April 2010

What You Need To Know About…Mortgages (Part II)

Author: Lew Wessel

A good first step in the home buying process is to locate a reputable local mortgage banker and go through a “pre-approval” process to get a professional opinion on how much of a mortgage you will be able to obtain. This is an informal process, and no actual commitments can be made until you have identified a property you want to buy; but taking this step will save you and your realtor from a lot of potential future disappointments.

As discussed in last month’s article, there were some absolutely bizarre mortgages available just a couple of years ago. There is still some variety, but, for the most part, mortgages now come in two basic flavors with lots of different toppings:

Fixed-Rate Mortgages: These are the simplest to understand and the safest for the borrower. With this type of loan, the interest rate is fixed and the borrower is required to pay off the loan in equal monthly payment for the entire term of the loan. The typical term of these loans is 30 or 15 years.

Note: Don’t let the 30 or 15 year terms scare you. The longevity of these contracts is entirely in the favor of the borrower. There are rarely prepayment penalties in these contracts, so that if market interest rates go lower, you can try to refinance the mortgage at better terms. If they go higher, you just keep paying the loan at your lower-than-market rate. Not so with the loans described below.

Variable or Adjustable Rate Mortgages (ARM): With these mortgages, the interest rate adjusts according to a contract formula tied to some index such as LIBOR (the London Interbank Offered Rate) or US Treasuries. These mortgages come in many varieties, one of the most popular being the 5/1 ARM. The 5/1 ARM typically amortizes over 30 years (i.e. uses a formula to pay the entire loan in 360 monthly payments), has a fixed rate for the first five years and then the rate adjusts every year after to the current market rate as calculated by the contractual formula.

Some ARMs are 30-year loan contracts in which your payments are at risk to increase if rates go up, but the payments are still stretched out for the full 30 years. Others require a full or “balloon” payment after a relatively short period such as three, five or 10 years. “Balloon” mortgages usually have the lowest interest rates, but you have to be prepared to pay them off or refinance on the day of reckoning.

As stated above, the rates on ARMs are typically tied to some formula which is typically tied to some index of interest rates. You need to know the worst-case number under your contract’s formula and decide if you are willing and able to afford the resulting increased payments. Fortunately, beginning January 1, 2010, new regulations require the mortgage lender to provide you with that number. A related issue is your contract’s “cap” formulas, or the amount the interest rate can adjust after the initial fixed period and subsequent periods. The variations here are infinite; make sure you understand how they work!

So, which is better, fixed or variable? As always in financial matters, it depends. As is clear in my attempt to describe the two types, ARMs can be significantly more complicated than fixed-rate mortgages. They also usually come with lower monthly payments, which make sense since you, the borrower, are at risk for both higher interest rates in the future as well as a potential liquidity issue with a balloon note. For most borrowers, the predictability, flexibility and safety of the 30-year mortgage will be the best bet.

In general, you want to put 20 percent down for two reasons. First, any less than that and you will be required to obtain mortgage insurance which will add about five percent to your rate. In addition, a lower down payment means more risk for the lender and that will be reflected in a higher interest rate as well. Having said that, there are still plenty of mortgages out there which do not require 20 percent down, including USDA loans (0 down), Federal Housing Administration( FHA) loans(about 5 percent) and Veterans Administration loans (0). Speaking of the latter, if you are a veteran, you are entitled to use this program and you should look into it. Any competent mortgage banker can help you with all three programs.
Amounts paid for mortgage insurance is currently deductible for most taxpayers, but only until the end of 2010.

Per Matt Couch and Brad Ellis, two very experienced residential mortgage bankers at Coastal States Bank, the mortgage process takes about 30 days from start to finish. The process goes something like this:

As with most local brokers, they suggest a visit BEFORE you begin your serious house hunting. This visit is free and without obligation and will be time well spent.

At that visit, or upon your identification of the property you wish to buy, the mortgage broker will fill out an application for you. Once you identify the property, the mortgage broker can quote you a rate and you have the opportunity to “lock” it or let it float, in which case it can go up or down any time prior to the actual “closing” (see below). The decision to lock or not to lock is simply a guess on your part as to where rates are headed in the short term. If you are happy with the rate you have been quoted, go ahead and lock it and worry about other things.

A word here about rates and points: You’ll hear quotes such as five and a quarter percent with one point, or five and a half percent with 0 points. One “point” is simply one percent of your total loan amount; e.g. one point on a $200,000 mortgage is equal to $2,000. In order to decide whether or not to “pay down” the rate and thus your monthly payment by buying points upfront, you simply have to do run the numbers. A handy calculator at money-zine.com will do this quickly for you.

Once the application is done, the mortgage banker will have a “loan package” to you within three days with all kinds of consumer protection disclosures, including a comprehensive “Good Faith Estimate” of your closing costs. These costs can most often be included in your mortgage and can be substantial. Here is one area where it may pay to shop around, as one mortgage banker may charge substantially more than another for such pure profit items as the “processing fee.” Note: It is usually worthwhile to include your own bank in this process as they will often waive or lower certain fees for their customers.

The application package will include a list of items the mortgage banker’s “underwriting department” will need to evaluate the loan. These will include paystubs from your job, bank statements, income tax returns, etc. As I’ve said, it’s a different world out there now; be prepared to bare your financial sole in order to get your mortgage approved.

Once you have provided the requested documents, the loan package will be given to the bank or mortgage company’s processing department which will order an appraisal of the property and title work from a local attorney.

After the appraisal is received (figure about a week on this step) the complete package will be given to the “underwriter” who will give the final thumbs up or down to your loan. A word of advice: Don’t pop the cork until the underwriter’s work is done. Last minute snags seem to be the norm these days.

Once approved, the loan process moves to the “closing department,” where final details are tidied up and the package is prepared for the closing attorney.

The “closing” is appropriately named as it is the culmination of the mortgage and home-buying process. It normally takes place in a local attorney’s office of your choosing. Per Cary Griffin, a partner in the McNair Law Firm, P.A. and a veteran real estate specialist, you are not legally required to actually be present at closing. “It is certainly better to be there,” he advises, but many closings are, in fact, done by mail in our area. Present or not, expect to sign a bazillion documents, including the mortgage, until your hand cramps up and you, finally, officially, become a HOMEOWNER! Note: You are entitled to review all closing documents in advance, and it’s a good idea so that you can ask the closing attorney to explain anything you do not understand. Remember, once you sign on the dotted line, you own it!

One final word: One reads a lot today of people simply walking away from their mortgages because their house is “underwater” (i.e. the mortgage balance is higher than the value of the house). Putting ethics aside, this is not a good idea in South Carolina. Your mortgage is secured by your house, but you are also personally liable for the full amount. Sure, you can stop paying your mortgage and lose your house, but if there is any balance remaining on the mortgage, the bank or other holder of the mortgage will come after you for it. The only way you’ll get rid of the obligation is if the bank issues a release, and that is not likely unless they are convinced you are truly destitute, OR, in fact, bankrupt. In either event, your credit rating will be destroyed.

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