I’ve received many emails lately from home buyers who are worried about not being able to find a good mortgage lender.
Either they had a bad experience with their former lender, or they’re nervous because of all the ink they’ve been reading about big banks writing down their bad mortgage loans.
Choosing the right lender takes some time, effort, lots of phone calls and maybe even a few hours on the Internet, as you search through a myriad of companies offering a cornucopia of mortgage loan programs.
Over this week and next, I thought we’d explore how to figure out which mortgage type is right for you and then how to find a good mortgage lender.
The first step is to know what you want. There are a handful of basic mortgage programs from which to choose. At its most basic, there are fixed-rate mortgages and adjustable rate mortgages (ARMs).
Fixed-rate mortgages mean the interest rate of the loan is fixed throughout the loan term. So if your loan is 15 years, 20 years, 30 years or 40 years in length, your payment will be fixed. The only change will be if your property taxes or insurance payments go up or down, and the lender requires you pay more or less into your tax escrow account. (You generally can count on the payments going up, by the way.)
ARMs are loans that may be fixed for 6 months, or anywhere from 1 to 10 years. At the end of that initial period of time, they adjust based on a financial index to which they’re pegged.
Typically, ARMs cannot go up more than 1 or 2 percent per year, and there is a lifetime cap on how high the payment can rise, typically 5 or 6 percentage points over the life of the loan. But some ARMs don’t have that 1 or 2 percent limitation on the first year that the ARM adjusts, so the increase can be as high as 5 or 6 percent for that year.
So if you get an ARM at 5.5 percent, and there is a 6 percent cap, the loan can never go over 11.5 percent. Which sounds insanely high today, but back in 1989, the interest rate on the first home we bought was over 11 percent.
Most other loan programs are variations on these two loan types.
A negative amortization loan (also known as “option ARMs”), are ARMs that start out at a super-low "teaser" interest rate. That teaser rate is typically several percentage points below the lowest market rate.
But you’re not getting the deal of a lifetime. Quite the contrary. What’s happening is that the interest you should be paying (but you’re not, because you’ve got a teaser rate) is actually added to the balance of your loan.
That’s right – the total amount of the loan you owe to the bank will go up as long as you have a teaser rate in place. So your monthly payments are low, but your total balance may rise from $100,000 to $105,000 over the course of the first year.
Interest-only loans allow you to pay only the interest that is owed on the money. The loan can be made as a fixed-rate mortgage or an ARM. But since most of what you pay in the first 10 years of a loan is interest, this won’t save you that much. Also, since you’re not paying down any principal, your balance remains the same. With an interest-only loan, if your loan amount is $100,000, your loan balance will still be $100,000 after five years later.
In your search for the right type of loan, you may run into "hybrid" mortgages, loans that are partly fixed and partly variable. They go by the name 5/25 or 7/23, pronounced "five twenty-five" or "seven twenty-three." These loans are fixed for the first 5 or 7 years, and then convert into a 1-year ARM, where after the initial fixer rate period the loan adjusts each year based on the financial index to which it is pegged.
These loans can be a good choice if you think you’re only going to stay in your home (or keep the mortgage) for 5 or 7 years, but you’re not quite sure. You’ll be able to get a slightly lower interest rate, and save some money, but you’ll have to figure out what you’re going to do when the loan converts to an ARM.
The other major type of mortgage is called a balloon loan, and these were very popular back in the 1940s and 1950s. With a balloon loan, you pay monthly on the loan. At the end of the loan term (typically 3, 5, 7 or 10 years), the entire remaining balance must be paid off in full.
When thinking about what loan to choose, don’t be confused by all the bells and whistles the lenders use to try and impress you. Stick with the basics, and figure out which type of loan makes the most sense for your life.
If you’re going to stay in your home for 7 to 10 years or more, I’d suggest a fixed-rate mortgage. If you’re going to sell sooner than that, or refinance your mortgage, then think about an ARM or hybrid ARM of some sort.
Recently, however, as some real estate markets have softened, homeowners have found out the hard way that isn’t all that easy to sell your home when you want to and for the price you’d like.
So give yourself enough cushion when selecting your next loan. If you think you will live in a home only three years, you might want to choose a 5-year ARM — just in case.