Deb and Dan are building their dream house after having their starter home destroyed by Hurricane Katrina. The mortgage loan officer at their bank convinced them the best loan for them would be a 5-year, interest-only, adjustable rate mortgage (ARM), which will start while they’re constructing their home. It’s a 0 percent interest loan for the first 5 years, with a penalty (6 months of payments) if they refinance before two years. They trusted the loan officer, who worked diligently to develop a rapport with them and led them to believe she was recommending the best product for their unique situation.
By the time they realized they could not refinance their loan if interest rates begin to rise before two years, they had already signed all of the mortgage papers. While no interest after construction may seem appealing, these are the same types of loans that have caused most of the million plus foreclosures in the U.S.
During the past year, media hype has focused on subprime mortgages to lower income borrowers. It’s an easier story to comprehend than the complex permutations involved with ARMs, which are now often referred to as “subprime” although they were often made to borrowers with good to excellent credit. At the time borrowers qualified for loan products categorized as “subprime,” they did not expect to have to refinance their loans. They thought the new interest rates, after reset, would be low and manageable with their incomes because that is what they were usually told by the loan officers and mortgage brokers selling the loans.
A 2008 study by the Congressional Budget Office (CBO) indicates that national delinquency and foreclosure rates are rising for both prime and subprime loans, particularly for ARMs. In the fourth quarter of 2007, 25.5 percent of all ARMs were delinquent while 6.3 percent were in foreclosure. At the same time, less than 2 percent of all fixed rate mortgages were experiencing foreclosure.
The U.S. Department of Housing and Urban Development (HUD) recommends consumers opt for an ARM under these circumstances:
- If you plan to own your home for only a few years
- The prevailing interest rate for a fixed rate mortgage is too high
- You expect a large increase in future earnings
There is a tendency for a new homeowner to depend on a 0 percent interest loan. It’s easy to believe the increased value of their house will build equity. This relieves them from paying on the principle portion of their mortgage to grow equity. It’s also common for borrowers to lull themselves into a false sense of security that results in waiting as long as possible to refinance a low interest ARM. If the real estate market changes and property values take a nosedive, homeowners who have not paid down principle can end up with far more debt than home value.
The current interest rate on 30-year, fixed rate mortgages, hovers in the 6 to 7 percent range. Deb and Dan both have FICO scores in the high 700s, solid incomes from secure careers, savings, and extremely low debt. They can qualify for any loan product. Since they never built a house before, they did not understand that the safest loan, in a volatile credit market, is known as a construction to perm loan with a fixed, locked interest rate. Available from many financial institutions, these loans close once — before construction begins. During construction, money is drawn out as needed to pay building costs and only interest is paid until it converts from a construction loan to a permanent loan.
A survey of major lenders throughout the country indicates that most still offer ARMs. While credit qualifications are far higher than they were during the borrowing boom of a few years ago, they are still sold to consumers because there is demand and they can be highly profitable products when they reset. It is important to remember that loan officers and mortgage brokers are not objective financial advisers; they are sales people compensated based on what they sell. Lenders push products they expect to generate the highest profits for the institution. And your loan officer is paid more to sell them — sometimes two or three times as much as a safe, fixed rate product, which may be better for you.
If Deb and Dan do not refinance their loan, it will reset at 12 percent. On a $500,000 loan, that will mean their payment will jump from $2083 per month at 0 percent interest to $5505 per month at 12 percent. Sound familiar?
Before you make a home loan decision:
- Carefully evaluate your life plans.
- Figure out what you can afford, realistically.
- Research all types of mortgages.
- Ask for comprehensive information (in writing) on different types of loans from several lenders.
- Insist on receiving detailed disclosure information for the full cost of your loan long before you make a lending decision. Understand application fees, origination fees, points, title insurance, and all closing costs.
Know: Until you sign the mortgage papers at closing, you can change your mind about your mortgage with no negative repercussions.
After all the financial challenges caused to homeowners by less than scrupulous lending practices perpetrated by financial institutions, you must be extremely cautious when you make a mortgage decision.
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