Read Nolo's Essential Guide to Buying Your First Home Online

Authors: Ilona Bray,Alayna Schroeder,Marcia Stewart

Tags: #Law, #Business & Economics, #House buying, #Property, #Real Estate

Nolo's Essential Guide to Buying Your First Home (29 page)

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Interest-Only ARMs
 
Another type of ARM is the interest-only variety: once very common, but increasingly difficult to find. (Although interest-only loans don’t
have
to be ARMs, they usually are.) This is, at least at the beginning, just what it sounds like: You start out paying only the interest that accrues on the loan principal, making for very low monthly payments. The downside is that you don’t reduce the amount you borrowed (there’s no “P” in your PITI). And of course, you have to start paying off the principal some day—usually between three and ten years later. At that time, you’ll either have to pay much higher monthly payments or, with a balloon loan, pay the whole thing off.
Interest-only loans are attractive when home prices are going up fast, with first-time buyers squeezing into the market. These buyers hope to make the low monthly payments long enough for their house to rise in value, then either sell without having to pay off the loan principal or refinance on better terms.
But as the recent turn in most real estate markets shows us, this can be a dangerous strategy. Such buyers pin all their hopes on the value of the property increasing, especially because interest-only payments don’t increase their equity. If the value of the property drops, the buyer could face a serious loss, particularly if forced to sell (maybe due to a job transfer) or after a change in the terms of the loan (an adjustment to the interest rate). And the buyer would remain responsible for paying the difference between the amount the house can be sold for and the remaining loan balance.
Buyers who pay down principal are in a much better position to weather unexpected drops in home prices. Even if forced to sell, they’ll owe less than their interest-only counterparts, because they’ll have built up some equity by reducing principal.
Option ARMs
 
The risk of an interest-only loan is surpassed only by the risk of an option ARM. Option ARMs, surprise, surprise, give you the
option
to pay an amount you want to each month. There are four options: (1) an accelerated payment that will help you pay off the loan over a shorter period than the actual loan term; (2) a payment of principal plus interest, as if you were paying off a normal, regularly amortized loan; (3) an interest-only payment; and (4) a payment that can be even less than interest-only (it’s a maximum payment, called a “payment cap,” based on your initial interest rate).
You can literally choose which payment to make each month—you don’t have to decide until you receive your bill. Since the loan is normally an ARM, the interest rate can fluctuate at each adjustment period (often month to month). If your interest rate has adjusted upward, more interest has accrued, and so each payment option will be a bigger dollar amount, except the fourth payment, since it’s locked according to the initial rate.
That last “locked” payment may sound appealing, but it presents a major problem: Your loan can negatively amortize, meaning your payment won’t cover the interest that accrued that month. That unpaid interest is added to the loan principal, and you’re further in the hole than when you started.
If you’re planning on living in your first home for less than ten years, a hybrid ARM can give you stability without the relatively high interest that you’d pay for a “real” fixed rate mortgage. However, if you stay in your home after the expiration of the fixed term, your interest rate may go up significantly.
To deal with negative amortization, some option ARMs require that the loan be “recast” every five years or so (or earlier if you reach a negative amortization limit imposed by the terms of the loan). That means that the lender will use your new principal balance—which might be higher than it was years before—to calculate a new payment schedule to dig you out of the hole.
Judging an ARM Beauty Contest
 
If you decide to get an ARM, here’s a summary of the features to examine:
•
Initial interest rate.
This should be significantly less than is available on a fixed rate mortgage, to balance the added risk of rate increases.
•
Adjustment period.
Look for annual or biannual (not monthly) adjustment periods.
•
Index.
A slow-changing index (such as the COFI) is preferable to a rapidly changing, volatile one.
•
Life-of-the-loan cap.
Don’t agree to pay a maximum interest rate greater than 6% above the initial rate.
•
Periodic cap.
The interest rate should change only a reasonable amount at each adjustment period; 2% is about right on a one-year ARM.
•
Low margin.
The margin should be as low as possible; around 2.5% on a six-month ARM or 2.75% on a one-year ARM.
•
No prepayment penalty.
You don’t want to be charged extra for making early payments or refinancing.
•
No negative amortization.
You don’t ever want to owe more principal than you started with; a good reason to avoid option ARMs.
•
Assumability.
ARMs are sometimes assumable, which means that when you sell the house, the next buyer can take over your loan. If interest rates are high then, this can be an incentive to prospective buyers.
 
 
Once the loan is properly amortized, you can repeat the same cycle over again: You can again negatively amortize your loan, and another recast will help you catch up. While this helps you limit negative amortization over the long haul, it doesn’t eliminate it entirely, and recasting prevents the very thing you’re probably seeking—low monthly payments.
Since the interest rate and minimum payment on an option ARM start out very low, it sounds like a good idea for someone who is disciplined enough to pay the accelerated or principal-plus-interest payment. But if you’re that disciplined, would the option ARM appeal to you? Probably not. You’d recognize that you’d be better off, long term, with a more stable loan. No wonder fewer lenders today offer option ARMs—they’ve had too many borrowers who chose them end up in financial distress.
Hybrid Loans
 
Hybrid loans, like hybrid cars, can save you money. While hybrid cars do it by eating less gas, hybrid loans do it through lower interest rates. They’re a safer and more realistic option for many first-time buyers who want to break into the market but don’t plan to be in their first homes forever.
Hybrids work like this: For a set period of time, you pay interest at a fixed rate—usually, below the market rate on a regular fixed mortgage—and after that, the rate becomes adjustable. The fixed-rate term is usually three, five, seven, or ten years. The frequency of the adjustment varies, but it’s usually every six months or one year. (A “5/1,” for example, means that the rate is fixed for five years, then adjusts every year.)
That means you want to know how long you’ll be in your home before signing up for a hybrid ARM. If you’re not sure or you want to maximize flexibility and reduce risk, select a hybrid with a longer fixed-rate term (such as ten years). You might have to pay a slightly higher interest rate, but you’ll save the cost of a refinance, if you realize at the end of the shorter term that you’re not ready to go. And you’ll save yourself the stress of trying to predict where you—and interest rates—are going to be in ten years.
Two-Step Loans
 
A two-step loan is essentially a hybrid loan with only one adjustment. During the first “step” of the mortgage—typically a period of five or seven years—the loan has a fixed rate that’s usually below comparable fixed rate mortgages. Then the rate adjusts to a newer fixed rate, but unlike a hybrid, it doesn’t keep changing every six months or year. The second step’s interest rate will be set based on the index at the time of the adjustment plus a margin.
If you see a loan referred to as 5/25 or 7/23, that may indicate that it’s a two-step loan. The first number is the number of years of the first “step,” and the second number indicates the length in years of the second “step.” Look closely, though, as some balloon mortgages are similarly labeled.
Of course, if you get a two-step mortgage, make sure you’ll be able to afford the second step. Since it’s impossible to know future interest rates, you may find that it makes more sense to refinance when the first step ends.
Getting Your Cash Together: Common Down Payment and Financing Strategies
 
Talk to anyone who bought their first home in the last few years, and you may hear, “We put zero down!” or “We got two mortgages so we could avoid private mortgage insurance!” Many buyers employed some creative down-payment strategies to help get into their first homes, and lenders obliged.
But with the market having done a huge turnaround, these methods have nearly dropped off the map. To make sure you understand the full range of possibilities, however, we’ll explain all the strategies here, from the traditional to the more creative.
The Traditional: 80/20
 
Lenders feel safe with buyers who pay 20% down and finance the rest. If you’re willing to pay that much up front, the lender is relatively confident that you’re not going to default: You’ve already shown you’re a serious saver, and you’ll have a lot on the line, too. Even if you default, the lender has a good chance of collecting what it’s owed if it sells the house through foreclosure, because you have more equity in the property. In turn, the advantage to you of putting 20% down is that you avoid paying for private mortgage insurance (PMI), and you’ll pay less interest overall.
Of course, if you’re in a very hot market, you may not want to wait until you’ve scraped together a 20% down payment. That’s especially true if increasing prices mean you’ll later have to pay even more for a house (uh oh, that 20% amount just became a moving target). You could end up being priced right out of the market. What’s more, if values are rising while you’re saving, you won’t reap the benefits of the increased value—instead, you’ll pay for it down the road, when you’re finally able to afford a place.
The Creative: 80/10/10
 
Sometimes called a piggyback loan, an 80/10/10 strategy allows you to avoid PMI by putting 10% down and getting two loans: a mortgage for 80% of the purchase price and a second loan for 10%. With this strategy, you’ll be making two payments each month, one on the primary mortgage, and one on the secondary mortgage. That second loan is commonly a home equity loan or home equity line of credit. Until fairly recently, some buyers even financed 100% with a piggyback, using an 80% mortgage and a second loan for the remaining 20%.
A home equity loan works a lot like a primary mortgage—you borrow a fixed amount of money, using the house as collateral. Usually, you get a fixed interest rate. Lines of credit, on the other hand, are more open-ended. While you still use your house as collateral, you can draw cash as you need it, as long as the line remains open. However, the interest rate on a line of credit is adjustable. Also, both of these types of loans are likely to have a higher interest rate than a primary mortgage, because the primary mortgage holder is the first in line to be paid if you don’t make payments and the house is foreclosed on. The risk of losing money is higher for the secondary loan holder, because it has to wait until the primary holder is paid before it recovers anything.
Not a Recommended Strategy
 
Homer:
Homer Simpson does not lie twice on the same form. He never has and he never will.
Marge:
You lied dozens of times on our mortgage application.
Homer:
Yeah, but they were all part of a single ball of lies.
—
The Simpsons
 
In the past, one of the major benefits of the piggyback loan was that the buyer didn’t pay PMI, which lenders usually require when the loan is for more than 20% of the purchase price. However, through 2010, PMI payments are tax-deductible. Until then, you may save money by getting one loan, paying and deducting PMI, and skipping the higher-interest second loan. It may be your only choice, anyway: Lenders in the last couple years have become reluctant to fund purchases with two loans. Second mortgage holders in particular worry they won’t recover what they’re owed if you don’t pay up and the home is foreclosed on. For this reason, a piggyback loan may not even be an option.
The Risky: Little or Nothing Down
 
Almost nonexistent today, 100% financing was all the rage just a few years ago, when up to one third of first-time buyers purchased this way. Today, lenders almost universally don’t allow borrowers to do it. If the value of the property drops and you haven’t paid off a significant portion of the mortgage, the lender stands to lose everything; and with the downturn in the housing market, lenders simply aren’t willing to risk that.
BOOK: Nolo's Essential Guide to Buying Your First Home
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