Which Mortgage is Right for You
Someone in the market for a new home, planning to sell
a present one or seeking investment property, should be aware of the new
mortgage plans available. Most of
these represent a departure from traditional mortgages, can involve more risk
for the buyer and are frequently tied to changes in the market.
However, they also may feature lower interest rates and allow more buyers
to qualify. Be sure to shop carefully for the right plan for you.
ASSUMABLE MORTGAGE
The buyer takes over the seller’s original,
below-market rate mortgage. Sometimes
the buyer wishes to assume an existing loan due to impaired credit.
The monthly payments are lower.
However, this may be prohibited if a “due on sale” clause is found in
the original mortgage. This is not
contained in most new fixed rate mortgages, but older documents frequently
permit this assumption.
BALLOON MORTGAGE
Monthly payments are based on a fixed interest rate,
usually short term. Payments may
cover interest only with principal due in full at the term’s end.
This offers low monthly payments, but possibly, very
little equity until the loan is fully paid.
When due, the loan must be paid off or refinanced, which normally
involves closing costs again. Refinancing
poses high risks if rates rise.
A balloon mortgage is a relatively short-term note
that usually does not provide for guaranteed refinancing. Balloon mortgages have a series of equal monthly payments and
then a large final payment. Although
there is usually a fixed interest rate, the payments may be for interest only.
The unpaid balance (frequently the original amount borrowed) matures in a
short period, usually within five years.
If you cannot make the final payment, you may have to
refinance or sell the property. Some
lenders guarantee refinancing when the balloon payment is due, although they do
not guarantee a certain interest rate. Without
this guarantee, you may be forced to go through the entire lending procedure
again, including the payment of closing costs and front-end charges.
BUY-DOWN
A developer (or third party) provides an interest
subsidy that lowers monthly payments during the life or portion of the loan. It can have a fixed or flexible interest rate.
This offers a break from higher payments during early
years. It enables a buyer with a
lower income level to qualify. With
flexible rate mortgage, payments may jump substantially at the end of the
subsidy.
The seller pays an amount up front to the lender.
This amount is put into escrow and is used to partially subsidize the
borrower’s payments for the period of the buy-down.
To make sure of the deductions, where applicable, establish that you, and
not the seller, paid the points. Otherwise,
the lender may simply deduct the points from the loan amount, which means the
immediate deduction of the full amount will be lost.
FIXED RATE MORTGAGE
This traditional mortgage instrument with a fixed
interest rate, usually long term, has equal payments of principal and interest
until the debt is paid in full.
This mortgage offers stability and long term
advantages. Interest rates may be
higher than other types of financing. New
fixed rate mortgages are rarely assumable.
The most common Fixed Rate Mortgages are 15 year and
30 year terms.
ADJUSTABLE RATE MORTGAGE (ARM)
Interest rate changes are based on a financial index,
resulting in possible changes in monthly payments, loan term and/or principal.
Some plans have rate or payment caps.
The starting interest rate is slightly below market,
but payments can increase sharply and frequently if the index increases.
Payment caps prevent wide fluctuations in payments, but may cause
negative amortization where the mortgage balance actually increases.
Rate caps can limit the amount which total debt can expand.
An Adjustable Rate Mortgage, also known as a flexible
rate mortgage, provides an interest adjustment at given intervals ranging from
six months to five years. Usually,
these rates are tied to some index that is readily available, verifiable and
beyond the control of the lending institution, for example, the Federal Home
Loan Bank Board index, based on T-bills.
Lenders tend to offer adjustable rate mortgages at
rates 1% to 2% below fixed rate mortgages.
However, they also tend to require borrowers to have more equity in the
property than in fixed rate mortgages. If
interest rates rise, you may pay more interest than stated in your original
mortgage. Some ARMs provide payment
or interest rate ceilings.
Their are several type of ARMs, the most common being a 1 year ARM in which
the interest rate is adjusted annually, normally with a 2% max annual increase
limit. Recently we have seen 3 and 5 year ARMs. ARM's can also be
combined with balloon payment mortgage.
Recent ARM Mortgage contracts now have prepayment
penalties if the loan is paid off early, usually within the first 2 to 3 years.
125% OVER EQUITY MORTGAGES
This type of mortgage is built on the tradition Fixed Rate or ARM
mortgage with the main difference being that you are borrowing 25% more than the
value or cost of the home.
WARNING! Normally you cannot deduct all the interest
on this type of loan on your tax return. Please consult your tax advisor.
NO DOCUMENT MORTGAGE
This really is not a type of mortgage but our goal is to educate so we
include it. A No Document Mortgage is a mortgage where you put down a larger
than normal amount of equity, 40% or more of the value or purchase price of the
house. For this larger down payment the bank or mortgage broker will waive most
document requirements such as copies of past tax returns etc.
GRADUATED PAYMENT MORTGAGE (GPM)
Lower initial monthly payments rise gradually (usually
over five to 10 years), then level off for the duration of the term.
It may include flexible interest rate, with additional payment changes
possible if index changes.
It is easier to qualify for this type of mortgage. It features negative amortization. The buyer’s income must be able to keep pace with scheduled
payment increases. With a flexible
rate, payment increases beyond the graduated payments can result in additional
negative amortization.
This mortgage may be especially attractive if you are
buying a home for the first time and expect your income to rise in the future.
This loan has monthly payments that are smaller during the early years of
the mortgage but gradually increase during the first five to 10 years and then
level off. The interest rate is usually fixed.
The drawback is that you will find
yourself taking longer than expected to build equity in the home since the early
payments usually do not cover interest. During
later years, the difference is made up by larger payments.
To counter balance this effect, the lender may require a somewhat larger
down payment.
GROWING EQUITY MORTGAGE (GEM)
This is a fixed rate instrument with an increasing
payment schedule. The increases are
applied to the principal.
It permits rapid payoff of debt because the payment
increases will reduce the principal. The
buyer’s income must be able to keep up with payment increases.
This mortgage carries a fixed interest rate, like a
traditional mortgage, except there are monthly payment increases (based on
specified indexes) applied totally to principal. These increases cause the principal to be paid much faster
than normal, usually within 15 years, thereby increasing home equity that much
faster.
The GEM is beneficial if your income keeps pace with
the increasing payments, and since the loan is paid earlier, you may be able to
save up to one-half the interest cost of a conventional mortgage.
Consequently, however, the plan does not offer as much in long-term
interest tax deductions.
SHARED APPRECIATION MORTGAGE (SAM)
This mortgage features a below-market interest rate
and lower monthly payments, in exchange for relinquishing a share of profits
when the property is sold on or before a specific date. There are many
variations on this plan.
If the home appreciates greatly, the total cost of the
loan jumps. If the home fails to
appreciate, a projected increase in value may still be due, requiring
refinancing at possibly higher rates.
In a SAM, monthly payments are relatively low and the
borrower pays a relatively low interest rate.
SAMs require sharing with the lender a set percentage of the home’s
appreciation (normally 30-50%).
Under some SAM agreements you may be
liable for the dollar amount of the property’s appreciation, even if you do
not sell the property at the agreed upon date.
Unless you have the cash, you may be forced to sell the property. Also, if property values remain constant or decrease, you may
still be liable for an additional amount of interest.
RENEGOTIABLE RATE MORTGAGE (Rollover)
The interest rate and monthly payments are constant
for several years; changes are
possible thereafter.
The less frequent changes in interest rate offer some
stability of payment schedule.
LAND CONTRACT
The seller retains the original mortgage.
No transfer of title takes place until the loan or contract is fully
paid. Interest Rates on Land Contracts tend to be 1% to 2% higher than standard
Fixed Rate Mortgages.
Normally, there is no equity until the contract is
fully paid. The buyer has few
protections from conflicts.
However the seller is acting as a bank, therefore your
credit rating or other problems may not enter the transaction.
Land Contract is a popular financing method for land
as many banks will not lend money to buy raw land.
RENT WITH OPTION
The renter pays an “option fee” for the right to purchase property at
a specified time and agreed upon price. The
rent may or may not be applied to the sale price.
This enables the renter to buy time to
obtain a down payment and decide whether to purchase.
It also locks in the price during inflationary times.
Failure to take the option, however, means the loss of the option fee and
rental payments. It is important to
read the contract very carefully since some permit the Landlord to re-sell the
property without notice and the equity is lost.
REVERSE ANNUITY MORTGAGE (Equity Conversion)
The borrower owns a mortgage free property and
needs income. The lender makes
monthly payments to the borrower, using property as collateral the mortgage
balance grows.
This mortgage can provide homeowners needed
cash. At the end of the term, the
borrower must have the money available to avoid selling the property or
refinancing.
SELLER TAKE-BACK
The seller provides all or part of the financing
with a first or second mortgage.
This may offer a below-market interest rate. It also may have a balloon payment requiring full payment in
a few years or refinance at market rates that could sharply increase.
WRAPAROUND
The seller keeps the original low rate mortgage.
The buyer makes payment to the seller, who forwards a portion to the
lender holding the original mortgage. A
Wraparound offers a lower effective interest rate on the total transaction.
The lender may call in the old mortgage and
require payment of a higher rate. If
the buyer defaults, the seller must then take legal action to collect debt.
PRE-PAID INTEREST (POINTS)
This normally cannot be taken for tax purposes
in the year paid but must be spread out over the repayment period.
However, prepaid interest points may differ from normal interest.
They may be deductible in the first year if the payment of points is an
established practice in the area where the loan was obtained, if the number of
points paid is also in accordance with local practice and if the points were for
an initial purchase, or as a result of refinancing in order to pay for
remodeling. Deductibility applies
only to points paid in connection with a principal residence.
ZERO RATE AND LOW RATE MORTGAGE
Appears to be completely or almost interest free.
A large down payment and one time finance charge is required.
The loan is then repaid in fixed monthly payments over a short term.
This method permits quick ownership.
It may not lower the total cost because of a possible increased sales
price, and it does not offer long-term interest tax deductions.
FINANCING ALTERNATIVES
If you are trying to finance the purchase of a
new home, you will find a number of alternatives available in addition to the
conventional fixed rate mortgage.
These are just some thoughts to consider.
Your tax advisor and attorney can provide more detailed information and
should be consulted before any action is taken.
A careful reading and understanding of the specific loan agreement is
essential prior to committing yourself to loan fees or assuming the liability.
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