Mortgage Shopping: Unraveling the complexities of home buying

Step, wrap, flex, blend. Bullet, balloon, assume, adjust. Step, vary. Step, adjust. Step, fix. The above may sound like the latest disco moves at Caf坢 Dallas, but these routines aren’t off the dance floor, they’re out of the board room. This is the vocabulary of money lenders. The words are the language of what used to be a fairly straightforward step: financing a home. Only a few years ago, you were all set to go house hunting if you had your tape measure in your pocket and the classifieds under your arm. No more. Today’s house-hunting tools must include a calculator in your wallet and the business section in tow. A crystal ball wouldn’t be a bad addition, either. When you buy a house in todays market, you’re not just buying shelter. You’re also buying the financing that goes with it. Pick the wrong financial package and your dream house will become a nightmare of responsibility. The complications of today’s financing and the high – and worse, volatile- interest rates create a gloomy picture. No longer does every mortgage look like a mortgage – fixed rates, level payments, fixed term. But if, before you buy, you get in step with the latest moves in the real estate market – if you know the creative twists that work for you and if you buy with those in mind – you may find quite a bargain.

With real estate sales down, a large number of houses on the market and financing tight, the goals of the game are changing. Sellers aren’t selling houses or condominiums; they’re selling financing.

“There are a lot of gimmicks, a lot of concessions being made. For example, some of the large-home builders are giving several months with no mortgage payments,” says David L. Fair, chairman of the board of Hexter-Fair Title Company.

Every deal is different. But the profusion of financial alternatives is more than just a lot of creative thinking. It’s a concerted effort by sellers and lenders to keep their own options open as they bring every potential home buyer they can find into a tight money market.

“I think that our mortgage lending industry has polarized more toward certain economic groups than ever before. Fifteen years ago, every home buyer applied for the same type of mortgage. Today, all these programs are designed for different groups of buyers,” says Fair.

Knowing the advantages and disadvantages of these financial alternatives will help you see them as individual, understandable mortgages -not a jumbled alphabet of ARMs, GPMs, RRMs, GPAMs and SAMs. Once you can see through the surface variations, the up-front come-ons, you’re in a better position to decide which financial instrument is best for you.

MUCH OF THE ACTION in the real estate market has obvious roots: With a tight money policy and a large federal deficit, the government gets first crack at the money supply. That leaves institutional lenders with less money to loan.

Enter, the seller. In a pragmatic step to sell their houses or condos, sellers are taking up a sizable amount of the country’s financing needs.

“The VA and FHA loans that have fixed rates are the foundation of seller financing. They’re the ones that start the vehicle, for the most part – those and old savings-and-loan notes that don’t have due-on-sale clauses,” says Fair. (Though specifics depend on wording, a lender can use a due-on-sale clause to call a loan or change the terms when the property is sold.)

At least for now, Veterans Administration-guaranteed and Federal Housing Administration-insured loans can be assumed by the borrower with no change in the interest rate. (When a buyer assumes a loan, he or she takes over financial responsibility for paying it off.) Older savings and loan mortgages (those written before 1970) also can be assumed without an escalation in rates. Take over one of these old mortgages and you’ve found a fixed-rate mortgage with a below-market rate.

With the assumption of the remaining balance on the old mortgage, you’ll probably still need additional financing to pay the difference between that balance and the seller’s asking price. Many sellers are willing to “take back a second” -act as lender to you, thus creating a second lien on the property.

You and the seller can set up the terms in practically any way you agree upon. Some sellers may want to draw out the financing over a long term; others may prefer a short term and thus, after a few years, may force you to seek financing elsewhere to pay off the balance. With a long-term financing agreement, you gamble on future financing conditions in exchange for moving into a house immediately.

“Some people got temporary loans last year because they thought the rates would come down. Many are about to give up. They can’t wait any longer [to refinance] because their loans are coming due,” says Georgia Hill, a vice president with Nowlin Mortgage Company.

Another variation of seller financing is the wraparound mortgage, which can be used only on existing notes that have no due-on-sale clause. The seller continues to hold and pay off the original note. He or she then combines or wraps the new financing you need with the balance due on the existing mortgage into a single note.

If a seller is holding a conventional note that’s been written within the last decade, you probably won’t be able to assume it, since it likely will have a due-on-sale clause. In the most strictly written version, the financial institution holding the mortgage has the right to call the loan due and payable when the property is sold. Other versions may allow the note to be assumed, but only with a change in terms.

Until recently, due-on-sale clauses have not been employed. But in an effort to clear their books of low-yielding loans, savings and loans have been enforcing the contracts. Some buyers and sellers have tried to skirt the financial institutions by selling the property without notifying the lender as required; a number of them have been caught. Rumor has it that the savings and loans have been searching legal records to discover these violators. Already, the institutions’ right to enforce the clause has been tested -and upheld -in Texas courts.

Even with the restrictions of a due-on-sale clause, you still may be able to get a fixed-rate mortgage at below-market rates. As a practical matter, the lender would prefer to make a new loan -not own the real estate. In fact, many are promoting a compromise rate, called a “blended” or “weighted” interest rate. You may hear such a deal referred to as the “Resale/Refinance Program.”

A new fixed-rate loan, one that combines the balance on the old note with new financing needed, is created by the institution holding the original note. The interest rate is set somewhere between the old rate and the prevailing rate. Since the computation is weighted, your rate comes out lower if the old mortgage balance is larger than the amount you need in new financing. The average blended rate in Texas is 13.195 percent on new loans originated through the Resale/Refinance Program, which is set up by Federal National Mortgage Association (FNMA). Popularly called Fannie Mae, FNMA supplies lenders with funds by “buying” their mortgages. To find out if it’s possible to take advantage of the program, the seller should contact his or her lender to see if the note has been sold to Fannie Mae. You would still deal with the original lender.

If the balance on the original note is small and the new financing is quite large, the weighted rate isn’t much help. Texas Federal Savings has recently initiated a Texas Equity Mortgage, available on notes that it owns, that also creates a below-market fixed-rate loan. As in blended-rate programs, the new loan combines the old note and the new financing. This note is designed for someone who can expect his or her income to rise at least 7 1/2 percent a year. With 10 percent down, you are offered a rate of 12 7/8 percent (the rate is subject to change); though the rate remains level, the payments increase by 7 1/2 percent each year until the note is paid off, in 10 to 11 years.

Though much of seller-financing in the past has been along more traditional lines – assumptions, seconds in the form of fixed-rate notes – sellers are becoming increasingly sophisticated and creative in their structuring of loans. Some are even making loans on which the interest rates periodically change. The key to a successful deal is to find a seller with needs that match your Own.

HOME BUILDERS are responding to the same problem that sellers are dealing with: selling a house in a tight money market. Moving a house out of inventory once it’s completed is crucial, since a builder must pay extremely high interim financing rates. In order to promote sales, builders are enticing purchasers in several ways. The most liquid builders are handling the financing themselves. Many others negotiate for end loans from their financial institution so that financing is in place for a qualified purchaser.

A few builders are offering “no interest” financing. If you’re in a position to put 30 to 40 percent down, you can own your home in a short time (as short as five years) with monthly payments that aren’t much higher than they would be with a fixed-rate mortgage at prevailing rates. You won’t have the extended benefit of interest deductions on your taxes; however, you will be able to make deductions while you’re paying off the loan. Uncle Sam doesn’t recognize the concept of “no interest” loans for tax purposes and arbitrarily sets an interest rate (called an “imputed rate”), which is currently 10 percent for homes purchased since July 1981.

As you might expect, the purchase price of the house or condominium is likely to be higher than it would be if conventional financing were used. Weigh the fast build-up of equity and extraordinary financing against the higher purchase price.

Because a builder often deals in volume, he is in a better position to negotiate for a note than is an individual purchaser. Thus, many builders line up the permanent financing on their houses and condos so that it is available to eligible purchasers. Even then, many borrowers have difficulty qualifying. To enhance the deal and lower the first years’ payments so a buyer can qualify, a builder may “buy down” the interest rate for the first few years – pay points up front to lower the rates. For example, the real rate of interest may be bought down 3 percent for the first year, 2 points the second year and 1 point the third year. This is sometimes called a “step” plan. As might be expected, the buy-down may result in a higher purchase price, depending on the competition in the market.

Not all financing lined up by builders will be permanent; it may last only three or five years. Here’s where a crystal ball might be helpful. If you’re betting that the financial climate will be better in a few years, you may wish to gamble with such a plan in exchange for moving in today. Keep in mind, though, that you will eventually have to pay origination fees and all the costs that go along with refinancing. And if you gamble wrong – if you’re unable to get financing when you need it – you could face foreclosure.

A FEW YEARS AGO, you could count the types of mortgages offered by institutional lenders on one hand – and, in some cases, on one finger. Now, hardly a week goes by that you don’t hear of some new program. Though the individual variations are endless, the basic types of mortgage deals are designed in response to a couple of basic situations: (1) the need for lenders to cover themselves should rates go up in the future, and (2) the need to lower the initial payments so more borrowers can qualify.

It’s no news that lenders made volumes of loans at low interest rates in past years that now have yields that are lower than the current cost of money. It’s also no news that lenders don’t intend to be burned again. Though some institutions still offer fixed-rate mortgages, these level-payment notes tend to disappear or be priced out of sight when rates are volatile.

Thus, lenders hedge their bets with mortgages designed to stay in line with the current rates. The key mechanism they use is called the Adjustable Rate Mortgage (ARM), the Adjustable Mortgage Loan (AML), or informally, the variable rate mortgage. As the name suggests, interest rates vary during the term of the note.

“Those who are buying homes who can expect their incomes to keep up with or exceed inflation are the ones who can afford and who are not committing economic suicide by getting into variable rate instruments,” says Fair.

Though there are many creative twists, the basic workings of an ARM go like this: When the loan is originated, you are given an initial interest rate on which all future rate changes will be based. At prearranged times during the term, the rate you’re paying is adjusted according to the difference between this initial rate and a rate that’s tied to and generally 2 1/2 to 4 points above a specified index. Treasury bills and securities are common indexes.

In the simplest versions, any adjustment of the rates results in an adjustment in your monthly payment. Common intervals include six months, and one, three and five years. However, it is possible to have the rate change without having an adjustment in payments. For instance, the rate adjustment may be based on six-month treasury bills, but the payment adjustment period may be every three years. Thus, during the three-year period, you actually may be paying more or less than necessary.

“To the extent that borrowers pay over, they would be having a relatively faster principal reduction,” says Jack W. Nichols, vice president of residential lending of Texas Federal Savings. “But to the extent that the payment doesn’t cover everything that’s required for principal and interest, it will be tacked onto the principal balance. They would be having negative amortization.”

Let’s assume that you were to pay $760.30 each month for the three-year period. To make matters simple, also assume that the rate stayed the same until the last six-month adjustment period, when the rate went up one-half percent. Though you would continue to pay the same each month, you would actually need to be paying $785.35 each month. The difference, $25.05 per month or $150.30 for the six months, would be added to the principal balance. Thus, your debt would be increasing (“negative amortization”) rather than being paid off (“amortization”).

Another situation, one that’s designed to safeguard the borrower against radical leaps in interest rates, can cause negative amortization. Some ARMs will have a “cap” or limit on the amount that either the rate or the payment can increase during any adjustment period. (Some also have a cap on the entire increase in the original loan amount, typically 125 percent.) If an increase in the rate or the payment was above the cap, the difference that you would need to pay would be added to the balance. You can, however, choose to waive the cap so that you don’t incur negative amortization.

The degree to which your interest rates vary depends on the index to which the rates are tied. Some indexes track short-term changes in the market and are more volatile; others track trends and tend to be less volatile.

“The six-month treasury bill rate is usually lower than the five-year treasury bill rate, but it’s more volatile and subject to larger changes. The Federal Home Loan Bank Board Rate on existing homes is usually the highest of the indexes, but it’s the most stable,” says Martin Currin, vice president of finance for Ebby Halli-day Realtors.

Your choice: Frequent and potentially large changes for a lower rate vs. locking in payments for a longer period with less dramatic changes but at a higher rate.

“The choice of the index should be based on the borrower’s perception of the movement of interest rates. For example, if you’re an optimist and believe that Reagonomics is going to work -that rates will drop and that there will be a sustained downward trend -then you might consider the shorter-termed plans. You’d get the benefits of the adjustment sooner and to a larger degree,” explains Warren O. Dinkins, Manager of Marketing, FNMA. “But if you’re pessimistic about the movement of rates, you may want to lock in the payments over a longer period. You’d know that your payments couldn’t go any higher for that period.”

When you talk with a lender, ask to compare a number of indexes over the last few years so you can see the differences. Then, before signing any contracts, make sure you understand (1) what the index is (2) what the rate is to which every other rate will be tied (3) how often the rate can change (4) how often the payment amount can change (5) if negative amortization can occur and (6) if there is a cap.

Similar in concept to the ARM is the Rollover. Rather than having the interest rate vary over a 30-year term, the entire note comes due and is renegotiated every few years (typically three or five) at the prevailing rate. Though there is no negative amortizatian, Rollovers do not carry the safeguards an ARM does and are typically considered riskier. If you’re thinking about one, be sure that refinancing is guaranteed. Otherwise, you could be out looking for a new mortgage every few years, or worse, if you can’t find refinancing you could be out on the street.

Whether interest rates are adjustable or fixed is of little concern if you can’t qualify for the mortgages in the first place. And that would be the plight of most consumers, if all mortgages were set at prevailing rates.

So, in order to qualify borrowers, lenders have come up with ways to lower the initial payments. The Graduated Payment Mortgage (GPM), used by FHA for a number of years and designed for the first-time buyer, was the first such instrument. In a popular version, the GPM starts out with low payments, which increase each year for five years, then level off in the sixth year and remain fixed.

But there’s a catch: Although you appear to pay at low rates initially, the actual rate is higher. Since you’re not paying enough to cover interest, you incur negative amortization initially. For instance, if you have a $50,000 note for 30 years with an interest rate of 16.5 percent, your payments for the first year (excluding mortgage insurance and taxes) would be $547.04. Each year the payments would increase by 7 1/2 percent until they reached $785.35 in the sixth year. Your outstanding balance would have increased to $56,166.57.

The assumption with GPMs is that your income will increase each year so that you can afford the higher payments. Though you build equity slowly and actually increase your debt for a time, there are two positive points: (1) Practically all your payment during the early years is interest and (2) you know exactly what you’re required to pay.

The newest variation on this mortgage is to shift into adjustable rates after the graduation period is over -typically three or five years. These notes are known as Graduated Payment Adjustable Mortgages (GPAMs) or Graduated Payment Adjustable Rate Mortgages (GPARMs). The adjustable portion of the mortgage carries with it the same risks and potential benefits (should rates go down) as other ARMs. Pay particular attention to the negative amortization aspect of a GPAM: Depending on the way it’s structured, you could have negative amortization on the adjustable portion of the mortgage as well as the graduated portion.

Another means of lowering initial payments-and thus qualifying a borrower-is for the purchaser, seller, or both to buy down the first year’s interest rates just as builders do. (The seller will be limited in the number of points he or she may put down.)

You may want to buy down your own interest rates. Though these points may be the deciding factor in your ability to qualify, you shouldn’t consider them a bonanza on your income tax the first year if you pay a large number of points. Though points are typically deducted in the year in which they are paid, it’s possible that you may have to spread them out if the number of points (excluding origination fees) is above what is generally charged in the area. Check with your accountant.

Though relatives have loaned young home buyers money for years, the investor is now making his way into the Dallas residential real estate market through a mortgage known as a Shared Equity Mortgage (SEM). The basic concept is this: An investor shares in the debt of purchasing a home in exchange for the tax shelter it provides, and ultimately, a piece of the action when the home is sold. The SEM is designed as a first step toward full ownership of a home, and is particularly aimed at those whose income may not stay in line with inflation.

One program developed locally by Dondi Group, Inc., the Rich Uncle Program, works like this: An investor is matched with a purchaser of a condominium. The investor and occupant equally share the costs of the down payment, monthly note payment, and home owner association fees. The investor-owner then leases his share to the occupant-owner (allowing the investor to take a depreciation in deduction against his investment income). Each deducts his own portion of the mortgage interest and ad valorem taxes. After three years, the two make a decision to either continue the same agreement, sell the property and divide the profit, or allow one to buy the share from the other. (If the occupant-owner buys, the investor-owner must take back a second or, of course, accept cash.) In case of default, specific guidelines are set up. If a forced sale does occur, the occupant-owner does recover any equity built up.

Many investors and lawyers are wary of another type of mortgage that, on the surface, is quite similar to the SEM. The Shared Appreciation Mortgage (SAM) also structured so that the investor, typically a mortgage company, puts up money to lower the interest rate in exchange for a portion of the profit in the sale of the home at a time set in the future. Many lawyers believe that the SAM conflicts with the homestead law, leaving an investor with no recourse to enforce his claim to recover any future profit. (For the legally minded: Since the money paid by investor with no recourse to enforce his claim to recover any future profit.

“It’s a serious gray area. The owner-occupant with a family in a house acquires a homestead right. When the investor-owner wants to get his money out, can he force the owner-occupant to pay, sell, or move? You run right into the homestead rights,” says Charles Shields, counsel for the Greater Dallas Board of Realtors. Other lawyers, such as Fair, believe that the investor-owner could enforce his homestead rights through foreclosure of the house if necessary; however, he questions if the investor could do so without going to court.

LIKE MOZART, lenders, sellers and builders produce many variations on a theme; like Wagner, they often intertwine those themes. For instance, it’s possible to get a graduated-style mortgage that has been bought down for the first years, then shifts into adjustable rates.

No matter how complex the mortgage initially appears, it’s crucial that you focus on each basic theme. From that close scrutiny, you can determine the motivations for creating it and thus for whom it’s designed. If a note, for instance, has rates that vary, you should realize that it should be used only by someone whose income can keep up with inflation. Or, if the instrument is graduated or stepped (bought down), it’s purpose is to aid a borrower in qualifying; the trade-off will be negative amortization or a higher sales price.

There are few, if any, situations in which you won’t have to make a trade-off. What is crucial is that you know what the trade-offs are and make your own decision about them, rather than finding out what you’ve swapped only after you’ve signed a contract.

Determining what’s fair to pay for a house in light of the financing that’s on it is one of those trade-offs.

“Financing is value, and the availability of affordable financing does create value,” says Dinkins of FNMA. “A 12 percent note rate may cause a property to move at $125,000. But a 17 percent note rate could reduce the price of that house.”

Assume that you’re looking at two houses that, to you, are comparable. If you can qualify for one loan and can’t qualify for the other, you don’t have much choice but to go with the one that may be artificially high because of the incentives on the loan. But if two houses are comparable and you can qualify for both mortgages, you’ll have to determine if a slightly higher sales price with more appealing financing is better or worse for you than less attractive financing but a sales price that seems to be more reasonable. Keep in mind the tax deductions and capital gains when you decide to sell your property.

Most importantly, you should look tothe future. With the exception of assumptions, it’s unlikely that a note that starts at107/8 percent will stay there for long.Though qualifying is essential, make sureyou know what you’re going to run into afew years down the road after all theallurements have faded. And if the payments are set throughout the mortgage,look at the true bottom line. Certainly, ahouse is not just an investment or a shelter.It’s the place where you put down roots.Just be sure that you’re not so caught up inthe short-term benefits that you get thoseroots ripped out from under you.


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