Did You Know? Basic Mortgage Traps and Pointers
What is a mortgage? In legal terms, a mortgage is a conveyance of a security interest in real property to secure the payment of a debt, typically evidenced by a mortgage note. The note imposes personal liability for the amount of the note on the person or persons who sign the note. The mortgage is a lien on the property.
From a REALTOR®’s perspective, a mortgage may be viewed in a variety of ways: as that “necessary evil” that the buyer typically needs to arrange so that the buyer can purchase a property, or maybe as part of the long lists of items printed in a title insurance commitment, or the major obstacle in the way of a smooth short sale. There is no end to the trouble that mortgage loans can cause, but REALTORS® can’t conduct a successful real estate practice without them!
There are two basic varieties of mortgages: fixed-rate and adjustable-rate mortgage (ARM). Fixed rate payments are steady and predictable, while the ARM payments start at a much lower rate yet pose the risk of dramatically higher payments later on. Beyond that basic distinction, mortgages comes in a whole array of varieties including FHA loans, VA loans, interest-only loans, home equity credit loans, Rural Development loans, reverse mortgages and so on.
For those embarking on the quest for a mortgage loan, or assisting a party in that endeavor, there are many traps for the unwary. The following practical pointers may help them steer clear of pitfalls, minimize the pain and derive the optimum benefits from the mortgage loan.
Buyers, particularly first-time buyers, may often have misconceptions about the mortgage loan process, including the following:
- Mortgage lenders are required to give borrowers the lowest rate available. That would be wonderful, but currently there are no federal or state laws requiring a mortgage lender to give a borrower the best rate available.
- The principal balance will go down each month as long as the borrower makes the required monthly payments. While this is true with a fixed-rate mortgage, with some option-ARMs and interest-only loans with teaser rates, for instance, the balance may not fall and instead may go up. This is the result of negative amortization that occurs when monthly payments cover only a part of the monthly interest owed and none of the principal. The interest not paid is added to the principal balance and thus the balance due actually increases.
- The monthly payment will stay the same from month to month. Unfortunately a borrower’s monthly payments could increase dramatically, if the borrower does not have a fixed-rate mortgage loan. Interest-only loans and option-ARMs feature lower initial payments but also carry a significant risk of payment shock – a large and sudden increase in the monthly payment amount when, for example, the interest rate adjusts or the interest-only period ends.
- If the lender is willing to lend the money for the home, then the borrower must be able to afford it. While reputable mortgage lenders will not lend beyond a person’s means, some others will. They may not consider the borrower’s ability to repay the loan over the long haul.
- Discounted interest rates are a good deal because they lower the monthly payments. Paying “discount points” or a “discount fee” in return for a lower interest rate may be beneficial in the short term, but the lower interest rate may only last until the first payment amount of interest rate adjustment.
Mortgage Practice Pointers
Savvy consumers ask the lender to “lock your loan,” which is basically an agreement from the lender that states that the loan applicant is entitled to a certain interest rate through a certain closing date, and get the lock in writing. Most companies have a rate lock form that spells everything out. If the lock expires, any changes will not be to the applicant’s benefit and the applicant will likely need to accept a higher rate. The lender generally cannot increase the loan fees to cover the cost of the higher rate.
If borrowers put down less than 20 percent on a house, they should expect to be required to purchase private mortgage insurance (PMI), which protects the lender in the event the borrower defaults on the mortgage loan. That means the borrower will have to pay PMI premiums, roughly $50 to $100 per month on average, in addition to the monthly mortgage payments.
Getting the PMI tax deduction
Starting with loans issued or refinanced in 2007, and continuing through 2011, borrowers can deduct each year’s premiums paid on PMI for the principal residence and for a non-rental second home. Unless it is extended again, the deduction won’t be available beyond the 2011 tax year.In general, the borrower can deduct PMI premiums in the year paid if the borrower itemizes deductions on his or her income tax return. However, if the borrower prepays PMI premiums for more than one year in advance, the borrower can deduct only the part of the PMI payment that will apply to that year. Rules can vary for mortgage insurance provided by the FHA, VA and Rural Housing Service, so it is always best to consult a tax adviser with any questions.
The deduction begins to phase out once the adjusted gross income reaches $100,000 ($50,000 for married filing separately) and disappears entirely at an AGI of $109,000 ($54,500 for married filing separately). Depending on the specific circumstances, this can potentially save a few hundred dollars each year. For more information, see the Internal Revenue materials at www.irs.gov/publications/p936/ar02.html.
Canceling the PMI as soon as a borrower is entitled can save thousands of dollars. Under the Homeowners Protection Act (HPA) of 1998, when a home is purchased after 1999, the lender is required to automatically cancel the PMI once the mortgage is paid down to a 78 percent (0.78) loan-to-value ratio (LTV), or once the homeowner has 22 percent equity. To figure the LTV, divide the outstanding loan amount by the original price of the home.
When the LTV reaches 80 percent, the homeowner can submit a written request to the lender to end the PMI. This can be a lengthy process and the lender may require an appraisal or other property valuation to confirm the property has not declined in value. See the Federal Reserve materials at www.federalreserve.gov/boarddocs/caletters/2004/0405/CA04-5Attach1.pdf for more information.
Mortgage Terminology 101
Adjustable-Rate Mortgage (ARM): A mortgage where the interest rates are tied to an interest-rate index. If the index rises or falls, the mortgage interest rate and the monthly payment amount go up or down accordingly.
Debt-to-Income Ratio (DTI): This ratio represents monthly fixed expenses divided by gross monthly income, which is the income before taxes and deductions. The lender uses this ratio to help determine how much they will lend a potential borrower. If the percentage is greater than 36, the ratio could negatively impact the ability to obtain a mortgage loan because the lender considers that the borrower has too much debt.
Interest-Only Mortgage: The borrower is required only to make interest payments for a specified number of years. When this initial period expires, the mortgage may begin to fully amortize and monthly payments of principal and interest make the payment amount increase significantly.
Loan-to-Value Ratio (LTV): This ratio compares the value of the loan with the fair market value of the home.
Negative Amortization: If the monthly payment amount does not cover the interest owed each month, sometimes as the result of a teaser rate, the unpaid interest becomes part of the principal. Thus, the principal balance increases and may eventually exceed what was borrowed in the first place.
Option-ARM: This loan typically offers the borrower three different monthly payment options: 1) payments of principal and interest, 2) interest-only payments, or 3) minimum monthly payments that don’t cover the monthly interest such that the unpaid interest is added to the principal loan amount. To ensure that the loan is repaid within the agreed-upon time, these loans “recast” after a set number of years (usually three or five) and monthly payments increase significantly so that the loan fully amortizes.
Payment Shock: Payment shock is a large and sudden increase – sometimes as much as double or triple – in monthly payments, often seen with interest-only loans and option-ARMs.
Private Mortgage Insurance (PMI): PMI is required by lenders when a borrower has less than 20 percent down. PMI protects the lender from default losses in the event a loan becomes delinquent.
Teaser Rates: These are low rates that lenders offer to make mortgage products more attractive. When the “teaser rate” period expires, the lender raises the interest rate for the remainder of the loan period.
Types of Mortgage Loans
Rural Development: www.rurdev.usda.gov/HAD-HCFPLoans.html
FHA loans: www.hud.gov/buying/loans.cfm [The Federal Housing Administration (FHA), which is part of HUD, insures the loan, so the lender can offer the borrower a better deal, as well as low down payments, low closing costs and easy credit qualifying.]
VA loans: www.benefits.va.gov/homeloans
Home Equity Credit Lines:www.ftc.gov/bcp/edu/pubs/consumer/homes/rea02.shtm and www.federalreserve.gov/pubs/equity/equity_english.htm [A home equity line of credit is a form of revolving credit in which the home serves as collateral.]
Reverse mortgages:www.ftc.gov/bcp/edu/pubs/consumer/homes/rea13.shtm [Those 62 years or older can convert part of their home equity into cash without selling.]
Interest-Only and Option-Payment ARMs: www.fdic.gov/consumers/consumer/interest-only/index.html