There are a multitude of loan programs available to consumers in the U.S. market. In part, this is because mortgage lenders make money only if they can find a way to make you a loan. In part, it is because home ownership has long been a priority of the U.S. government and they have put money and programs behind this priority.
Much of the diversity in mortgage loan programs can be understood with reference to three factors:
- The “Term” — 10, 15, and 30 year loans
- The “Payment Structure” — fixed rate, adjustable rate, and balloon.
- The “Source” — FHA, VA, conventional, and jumbo loans
The Term of the Loan
From the Buyers point of view, choosing a loan term revolves around three factors:
- Affordability. Most first time home buyers opt for 30 year loans. When a bank qualifies you for a loan, you are qualified not for a specific loan amount but for a specific monthly payment. At a 6% interest rate and a 30 year term, a $1200 payment will qualify you for a loan of about $200,000. On a fifteen year term at 6% interest, the same payment will allow you to borrow only about $142,000. In an expensive market buyers opt for longer term loans because it allows them to buy a better property and to keep their monthly payment at a comfortable level.
- Gaining Equity in the Property. The longer the term of the loan, the more slowly you gain equity in the property. In the first month of the 30 year loan outlined in the previous paragraph, only about $200 of your $1200 payment will go toward paying off the principle of your $200,000 loan. The rest, $1,000, pays the monthly interest charged on the principle borrowed. So, in the first year, you will have paid $14,400 in monthly payments, but you will have paid off only $2450 of your $200,000 loan. With the 15 year loan, your monthly payment is about $1700, but the full $500 extra per month goes toward the payment of principle. With the 15 year loan, then, you would have paid out about $20,400 and paid off about $8450. With the 30 year loan, only about 17% of your payment is going toward principle; with the 15 year loan, about 41% does. Moreover, because you’re paying down the loan principle more rapidly, the portion of the payment going to interest drops off more rapidly as well. For example, by the time you reach the fifth year of your loan, you’d be paying about $875 a month to principle with the 15 year loan (about 52%) but only about $250, or 21%, with the 30 year loan.
- Interest Rates. These advantages of the shorter term loan are magnified by the fact that the interests rates for shorter term loans will typically be less than those for longer term loans. Generally, the shorter the term of the loan, the lower the perceived risk to the lender. So interests rates for a 10 or 15 year loans will generally be lower than 30 or 40 year loans. The difference varies, but is commonly between .5% and 1% lower.
So why would any sane buyer opt for the 30 year loan? There are several very good reasons:
- It’s Your Home. You’re getting the mortgage loan to buy a home, not a stock portfolio. While the investment aspect is important, if you can’t buy the home you need and where you need it with a 15 year loan, it makes perfect sense to use the longer term loan to make your life work. Paying out $14,400 to gain $2450 in equity (and some tax advantages) may not look good when compared to buying with a 15 year loan, but it sure looks good when compared to shelling out a similar amount for rent to live in the home and the community you want to live in.
- Flexibility. With very few exceptions, you can make additional payments to principle on any loan. So many buyers opt for a 30 year loan, but make payments on the loan as if it had a 15 year term. The advantage is that you can gain equity at the 15 year rate, but have the flexibility of lower payments if you loose a job or need the extra case to pay your kids’ college tuition.
- The Investor’s Perspective. Many real estate investors try to minimize the cash they put into a property, both at the outset as down payment and as a portion of monthly payment. Indeed, some investors will opt for “interest only” loans, where there is no payment of principle in the monthly payment. In part, their logic is as follows: Let’s say I buy a property for $200,000 and I sell it in 10 years for $325,000 (5% appreciation per year), so I’ve “cleared” $125,000. If my down payment was $10,000 and I got $1200 a month rent for the property, enough to cover my payment on the 30 year loan, I’ve made $125,000 on a $10,000 cash investment, multiplying my investment by a factor of 12.5. If I’d opted for the 15 year loan on the same purchase, I’d have invested $48,000 more in the property over the 10 year period, so I would have made $125,000 on $58,000 invested, multiplying my gain on the cash invested by a factor of only 1.16.
The Payment Structure of the Loan?
- Fixed Rate Mortgages. With a fixed rate mortgage, the interest rate and the payment (excluding property taxes and insurance) are fixed, or stable, for the life of the loan. That is, if you get a $200,000 loan at 6% interest for 30 years, you know you’ll pay about $1200 each month for principle and interest for as long as you choose to keep the property and the loan. Historically, most mortgage loans in the U.S. have been fixed rate loans.
- Adjustable Rate Mortgages (ARM). With an ARM, the interest rate and monthly payment (excluding property taxes and insurance) are fixed for a specified initial time frame and then adjust at specified intervals to follow changes in market interest rates either upward or downward. The initial fixed rate period may only be a month or two, or it may be several years. Once the initial fixed rate period is over, most ARMs adjust yearly, but many adjust monthly or biannually. If you see a loan marketed as a 5/1 ARM, this typically means it has an initial fixed period of 5, 7 or 10 years and then adjusts annually. Interest rates on ARMs are almost always lower than rates for fixed mortgages, since the borrower is sharing the investor’s risks regarding long term interest rates changes. Generally, the shorter the initial fixed period and the more frequent the adjustments, the bigger the difference between the ARM rate and the fixed rate. Depending on market forces, the interest rate on a 1/1 ARM may be anywhere from 0% to 2% lower than that of a fixed rate loan. Almost all ARMs mitigate the buyer’s risk of increasing interest rates by placing caps on how much interest rates can go up (or down) during each adjustment period and how much they can increase (or decrease) over the life of the loan. This allows the borrower to anticipate the worst case scenario in possible monthly payment increases.
These common interest rate structures can be modified to produce two variants that are used primarily in high interest rate markets or as a means of qualifying buyers for properties that they otherwise couldn’t afford.
- Balloon Mortgages. As with an ARM, rates on balloon mortgages are lower than rates on fixed mortgages because the borrower is sharing risks of long term interest rate changes with the investor. Payments on a balloon mortgage are generally calculated as if the loan was for a 30 year fixed term, but the loan actually has to be paid off or refinanced (with a large “balloon payment”) at the end of an initial 5, 7 or 10 year term. Generally, the lender will guarantee to refinance the loan at the end of the initial term, but at the market rates prevailing at that time.
- Buy Down Mortgages. A “buy down” is generally a fixed rate mortgage for which someone (the seller, the buyer or the lender) has made an initial cash payment that reduces the buyer’s monthly payment for the first 2-3 years of the loan term. This may be attractive to buyers who anticipate an increase in income within a year or two. They are also offered by many home builders since they increase the number of buyers who can qualify to purchase their homes.
Because of the risk of increasing interest rates associated with ARM loans, many buyers don’t give them serious consideration. But there are some good reasons that 20% of American (and 80% of British) homeowners choose ARMs. Consider:
- Because they offer lower interest rates, ARMs allow some homeowners to buy when or where they otherwise could not. With increasing prices in many real estate markets, it can make sense to purchase with an ARM loan rather than waiting to qualify for a fixed rate loan only to find that increasing prices have locked you out of the market.
- If the buyer is planning on selling a property with just a few years, or if they are planning on paying off or refinancing the loan, it makes little sense to take a fixed rate loan with an interest rate that is a point or two higher than an ARM.
- If interest rate differentials between ARMs and fixed rate mortgages are very high, smart, disciplined buyers can use ARMs to their advantage. For example, at an initial interest rate of 4%, the payment on the 30 year $200,000 loan used in our example above would be about $950, compared to $1200 at a 6% fixed rate. By paying that same $1200 monthly on the 4% ARM, the borrower pays an extra $250 per month to principle, that is, about $450 a month rather than $200 a month. This $450 is almost 38% of the monthly payment, just short of the 41% we calculated for the 15 year loan. Assuming interest rates don’t increase, the buyers making $1200 payments on the 4% ARM will pay off their loan about 10 years earlier than the buyers making the same payment on the fixed rate mortgage.
The Source of Funds?
When defined in terms of the “investor” or source of funds, the vast majority of loans in the U.S. come from the following sources:
- Conventional Loans. Most conventional loans are funded by either Freddie Mac or Fannie Mae, each of which has its own set of loan programs and rules. These programs have a maximum loan limit, which applies nationwide and changes from time to time. As of January of 2008, the general limit for conventional loans was $417,000. Traditionally, conventional loan programs required a minimum 5% down payment, with at least 3% of the funds coming from the borrower’s own funds rather than as a gift. In recent years, conventional loans of 97% and 100% of the purchase price have been offered, but the income and credit requirements are much stricter.
- Jumbo Loans.: Loans that exceed the conventional loan limit established by Freddie Mac and Fannie Mae are funded by a multitude of investors, each of whom establishes their own programs, rules and qualifications. Generally, these loans will require a minimum of a 5% down payment. Most require 10% or more.
- FHA Loans. Federal Housing Authority (FHA) loan programs were established by the federal government in order to minimize the financial impediments to home ownership. The standard FHA loan requires a 3.5% down payment. All funds required for down payment and closing costs can come as a gift from a relative or from certain other sources. Income requirements and other rules are comparatively liberal. Loan limits are established on a county by county basis. They are adjusted relative to housing costs from time to time. As of December 2003, loan limits for Boulder County were$348,460. In Weld County, across County Line Road to the east, they were $$274,550. In Broomfield and Jefferson Counties they were $308,370.
- VA Loans. Veterans Administration loans are available only to eligible veterans. VA loans are limited to the ceiling set for conventional loans. The VA has offered 100% loans for many years.
Generally, interests rates for conventional, FHA, and VA loans will be very similar, although occasionally FHA or VA rates may sometimes be slightly lower than conventional. Jumbo loan rates will generally be 1/2 point to a full point higher than conventional loan rates since larger loans are perceived to involve higher risks for the lender. Given market competition, fees and closing costs will also be similar from one funding source to another, although fees for FHA and VA loans can be lower because FHA and VA regulations limit some fees.
Each of these investors offers a wide range of specific loan programs. Generally, these are based on the various loan terms and payment structures we discussed earlier. Building on this foundation, however, these investors (and others) have developed a near limitless array of specialized programs. There are special programs for borrowers with extremely good or extremely bad credit ratings. There are even specialized loan programs designed for medical doctors moving to establish a practice in a new city and for immigrants without green cards.
So, while it’s useful to know the basics, it’s impossible to know it all. That’s what a good loan originator, and their support network, are for (see Mortgage Lender Staff). Use their expertise to help you sort through the options. That’s what they do for a living.