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Government Loans
Generally there are two types of loan programs; government loans, and conventional loans. The difference has to do with whether or not the government in some way facilitates the program or not. There are a handful of government programs that actively facilitate mortgage lending today, they are:
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FHA: FHA stands for Federal Housing Authority. FHA was actually the first government lending entity and helped the country get back on its feet after the Great Depression by putting homeownership within the reach of more people than ever before. FHA is self-funding in that it charges borrowers a mortgage insurance premium that it uses to facilitate the program. FHA financing offers the flexibility of lower down payment requirements and more flexibility in dealing with credit issues.
The only limitations a borrower has on using FHA financing is that the maximum loan amount is set by the government and is based on the average cost of housing in each county, and with minor exceptions a borrower can’t have more than one FHA loan out at any given time. FHA currently offers a Fixed Rate, and a One Year Adjustable Rate Mortgage as options.
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VA: VA stands for Veterans Administration. VA loans were designed as a benefit for returning servicemen coming back from WWII as a way to re-integrate them back into society. Any veteran that meets the criteria can qualify. The primary attraction of a VA loan is that the veteran is not required to make a down payment and can even negotiate to have the seller pay all the closing costs as well. VA also charges a guarantee fee that the borrower can finance to facilitate the program. The Veterans Administration wants to do all it can for Veterans so it is similarly flexible in dealing with credit issues.
Any eligible Veteran can qualify for a VA loan and can use the program multiple times. VA does have a maximum loan amount with no down payment including the financing of the guarantee fee. VA currently offers a Fixed Rate Mortgage and a Hybrid Adjustable Rate Mortgage as options.
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RCD: RCD stands for Rural Community Development. It used to be referred to as Farmer Mac and is run by the Department of Agriculture and can best be described as the rural equivalent of FHA. Its goal is to facilitate homeownership in rural agricultural areas. RCD loans have no down payment requirement, but the borrower must have reasonable credit quality.
RCD loans are limited to rural areas of limited population as designated by the Department of Agriculture. There are loan, income, and other restrictions on these loans as well.
Housing Agencies: Housing Finance Agencies exist in many states and are chartered as state, county, and sometimes city entities. These agencies generally facilitate low-income housing initiatives; specifically First Time Homebuyers Bond Programs.
These bond programs offer first time homebuyers the ability to obtain mortgage financing at a significantly below market interest rate; making it easier for them to qualify. There is also often the ability to receive down payment assistance so the borrower can close on a transaction with as little or not out of pocket expense. The loan programs are generally structured as an FHA loan. In addition to being limited to first time buyers, there are purchase price, and income limits as well.
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Conventional Loans
Conventional loans are loans that are generated without any direct government involvement. They are subject to laws with regard to Fair Housing, Equal Credit Opportunity, and the Real Estate Settlement Procedures Act, as well as state laws. There are numerous types and variations of conventional loans, but generally they are going to end up one of four places.
FNMA: Fannie Mae began as a government entity that was set up to purchase FHA mortgages. With the advent and popularity of private mortgage insurance, there was a market for private or conventional mortgage securitization so FNMA was split into GNMA (Ginnie Mae), which would buy government loans, and FNMA, which would buy conventional loans. Fannie Mae has since been privatized and is a for profit corporation.
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FHLMC: Freddie Mac also began as a government entity. FNMA was initially setup to purchase mortgages from banks and mortgage companies, Freddie Mac was set up to do the same thing for Savings and Loans. The lines have long since blurred and both entities buy from everybody. Freddie Mac has similarly been privatized. Because they are head to head competitors, for all intents and purposes, Fannie Mae’s and Freddie Mac’s credit policies are almost identical.
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Loan Program Types
Loan programs can generally be grouped into four major categories; fixed rate mortgages, balloon mortgages, adjustable rate mortgages (ARMs), and interest only mortgages.
Fixed Rate Mortgages
As the name implies on a fixed rate mortgage, the interest rate you pay is fixed or does not change for the life of the loan. A simple fixed rate loan means that every month the principal and interest payment of the mortgage will remain the same and the loan will fully amortize. A fully amortizing loan means that at the end of the loan term the balance will be zero; the loan will have been completely paid off. Fixed rate loans, because of their relative safety, represent the vast majority of loans originated in the country. The most popular loan term for Fixed Rate Mortgages is 30 years, but a fixed rate loan can be obtained for shorter terms as well; generally 10, 15, 20, or 25 years.
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Balloon Mortgages
A Balloon Mortgage is a loan where the borrower makes equal payments on the loan for a period of time, just like on a fixed rate mortgage. The difference is that the balloon loan comes due or balloons, with the entire remaining balance due and payable well before the loan is paid off. The advantage of a balloon mortgage is that because the lender knows the loan is only going to be outstanding for the period before the balloon, they generally offer a lower rate of interest to the borrower on the loan, meaning a lower payment. Balloon mortgages are generally set up with payments based on a 30 year amortization or payout, but balloon at the end of 5 or 7 years.
ARMs (Adjustable Rate Mortgages)
Adjustable Rate Mortgages are appropriately named because the rate on these loans is subject to change at some regular interval based on certain criteria. Because the lender has the ability to change the interest rate on the loan if rates increase, they are willing to offer the loan at a lower rate initially. The variables that affect how the loan might adjust are the adjustment frequency, the adjustment caps, the index, and the margin.
The adjustment frequency is how often the interest rate on the loan is subject to change. Depending on prevailing interest rates at the time the rate may or may not change. The frequency is merely how often it might change. Adjustment frequencies vary but the most common frequencies are annually (once a year), every six months, and monthly. In most cases, the more often the lender has the ability to re-evaluate and potentially adjust the interest rate, the lower the initial rate they will offer on the loan.
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A Note on Hybrid ARM’s:
A Hybrid ARM is a combination of a fixed rate and an adjustable rate. They offer the security of a fixed rate for an initial period of time and then become adjustable and subject to regular adjustments thereafter. A Hybrid ARM is a popular alternative, generally offering a lower rate than a fixed rate mortgage with less interest rate risk than a loan that is subject to adjustment immediately. The most common and popular hybrid ARMs are the 3/1, 5/1, 7/1, and 10/1. The numbers simply mean that the initial fixed period is the first number (3, 5, 7 or 10) and the subsequent adjustment frequency is annually or once a year (1).
The adjustment caps are the limit the loan can adjust at any given time and over the life of the loan. Adjustment caps are generally expressed as an interest rate cap but on some loans may be expressed as a payment cap (a 2% increase in interest versus a 15% increase in the payment). Typical adjustment caps would be 2% on any given adjustment and 6% over the life of the loan. The caps serve to give the borrower some measure of security or limits on how much the loan may adjust.
It is important to know that rates can go down as well (subject to these same caps) if rates are in fact, declining.
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The index is the economic indicator that the loan is tied to for the purpose of determining a possible interest rate adjustment. Generally, if the economic indicator goes up, your interest rate will go up when it’s time to adjust. The economic indicator used varies. The more volatile the indicator (in other words, the more quickly it will react to the movements of interest rates in general) the more aggressive the lender is in pricing the rate they will offer on the loan. Common indexes used include the 1 year T-Bill, the 1 year CMT (Constant Maturity Treasury), the Six Month LIBOR (London Interbank Offered Rate) and the COFI (Cost of Funds Index). Each index in the board spectrum does the same thing; is an indicator of whether rates in general are going up or going down.
The 1 year T-Bill or Treasury Bill is a loan to the US government for a period of one year. The government uses T-Bills along with other security instruments to manage cash flow for it’s expenses.
The 1 Year CMT or Constant Maturity Treasury is the average yield on United States Treasury securities adjusted to a constant maturity of 1 year.
The LIBOR or London Interbank Offered Rate is the rate banks in London charge each other to borrow overnight to meet deposit requirements.
The COFI (Cost of Funds Index) is the average rate of return on all deposit instruments in all member banks of the 11th District of the Federal Reserve system.
T-Bills, CMT’s and the COFI indexes are considered to be lag indicators, or more on the back end of interest rate changes. The LIBOR index is considered a more volatile or more leading indicator of what rates will do.
The margin is the amount added to the index to determine if a change in the interest rate is warranted when its’ time to be re-evaluated. The margin does not change over the life of the loan. Typical margins are anywhere from 2 – 3% on an annually adjusting mortgage.
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How an ARM Adjusts
The adjustment on an ARM then is simply the addition of the margin to the index at the time of the periodic adjustment to determine if the rate should adjust subject to the adjustment caps.
Let’s say you take out a one year adjustable rate mortgage with a first year rate of 5%.
Let’s say the caps are 2% per year and 6% over the life of the loan and the margin is 2.75%.
Let’s also say that the index is the 1 Year CMT and is currently a 4.5%
If the loan were a year old we would add the index of 4.5% to the margin of 2.75% and come up with a rate of 7.25%. Since there is a per adjustment cap or limit of 2%, the maximum rate adjustment would be limited to 7.00% and that is what the loan would be adjusted to.
The important things to remember about Adjustable Rate Mortgages, is that like any other financial instrument, they are priced to risk. The more risk the borrower is willing to take (higher adjustment frequency, higher caps, higher margin, more volatile index) the lower rate the lender will offer on the loan because the more risk you take the less risk the lender takes.
Adjustable Rate Mortgages usually make the most sense as an alternative to Fixed Rate Mortgages when you are confident the mortgage is going to be relatively short term and the risk of adjustments is therefore minimized.
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Other Twists and Turns
Other aspects of mortgages that you may have hear about include Interest Only mortgages, Negative Amortization mortgages, No Closing Cost loans and Pre-payment Penalties.
An Interest Only mortgage is as the name implies a loan where the only payment due on the loan is the simple interest that accrues. Because the loan payment does not include any principal, the loan balance does not reduce or amortize. They are a popular option as the interest only feature reduces the payment somewhat. Interest Only mortgages generally are interest only for a period of time (generally no more than 10 years) at which time they reset to fully amortize the loan balance. Interest Only mortgages are available both as fixed rate and adjustable rate mortgages.
A Negative Amortization mortgage is a loan where the payment being made is not enough to cover the interest due so there is an outstanding balance. That balance is added to the loan so instead of the loan amortizing or paying off, there is negative amortization; in other words the loan balance actually increases. The loan isn’t quite as scary as it sounds. Negative Amortization loans are designed to offer a low minimum payment on a loan but the ability to pay a higher payment. An example would be a borrower who receives a large bonus at the end of every year. During the year they make a minimum payment that creates the loan balance to increase or negative amortization. At the end of the year when they receive their bonus they pay more than the minimum and catch up the amortization. It was always felt that the appreciation or increase in the value of the real estate the loan was on would outpace any negative amortization and these types of loans do have a limit on how much the loan balance can increase. Negative Amortization loans are only available as Adjustable Rate Mortgages.
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No Closing Cost Loans
One Fee, Flat Fee, and No Closing Cost Loans are becoming increasingly popular. An intriguing idea and depending on your circumstances may be a great option for you to consider for your loan. Here’s how they work:
If the market rate of say 30 year fixed rate mortgages is 6.50%, and the lender delivers to the investor a loan with a higher than market rate; the lender earns a premium on that loan. That premium can be used to pay all or a portion of your closing costs and prepaid expenses. Here is an example of how that may work:
Let’s say you’re getting mortgage of $150,000. At the rate of 6.50% on a 30 year fixed rate loan, the principal and interest rate would be $993 a month. Normal closing costs on a loan that size will vary somewhat from market to market but a reasonable average would be around $3,200.
On a No Closing Cost loan, the interest rate would be 7.00%. At that rate the principal and interest payment would be $1039, but the closing costs would be zero. So the trade off is $46 more a month in monthly payment versus $3200 in additional up front fees. If you do the math, you would have to live in the house over 70 months; almost six years, to be better off as far as total cost is concerned.
The option looks even better if you consider that because the payment difference is all mortgage interest, which makes it tax deductible. So the difference on an after tax basis will be even less, maybe a lot less depending on your individual tax bracket. Looking at it with after tax dollars the time to recover the up front investment is even longer, and when you consider that you could take that money and invest it the option becomes even more compelling.
A One Fee or a Flat Fee loan is a slight variation on this theme. The lender uses a premium from a slightly higher interest rate mortgage to pay most of your closing costs and they ask you to pay a predictable single or flat fee for the balance.
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A Prepayment Penalty is a fee a lender would charge to pay a loan off before a certain period of time. They are most common on Adjustable Rate Mortgages. The concept is that the lender offers a low start rate and in exchange for that low rate asks the customer to not pay off the loan for a certain period of time. If you take a loan with a prepayment penalty and pay the loan off early, the fee is due. Prepayment penalties are not necessarily a bad thing depending on your circumstances, just something to be aware of.
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