If you're considering buying a home, you're likely aware of the complexity
of the endeavor. Because of the numerous factors to consider when purchasing
a home, it's important to prepare as best you can. Some common home-buying
principals and caveats are presented here for your consideration. By keeping
them in mind, you'll help create a successful and more enjoyable experience.
Since your home could cost you 25 to 40 percent of your gross income,
it's important to conduct research, ask questions and study the process
carefully.
A third reason why homeowners refinance is to consolidate debts and replace
high-interest loans with a low-rate mortgage. The loans being consolidated
may include second mortgages, credit lines, student loans, credit cards,
etc. In many cases, debt consolidation results in tax savings, since consumers
loans are not tax deductible, while a mortgage loan is tax deductible.
The answer to the question "Should I refinance?" is a complex
one, since every situation is different and no two homeowners are in the
exact same situation. Even the conventional wisdom of refinancing only
when you can save 2% on your mortgage is not really true. If you are refinancing
to save money on your monthly payments, the following calculation is more
appropriate than the rule of 2%:
Sometimes, you do not have a choice-you are forced to refinance. This happens
when you have a loan with a balloon provision, but with no conversion
option. In this case it is best to refinance a few months before the balloon
comes due.
Whatever you choose to do, consulting with a seasoned mortgage professional
can often save you time and money. Make a few phone calls, check out a
few web sites, crunch on a few calculators and spend some time to understand
the options available to you.
The best way to decide whether you should pay points or not is to perform
a break-even analysis. This is done as follows:
- Calculate the cost of the points. Example: 2 points on a $100,000
loan is $2,000.
- Calculate the monthly savings on the loan as a result of obtaining
a lower interest rate. Example: $50 per month
- Divide the cost of the points by the monthly savings to come up with
the number of months to break even. In the above example, this number
is 40 months. If you plan to keep the house for longer than the break-even
number of months, then it makes sense to pay points; otherwise it does
not.
- The above calculation does not take into account the tax advantages
of points. When you are buying a house the points you pay are tax-deductible,
so you realize some savings immediately. On the other hand, when you
get a lower payment, your tax deduction reduces! This makes it a little
difficult to calculate the break-even time taking taxes into account.
In the case of a purchase, taxes definitely reduce the break-even time.
However, in the case of a refinance, the points are NOT tax-deductible,
but have to be amortized over the life of the loan. This results in
few tax benefits or none at all, so there is little or no effect on
the time to break even.
If none of the above makes sense, use this simple rule of thumb: If you
plan to stay in the house for less than 3 years, do not pay points. If
you plan to stay in the house for more than 5 years, pay 1 to 2 points.
If you plan to stay in the house for between 3 and 5 years, it does not
make a significant difference whether you pay points or not!
Zero-Point/Zero-Fee Loans
Whatever happened to the conventional wisdom of waiting for the rates
to drop 2% before refinancing?
You have a 30-year fixed loan at 8.5%. A loan officer calls you up and
says they can refinance you to a rate of 8.0% with no points and no fees
whatsoever.
What a dream come true! No appraisal fees, no title fees and not even
any junk fees! Is this a deal too good to pass up? How can a bank and
broker do this? Doesn't someone have to pay? Whose money is being used
to pay these closing costs?
No-this is not a scam. Thousands of homeowners have refinanced using
a zero-point/zero-fee loan. Some refinanced multiple times, riding rates
all the way down the curve in 1992, 1993 and, more recently, in 1996.
Some homeowners used zero-point/zero-fee adjustable loans to refinance
and get a new teaser rate every year.
The way this works is based on rebate pricing, sometimes also known as
yield-spread pricing, and sometimes known as a service-release premium.
The basic idea is that you pay a higher rate in exchange for cash up front,
which is then used to pay the closing costs. You will pay a higher monthly
payment-so the money is really coming from future payments that you
will make.
You can also think of this as negative points! For example, a 30-year
fixed loan may be available at a retail price of:
8.0% with 2 points or
8.25% with 1 point or
8.5% with 0 points or
8.75% with -1 point or
9% with -2 points
On a $200,000 loan, the loan officer can offer you 8.75% with a cost
of -1 point, which is a $2,000 credit towards your closing costs. A mortgage
broker can use rebate pricing to pay for your closing costs and keep the
balance of the rebate as profit.
What are the benefits of a zero-point/zero-fee loan?
The main benefit is that you have no out-of-pocket costs. As a result,
if the rates drop in the future, you could refinance again even for a
small drop in rates. So if you refinanced on the zero-point/zero-fee loan
to get a rate of 8.75% and if the rates drop 1/2%, you can refinance again
to 8.25%. On the other hand, if you refinanced by paying 1 point and got
a rate of 8.25%, it may not make sense to refinance again. Now, if the
rates drop another 1/2%, a zero-point/zero-fee loan can drop your rate
to 7.75%, whereas if you paid points, you may have to do a break-even
analysis to decide if refinancing will save you money.
The zero-point/zero-fee loan eliminates the need to do a break-even analysis
since there is no upfront expense that needs to be recovered. It also
is a great way to take advantage of falling rates.
Some consumers have used zero-point/zero-fee loans on adjustable loans
to refinance their adjustables every year and pay a very low teaser rate.
What are the disadvantages of a zero-point/zero-fee loan?
The main disadvantage is that you are paying a higher rate than you would
be paying if you had paid points and closing costs. If you keep the loan
for long enough, you will pay more-since you have higher mortgage payments.
In the scenario where you plan to stay in the house for more than 5 years,
and if rates never drop for you to refinance, you could wind up paying
more money. If, on the other hand, you plan to stay at a property for
just 2-3 years, there really is no disadvantage of a zero-point/zero-fee
loan.
Whose money is it?
Since you are being paid "cash" upfront in exchange for a higher
rate, it really is your own money that will be paid in the future through
higher payments. Investors who fund these loans hope that you will keep
the loans for long enough to recoup their upfront investment. If you refinance
the loans early, both the servicer and the investor could lose money.
To summarize, zero-point/zero-fee loans in many cases are good deals.
Make sure, however, that the lender pays for your closing costs from rebate
points and NOT by increasing your loan amount. So if your old loan amount
was $150,000, your new loan amount should also be $150,000. You may have
to come up with some money at closing for recurring costs (taxes, insurance,
and interest), but you would have to pay for these whether you refinanced
or not.
Zero-point/zero-fee loans are especially attractive when rates are declining
or when you plan to sell your house in less than 2-3 years.
Zero-point/zero-fee loans may not be around forever. Lenders have discussed
adding a prepayment penalty to such loans, however few lenders have taken
steps to implement such a measure.
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What is a FICO score?
A FICO score is a credit score developed by Fair Isaac & Co. Credit
scoring is a method of determining the likelihood that credit users will
pay their bills. Fair, Isaac began its pioneering work with credit scoring
in the late 1950s and, since then, scoring has become widely accepted
by lenders as a reliable means of credit evaluation. A credit score attempts
to condense a borrowers credit history into a single number. Fair, Isaac
& Co. and the credit bureaus do not reveal how these scores are computed.
The Federal Trade Commission has ruled this to be acceptable.
Credit scores are calculated by using scoring models and mathematical
tables that assign points for different pieces of information which best
predict future credit performance. Developing these models involves studying
how thousands, even millions, of people have used credit. Score-model
developers find predictive factors in the data that have proven to indicate
future credit performance. Models can be developed from different sources
of data. Credit-bureau models are developed from information in consumer
credit-bureau reports.
Credit scores analyze a borrower's credit history considering numerous
factors such as:
- Late payments
- The amount of time credit has been established
- The amount of credit used versus the amount of credit available
- Length of time at present residence
- Employment history
- Negative credit information such as bankruptcies, charge-offs, collections,
etc.
There are really three FICO scores computed by data provided by each
of the three bureaus-Experian, Trans Union and Equifax. Some lenders
use one of these three scores, while other lenders may use the middle
score.
Frequently Asked Questions:
How can I increase my score? While it is difficult to increase
your score over the short run, here are some tips to increase your score
over a period of time.
This leads to a fundamental concept:
- Pay your bills on time. Late payments and collections can have a serious
impact on your score.
- Do not apply for credit frequently. Having a large number of inquiries
on your credit report can worsen your score.
- Reduce your credit-card balances. If you are "maxed" out
on your credit cards, this will affect your credit score negatively.
- If you have limited credit, obtain additional credit. Not having sufficient
credit can negatively impact your score.
What if there is an error on my credit report? If you see an error
on your report, report it to the credit bureau. The three major bureaus
in the US, Equifax (1-800-685-1111), Trans Union (1-800-916-8800) and
Experian (1-888-397-3742) all have procedures for correcting information
promptly. Alternatively, your mortgage company may help you correct this
problem as well.
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Why do interest rates
change?
To understand why mortgage rates change we must first ask the more general
question, "Why do interest rates change?" It is important to
realize that there is not one interest rate, but many interest rates!
- Prime rate: The rate offered to a bank's best customers.
- Treasury bill rates: Treasury bills are short-term debt instruments
used by the US Government to finance their debt. Commonly called T-bills
they come in denominations of 3 months, 6 months and 1 year. Each treasury
bill has a corresponding interest rate (i.e. 3-month T-bill rate, 1-year
T-bill rate).
- Treasury Notes: Intermediate-term debt instruments used by
the US Government to finance their debt. They come in denominations
of 2 years, 5 years and 10 years.
- Treasury Bonds: Long-debt instruments used by the US Government
to finance its debt. Treasury bonds come in 30-year denominations.
- Federal Funds Rate: Rates banks charge each other for overnight
loans.
- Federal Discount Rate: Rate New York Fed charges to member
banks
- Libor: London Interbank Offered Rates. Average London Eurodollar
rates.
- 6 month CD rate: The average rate that you get when you invest
in a 6-month CD.
- 11th District Cost of Funds: Rate determined by averaging a
composite of other rates.
- Fannie Mae-Backed Security rates: Fannie Mae pools large quantities
of mortgages, creates securities with them, and sells them as Fannie
Mae-backed securities. The rates on these securities influence mortgage
rates very strongly.
- Ginnie Mae-Backed Security rates: Ginnie Mae pools large quantities
of mortgages, secures them and sells them as Ginnie Mae-backed securities.
The rates on these securities influence mortgage rates on FHA and VA
loans.
Interest-rate movements are based on the simple concept of supply and
demand. If the demand for credit (loans) increases, so do interest rates.
This is because there are more buyers, so sellers can command a better
price, i.e. higher rates. If the demand for credit reduces, then so do
interest rates. This is because there are more sellers than buyers, so
buyers can command a lower better price, i.e. lower rates. When the economy
is expanding there is a higher demand for credit, so rates move higher,
whereas when the economy is slowing the demand for credit decreases and
so do interest rates.
This leads to a fundamental concept:
- Bad news (i.e. a slowing economy) is good news for interest
rates (i.e. lower rates).
- Good news (i.e. a growing economy) is bad news for interest
rates (i.e. higher rates).
A major factor driving interest rates is inflation. Higher inflation
is associated with a growing economy. When the economy grows too strongly,
the Federal Reserve increases interest rates to slow the economy down
and reduce inflation. Inflation results from prices of goods and services
increasing. When the economy is strong, there is more demand for goods
and services, so the producers of those goods and services can increase
prices. A strong economy therefore results in higher real-estate prices,
higher rents on apartments and higher mortgage rates.
Mortgage rates tend to move in the same direction as interest rates.
However, actual mortgage rates are also based on supply and demand for
mortgages. The supply/demand equation for mortgage rates may be different
from the supply/demand equation for interest rates. This might sometimes
result in mortgage rates moving differently from other rates. For example,
one lender may be forced to close additional mortgages to meet a commitment
they have made. This results in them offering lower rates even though
interest rates may have moved up!
There is an inverse relationship between bond prices and bond rates.
This can be confusing. When bond prices move up, interest rates move down
and vice versa. This is because bonds tend to have a fixed price at maturity-typically $1000. If the price of the bond is currently at $900 and
there are 10 years left on the bond and if interest rates start moving
higher, the price of the bond starts dropping. The higher interest rates
will cause increased accumulation of interest over the next 5 years, such
that a lower price (e.g. $880) will result in the same maturity price,
i.e. $1000.
Effect of economic data on rates
Number of arrows indicates potential effect on interest rates:
1 arrow = least effect, 5 arrows = max. effect
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What is the difference between
pre-qualifying and pre-approval?
A pre-qualification is normally issued by a loan officer, who, after
interviewing you, determines the dollar value of a loan you can be approved
for. However, loan officers do not make the final approval, so a pre-qualification
is not a commitment to lend. After the loan officer determines that you
pre-qualify, he/she then issues you a pre-qualification letter. This pre-qualification
letter is used when you are making an offer on a property. The pre-qualification
letter indicates to the seller that you are qualified to purchase the
house you are making an offer on.
Pre-approval is a step above pre-qualification. Pre-approval involves
verifying your credit, down payment, employment history, etc. Your loan
application is submitted to an underwriter and a decision is made regarding
your loan application. If your loan is pre-approved, you are then issued
a pre-approval certificate. Getting your loan pre-approved allows you
to close very quickly when you do find a house. A pre-approval can help
you negotiate a better price with the seller, since being pre-approved
is very close to having cash in the bank to pay for the house!
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What is a rate lock?
You cannot close a mortgage loan without locking in an interest rate.
There are four components to a rate lock:
1. Loan program.
2. Interest rate.
3. Points.
4. Length of the lock.
The longer the length of the lock, the higher the points or the interest
rate. This is because the longer the lock, the greater the risk for the
lender offering that lock.
Let's say you lock in a 30-year fixed loan at 8% for 2 points for 15 days
on March 2. This lock will expire on March 17 (if March 17 is a holiday
then the lock is typically extended to the first working day after the
17th). The lender must disburse funds by March 17th, otherwise your rate
lock expires, and your original rate-lock commitment is invalid.
The same lock might cost 2.25 points for a 30-day lock or 2.5 points
for a 60-day lock. If you need a longer lock and do not want to pay the
higher points, you may instead pay a higher rate.
After a lock expires, most lenders will let you re-lock at the higher
of the original price and the originally locked price. In most cases you
will not get a lower rate if rates drop.
Lenders can lose money if your lock expires. This is because they are
taking a risk by letting you lock in advance. If rates move higher, they
are forced to give you the original rate at which you locked. Lenders
often protect themselves against rate fluctuations by hedging.
Some lenders do offer free float-downs-i.e. you may lock the rate
initially and if the rates drop while your loan is in process, you will
get the better rate. However, there is no free lunch-the free float-down
is costly for the lender and you pay for this option indirectly, because
the lender has to build the price of this option into the rate.
What do you do if the rates drop after you lock?
Most lenders will not budge unless the rates drop substantially (3/8%
or more). This is because it is expensive for them to lock in interest
rates. If lenders let the borrowers improve their rate every time the
rates improved, they spend a lot of time relocking interest rates, since
rates fluctuate daily. Also they would have to build this option into
their rates and borrowers would wind up paying a higher rate.
Lock-and-shop programs.
Most lenders will let you lock in an interest rate only on a specific
property. If you are shopping for a house, some lenders offer a lock-and-shop
program that lets you lock in a rate before you find the house. This program
is very useful when rates are rising.
New-construction rate locks.
Most lenders offer long-term locks for new construction. These locks
do cost more and may require an upfront deposit. For example, a lender
might offer a 180-day lock for 1 point over the cost of a 30-day lock,
with 0.5 points being paid upfront, as a nonrefundable deposit. Most long-term
new-construction locks do offer a float-down-i.e. if rates drop prior
to closing, you get the better rate.
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Can my loan be sold? What
happens if
my lender goes out of business?
Your loan can be sold at any time. There is a secondary mortgage market
in which lenders frequently buy and sell pools of mortgages. This secondary
mortgage market results in lower rates for consumers. A lender buying
your loan assumes all terms and conditions of the original loan. As a
result, the only thing that changes when a loan is sold is to whom you
mail your payment. If your loan has been sold, your existing lender will
notify you that your loan has been sold, who your new lender is, and where
you should send your payments from now on.
If your lender goes out of business, you are still obligated to make
payments! Typically, loans owned by a lender going out of business are
sold to another lender. The lender purchasing your loan is obligated to
honor the terms and conditions of the original loan. Therefore, if your
lender goes out of business, it makes little difference with regards to
your loan payments. In some cases, there may be a gap between the date
of your lender's going out of business and the date that a new lender
purchases your loan. In such a situation, continue making payments to
your old lender until you are asked to make payments to your new lender.
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What is PMI? Can I get rid of
the PMI on my loan?
PMI or Private Mortgage Insurance is normally required when you buy a
house with less than 20% down. Mortgage insurance is a type of guarantee
that helps protect lenders against the costs of foreclosure. This insurance
protection is provided by private mortgage-insurance companies. It enables
lenders to accept lower down payments than they would normally accept.
In effect, mortgage insurance provides what the equity of a higher down
payment would provide to cover a lender's losses in the unfortunate event
of foreclosure. Therefore, without mortgage insurance, you might not be
able to buy a home without a 20% down payment.
The cost of PMI increases as your down payment decreases. Example: The
cost of PMI on a 10% down payment is less than the cost of PMI on a 5%
down payment. Your PMI premium is normally added to your monthly mortgage
payment.
The decision on when to cancel the private insurance coverage does not
depend solely on the degree of your equity in the home. The final say
on terminating a private mortgage-insurance policy is reserved jointly
for the lender and any investor who may have purchased an interest in
the mortgage. However, in most cases, the lender will allow cancellation
of mortgage insurance when the loan is paid down to 80% of the original
property value. Some lenders may require that you pay PMI for one or two
years before you may apply to remove it.
To cancel the PMI on your loan, contact your lender. In most cases, an
appraisal will be required to determine the value of your property. You
will probably also be required to pay for the cost of this appraisal.
Another way of canceling the PMI on your loan is to refinance and to get
a new loan without PMI.
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What is an APR?
The annual percentage rate (APR) is an interest rate that is different
from the note rate. It is commonly used to compare loan programs from
different lenders. The Federal Truth in Lending law requires mortgage
companies to disclose the APR when they advertise a rate. Typically the
APR is found next to the rate.
Example:
| 30-year fixed |
8% |
1 point |
8.107% APR |
The APR does NOT affect your monthly payments. Your monthly payments
are a function of the interest rate and the length of the loan.
The APR is a very confusing number! Even mortgage bankers and brokers
admit it is confusing. The APR is designed to measure the "true cost
of a loan." It creates a level playing field for lenders. It prevents
lenders from advertising a low rate and hiding fees.
If life were easy, all you would have to do is compare APRs from the
lenders/brokers you are working with, then pick the easiest one and you
would have the right loan. Right? Wrong!
Unfortunately, different lenders calculate APRs differently! So a loan
with a lower APR is not necessarily a better rate. The best way to compare
loans in the author's opinion is to ask lenders to provide you with a
good-faith estimate of their costs on the same type of program (e.g. 30-year
fixed) at the same interest rate. Then delete all fees that are independent
of the loan such as homeowners insurance, title fees, escrow fees, attorney
fees, etc. Now add up all the loan fees.
The lender that has lower loan fees has a cheaper loan than the lender
with higher loan fees.
The reason why APRs are confusing is because the rules
to compute APR are not clearly defined.
What fees are included in the APR?
The following fees ARE generally included in the APR:
- Points — both discount points and origination points
- Pre-paid interest. The interest paid from the date the loan closes
to the end of the month. Most mortgage companies assume 15 days of
interest in their calculations. However, companies may use any number
between 1 and 30!
- Loan-processing fee
- Underwriting fee
- Document-preparation fee
- Private mortgage-insurance
The following fees are SOMETIMES included in the APR:
- Loan-application fee
- Credit life insurance (insurance that pays off the mortgage in the
event of a borrowers death)
The following fees are normally NOT included in the APR:
- Title or abstract fee
- Escrow fee
- Attorney fee
- Notary fee
- Document preparation (charged by the closing agent)
- Home-inspection fees
- Recording fee
- Transfer taxes
- Credit report
- Appraisal fee
An APR does not tell you how long your rate is locked for. A lender
who offers you a 10-day rate lock may have a lower APR than a lender
who offers you a 60-day rate lock!
Calculating APRs on adjustable and balloon loans is even more complex
because future rates are unknown. The result is even more confusion
about how lenders calculate APRs.
Do not attempt to compare a 30-year loan with a 15-year loan using
their respective APRs. A 15-year loan may have a lower interest rate,
but could have a higher APR, since the loan fees are amortized over
a shorter period of time.
Finally, many lenders do not even know what they include in their APR
because they use software programs to compute their APRs. It is quite
possible that the same lender with the same fees using two different
software programs may arrive at two different APRs!
Conclusion
Use the APR as a starting point to compare loans. The APR is a result
of a complex calculation and not clearly defined. There is no substitute
to getting a good-faith estimate from each lender to compare costs. Remember
to exclude those costs that are independent of the loan.
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