The next seven

Roger Schlesinger
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Posted: Oct 18, 2006 3:43 PM

On September 21 of this year I wrote a column, "I Didn't Know This - Did You?" talking about seven instances in the mortgage industry that either confused most people or were completely unknown by the group. I received a fair amount of correspondence that ratified my suspicion that most people have a desire to understand more about mortgages. I decided to continue on with another seven, and hope the results might be as good or better than the earlier article. I am going to talk with you about interest only loans, paying points, bi-weekly mortgage payments, the option arm, sub prime loans, margins in a variable loan, and the cost of rental unit financing. I think you are going to be surprised about what you know and don't know about mortgage loans.

Let's start with a shocker. Interest only loans do not exist. Interest only is an optional way to pay a standard loan – it is not a type of loan. One can have an interest only option on a 30-year fixed, or a five year arm, or on a straight variable, etc. I believe there are even some companies that offer interest only on loans that are amortized less than 30 years, but I haven't personally seen one.

Interest only options are set for a period of years and can be used every month, or once in a while (say three months a year), or never at all, your choice. The option provides you the opportunity to pay just the interest on the loan, not the principal, whenever you choose to do that. It results in a lower payment and doesn't have any negative side effects, as your balance remains the same when you pay interest only.

You can now understand why Wall Street is wrong about the interest only option. It doesn't hasten the loss of a home by anyone, as you have the remedies to fix the problem of property valuation within your loan: the ability to pay the principal down anytime you are worried about the equity or lack thereof in your house.

Now it is time to get to the point, so to speak. What is a point? When should it be used and not used? And what are the tax ramifications of point(s)? One point is equal to one percent of the loan balance, and is prepaid interest given to a lender to get a lower interest rate. The way to analyze the value of the point(s) is to take the difference in the monthly payments with a point and without a point and then divide the difference into the cost of the point. This will tell you, in months, how long it will take you to pay yourself back by the monthly savings you get from the lower interest rate. Two years or less is great, two years to three years is okay but over three years is questionable.

Example: A $300,000 loan that is 30 year fixed. Rate of 6.375% with zero points or 6.125% with one point.

The cost of the point (1% of the loan amount) is: $3,000

The monthly payment with the 6.375% rate is: $1,871

The monthly payment with the 6.125% rate is: $1,823

Your difference in payments is: $ 48

Dividing $3,000 by the $48 savings equals 62+ months.

Points are generally worthwhile on loans shorter than those amortized over 30 years, as most people stay in those types of loans for twice as long as they do in a 30 year loan. I am referring to 20 year, 15 year and 10 year fully amortized loans.

Points are tax deductible on a purchase, but must be amortized over the life of the loan on a refinance. This leads to some interesting tax planning. If you have paid a point or more in a refinance on a 30-year loan within the last 5 years, the most you could have written off is 5/30 of the point(s). If you were to refinance now you could write off the balance of the unamortized points and get a tax write off this year while taking a loan that works better for you. More to follow later on points….

Bi-weekly mortgages are not magical, as most people are led to believe. These are mortgages that you pay every two weeks, 26 times a year. They reduce a 30-year emaciation from 30 years to about 22 years. This happens because of only one thing: you are making 13 monthly payments a year instead of 12.

I think the borrowers who can make the best use of a bi-weekly payment are those who are paid bi-weekly and can match their payments to their income stream. If you are interested in paying down your mortgage faster, remember as the principal goes down, so does the interest on the principal, so each monthly payment has more going to principal and less to interest. A bi-weekly mortgage has the 13th payment being made in small increments all year long. A better solution is to make the extra payment at the beginning of the year and have a smaller principal balance at the beginning of the year and thus great principal pay down all year.

An option arm is one that gives the borrower 4 payment options: (1) teaser rate, (2) interest only payment, (3) a 15-year payment, or (4) a 30 year payment. The teaser rate leads to negative amortization, where your balance increases by the amount of interest you aren't paying each month (interest only payment less the teaser payment), and can cost people their house if they let it get out of hand. The other three options have too high of an interest rate.

The only unique point of an option arm is the worst part, the teaser rate. You can have all three other options if you take a regular 30-year amortizing loan with an interest only option. You will get a much better interest rate that way.

Sub prime loans are thought of as loans to people with poor credit. That is correct, but they are also for people with unusual properties, unusual credit problems, no reserves, unusual earnings documentation or unusual requirements. Because most sub prime lenders set their rates by loan to value and credit scores, they can at any given time have the best rates for the most qualified borrowers on the street: 700 plus credit scores and loan to values under 65%. My largest loan of recent times was to a borrower with a 700+ credit score, a loan to value below 65%, and documentation of a current W-2, a 1099 from another company in which he was a partner, and a lease on an industrial building where he was the beneficiary and his company was the lessee. The loan was $3.2 million, with $1.8 million cash out, and was a 5-year arm at 5.125%. It is now 3 years old and at the time of origination, no prime lender would give such a loan or meet the interest rate.

When we talk about variable rate loans, especially those that change monthly, quarterly, semi-annually or annually, it is all about the margin. I know there is a lack of knowledge about variable loans when I ask, "What's your margin" and the answer comes back, "What is a margin?" The margin on a variable loan (short for profit margin) is the amount added to the index to determine the rate at the time of change. The index generally moves up and down during the life of the loan, the margin is fixed.

The best margins are 1% to 1.875%, good margins are 2% to 2.25% and up to 3% is fair. Over 3% is not worth taking unless you need to take the loan.

Fixed arms – those that are fixed for 2 years, 3 years, 5 years, 7 years or 10 years – generally have high margins. These are not as important, as most people either sell or refinance after the fixed period.

Now that we realize the importance of margins, it is time to finish up with the pricing on investment property, one to four units. These are the highest cost of all the prime loans for one basic reason: In a crunch, the borrowers will always let the investment property go first. Lenders understand that, and therefore charge higher fees to reflect the higher risk.

We are still just scratching the surface in helping you understand the ins and outs of the mortgage industry. Most of what I have chosen to write about has come from listener inquiries. Feel free to write and ask any question that pertains to real estate that you would like to know. The more you improve your knowledge, the better you are going to do in the real estate world.