CHAPTER 6
Loan Programs: Which Is Right for You?
RECENT CHANGES in the mortgage industry are many. Many loan programs are disappearing, which makes it even more critical to determine the right mortgage program at the outset. At one point in the mid-2000s, the subprime and alternative loans made up about 40 percent of all the mortgages made.
Suddenly, loan programs began popping up from seemingly out of nowhere, sometimes appearing to accommodate a potential market that was unable to qualify for a home loan. Someone with bad credit? No problem, here’s a new loan for you. No down payment? No problem.
 |
About 40 percent of all mortgage programs have gone away |
|---|
As those loans finally went away, the stalwarts remain. Those stalwarts are conventional loans from Fannie and Freddie and government-backed loans (VA, FHA, and USDA).
Government loans still play a key role for those who qualify, and there are even a few portfolio lenders who are still in the mortgage game catering to specific clients. Portfolio lenders are companies that make their own mortgage loans with no intention of selling them in the secondary market or to other lenders. They instead keep them in their own “portfolio.”
When deciding which loan program is right for you, it is first best to analyze your current financial situation based on credit, income, amount you want to borrow, and the amount you have available for down payment.
If you have good credit, your debt ratios are in line with typical guidelines, and you have 20 percent or more available as a down payment plus closing costs then you have your choice of loan programs. You can go conventional or you can go government.
Government loans will require a mortgage insurance premium in the case of FHA loans regardless of the amount down. This will add an additional monthly payment should you select an FHA loan. VA loans also have their funding fee, usually 2.15 percent of the loan amount. Although you can roll the funding fee into your loan, there is no need to take a VA loan if you have down payment money, regardless if you’re a qualifying veteran.
If the down payment is not a problem for you and you have 20 percent or more down, then you should choose a conventional mortgage. Conventional loans underwritten to Fannie Mae and Freddie Mac guidelines are the most common mortgage type there is and they are offered by both direct mortgage lenders and mortgage brokers.
When there is a lot of something and a lot of businesses are trying to sell it, it follows that the price of that product would be low due to the amount of competition there is in the market.
CONVENTIONAL LOANS
If you have 20 percent for a down payment, go conventional. The same goes for conventional mortgages. You’ll find the lowest rates at the lowest cost when you go conventional. There really is no reason to look any further or listen to sales pitches from loan officers trying to talk you into other loan programs.
Having 20 percent down also negates the requirement for mortgage insurance. Recall that any first mortgage with less than that amount down will require a mortgage insurance policy to be in place. Having 20 percent down also means you’re not required to escrow your tax and insurance payments. Called “impounds” in various parts of the country, escrow accounts are set up to collect one-twelfth of your annual homeowners insurance and property tax bills. As your property taxes become due, your lender will pay your property tax bill on your behalf from the escrow account you established. The same goes for your homeowners insurance policy. As the insurance policy comes up for renewal, there are funds in your escrow account that have accumulated to be used to automatically renew your insurance policy.
Conventional vs. FHA Loans
With less than 20 percent down, you as a consumer don’t have a choice—escrow or impound accounts will be required. If you have less than 20 percent down, say 10 or 15 percent down, conventional loans are less of a hands-down decision, but it does take some math to decide your best route.
First, determine the loan amount won’t exceed the FHA limits for your area. You do this by visiting HUD’s website at https://entp.hud.gov/idapp/html/hicostlook.cfm. If your loan amount will be above the limits shown on the site, then you’ll need to stay in the conventional loan market. If your loan amount will be at or below the limits shown, then proceed to compare the FHA and conventional offerings with both 10 and 15 percent down. Let’s do this with a $200,000 sales price and a market rate of 5.50 percent on a 30-year loan.
| Conventional | FHA | |
| Loan amount | $180,000 | $180,000 |
| MIP (FHA) | $ 3,150 | |
| Final loan amount | $180,000 | $183,150 |
| Payment | $1,022 | $1,039 |
| MI payment | 93 | 76 |
| Total with MI | $1,115 | $1,115 |
Did you see what happened? We’ll explore FHA loans in more detail later on in this chapter, but the total monthly payments for a conventional and FHA are the same. Notice a couple of things, though.
FHA requires an upfront MIP at 1.75 percent of the loan amount, or $3,150 in this example, to be paid at closing. This is an FHA cost that you can include with your loan amount, and since it is relatively substantial, most borrowers do in fact roll it into the loan, increasing the amount borrowed, rather than paying for it out of pocket.
While the monthly payments are similar for both FHA and conventional, the increased loan amount will increase the amount of interest paid over the life of the loan when choosing an FHA loan. In addition, the monthly MIP payment remains during the life of the loan as well.
With conventional mortgage insurance, the mortgage insurance payment can go away at some point when the loan amount falls below 80 percent of the current value of the home. For instance, the home was purchased for $200,000 but one year later it appraises at $225,000. Since the $180,000 loan balance is exactly 80 percent of the value, the homeowner can contact his mortgage company and begin the process for removing PMI.
Removing PMI is nothing more than paying a marginal fee of about $350 and having a new appraisal done. With an FHA loan, MIP can’t be removed until the loan itself is retired, either by paying off the mortgage or refinancing into a new loan that doesn’t need mortgage insurance (MI).
Now let’s look at that same scenario comparing a conventional with an FHA using 15 percent down.
| Conventional | FHA | |
| Loan amount | $170,000 | $170,000 |
| MIP (FHA) | $2,975 | |
| Final loan amt | $170,000 | $172,975 |
| Payment | $965.24 | $982 |
| MI payment | 54 | 71 |
| Total with MI | $1,019 | $1,053 |
You’ll notice the total monthly payment dropped a bit more than the FHA loan. That’s because with 15 percent down, conventional mortgage insurance requires less coverage while the FHA loan requirement stays the same at 0.25 percent of the loan amount.
Now let’s figure this one more time using a 15-year instead of a 30-year fixed and the same 15 percent down.
| Conventional | FHA | |
| Loan amount | $170,000 | $170,000 |
| MIP (FHA) | $2,975 | |
| Final loan amount | $170,000 | $172,975 |
| Payment | $1,389 | $1,413 |
| MI payment | 93 | 0 |
| Total with MI | $1,482 | $1,413 |
A quirk in the FHA loan is that with 15 percent down, there is no monthly mortgage insurance premium, but there is still the initial upfront mortgage insurance premium of $2,975.
When borrowers consider putting 15 percent down instead of 20 percent, I suggest they evaluate the possibility of holding off and saving up the additional funds for a down payment. Again, with a $200,000 loan, 20 percent is $40,000 and 15 percent is $30,000. Ten thousand dollars is certainly not a trivial amount, but for those who have the wherewithal to make a down payment large enough to avoid mortgage insurance, they should.
Why? For many, mortgage insurance is not a tax-deductible item. Unless you’re a first-time homebuyer, the mortgage insurance monthly payment isn’t tax deductible. You can’t write it off like mortgage interest.
It may not sound fair to allow mortgage insurance deductibility only to a particular class, but you can bet mortgage insurance companies will keep trying to get that changed. Tax deductibility of mortgage insurance came about in the mid-2000s as a temporary inducement to first-time homebuyers who might have a problem saving up for a 20 percent down payment. One year after the temporary rule was enacted, the deductibility feature was made permanent.
You Might Now Be a First-Time Homeowner (Even if You Aren’t)
An interesting feature of all first-time homebuyer loans is how a firsttimer is actually defined. A first-timer must not have owned a home in the previous three years. That’s it. One could have owned a home four years ago and still qualify for the mortgage interest tax deduction.
Here are two important notes that reflect new rules issued by mortgage insurance companies:
- 1.Some mortgage insurance companies will not issue a policy if the loan was originated by a mortgage broker. If you’re using a mortgage broker and you have less than 20 percent down and may need mortgage insurance ask the broker if they have a source for mortgage insurance.
- 2.Mortgage insurance companies may not issue policies for condominiums and townhomes if the down payment is less than 10 percent. In essence, this eliminates mortgage insurance for condos and townhomes for anyone with little down. If the buyer has 10 percent down, then a piggyback loan would be the choice.
You Can Piggyback, Too
Another option for conventional loans with less than 20 percent down is by using a “piggyback,” or second mortgage lien. In fact, before mortgage insurance became tax deductible, it was the preferred method of avoiding mortgage insurance. A borrower would take two mortgage loans; one at 80 percent of the sales price and a second mortgage based on the amount of down payment.
If the borrower had 15 percent down, the second mortgage would be 5 percent of the sales price. With 10 percent, the second mortgage would be 10 percent of the sales price, and with 5 percent down, the second mortgage would equal 15 percent of the sales price. A piggyback scenario looks like this—again, with the same $200,000 sales price, a 5.50 percent rate on the first and a 7.50 percent rate on the second, a common spread between a first and second mortgage.
| 80-15-5 | (5 percent down) | Monthly Payment |
| First loan | $160,000 | $908 |
| Second loan | 30,000 | 209 |
| Total | $1,117 |
| 80-10-10 | (10 percent down) | Monthly Payment |
| First loan | $160,000 | $908 |
| Second loan | 20,000 | 139 |
| Total | $1,047 |
The difference between total monthly payments is $70 per month. If you’re not a first-time homebuyer and don’t qualify for the mortgage insurance premium tax deduction and wanted to put less than 20 percent down, then you would want to structure a piggyback loan instead of paying mortgage insurance.
Say you do, however, qualify as a first-time homebuyer, how do the two scenarios stack up? With 10 percent down, the comparisons look like this:
| 80-10-10 | Monthly Payment |
| First loan | $908 |
| Second loan | $139 |
| Total | $1,047 |
| 10 Percent Down with Mortgage Insurance | Monthly Payment |
| First loan | $1,022 |
| MI payment | 93 |
| Total with MI | $1,115 |
In this comparison, the monthly payments for the 80–10–10 loan is $68 per month less, and the obvious choice is the 80–10–10 scenario.
As interest rates rise and fall, it is important to consider a loan with mortgage insurance versus a piggyback, as sometimes the choice might indeed be one with mortgage insurance. It would be the case if rates were higher than 5.50 percent and 7.50 percent. Say, rates were at 7.50 percent and 9.50 percent. The payments would then look like this:
| 80-10-10 | Monthly Payment |
| First loan | $1,118 |
| Second loan | $168 |
| Total | $1,286 |
| 10 Percent Down with Mortgage Insurance | Monthly Payment |
| First loan | $1118 |
| MI payment | 93 |
| Total with MI | $1,211 |
As mortgage rates rise, a loan with mortgage insurance can be the better choice, sometimes even without the added advantage of mortgage insurance deductibility. Mortgage insurance premiums are based on a set percentage and do not take into account current mortgage rate conditions.
If you’ve got 10 percent or more down and your loan amount is at or below current conforming loan limits, then the conventional loan is without a doubt your best choice.
VA LOANS
If you’re qualified for a VA loan and have some down payment money, then it’s not to your advantage to use your VA eligibility for a VA loan. Since every VA loan requires a funding fee of 2.15 percent, this gets added to your loan amount, wiping out that same amount you used as a down payment. If you had 20 percent down and your sales price was $300,000, then your down payment would be $60,000. The 2.15 percent funding fee adds up to $6,450, which is then added to your loan amount. Instead of your loan amount being $240,000 with a conventional loan, the VA loan amount would be $246,450. Comparing the interest paid over the life of each loan at 6.00 percent the interest charges would add up like this:
| VA | $285,270 |
| Conventional | $277,680 |
That’s a difference in total interest paid of $7,590, not to mention the increase in monthly payment of $38. But if you do have little or nothing available for a down payment, then there is absolutely no comparison between a conventional, FHA, or USDA, and a VA. It’s a VA loan. If you’re VA eligible and want to learn more about VA mortgages in detail, I suggest reading my book Your Guide to VA Home Loans. Chapter 3 also has more information on VA loans.
FHA LOANS
If you don’t have 10 percent or more down and you’re not VA eligible, then you need to consider an FHA loan. Although FHA caters to first-time homebuyers more than any other class due to its lower down payment requirements, it’s not just for first-timers. The only restrictions placed on FHA loans are the ones reserved for the maximum loan amounts, which can be found at HUD’s website, https://entp.hud.gov/idapp/html/hicostlook.cfm. The drawback with FHA loans is that their limits are usually lower than their conventional cousins.
FHA loans are typically easier to qualify for in terms of credit and relaxed debt ratios when compared to a conventional loan. As pointed out in Chapter 3, while FHA loans do not have a minimum credit score, lenders in general have set the minimum credit score bar at 620.
FHA loans also carry two unique characteristics when compared to conventional as well as VA and USDA loans: source of down payment funds and nonoccupant co-borrowers.
FHA Loans Limit the Source of Down Payment Funds
For those fortunate ones who have relatives or another qualified entity with the ability and willingness to help financially with a down payment and closing costs, FHA should be strongly considered. Most often, these financial gifts come from immediate family members, but FHA does allow for other entities to provide financial gifts:
Nonprofit organizations- Churches/synagogues/religious institutions
- Government grants
- Life partners
Big Change: No More Seller-Assisted FHA Loans
One recent major change regarding gifts and FHA loans is the elimination of “seller assisted” down-payment funds. Because FHA requires gift funds to come from a family member or a nonprofit, for years companies were set up as a nonprofit for the sole purpose of facilitating an FHA purchase. It worked like this:
Buyers needed a 3 percent down payment to buy a $100,000 home but didn’t have it. The seller could assist with the down payment but only by first giving it to the nonprofit set up to handle the gift. The seller would give the funds to the nonprofit, which would in turn send those funds to the closing agent. The nonprofit would charge a nominal fee.
In reality, this was nothing more than a loophole in the law. Sellers can’t give buyers down payment funds. Sellers can contribute toward buyer closing costs but not toward down payment.
It was later discovered that these seller-assisted down payment arrangements carried a much higher default rate when compared to the same FHA loan where the buyers saved up their own money for the down payment or got the funds from a traditional nonprofit group. HUD ultimately made such transactions illegal, a significant ruling on a procedure that had grown in size and scope for the previous 10 years.
You May Only Need $500
A neat characteristic of FHA gifts is that the borrower only has to have a limited amount of funds in a purchase transaction. This minimum amount is just $500. By contrast, with a conventional loan that has a gift involved, the borrowers need to have 5 percent of their own funds in the down payment in addition to the gift. This requirement is waived only if the gift is 20 percent or more of the sales price. That means if the gift represents 5 or 10 percent of the sales price, then FHA is the way to go if the buyers have limited funds available.
Cosigning for Conventional Loans No Longer Makes Sense
FHA also has a unique advantage when additional qualifying income is needed. Sometimes borrowers need someone to cosign the mortgage to help them qualify from an income perspective. Usually, that means mom and dad agree to sign on the loan along with their kid.
While conventional loans allow for nonoccupant coborrowers, conventional loans still require the primary occupants, the borrowers, to qualify on their own without the additional income from their folks. This is a relatively recent change for conventional loans and negates the advantages of having a cosigner in the first place.
FHA loans don’t have that requirement. The borrowers don’t have to qualify on their own income, and in fact, don’t have to have any income at all if the co-borrowers agree to cosign and can qualify based on their own income and current debt load.
You may have heard the term “kiddie condo.” This is a term stemming from FHA loans, where the parents buy a house or condo but don’t live there while putting their son or daughter on the note, as long as the son or daughter lives in the house or condo purchased. This is a common way for some parents to buy real estate for their child to live in while they attend college in lieu of renting an apartment or a house for four or more years.
USDA loans really have no peer, hence no competition. If the property is categorized as rural, there are little or no down payment funds available, and relaxed credit guidelines are required, then a USDA loan is the first choice.
CHOICE CHANGE: FIXED VERSUS ADJUSTABLE LOANS
Now that we’ve examined which type of loan program is best for you, let’s consider another loan option: fixed rate or adjustable rate.
A fixed rate is easy to explain: The rate never, ever changes. Even if the loan is sold to another lender, the interest rate can never change. An adjustable rate takes a bit more explanation.
An adjustable rate mortgage, or ARM, has an interest rate that can vary throughout the term of the loan. It can go up, go down, or remain the same. But not randomly so, as the rules for rate adjustments are built into the mortgage.
Adjustable rate mortgages have three main characteristics:
- 1.Index
- 2.Margin
- 3.Caps
The index is the number that the mortgage is tied to. An index can be most anything that the mortgage describes but common indexes are the one-year Treasury bill or the prime rate, for example. Whatever the rate is on the one-year Treasury bill on the day your rate is to adjust, that’s the index that will be used to help establish your rate.
The margin is the amount, in percent, that is added to the index to get your final interest rate. If the index is 5.00 percent and the margin is 2.50 percent, then 5.00 + 2.50 = 7.50 percent. Your interest rate on your adjustable rate mortgage would be 7.50 percent until your next adjustment.
Caps come in two varieties: interim and floor/ceiling. The interim cap is the maximum amount the rate can change at each adjustment. This helps protect the borrower from wild rate swings. Say, for instance, the prime rate the first year is 3.00 percent and the next year the prime is at 10.00 percent. With a margin of 2.50 percent, the first mortgage rate would be 3.00 + 2.50 = 5.50 percent. The following year, with the prime rate being 10.00 percent, the mortgage rate would be 10.00 + 2.50 = 12.50 percent.
On a $300,000 mortgage, that monthly payment difference is staggering. On a 30-year fixed-rate term, 5.50 percent comes to $1,703, and the 12.50 percent rate gives us a $3,201 payment. Should the prime rate increase that dramatically, almost doubling the house payment, consumers could find themselves suddenly unable to pay the mortgage.
Caps limit the amount that the rate can go up or down at each adjustment to compensate for rate changes. Common caps are 1 percent every six months or 2 percent per year, and so on. There are also loans that have monthly caps as well, although those are typically reserved for second lien mortgages.
In the previous example, with a 2 percent annual cap, the rate wouldn’t increase from 5.50 percent all the way to 12.50 percent, but would stop at 7.50 percent due to the 2.00 percent cap. The adjustment period is the point at which the rate can adjust. Most often, this adjustment period is six months or one year. Each year, for the life of the loan, the interest rate can change at the adjustment period based on the index and margin and capped at the appropriate level when necessary. The interest rate would then adjust to its new rate until the next adjustment period.
Caps are also put in place for the maximum and minimum, or floor, rate. These are called “lifetime” caps. Common lifetime caps are 6 percent above the initial, or start, rate. If the rate started out at 5.50 percent and the lifetime cap were 6 percent, then the highest the rate could ever go would be 5.50 + 6.00 = 11.50 percent.
Using the previous example, even if the rate added up to 12.50 percent, it would never get there because of the 6 percent lifetime cap. The floor rate is the lowest the rate could ever get. I’ve never seen floor rates below 3 percent, regardless of the index and margin.
Psst: There’s a Cross Between a Fixed and an ARM
Another version of the ARM is called a hybrid. A hybrid is an ARM that is fixed for a predetermined number of years before turning into an ARM that adjusts every six months or every year.
Common hybrids are fixed for 3, 5, 7, and 10 years, then turn into an adjustable rate that adjusts either every six months or ever year. Hybrids are commonly noted as 3/1, 5/1, 7/1, and 10/1. A 3/1 ARM is fixed for three years and adjusts once per year. A 5/1 ARM is fixed for five years, and so on. For a hybrid that adjusts every six months, the notation is 3/6 or 5/6, for example. Hybrids have their own index, margins, and caps.
To ARM or Hybrid?
Primarily, you need to see where rates are when you’re closing on a loan and how long you intend to keep the loan. ARMs can start out with artificially low teaser rates—rates below their true rate by adding the index and margin together. These teaser rates can be lower than what might currently be available with a fixed-rate loan.
Hybrids can also offer slightly more competitive rates than a fixed-rate loan but also just a tad higher than an ARM’s teaser rate. A common spread might look like this:
| ARM | 4.00 percent |
| 3/1 | 4.50 percent |
| 30-year fixed | 5.00 percent |
Sometimes the interest rate markets act a bit odd and these spreads aren’t so typical. One might find that an ARM or hybrid is nearly identical, or in some cases higher, than a fixed rate.
If, however, the spreads are similar to the ones just listed, then you might consider an ARM if you are short term and don’t intend to keep the property very long or will otherwise retire the mortgage early by paying it off.
From a historical standpoint, it makes sense to take an adjustable rate mortgage when rates are at relative highs and to take fixed rates when rates are at or close to their lows. Interest rates move in cycles over the years. One of the better interest rate sites that I use is at www.hsh.com. By logging onto this website, you can research rates over the past 30 years. You can compare current market rates with historical ones to get an idea on where rates are in their cycle.
Negative Amortization Loans: You Can No Longer Find Them
Negative amortization loans is a complicated-sounding term that applies to adjustable rate mortgages and has essentially vanished. These loans have been around for the past 30 years and made their mark in the heydays of the early 1980s, when interest rates were at historical highs—as in 18 to 20 percent for a mortgage loan!
Negative amortization, or neg-am loans, are labeled such because the loan can actually increase rather than decrease when payments are made. That sounds odd, but neg-am loans give you a choice of how much to pay on your mortgage each month.
These loans were popular in the 1980s, essentially vanished in the 1990s, and reared their head again in the early 2000s, this time with a much more palatable moniker: payment option arms.
No matter what they’re called, they’re a bad deal, and they work like this:
You select a neg-am loan and it has three or four rate offerings each month: the contract rate, the fully indexed rate, interest only, or fixed and fully amortized.
The contract rate is the minimum amount you must pay, often as low as 1 percent. The fully indexed rate is the interest rate when the margin is added to the index as previously described. Interest only is simply paying the interest on the loan and none of the principal, which means the loan would never get paid down. And finally, the fixed and fully amortized rate is where the payment is fixed each and every month and paid off completely in a specified period.
A common neg-am loan might look similar to the following:
| Loan amount | $300,000 |
| Contract rate | 1 percent |
| Fully indexed | 5.50 percent |
| Fixed and amortized | 6.00 percent |
The neg-am is sometimes called the pay option because you in fact have choices, but not for very long. If you don’t at least make the interest payment, your loan will grow; hence the term “negative amortization.”
If you make only the contract rate of 1 percent, or $964 instead of the fully indexed payment of $1,873, then while the lender will let you do that, the difference between those payments is literally added back to the loan balance. In this instance, $909 is added back to your loan. If you continue to make only the contract rate payment, your loan will eventually grow to 110 percent of its original value, or in this example, $330,000.
When your loan grows to 110 percent of your original value, your loan changes into the fixed and fully amortized rate. Your mortgage payment would jump to $1,978 per month. Would you be able to afford that?
Neg-am loans can have their place when given to the right borrowers, such as someone who gets seasonal or irregular income and there’s a choice between making a smaller payment every now and then when income is diminished.
Neg-am loans or payment option ARMs, whatever the name, should never be your choice for mortgage financing. Neg-am loans have now vanished, but as in the past, they tend to find their way back into the marketplace in one form or another.
LOAN TERMS
Another important consideration in choosing the right loan program for you is the actual loan term. Loan terms historically have been the standard 30-year fixed-rate loan. The loan starts and ends at preset dates and the payments never change. But there are other terms to consider as well. Why review various terms? Loans with longer terms require more interest to be paid, while loans with shorter terms ask for less in mortgage interest. But with a catch: The payments are higher. Sometimes they are much higher.
Loans can be amortized over 40 years, 30 years, 25 years, 20 years, 15 years, and 10 years. Let’s take a quick look to see how the payments change as the loan term is shortened on a $300,000 loan at 6.00 percent.
| Term | Payment |
| 40 years | $1,650 |
| 30 years | $1,798 |
| 25 years | $1,932 |
| 20 years | $2,149 |
| 15 years | $2,531 |
| 10 years | $3,330 |
Notice that the 10-year loan payment is twice that of the 40-year rate! Now let’s look at the amount of interest paid over the life of that same loan.
| Term | Payment | Lifetime Interest |
| 40 years | $1,650 | $492,000 |
| 30 years | $1,798 | $347,280 |
| 25 years | $1,932 | $279,600 |
| 20 years | $2,149 | $215,760 |
| 15 years | $2,531 | $155,580 |
| 10 years | $3,330 | $99,600 |
Although longer terms make for lower payments, the result is more interest paid over the life of the loan.
PREPAYMENT PENALTIES
Another major change in mortgage loans is the absence of prepayment penalties. Prepayment penalties are funds paid to the mortgage company if you pay anything extra on your mortgage in addition to the standard monthly payment. For instance, if you made a $2,000 payment and the standard payment is $1,000, then a prepayment penalty could be applied to the additional $1,000. For example, a lender could impose a 50 percent penalty to the additional $1,000 paid, which would result in just $500 being paid toward the loan balance and $500 to penalties instead of the entire $1,000 being applied to the loan balance.
Prepayment penalties have gone away with the subprime and alternative mortgage loans. And good riddance. Here’s a trick: You can get a 30-year loan and treat it like a 15 (at your leisure). Because now you can get a 30-year fixed-rate loan and pay it as if it were a 25-, or 20- or 15-year loan, without the pressure of higher required monthly payments.
I find many of my clients selecting a 30-year loan and then making regular extra payments to pay the loan off sooner. That way, if some financial emergency occurred and the homeowner would feel pinched by making a higher payment, there is some breathing room. The homeowner would only make the 30-year payment and perhaps make the extra payment at a later date.
Is there any concrete advice about which term to take? Yes. Take the shortest term available that is also comfortable with your financial planning.
Using the previous example, if a 10-year payment of $3,330 is too much, although you’ll save a significant amount of interest payments, then try the 15-year payment at $2,531. If that’s too much still, then move to the 20-year plan, and so on.
What’s comfortable? That depends on you, but lenders still use their own debt ratio guidelines, and typically the total monthly payment (PITI) should be around 30 percent of your gross monthly income. But that shouldn’t be your own rule. If 30 percent sounds fine, then by all means go for it. If it sounds high, then lengthen the term, reduce your rate, or borrow less.
LOAN LIMITS
The next consideration is how much you’re going to borrow, and this is limited by the loan limits established by the VA, Fannie and Freddie, USDA, and FHA. For instance, in Chapter 2, we discussed conventional loan limits being set at $417,000. This is a moving target, depending on which part of the country you’re buying in. Larger metropolitan areas carry higher conventional limits compared to less populated, rural areas. Places like California and New York have areas where the median home price is much higher than in places such as Texas or Wyoming (http://www.fanniemae.com/aboutfm/loanlimits.jhtml). But what if the amount of money you need to borrow is above those limits? You can find what the current conventional limits are by visiting Go Jumbo.
Jumbo loans are defined as loan amounts above conforming and government limits. If the conforming limit is $417,000 in your area and you’re borrowing $418,000, then you’re going to be charged much higher rates than a conventional or government loan would charge, as explained in Chapter 2.
Avoid Jumbo Rates with a Piggyback
You can take the higher jumbo rates or you can use a piggyback mortgage to supplement your first mortgage loan. There are two loans with this method, a first and a second. By doing so, you’ll secure lower overall rates and the subsequent payments that go along with them.
When the mortgage market imploded in the 2000s, piggyback loans got their fair share of bad press. Piggyback loans were made to those who didn’t have 20 percent of their own money for down payment. In fairness, as alternative and subprime loans expanded their market share, they began to include piggyback loans in their offerings. The toxic aspect of piggyback loans in the environment occurred when they were made to those with no down payment or tarnished credit or who could not document their income or assets. Piggyback loans did not mix well with alternative or subprime loans. The lenders who made those loans are no longer in business.
But over the past several decades, piggyback mortgages have taken a predominant and needed role in the mortgage lending industry. Properly placed of course. Here are a couple of ways to use a piggyback loan that will keep your payments lower and help you qualify for a jumbo mortgage.
| Sales price | $500,000 |
| Down payment | $50,000 (10 percent) |
| Loan amount | $450,000 |
Using a jumbo rate of 8.00 percent on $450,000 and a 30-year loan, the payment would be $3,301 per month. If you borrowed the market limit of $417,000 and used a conforming rate of 6.50 percent, the payment would be $2,635, a savings of $666 per month. But you had to come in with more than 10 percent down. You had to come in with not $50,000, but $83,000.
What if you didn’t have that? Would you be forced to take the higher jumbo rate and payment? No. Consider the piggyback.
| Sales price | $500,000 |
| Down payment | $ 50,000 (10 percent) |
| Loan amount | $417,000 |
| Second loan | $33,000 |
Now using two mortgages and with market rates, the payments would look like:
| First loan at 6.50 percent | $2,635 |
| Second loan at 7.50 percent | $230 |
| Total | $2,865 |
Jumbo mortgage at $450,000? $3,301. Piggyback? $2,865. You just saved $436 per month by using a piggyback. Next example, and with a higher loan amount:
| Sales price | $800,000 |
| Down payment | $160,000 (20 percent) |
| Loan amount | $640,000 |
Monthly payment at 8.00 percent is $4,696. As jumbo rates are typically 1.0 to 1.5 percent higher than conforming conventional loans, the conforming rate would be 6.5 percent. But keeping the first mortgage at $417,000 with a 6.5 percent rate, the payment would be $2,635. Now add the second to make up the difference.
| Sales price | $800,000 |
| Down payment | $160,000 (20 percent) |
| Loan amount | $417,000 |
| Second loan | $223,000 |
With a second loan rate at 7.50 percent, the payment works to $1,559. Add the first and second together, and the total payment is $4,194, or $502 less per month. Plus, since there are no prepayment penalties, one can pay down the second mortgage more aggressively than the first and eventually be left with one loan at the lower conforming rates.
You can find piggyback loans at most lenders, but most often they’re issued by retail banks, separate and apart from the lender making the first mortgage. Regarding retail banks, they can sometimes offer yet another alternative: portfolio loans.
There Are Still Portfolio Loans; Just Harder to Find
Portfolio loans, loans that are issued but will remain in the bank’s “portfolio,” are loans that can be issued under almost any circumstance the bank deems worthy. These loans fall outside typical lending guidelines dictated by conventional and government rules.
Portfolio loans are usually reserved for jumbo loans and also either as ARMs or hybrids. There are even a few banks that operate wholesale divisions to help market these loans, but primarily, portfolio loans are issued by the original bank to one of its customers.
A portfolio loan might have a lower down payment requirement while negating the need for mortgage insurance or a piggyback. It could issue a loan program that requires only 10 percent down, no mortgage insurance with a maximum loan amount of say $900,000.
Banks don’t underwrite portfolio loans to any universal standard because there’s no secondary market they need to conform to. Banks may try and mimic each other’s portfolio offerings if the mortgage seems popular with the consumer, but primarily the loan guidelines are, “What is the certainty we’ll be paid back on time, every time?”
Portfolio lenders can’t afford to make any mistakes. One or two bad portfolio loans can seriously affect a bank’s viability and could even force a takeover by the FDIC. Portfolio loans are made to those with good credit, some down payment, and substantiated income.
Portfolio lending comes in cycles. When times are good, banks will be more likely to make a loan to one of their customers than when times are bad and money is tight. If you’re in a situation where you don’t fit the underwriting box of conventional and government loans, then you might try for portfolio lending at your local bank.
DOCUMENTATION
Documentation is the process where the lender collects third-party evidence that what you put in your loan application is true and correct. If you tell a lender you have good credit and you very well might—just don’t think the lender won’t pull an independent credit report to verify your claim. They most certainly will.
At the same time, the lender will collect information from your employer to verify your employment and review pay stubs to verify how much money you make and when you make it. Lenders can also review past income tax returns to verify income and look at bank or investment statements showing how much you have saved for a down payment and closing costs.
The documentation process can come in degrees of verification In the past, loans were documented and then reviewed by an underwriter. Now, the loan is put through the AUS before any evidence is collected. If the borrower has an excellent credit score of, say, anything above 740 and has 20 percent or more available for the down payment, then the documentation process will be less thorough than for someone with a 620 score and 5 percent down. Here are a few examples.
Income Must Be Documented
If you’re a strong borrower, the loan will likely require only what is called a verbal verification of employment, or verbal VOE. With a verbal VOE, the lender looks up your employer’s phone number and asks for the human resource department, and simply asks, “Does David Reed work there?” and, “When did he start?” The HR department will answer over the phone, and the lender enters the information on the verification form. The verbal VOE is then combined with a paycheck stub to verify the income.
That’s it.
If you are not so strong a borrower, the lender would ask for last year’s W-2, two most recent pay stubs covering 30 days, and a written VOE.
A written VOE is a form that is sent to the employer either by mail or fax or as an attachment in an e-mail. The employer completes the form and enters how long the person has worked there in addition to their pay structure.
The written VOE is then compared with the W-2s provided and the pay stubs. If there is any discrepancy the lender will need an explanation. For instance, if the pay stub says the borrower makes $5,000 per month but the W-2s only show $45,000 in income, something’s not quite right: 12 months at $5,000 per month is $60,000, not $45,000. The lender needs an explanation. Perhaps the employee changed jobs or went from being a commissionearning salesperson to a salaried employee. Whatever the discrepancy, there must be a plausible and verifiable explanation.
If the borrower is self-employed and a strong borrower, the lender would likely only ask for a copy of last year’s tax returns and use the income listed on the returns. If the borrower is self-employed and a weaker borrower, the lender might ask for two years of tax returns and perhaps a year-to-date profit and loss statement.
Lenders Require New Documentation from the IRS
The new guidelines also document income with a new method: the IRS form 4506T.
With the advent of software and computer technology, it’s easier to fake a pay stub and even a W-2. Lenders can find themselves victims of fraudulent activity, all the while reviewing legitimate-looking documentation.
The 4506-T form is an IRS form that the borrowers sign and return to the lender upon application. This gives the lender permission to contact the IRS for copies of their previous year’s tax returns and W-2s.
The form is faxed to the IRS, the IRS pulls the information (electronically) and the result of all that detective work takes about one to three days. When the returns and W-2s are forwarded to the lender, the lender compares the information supplied by the IRS with the information supplied by the borrower. This form is now required on all loans. Quite frankly, it should have always been the case to avoid the mortgage meltdown in the late 2000s.
Assets are also verified to evidence sufficient funds to close on a transaction. Again, strong borrowers might require less documentation than weaker borrowers. Strong borrowers might only require the most recent bank statement. Weaker borrowers might be asked to provide three months’ worth of statements, plus a written verification of deposit, or VOD.
Lenders Now Verify Everything
This means there is no such thing as the stated documentation or “No doc” loans. Popular for years but really popular for those who couldn’t or wouldn’t document evidence of income, these loans required little, if any, documentation.
The borrowers would simply “state” on their loan application how much they made, and lenders would use that amount to underwrite the file. Needless to say, once some borrowers and crooked lenders got wind of the potential, it seemed nearly every other loan was stated or no doc. This makes sense, because in the mid-2000s, these loan types made up nearly 40 percent of the mortgage market.
Even now, I will still get the occasional phone call from someone who says, “I need a ‘stated’ loan; do you do those?” The answer, of course, is no, and neither does anyone else. And that’s a good thing.
SUMMARY
- There are two primary types of mortgages; conventional and government-backed.
- If you have a down payment of 10 percent or more, you should strongly consider the conventional loan.
- If you’re VA qualified and have no down payment, take the VA loan hands-down.
- If you’re not qualified for VA and have little down, explore the FHA loan, making sure the amount you want to borrow doesn’t exceed FHA’s loan limits for your area.
- USDA loans are specifically designed for rural areas. If you have little or nothing down and live in a qualified rural area, USDA is the way to go.
- If you need a financial gift or someone to cosign for you, choose FHA.
- If you have enough money to put 20 percent down, do so.
- If you don’t, then consider PMI or a piggyback.
- If you’re a first-time homebuyer, both PMI and mortgage interest are tax deductible.
- If you’re not a first-time homebuyer, only mortgage interest is tax deductible.
- Mortgage insurance may not work with mortgage brokers and may restrict first-timers.
- Lock in low fixed rates when rates are at historical lows.
- Consider ARMs and hybrids only if rates are at relative historical highs.
- Use a piggyback loan to avoid higher jumbo loan rates.
- Some banks still offer “outside the box” portfolio loans.
- Lenders no longer offer no doc or stated documentation loans. Everything is verified.