5. The Many Flavors of Loans

FlavorsIf you can imagine it, it’s probably available. There are literally thousands of loan schemes out there. But here’s a rundown on the key good and bad mortgage loans, from Adjustable, to Fixed Rate, to Semi-Adjustable-Fixed-Rate-when-the- Moon-Is-Full.

FIXED RATE MORTGAGES: The interest rate and the payment don’t change over the life of the loan. Fixed Rate mortgages generally cost more during the first years of a mortgage than Adjustable Rate mortgages, but they may offer a better deal long-term, particularly if you plan to live in your home for more than five to ten years.

Fixed rate mortgages are generally available for 15 and 30 year terms. Compared to the 30-year FRM, a 15-year FRM typically offers a lower interest rate but higher monthly payment; the total interest paid on a 15-year loan is also substantially less than a 30-year mortgage.

The advantages of a fixed rate mortgage include certainty and security. You know exactly what your costs and monthly payments will be. If interest rates should rise to double digits (and anyone who remembers the early eighties knows that can happen), you need not worry. If you plan to live in your home more than five years, particularly ten or fifteen or more years, the appropriate FRM is often cheaper in the long-term than most ARMs. Fixed rate mortgages are also simple to understand; they don't have all the "moving parts" you must consider in an ARM.

The disadvantages of a FRM include the necessity to refinance the loan to take advantage of falling interest rates. The fixed interest rate is also usually higher than the initial rates offered by ARMs and therefore in the beginning the payments are higher than the initial payments on ARMs.

ADJUSTABLE RATE MORTGAGES, called “ARMs”: Most people would give their right arm for a good mortgage like this. ARMs can be good for you, because they allow you to benefit when rates go down. ARMs can be bad for you, because they force you to pay more when rates go up. And there are "Option ARMs " that used inappropriately can lead to financial disaster. But, generally speaking, an ARM is worth considering. A well-chosen ARM may offer several advantages. Because ARMs typically offer lower interest rates early in the loan term, they may offer a lower cost mortgage option for people who know they will be in a home for a relatively short time typically five years or less. This can be particularly true with an ARM that fixes the rate for three to five years before the first adjustment period. If interest rates fall, an ARM allows you to benefit, at adjustment time, from the falling rates without refinancing. Lower initial monthly payments for ARMs compared to fixed rate mortgages may also allow you to afford more house. Disciplined savers can also invest the money freed up by the lower payment.

But the advantages of an ARM can also be a two-edged sword. If interest rates rise, the interest rate and payments of an ARM can rise sharply over the life of the mortgage. Because initial ARM interest rates are set artificially low, in even the best ARM the interest rate and payments will eventually rise higher than a comparable fixed-rate mortgage even if the economy doesn't change. If the economy does spur rising interest rates, even if you have a good life-time cap of 5% or 6%, you could see your 5% ARM rise to 10% or 11% in a few years. If you have an ARM where the typical annual cap of 2% interest raise doesn't apply to the first adjustment, you could see a large increase at your first adjustment depending on what's happening in the economy. The many variables in ARMS make them more difficult to understand. These are also reasons to make sure that you've done some homework on ARMS before you begin comparing loans. The following information and links will get you started.

    • ARMs come in many flavors. As we’ve mentioned a lot earlier, some mortgage companies have ARMs that raise the rate quickly when rates go up, but don’t lower it quickly when rates go down. You don’t want an ARM like that. All ARMs have the inherent risk that the interest rate will go up, but an appropriate ARM may also allow you to take advantage of a lower interest rate in the beginning of the loan term compared to the interest rate of a fixed-rate-mortgage (FRM).

      Among the most popular ARMs are hybrids that fix the initial interest for a set period before rate adjustments begin to take place. Fixed periods typically run from 3 to 10 years. Directions Credit Union offers fixed periods of 3 or 5 years. Once the fixed period ends, rate adjustments typically occur once a year. (Smart consumers will reject any ARM with a shorter adjustment period, such as monthly or every six months.)

      Because so many factors beyond the interest rate play a role in how much an ARM may cost, evaluating the pros and cons of an ARM can be much harder than evaluating a fixed rate mortgage. If you're considering an ARM, make sure you consider all the terms to make sure they fit your needs.
    • Some mortgage companies offer “Deferred interest ARMs.” These are the nice folks who say “Hey, we’re your friend! We won’t raise your payments when rates go up!” That “too-good-to-be-true” promise is just that. These loans are called “negative equity loans,” or "negative amortization loans" and you should avoid them like you avoid dental surgery without anesthesia. In many places these are illegal now.
    • "Option ARMs " combine an adjustable rate mortgage with a variety of payment options. For example, an Option ARM typically offers you the option monthly of making a minimal payment (negative amortization option), "interest only" payment, or conventional amortizing payment based on 30 years or 15 years (your payment applies to both interest and principal). Some Option ARMs even allow you to "skip" a payment. The swiftly rising prices of homes in many regions about 6 to 8 years ago led many lenders to push the "flexibility" of Option ARMs and their ability to "put you in more house." Unfortunately, these lenders don't often point out the real hazards. For example, take advantage of the minimum and interest only payments too often and you could owe more on your mortgage than you borrowed or, in a depressed housing market, you could owe more than the home is worth. In the last few years, the news was full of stories about homeowners who experienced this scenario, and foreclosures nationally rose as a number of homeowners were unable to meet the higher payments required when their option ARMs “reset.”

INTEREST ONLY MORTGAGES: An interest-only mortgage (IO) allows the borrower to pay only the interest on the mortgage for a specified period of time — typically 5 or 10 years. Both fixed-rate and adjustable rate mortgages are available with interest-only options. During the "interest-only" period, the monthly payment contains no principle. Because the borrower is paying only interest on the loan, the payment during this period is lower than it would be with a conventional fully-amortizing loan where the payment includes both principal and interest. At the end of the interest-only period, however, the IO loan becomes fully amortizing for the remainder of the loan term. At this point, the monthly payment amount also rises dramatically. During the IO term, the borrower can make payments on principal but such payments aren't required. If no principal payments are made during the IO period, then the borrower builds equity in the house only if its value appreciates. If the value of the house falls, then you could actually owe more on your loan than your house is worth. Interest only mortgages should be considered only with the very greatest caution.

BALLOON MORTGAGES: Watch out! A balloon mortgage gives you a fixed number of payments, but doesn’t fully pay off your loan. At the end of the payments, you’ll have a whopping final payment. And you can’t walk away from the final payment on a balloon mortgage. If you’re very careful, balloon mortgages can be useful in certain circumstances. For instance, if you know for an absolute fact you’re going to sell your home in ten years, a ten-year balloon is a good way to have a lower house payment right now. You can make small payments on your mortgage for those ten years then pay off your loan when you sell the home in ten years. The whopping final payment in our example would be paid out of the sale of the home. Sounds very reasonable. But in the real world property values don't always rise and homes don't always sell as quickly as you need to happen, so don’t fall for a balloon without doing your homework and taking all the potential negatives into account. Also, talk to us. Good advice is where Directions Credit Union shines, too: we won’t recommend a mortgage plan that isn’t good for you.

"PIGGYBACK" MORTGAGE LOANS. Recent figures from the National Association of Realtors indicate that 88% of homebuyers financed their purchase and financed about 90% of the cost. If your down payment is less than 20% of the value of the home, however, you must purchase Private Mortgage Insurance (PMI) or use a home equity loan or home equity line of credit to borrow the down payment. This loan used to borrow the down payment is called a "piggyback" loan because you are in essence adding it on to the mortgage loan. More first time homebuyers have been choosing the piggyback, most typically as a line of credit loan. The danger? Home equity lines of credit usually have variable rates and no fixed payment schedule. Rates could rise and you could easily have a higher minimum payment as well as a higher payoff.

BRIDGE MORTGAGES: A mortgage loan that lets you borrow some of the equity in your home until that home sells. People usually use bridge mortgage loans to help them buy a second house before their first house has sold. Bridge loans can be very dangerous—what if the first home doesn’t sell? Can you afford to support two mortgages? Be careful with these loans.

CONVERTIBLE ADJUSTABLE RATE MORTGAGES, or “CARMs.” CARMs allow you to convert an ARM, an adjustable rate mortgage, to a fixed mortgage. CARMs can be great if interest rates are high now, but will probably be lower later. You can adjust to a fixed mortgage when the rates drop. That’s the theory, but there’s an element of gambling here. In the last few years, however, interest rates have been at historic lows, so the CARM has been less attractive.

FIRMs or “FIXED INTERIM RATE MORTGAGES”: FIRMs are generally 30-year mortgages that are fixed for a number of years, then convert to an ARM, or adjustable rate mortgage. Again, depending upon your personal financial situation and the interest rate market, FIRMs can be really good or really bad. Again, do a full evaluation of your financial picture before you opt for this type mortgage.

GEMs, or GROWING EQUITY MORTGAGES: GEMs feature a gradually increasing payment, but all the payment increase goes to reduce your loan principal. GEMs allow you to pay mortgages off earlier, save tens of thousands in interest payments, and build equity quickly. For instance, a 30-year GEM mortgage, depending on the interest rate, can usually be paid off in 18 years!


If you’re thinking about touring model homes, be wary of the “fast close.” Many states are chock full of wonderful new housing developments and subdivisions, and very few activities are as much fun as visiting them. But beware of developments that put you through a “fast track” sales system designed to get you to contract quickly to buy one of their homes.

    • Fast track systems are good for the seller’s pocketbook—not your pocketbook. Some homebuilders and subdivisions, for instance, literally won’t let you tour a model home without going through the builder’s sales office!
    • Some try to push you into signing a “Builders Contract” the first time you visit a model home. In many states, Builders Contracts are not standardized. For “just a few hundred dollars” these contracts legally bind you to buy a home and use the builder’s mortgage company and agents.
    • Many “Fast Track” builders and subdivisions promise you “upgrades” if you sign with them on the spot. What should you do if this happens? Forget the upgrades! Don’t ever enter into a relationship with a mortgage company or subdivision representative without comparing costs and services. We help you do that.

A quick tip: be wary of “Arbitration Clauses” in home contracts. Binding Mandatory Arbitration (BMA) clauses say you must generally submit to binding mandatory arbitration to settle any difference with a builder or seller and you sign away your right to sue or use the regular court system for redress. Voluntary arbitration clauses in certain circumstances can be good. But, in my opinion, they are generally bad for the consumer, particularly when it comes to homes. Read this article on Arbitration clauses, if you want more details.

Be cautious of buying foreclosure properties without doing your homework. These properties are almost always sold “as is,” a very expensive phrase in the real estate world. Be extra cautious in checking out the home.

Next chapter: 6. A Look at "Closing Costs"

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