Conforming loans represent home loans/mortgages that meet specific underwriting guidelines as set forth by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Fannie Mae and Freddie Mac are often referred to as agencies of the Federal government. While this is true, understand that they are not government owned and operated.
In fact, they are both shareholder owned private corporations which are actively traded on the under ticker symbols FNMA (Fannie Mae) and FMCC (Freddie Mac).
Prior to the creation of Fannie Mae and Freddie Mac, the mortgage industry consisted primarily of banking type institutions making home loans to homeowners and servicing these loans until they were paid off. The problem was that as an institution began running out of available funds for lending, they would increase their lending interest rate. This lead to widely fluctuating interest rates both locally and nationally.
With the creation of Fannie Mae and Freddie Mac, these mortgage originators (banking type institutions) were suddenly able to replenish their available funds for lending by selling their existing mortgages to Fannie Mae or Freddie Mac. This action made more funds available to homeowners while adding consistency to interest rates throughout the nation.
An FHA loan is a government loan that is insured by the Federal Housing Administration. FHA loans are commonly used by first-time home buyers that have less available assets to make a large down payment, or borrowers with middle to lower credit scores. These mortgages allow you to put as little as 3.5% down and can be in the form of a gift or grant.
Monthly Mortgage Insurance
The Federal Housing Administration reduces lender risk by promising to pay the mortgage in case of default. This gives lenders more incentive to lend to borrowers that may not qualify or can not afford a traditional mortgage. As a result of insuring the mortgage, the FHA requires borrowers to pay a monthly mortgage insurance premium (MIP) along with their principal and interest payment to offset the risk of potential default. The MIP ranges from .80% to .85% annually, and is paid as an added monthly payment. The MIP only falls off after the borrower makes 120 payments, however many borrowers become eligible to refinance into a conventional loan before that period has been reached.
Most active duty members of the military, veterans, surviving spouse are eligible for a VA home loan. VA loans are known for their $0 down payment, low interest rates and not having the added cost of mortgage insurance. These loans are secured by the Department of Veterans Affairs by guaranteeing a portion of the loan in case of default.
Most lenders require a 620 minimum credit score in order to qualify for a VA loan. Some lenders do go lower on credit score, but the interest rate often increases once below this threshold.
Similar to FHA, there is an upfront funding fee for a VA loan which can either be paid at closing by the borrower, covered with lender credit, or financed on top of the loan amount. On a purchase, the VA Funding fee is determined by the down payment percentage and whether it is your first time using the benefit or subsequent use. VA Funding Fees are also required on VA Interest Rate Reduction Loans (IRRRLs) and VA Cash-out Refinances. These funding fees vary across loan types. A chart for VA Funding Fees can be viewed by clicking the following: VA Funding Fee Table
“The name says it best”. Any loan amount above the conforming loan limit as determined annually by Fannie Mae and Freddie Mac (currently $510,400), is classified as a jumbo loan. However, in High-Cost Areas, such as the Bay Area and the LA Area, Fannie Mae will expand their conforming limits up $765,600. The premium for these loans typically fall between 1/8 % to 3/8 %. The essential reason for this is liquidity. Liquidity in this sense is the amount of time necessary to turn an asset, in this case a mortgage, into cash. The faster this can be accomplished, the more liquid the asset.
These mortgages have interest rates that remain the same over the entire length of the loan term. Historically, these loans have had terms of fifteen and thirty years. However, in recent years, the industry has made both ten and twenty year terms available. More recently, some lenders are allowing any term up to thirty years (360 months). For example, if you desire a 22 ½ year term (270 months), it is usually available.
Having the same interest rate over the entire loan term means that the monthly payment will remain the same. Additionally, this means the last payment will be equal to the first. When the last payment is made, the loan balance will be paid in full.
Varying the term of a fixed rate mortgage will vary the scheduled monthly payment. It only stands to reason that if you desire to payoff a loan in a shorter period of time this can be accomplished by increasing the monthly payment.
Unlike a fixed rate mortgage, where the interest rate cannot change over the entire term of the loan, an adjustable rate mortgage (ARM) does not guaranty an interest rate.
Adjustable rate mortgages were effectively introduced in the United States in the 1980’s. Interest rates at that time were extraordinarily high. The prime lending rate was in excess of 20%, the 30 year government bond rate was approaching 20% and a very good 30 year fixed interest rate was 16.25%. This last rate made it very, very difficult for prospective home buyers to qualify for mortgages. Hence, the introduction of adjustable rate mortgages in the United States.
The primary reason that ARMs achieved some degree of popularity in the U.S. at that time is essentially the same reason they are still around today. That is, ARMs typically have a low introductory rate or start rate, often referred to as a “teaser rate”.
Generally speaking, ARMs have fixed rate terms of 3, 5, 7 & 10 years. Typically, the shorter the fixed rate term, the lower the fixed interest rate. Theoretically this is a function of the interest rate market being able to forecast expected interest rates over a three year period better than over a ten year period, hence, the lower rate/shorter term relationship.
Currently, these ARMs are referred to as 3/1, 5/1, 7/1 & 10/1 loans. The common characteristics of these loans are: each has a fixed rate for a specific period of time; each has a term of thirty years; and, at the end of the fixed rate term, each adjusts to an adjustable rate mortgage for the remainder of the thirty year term. In other words, a 3/1 ARM would have a fixed rate for three years and an adjustable rate for 27 years, a 5/1 would have a fixed rate for five years and an adjustable rate for 25 years, and so on.
Like Adjustable Rate Mortgages, the Intermediate ARMs have caps to minimize the borrower’s interest rate exposure during periods of escalating interest rates. However, there is one important difference. Whereas Adjustable Rate Mortgages have a cap format of 2/6 (explained in our section on ADJUSTABLE RATE MORTGAGES), Intermediate ARMs have a cap that is communicated to the borrower in the following format: 6/2/6. The difference is that the first adjustment could be as high as 6.00% over the initial term interest rate. After the first adjustment, the cap acts exactly like the aforementioned Adjustable Rate Mortgage cap.
Important “ARM” Terms
This is the rate that gets the attention of a potential borrower. You may see the advertised rate as low as 1.00%. This is certainly low enough in any market to grab the attention of a borrower. However, remember: a teaser rate is typically good for only 1 to 12 months. The lower the teaser rate, the shorter period of time until the first interest rate adjustment.
The index is the anchor point in the determination of an ARM’s interest rate. It is the component of the rate that creates the variable interest nature of an ARM… indexes move up or down depending on what is happening in the general and sometime specific financial markets. While there are many indexes available for use, some of the more common indexes are:
- LIBOR (London Inter-Bank Offered Rate)
- 11th District Cost of Funds
- 1 Year Treasury Bills
The margin represents the fixed component of an ARM. It is the spread over and above the index value that compensates the lender for any and all risks associated with making an adjustable rate mortgage to a borrower. Oftentimes downplayed, this is a very significant component of an ARM. In most cases, it can range from a low of under 2.00% to well above 3.00%.
Caps are protective devices that are incorporated into ARMs and help to minimize the borrower’s exposure to rapidly increasing interest rates. They are often communicated to borrowers in the following format: 2/6. This means that there is a limit as to how high an interest rate can be adjusted during each adjustment period as well as over the life of the loan. To illustrate this, let’s assume that a borrower received a one year ARM with an initial teaser rate of 4.00%… a 2/6 cap means that after the first year, when the interest rate is adjusted, it cannot exceed 6.00% (teaser rate of 4.00% plus annual cap of 2.00%) and under no circumstances could the interest rate ever exceed 10.00% (teaser rate of 4.00% plus lifetime cap of 6.00%).
Here are some very general advantages and disadvantages of Adjustable Rate Mortgages:
- Teaser rate
- Ability to minimize cash outflow for mortgage payment
- Qualify for larger loan amount
- Uncertainty of future rates
- Costs associated with securing the loan
- Prepayment penalties
- Potential for negative amortization
- Not understanding your loan
For years, these loans were made available by various savings institutions such as banks, savings and loan associations, credit unions and thrift associations. These institutions would make these loans and hold them until they became due, typically five years after origination. Because these institutions were forced to hold these loans for the duration of their term, they essentially lost liquidity and, as a result, the institutions charged an interest rate premium for these loans.
Recently, the mortgage industry has embraced this concept and has begun originating interest only loans and allowing these loans to be bought and sold in the secondary mortgage market. This has allowed these loans to become liquid and, as such, they have become more competitively priced, and, therefore, have lower interest rates.
How is this different from a Fully Amortized Loan?
In a more traditional, fully-amortized mortgage, the borrower agrees to make a payment that includes both a principal reduction amount as well as the current interest due. When applied to the loan balance, the principal reduction amount decreases the loan balance and as the loan balances decreases so does the current interest due.
Opting for an interest-only loan rather than a fully amortized loan reduces your monthly payment, but fails to reduce your loan balance. The vast majority of interest-only mortgages are written with terms similar to terms for Fixed Rate ARMS, i.e., 3, 5, 7 & 10 years. This means for that fixed term you are sacrificing the opportunity to build equity in your home for the ability to have lower payments
While the reduced monthly payment is enticing, there are some borrowers who opt for interest-only loans for a different reason. That reason being the borrower can qualify for a larger loan amount using an interest-only loan rather than the more conventional fully amortized loan.
We like to describe HELOCS as being quite similar to a credit card, a giant credit card that is, you are able to use them as a revolving account. In essence, a revolving account allows you to borrow and payback as your needs and abilities warrant. For instance, if you receive a HELOC in the amount of $50,000, this entitles you to borrow any amount up to $50,000 at any point in time during the “draw period” and likewise repay or partially repay at any time during this period. If you have a balance outstanding at any point during a month you will be required to make a minimum monthly payment to the lender.
Typically, the interest rate you pay on a HELOC will be lower than that which you would pay on a credit card. The essential reason for this is a HELOC is secured by real property (your home) whereas a credit card is unsecured (personal guarantee). If you default on a HELOC, you could ultimately lose your home through a lender foreclosure. A similar default on a credit card will not negatively impact home ownership, but will take a serious toll on your credit rating.
HELOCS have variable interest rates which are typically tied to the prime lending rate plus or minus a margin. The interest paid on a HELOC loans is tax deductible with certain limits and restrictions set forth by the government. This tax deductibility feature is the result of the loan being secured by your home. Hence, it is a mortgage and as such the interest paid qualifies as a tax deductible expense.
In addition to the revolving account and tax deductibility features of this type of loan we believe perhaps the most beneficial feature of a HELOC is the security feature that it affords a borrower. In the event of an emergency or family crisis, these funds are readily available without the necessity of applications, questions and or explanations.
Along with advantages be assured there are disadvantages to HELOCS. A “giant credit card” in the hands of a fiscally irresponsible person is a catalyst for financial disaster. Thankfully, most borrowers do not fit this mold and as such, potential financial disaster from the misuse of a HELOC is not a norm but rather an extreme. We believe a much more serious disadvantage is the potential impact of the variable interest rates on HELOCS.
A bridge loan, sometimes referred to as “gap financing”, provides a borrower with temporary funds that will be paid back in a relatively short period of time. The source for payback would be a clearly defined event, the occurrence of which would generate the funds necessary to payback the loan.
Bridge loans, when available, tend to be more expensive than more conventional forms of financing. A more conventional way to fill this gap would be to have a Home Equity Line of Credit (HELOC) available to extract the equity from one property and transfer it to the new property. However, sometimes timing is such that it necessitates a Bridge Loan. Preferred Financial frequently can accommodate our client’s needs for this type of loan.
With traditional mortgages, when a borrower makes a mortgage payment, a portion of that payment goes to pay interest charges on the current loan balance and the remaining portion of the payment reduces principal loan balance. In other words, when a monthly payment is made on a traditional mortgage, the loan balance is decreased and the borrower’s equity in the home is increased by the exact same amount.
With a reverse mortgage, the borrower does not have any obligation to pay back the lender as long as the borrower resides in the property. This gives the homeowner an opportunity to turn a portion of his/her equity into cash. This can occur in one of the following ways or in a combination thereof:
- In a single lump sum at the closing of the mortgage;
- As a predetermined monthly cash advance;
- As an equity line of credit (more frequently referred to as a credit line in the context of a reverse mortgage), allowing the borrower to decide how much and when distributions are made.
More often than not, reverse mortgages pay out with a large initial sum disbursed followed by either a predetermined monthly advance or an equity line.
Typically, to be eligible for a reverse mortgage, you must own your home and be 62 years of age or older. If you have a spouse that is also on the title to the home, the spouse must be at least 62 years old as well. Owning your home does not mean it has to be free and clear of any debt. Since reverse mortgages generally must be a first loan, any currently existing loans on the home would have to be paid off before or at the time a reverse mortgage is recorded. This normally does not create a problem since the borrower can take an initial cash draw from their reverse mortgage at time of closing to pay off their existing mortgage.
Unlike traditional mortgages, which require a borrower to “qualify” for a loan, a reverse mortgage does not require the borrower to submit income or credit documentation to the lender. This is because the borrower will not be required to make any payments to the lender during his/her lifetime. However, like traditional mortgage lenders, reverse mortgage lenders require that the property “qualify”. Qualification is determined through a property appraisal report. In cases where the property is in the state of disrepair, the lender may require that the property be improved. This can be done with an initial cash draw.
Preferred Financial strongly recommends that if you have any further interest in pursuing a reverse mortgage, please visit the AARP website http://www.aarp.org/revmort or call the AARP Foundation at 1-800-209-8085 and request their free publication “Home Made Money: A Consumer’s Guide To Reverse Mortgages”…You’ll be happy you did.