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Weighing the Choices on Mortgages
SOME long-time homeowners like to muse about the good old days of the 1950's and 60's, when mortgage interest rates were 5 or 6 percent, nearly everybody got the standard long-term fixed-rate loan and the homeowning was easy.
Since that period, adjustable-rate mortgages have emerged as an alternative to fixed-rate loans and -- in the long period of inflation and high interest rates in the 70's and early 80's -- usually the only choice.
But there has been a steady drop in mortgage-interest rates over the last six years. It has not quite brought back the good old days, but it has helped forge a comeback for the plain-vanilla fixed-rate long-term loan. Mortgage interest rates have stayed below 10 percent for close to a year now, and the national average for a 30-year fixed rate in mid-December was 9.66 percent, down from 9.8 percent a year ago and 10.7 the year before that.
The market may be responding. Sales of existing homes jumped 3 percent in November to 3.14 million units, after two months of declining sales rates in September and October, the National Association of Realtors announced on Wednesday. The group attributed the rise in sales rate to lower mortgage interest rates and declining consumer worries about the Gulf crisis.
Mortgage economists usually discount prevailing interest rates by the rate of inflation, which represents dollars that will not, in a sense, be paid back. They call the resulting number the "real" interest rate, and here, too, the news is positive.
For example, the average fixed 30-year mortgage rate in 1984 was 13.76 percent and inflation was 3.9 percent, so the "real" mortgage rate was a whopping 9.86 percent. By 1987 mortgage rates had come down to 10.29 and inflation stood at 4.4 percent, leaving a "real" rate of 5.89 percent.
For someone taking out a fixed-rate mortgage today at 9.7 percent, the 11-month inflation rate of 6.4 percent produces a real interest cost of 3.3 percent, representing a huge drop in actual cost to consumers since 1984.
For most borrowers, the lower rates seem to argue in favor of fixed-rate, as opposed to adjustable-rate, mortgages. Adjustable-rate mortgages are essentially bets -- gambling images crop up regularly in experts' discussions of mortgage choices -- that interest rates are going to go down, and many buyers evidently do not believe rates can drop much more. So there has been a steady slide in the proportion of new mortgages that are adjustable, from more than 40 percent two years ago to 23 percent today.
At the same time, adjustable rates themelves may be headed downward. Two weeks ago the Federal Reserve Board cut its discount rate (the cost of funds to big banks that borrow from the Federal Reserve banks) for the first time in four years, continuing a general easing in monetary policy. Just before Christmas, the big banks cut their prime rates, the rates charged to their largest and best customers. Since adjustable-rate mortgages are pegged to one or another of the indexes of borrowing costs, the general decline could result in lower rates for adjustable mortgages. Many banks are responding to the lower fixed rates with sales campaigns to have their borrowers who hold adjustable-rate mortgages, or ARMs, refinance with fixed-rate mortgages. A logical step, it may seem, but banks normally charge between 2 and 4 percent of the loan principal as their fees for such refinancing. Those fees must be a borrower's main concern in the decision to refinance, said Paul Havemann, vice president of HSH Associations, a Butler, N.J., mortgage consulting firm.
"Anyone with an adjustable mortgage right now is on the wire," he said, "because they could either refinance and take advantage of these low fixed rates or hang on to see what their ARM will do for them in the next few months."
Because the country has how had more than a year of single-digit rates, Mr. Havemann noted, people with ARMs have begun to see their rates drop for the first time in the last three years, when the number of ARMs skyrocketed.
The latest index -- the underlying, moving rate -- on most one-year adjustable mortgages is 7.24 percent, down from 7.73 two years ago. With an average margin of 2.3 percent, hundreds of thousands of adjustable-rate mortgages this winter are dropping below 10 percent for the first time.
"So if your adjustable mortgage is going to adjust over the next month or so, you will end up with a rate of about 10 percent without having to pay three or four or five thousand dollars to get there," Mr. Havemann said.
Someone who expects to remain in place and keep the mortgage for a long time should perhaps not take the risk of a long-term rise in rates just to get a year of lower payments, Mr. Havemann said. But someone who expects to keep his present mortgage for a short time might do better to stick with the ARM and give its principal attraction -- its ability to follow rates downward -- a chance to pay off.
Not having the several thousand dollars to refinance a mortgage is obviously another argument for doing nothing. This has not always been a problem, because until three or four years ago lenders often let borrowers roll their loan origination fees, as they are formally known, into the loan. But in recent years the secondary mortgage market, which buys most home loans and recycles them as securities, has made it harder to borrow the fees.
Although the formula is complicated, the secondary markets make lenders meet certain yield targets on a loan, meaning that if the lender wants to let a borrower roll the points into the loan, the interest rate must be raised to reflect the smaller share of the borrower's total indebtedness passing to the secondary market. The difference may amount to 25 basis points, or a quarter of one percentage point, and a quarter-point increase on a $100,000, 30-year mortgage amounts to an extra $20 a month on the mortgage payment.
The secondary market, dominated by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddy Mac), has been a great boon to the mortgage market, bankers and lenders say, by constantly pumping fresh cash into the mortgage pool.
By letting mortgage money flow back and forth on a national scale, this system has eliminated the problem of mortgage scarcity in rural areas and mortgage surpluses in richer coastal regions, a situation that lasted into the late 60's and early 70's. Indeed, some economists speculate that the high cost of mortgages in money-poor parts of the Midwest and rural South helped keep real estate prices low there, while the ready availability of loans in the big coastal cities may have reduced buyer resistance to price rises there.
But the system that freed money to follow the market also produced a system of unitary mortgage underwriting rules that leaves lenders with little discretion to tailor a mortgage to particular customers.
That is why the underwriting rules for qualifying for a mortgage have in recent years become all but law in banking circles. At least it is a law that allows home buyers to figure out beforehand how much money they will normally be able to borrow.
The standard rule is that owners may not exceed 28 percent of their gross monthly income for principal, interest, taxes and insurance payments -- PITY, in the banking world's heartfelt acronym -- and 36 percent of income when other monthly expenses, such as credit card and car payments, are included.
So, to use a standard example, a couple earning $50,000 a year have a gross monthly income of $4,166. A 28 percent monthly PITY payment amounts to $1,200, which, at a 10 percent interest rate, would cover a $135,000 mortgage. So with a $33,000, or 20 percent, down payment, the couple would typically be able to buy a $168,000 property.
If underwriting rules are fairly standardized, the types of loan, in addition to fixed rate and adjustable, are as varied as the names that have been applied to them. Two recent variants on the adjustable-rate mortgage that are becoming popular are the rollover balloon and the two-step.
The balloon is probably the oldest form of mortgage in the country, but today's is an updated version of the kind used before President Franklin D. Roosevelt created federally chartered savings and loan associations. In those days, balloons were typically five-year loans with payments for interest only, with the principal falling due at the end of the term. The bank then had the option of renewing, at a new rate; paying off a mortgage loan to win free and clear title was difficult.
Today, with the average life of a mortgage shrinking from 10 years, in 1970, to seven years, more and more restless people are interested in such short-term debt. Today's balloons schedule interest payments on a 30-year, fully amortizing scale, however, and include a guaranteed renewal, or rollover, for the remaining 25 years at a negotiated rate at that time.
Fannie Mae has approved its own version of this mortgage in the two-step, which rolls over in five or seven years. The new rate is not subject to negotiation; it is based on index agreed upon agreed upon at the time when the mortgage is first taken out.
In neither the two-step nor the rollover are new loan origination fees charged for having the loan extended. Fees are limited to the cost of a reappraisal and a drive-by inspection, amounting to under $200, to qualify.
THE first terms of such loans tend to charge a little less than a similar 30-year fixed rate, since the bank is protected against large increases in its cost of funds by the short term of the initial stage of the loan. By saving about a quarter of a percentage point off the interest rate, a borrower may qualify for a larger loan using a two-step or rollover than he would with a fixed rate. This is similar to the manner in which adjustable-rate loans, by starting out at a lower rate, typically let borrowers take on more debt than they would qualify for with a fixed-rate loan.
In both cases, the bank assumes that the borrower's income will increase enough over the years to cover the higher rate, if one applies, when the loan is rolled over.
One of the last places where the borrower still has a great deal of latitude in dealing with lenders is on the question of down payments. The 20-percent-down mortgage is still the rule, and is used for more than three quarters of all mortgages. But despite evidence that default rates are higher for higher loan-to-value-ratio mortgages, where more of the value of the property is borrowed, many banks still allow down payments as low as 5 percent.
But at a cost. Low-down-payment mortgages uniformly require the borrower to take out mortgage insurance, whose fees usually amount to about 0.5 percent of the principal on the first year, and a third of a percentage point for the years two through ten, by which time the mortgage has usually been reduced to an 80 percent loan-to-value ratio.
Mortgage insurance is also available on a one-shot premium basis, and normally costs close to three percent of the loan.
So should a home buyer with the 20 percent down payment put all of it or just some of it down? During the last decade's golden age of debt, there was a widespread belief in leveraging money, borrowing as much as possible with as little as possible of one's own.
That approach makes sense when buyers recall that mortgages allowe a buyer to pocket all of the increased value in a property while having to contribute only a fraction of its cost, through the down payment.
Looked at this way, a $30,000 profit in the sale of a house that was bought with $5,000 down produces a 500 percent return on investment, while the same profit from a house bought with $20,000 down produces a 150 percent return. This little insight into the mechanics of getting a lot back for a just a little down was the engine that drove much of the real estate speculation by developers in the 1980's, when no-money-down development deals were common.
But lower down payments also means more to pay each month in mortgage payments, and high payments can make it harder for an owner to stay financially afloat, as so many bankrupt real estate developers also found out when the economy and their business slowed down.
For example, the monthly payment on a $100,000 mortgage at 9 3/4 percent and 20 percent, or $20,000 down, is $687. But if the borrower puts only 5 percent down, the monthly payment jumps to $816.
With tax reform's reduction in rates, the borrower will get only 28 or 31 percent of that additional interest payment back from the Internal Revenue Service, reducing the attractiveness of high indebtedness as a tax shelter. "These days, you are always better off by avoiding debt to the extent possible, rather than counting on the tax savings of a larger one," said Mr. Havemann.
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