Risks and Rewards of Specialty Mortgages

If you are looking for a home in a high-priced housing market, it can be difficult to afford a home. That’s why a growing number of home buyers are forgoing traditional fixed-rate mortgages and standard adjustable-rate mortgages and instead opting for a specialty mortgage that lets them “stretch” their income so they can qualify for a larger loan.

But before you choose one of these mortgages, make sure you understand the risks and how they work.

Specialty mortgages often begin with a low introductory interest rate or payment plan — a “teaser”— but the monthly mortgage payments are likely to increase a lot in the future. Some are “low documentation” mortgages that come with easier standards for qualifying, but also higher interest rates or higher fees. Some lenders will loan you 100 percent or more of the home’s value, but these mortgages can present a big financial risk if the value of the house drops.

Specialty Mortgages Can:

·     Pose a greater risk that you won’t be able to afford the mortgage payment in the future, compared to fixed rate mortgages and traditional adjustable rate mortgages.

·     Have monthly payments that increase by as much as 50 percent or more when the introductory period ends.

·     Cause your loan balance (the amount you still owe) to get larger each month instead of smaller.

Common Types of Specialty Mortgages:

·     Interest-Only Mortgages: Your monthly mortgage payment only covers the interest you owe on the loan for the first 5 to 10 years of the loan, and you pay nothing to reduce the total amount you borrowed (this is called the “principal”). After the interest-only period, you start paying higher monthly payments that cover both the interest and principal that must be repaid over the remaining term of the loan.

·     Negative Amortization Mortgages: Your monthly payment is less than the amount of interest you owe on the loan. The unpaid interest gets added to the loan’s principal amount, causing the total amount you owe to increase each month instead of getting smaller.

·     Option Payment ARM Mortgages: You have the option to make different types of monthly payments with this mortgage. For example, you may make a minimum payment that is less than the amount needed to cover the interest and increases the total amount of your loan; an interest-only payment, or payments calculated to pay off the loan over either 30 years or 15 years.

·     40-Year Mortgages: You pay off your loan over 40 years, instead of the usual 30 years. While this reduces your monthly payment and helps you qualify to buy a home, you pay off the balance of your loan much more slowly and end up paying much more interest.

Questions to Consider Before Choosing a Specialty Mortgage:

·          How much can my monthly payments increase and how soon can these increases happen?

·          Do I expect my income to increase or do I expect to move before my payments go up?

·          Will I be able to afford the mortgage when the payments increase?

·          Am I paying down my loan balance each month, or is it staying the same or even increasing?

·          Will I have to pay a penalty if I refinance my mortgage or sell my house?

·          What is my goal in buying this property? Am I considering a riskier mortgage to buy a more         expensive house than I can realistically afford?

 Learn about the NATIONAL ASSOCIATION OF REALTORS® Housing Opportunity Program at www.REALTOR.org/housingopportunity. For more information on predatory mortgage lending practices, visit the Center for Responsible Lending at www.responsiblelending.org.

Notes from the Mortgage Professor - Is Paying off your Loan a Sound Investment?

Don’t let misconceptions prevent you from paying down your mortgage balance. In today’s market, it is the best investment most borrowers can make.

One of the vexing features of the post-crisis financial system is the dearth of riskless investments paying a decent return. The rates on federal government securities and insured CDs are not much greater than zero. Yet every homeowner with a mortgage has the opportunity to earn a return equal to the interest rate on the mortgage, with no risk, simply by making extra payments.

The only downside to using mortgage repayment as an investment is that it has no liquidity — once you make the payment, you can’t take it back if you have an unexpected need for funds. But most homeowners with mortgages who place their savings in bank deposits or money market funds paying less than 1 percent, rather than earning 3 to 6 percent by paying down their mortgage, do it for reasons other than a need for liquidity. The main reason is confusion about one or another feature of loan repayment.

Some borrowers have trouble viewing mortgage repayment as equivalent to buying a bond or a CD. Yet in both cases, you pay out money now and receive a stream of income in the future based on the contracted interest rate. The only difference is that the income received from a mortgage repayment is cancellation of interest that you would have had to pay otherwise. The difference between receiving $1,000 of interest, and eliminating the payment of $1,000 of interest, is one of form but not of substance.

Those with a mortgage can actually earn a little more than the interest rate on their mortgage by taking advantage of the 10- to 15-day payment grace period that is found in all mortgage contracts. By adding the extra payment to the scheduled payment, the borrower will save interest for the entire month, even though they do not provide the funds until 10 or 15 days into the month. (Note: If borrowers make a separate payment after the grace period, their loan balance may not be reduced until the following month, which would reduce their return on investment.)

Some borrowers who itemize their tax deductions don’t want to repay their mortgage because it entails the loss of a deduction. But the loss is exactly the same as that on a taxable investment. For example, a borrower in the 33 percent tax bracket who repays a 3 percent mortgage earns 2 percent after tax. If instead the borrower purchased a CD paying 1 percent, the after-tax return is 0.5 percent. If the before-tax rate on the repaid mortgage is above the before-tax rate on the alternative investment, the same will be the case after taxes.

Some borrowers believe that they missed the boat on loan repayment because they didn’t do it in the early years of their mortgage when the regular payment went largely to interest, rather than later, when most of it goes to principal. But the rate of return on mortgage investment is not affected by where the mortgage is in its life cycle. While the allocation of scheduled payments between principal and interest changes over the life of the mortgage, extra payments go entirely to principal, no matter what stage of its life cycle the mortgage is in.

Other borrowers are immobilized by plans to sell the home, as if somehow this would prevent their obtaining the expected benefit from making extra payments. But it wouldn’t. In fact, the benefit would become glaringly evident in the smaller loan balance they have to pay off out of the sale proceeds. A similar point applies to those planning to retire with reduced income. If and when they need a reverse mortgage in the future, they will have to pay off their existing mortgage in the process, and the lower the balance, the more they will be able to draw on the reverse mortgage.

I have also heard the concern that the lender won’t credit a borrower’s account until the end of the term. This is not true; the account is credited immediately or even a few days early. A variant is that the lender will use the extra payments for some purpose other than reducing the loan balance. The only substance to this concern is that the lender will indeed apply extra payments to any unpaid obligations, of which the most likely is an underfunded tax/insurance escrow account. Aside from that, the only thing the lender can do with extra payments, other than credit them to the loan balance, is to steal them, which they never do.

With one exception, borrowers making extra payments need not provide special instructions as to how the payments should be applied. The exception applies when the extra payment is an exact multiple of the scheduled payment — the payment the borrower is obliged to make each month. If the scheduled payment is $600 and the borrower sends in a check for $1200, the lender does not know whether the borrower wants to apply the extra $600 to principal, or is paying for two months. To avoid this problem, do not make extra payments an exact multiple of the scheduled payment.

Source: Jack Guttentag, professor emeritus of finance at the Wharton School of the University of  Pennsylvania.