Spectrum Of Loan Programs

If you were to rate every possible loan program on a scale from the most conservative to the least conservative, you’d have the 30-year and 40-year fixed amortizing loans on the conservative end and the negative amortization variable-rate loans on the opposite side. Those are the two extremes.

On the conservative end, you’re paying off the loan at a fixed interest rate. Nothing changes. Your payment is exactly the same each and every month, for 30 or 40 years. That means you make the exact same payment today as you will in the year 2036, or even 2046.

On the aggressive end, you’ve got a loan where your payment isn’t even enough to pay the interest on the loan! So the size of the loan is actually getting bigger each month. To make matters worse, the underlying interest rate is variable. That means you can’t even plan the extent to which your loan balance is expected to grow.

We’ll take a look at the whole spectrum but first, we need to examine the interest rate structure. The 30-year fixed mortgage is one of the most conservative options available. It has the least amount of risk. Well, for the bank, the opposite is true. By reducing risk for the borrower, all the market risk is transferred to the bank. If interest rates sky-rocket, the bank cannot change the rate on your mortgage. It’s fixed. They also can’t “call” the loan because you’ve got a full 30 years to pay it off. So the bank could be making more money but they’re stuck with you and your low fixed-rate mortgage.

That’s a risk the bank takes when it gives you a fixed-rate mortgage. And as a result, the bank charges a premium for 30 or 40-year fixed mortgages. In fact, all other things being equal, interest rates get higher when you fix them for a longer period of time. An interest rate that’s fixed for 5 years will be slightly higher than one that’s fixed for only 3 years. A 7-year fixed is higher than a 5-year fixed. A 10-year is higher than a 7. A 15-year is yet higher and a 30-year fixed interest rate has traditionally been the highest. Of course, recently, the lending community has come out with the new 40-year mortgages. When fixed for the full 40 years, the rate is slightly higher than the 30-year. You pay for the luxury of a fixed interest rate; the longer it’s fixed, the higher the rate is.

Remember: “all other things being equal.” That’s what we’re talking about here. Given the exact same credit, income and assets; given the exact same closing cost structure; given the same down payment or equity; the interest rate will be higher as you fix it for a longer period of time. There’s no question that rates could be higher or lower if other things in the file are different. For example, if you’re comparing a 2-year fixed Subprime loan to a 5-year fixed A-paper loan, the 5-year fixed would have a lower rate than the 2-year Subprime but there are big differences between A-paper and Subprime loans.

The 30-year fixed is, historically, the most conservative choice. You pay for that security with a slightly higher interest rate but the risk is extremely low. The new 40-year mortgage is now increasingly common and by amortizing the loan balance over a longer period, it allows for slightly lower payments. Both of these loans have traditionally required “amortizing” payments; that is, they include both principle and interest.

Recently, the option of a 10-year Interest Only period has been introduced. The rate remains fixed for a full 30 years but you only have to pay interest for the first 10. If you think about it, there’s no reason to have a 40-year loan if you also select the Interest Only option. If you’re only paying interest, the amortization period become irrelevant. Either way, you’re only paying interest. The difference would show up after the Interest Only period expires. With a 30-year loan, the remaining amortization period would be squeezed into the last 20 years. With a 40-year loan, you’d still have a full 30 years to pay the principle down.

Now, how many of us actually plan to spend the next 30 or 40 years in the same house? Perhaps some of us are but the majority plan to move into a different place sometime before 2036 (30 years from now). The trick is to balance the fixed period with the length of time you intend to stay in the property. There’s no sense fixing the interest rate for a period of time when you’ll no longer have the mortgage. There’s no sense paying for a luxury you’ll never benefit from.

In today’s marketplace, you can fix an interest rate for 1 month, 6 months, 1 year, 2 years, 3, 5, 7, 10 years, 15, 20, 30 or even 40 years. So take a minute and think about how long you intend to stay in your current property. 5 years? Maybe 7? If that’s the case, you should only fix your interest rate for 5 or 7 years; maybe 10, just to be safe. That way, you’ll get the lowest interest rate possible while still getting the security of a fixed interest rate for the period of time you expect to keep the mortgage.

Most of these loans – the ones that are only fixed for 3, 5, 7 or 10 years – still have a full 30-year term. The payment is still calculated as if it was a 30-year amortizing loan. Again, if you select an Interest Only option, the amortization schedule becomes irrelevant. It doesn’t matter; you’re only paying interest anyway, at least until the fixed period expires. But for an amortizing loan, the payment is based on a 30-year amortization period and is completely fixed during the initial fixed period. After that, the rate changes to an index plus margin and the loan becomes variable. The margin never changes but the index can move up or down depending on trading activity in the bond markets.

In what circumstances should you select an Interest Only mortgage? Many homeowners today are stretching to make their monthly mortgage payments. Home prices have risen much faster than salaries, so it’s a bigger strain on homebuyers than it was years ago. If you select an amortizing mortgage, you’re basically putting yourself into a forced savings program. Any money you put towards your principle increases your equity. You get all that money back when you sell the house because your loan balance will be lower than it would otherwise, leaving you with more equity. An amortizing mortgage is definitely the ‘conservative’ choice.

On the other hand, you can look at an amortization schedule and see how much of the principle you actually pay down during the first 5 years of a 30-year mortgage. Not much. If you’re only planning to stay in the property for 5 years, the difference in your equity is fairly minimal. Meanwhile, paying interest only would reduce your monthly payment. In California, Interest Only mortgages are extremely common and they definitely serve a purpose for those homeowners who are planning to get into a new, perhaps bigger, property within a few years.

The important thing to remember, obviously, is that your original principle balance never gets any smaller. In that sense, you’re basically renting the house and banking on appreciation to build equity. During the past 10 years with house prices rising between 10 and 20% each year, this strategy has paid-off handsomely. But what happens when the market starts going sideways as it is today? What happens if prices remain the same or even go down a bit?

Also, consider the fact that you’ll have to pay 5 or 6% real estate commissions when you sell. If you put 20% down on a house and only pay interest for 5 years and if house prices remain stable, you’ll actually lose money on the deal. You’ll start with 20% equity. If you end up paying 5% real estate commissions, you’ll sell the place with only 15% equity (20%-5%) so you’ll have less money after you sell the place than when you bought it 5 years earlier. And that doesn’t include the closing costs associated with the original purchase. Those generally run about 2% so you’d end up losing 7% of the house’s value during the 5-year period.

If the place actually drops in value, the situation gets even worse. I recently spoke with someone in this situation. He bought a place 10 months ago and can’t keep up with the mortgage payments. His situation is even worse because he’s got a prepayment penalty in his loan. Meanwhile, his home hasn’t appreciated a cent. Between real estate commissions and the penalty, he’ll be out over $35K if he sold today (he originally did 100% financing). If he rents it out, he’ll still be under water about $1500 per month. Either way, he’s in a bad situation. You have to be careful. Profit is not guaranteed.

That brings me to the last major loan program; one that is gaining in popularity. It’s a bit scary, actually, because this last type of mortgage is the least conservative of the bunch. It’s called an Option ARM and it gives the borrower a choice of 4 different payment options each month. They can pay a minimum payment which is based on an artificial starting interest rate of just 1%. They can pay the Interest Only payment. They can pay the 30-year amortized payment or they can pay the 15-year amortized payment – the highest of the 4.

We’ve all heard about these 1% mortgages. They’re heavily promoted and most of the marketing is deceptive. I personally believe that less than 10% of the people who get into these loans truly understand what they’re getting into. There’s no research to support that – it’s only my opinion. Let’s take a closer look and unravel the hype surrounding these loan products. Believe me; they’re not as great as they may appear.

First off, rates have never been 1% and they never will be. 1% is a marketing label that helps sell loans. They calculate the payment assuming a 1% start rate, but this minimum payment is less than the Interest Only payment. You’re under water right from the start. The difference between this minimum payment and the Interest Only payment is referred to as “deferred interest” and it gets added to your mortgage balance each month. It’s called Negative Amortization and it erases your equity every time you make that low minimum payment.

The next thing is that these loan programs are not fixed. They’re variable right from the first month. The minimum payment structure is indeed fixed for the first 7 years (in most cases), but that’s an artificial payment – a Negative Amortization payment. Those minimum payments don’t reflect the true interest rate at all. The underlying interest rate on these loans is variable and can change every month.

Third, the 30-year amortized payment is not fixed either. When people hear “30-year”, they automatically assume “fixed”. That’s not the case here. There’s a big difference between “amortized” and “fixed”. With a variable interest rate, the 30-year amortized payment changes each month. And these days, it’s probably getting higher, not lower.

We have to admit that there is value in these programs for people who fully understand them. In an appreciating real estate market, they can make it easier to maintain an investment property or provide flexibility for someone with an uneven income stream. But if the real estate is not appreciating, these programs erase your equity and destroy potential profits. So be careful.