep her condominium for
herself and her two children.
And, in the "Add Insult to Injury" Department, she also has
a prepayment penalty on the loan that was not made clear
to her.
She could be the Poster Girl for the current excesses that
have taken place in liberal underwriting and approvals, and
also how misplaced trust in financial advisors can create
bigger problems.
Let's look closely at some of these details.
First, she was emotionally attached to wanting to keep her
condominium for comfort and security and that framed her
decision-making at every turn. She never seriously considered
selling the home and splitting the proceeds with her former
spouse because she didn't want to rent or downsize to a
smaller place.
Second, the low payments that the deferred interest option
loan offered were very attractive to her, and were affordable.
Although she seemed to recall having some of the conse-
quences of that loan explained to her, she never thoroughly
understood how it worked.
When she got the loan, the amount of interest deferral was
modest, but as interest rates have increased over the last
year and a half, she is looking at her loan balance increasing
significantly each month.
The loan allows for the principal balance to increase no higher
than 110% of the original loan amount. When the loan began
the projection was that it would not happen for many years,
but with the higher interest deferral she may be facing signi-
ficantly higher payments within the next year.
Third, she obtained her loan, and bought out her ex-husband
near the top of the real estate market. Property values have
dropped, and combined with her loan balance increasing, her
equity is being squeezed very close to nothing.
Fourth, by relying on the "stated income" qualifying feature,
she allowed herself to be put into a situation that could become
increasingly unaffordable. I did not get all the details of what
she really made versus what was represented on her loan
submission, but she may have been optimistic about having
additional income that did not come to fruition.
Lastly, the prepayment penalty handcuffs her to the existing
loan unless she wants to pay thousands of dollars to get out
of it. Of course, she does not have the equity in the property
or the cash in reserves to absorb this kind of expense.
What can we learn from her ordeal?
A. Seek out many solutions to the problem and don't rule out
any of them until you have a chance to assess the merits
of all of them.
There is a saying that when your only tool is a hammer,
you treat everything like a nail. But be cautious that the
person from whom you are seeking advice is helping you
brainstorm solutions to your problem and not just promoting
their product.
In too many cases, if you speak with a real estate agent,
they will want you to list the house with them. If you speak
with a mortgage originator, they want to sell you a new loan.
But there are quality professionals in both industries that will
give you honest advice and resources to explore to make sure
that you are well-cared for.
B. Thoroughly understand why the proposal that is being
offered is good for you, and take the time to understand the
details.
I know that the mortgage business can be confusing, and some
originators are not that great on explaining the features without
using verbal shorthand, but you have to insist that they keep
explaining it until you understand it properly. If they are unable
to communicate to you effectively, you should find someone
who can. The consequences of misunderstandings or failure
to disclose pertinent terms to you are just too expensive in
both dollars and emotional distress.
C. Forecast what the "worst-case scenario" is, especially if
you are considering an adjustable rate loan. We can make
projections based on reasonable assumptions but insist on
knowing how the loan performs if everything goes crazy.
That is the only way that you can satisfy yourself that you
have a plan that can work for you no matter what.
I know that I keep repeating this, but it is important that you
find the right people to counsel you, and who are truly looking
out for you best interests.
If she comes to me to help brainstorm a solution to her
problem, I will do my best to help her, irrespective of whether
it creates a new loan for me or not.
When you come to me for help, advice, or mortgage services
you can be confident that I will do the same for you.
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