Tutorial on Selecting Mortgage Features

Planning to shop for a mortgage on-line? You need to answer the following questions first, so you know exactly what you are shopping for.      1. What Type of Mortgage Should I Select? 2. Which Mortgage Options Should I Select? 3. How Long a Term Should I Take? 4. How Many Points Should I Pay? 5. How Large a Down Payment Should I Make? 6. If I Put Less Than 20% Down, What Type of Mortgage Insurance Should I Select? 7. How Long a Lock Period Do I Need, and When Should I Lock? 8. What Documentation Requirements Should I Seek? What Type of Mortgage Should I Select?  Adjustable-rate mortgages (ARMs) have lower payments in the early years than fixed-rate mortgages (FRMs) but expose borrowers to the risk of higher payments in later years. Among the different types of ARMs, those with a short initial rate period have lower initial rates and payments than those with longer initial rate periods, but carry greater risk of future rate and payment increases. Many FRM and ARM programs today offer an interest-only (IO) option on which the borrower need only pay interest for up to 10 years. But lenders charge a higher rate (or points) for the option, and payments in the later years are larger. See my Tutorial on Interest Only.   Given the prices of various mortgages in the market, your selection of a mortgage type (including an IO option) should be governed by: 1) Your time horizon � how long you expect to have the mortgage, and how certain you are about it; 2) Your preference (if any) for low required payments in the early years of the loan; and 3) Your tolerance for the risk of higher interest rates and payments in the future. Here are some concrete illustrations: 1. Your Time Horizon Exceeds 10 Years and You Don�t Want Any Risk of Rising Payments: Select an FRM. The major question with an FRM is the term, which is discussed later.   2. Your Time Horizon Is Less Than 10 Years and Quite Certain: If you are 95% sure that you will be out of your house within, say 5 years, select an ARM with an initial rate period of 5 years. Similarly, if your expected period in the house is 3, 7 or 10 years, take the ARM with the same initial rate period. In this situation, the initial rate on the ARM is the only rate feature that matters. The index, margin and rate caps are not relevant if you pay off the mortgage before the initial rate period ends.   3. You Expect to Pay Off the Mortgage Within 3, 5, 7 or 10 Years But You Aren�t Sure: This is a more complex situation, and also a very common one. In assessing it, you must balance the rate savings on the ARM relative to an FRM during the initial rate period of the ARM, with the risk of rate increases when the initial rate period ends -- if it turns out that you still have the mortgage at that point. If the rate savings do not justify the risk on a 3-year ARM, you can try again on the 5, 7, or 10-year ARM. If the risk is too great on all of them, select an FRM.  The rate saving is the FRM rate less the ARM rate at about the same number of points. Good web sites to use for obtaining these rates are www.eloan.com, www.mortgage.com, and www.indymac.com.  The comparisons won�t be exact because lenders set points at odd numbers, but will be close enough for what is a highly subjective process anyway. You can quantify the risk of rate increases after the initial rate period ends with my calculator 7b. For your ARM, you must know the current value of the index, margin, rate adjustment cap, and maximum rate. You must also specify an assumption about what happens to interest rates. The calculator will give you several options, including the �worst case� possible. The worst case has a very low probability of occurrence, but it is nice to know you could manage it. You can also check out a strategy used by some astute borrowers, which is to take an ARM but make the payment that they would have made had they taken an FRM. By paying the ARM balance down faster, the cost imposed by rising rates in the future, if you still have the mortgage, is reduced. You can check out an ARM using this strategy at ARM Tables Tutorial. 4. You Want to Minimize the Expected Cost of the Mortgage and Are Prepared to Take the Risk: Select an ARM with an initial rate period less than 3 years, because they have relatively low margins. 6-month and one-year Libor ARMs in particular have margins that are often well below those on longer ARMs. This means that the potential savings over an FRM in a stable or declining rate market are relatively large. See my Libor Loan Tutorial.    5. You Have a Short Time Horizon and Want to Buy as Much House As You Can: Select an option ARM, on which the initial rate holds for a month. It provides the lowest initial payment of any ARM, and also the greatest risk of  future payment increases. See my Option ARM Tutorial. 6. You Have a Long Time Horizon and Are Risk Averse But Still Want to Buy as Much House As You Can. Select an FRM with an interest-only option.  7. Your Income Has Dropped and If You Cannot Reduce Your Current Mortgage Payment Significantly, You Will Have to Default. Refinance with an option ARM -- before you become delinquent! 8. Your Income Fluctuates Markedly, So You Want a Low Required Payment, Which You Can Add to When You Are Flush. Add an interest-only option to the mortgage you would otherwise prefer. 9. You Have a High-Rate Second Mortgage or Other Debt Which You Want to Pay Down As Quickly As Possible. Add an interest-only option to the mortgage you would otherwise prefer, or take an option ARM.  Which Mortgage Options Should I Select? Three options are available on most mortgages: whether to pay points, to waive escrows, and to accept a prepayment penalty. Points: Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. On a $100,000 loan, 2 points means a  payment of $2,000. Points are traded off against the interest rate. For example, I took the following schedule for 30-year FRMs from www.countrywide.com on September 7, 2005. Interest Rate Points 5.125 3.75 5.25 3.25 5.375 2.75 5.5 2.375 5.625 1.875 5.75 1.375 5.875 1.00 6 0.625 6.125 0.375 6.25 0.0 6.375 -0.375 6.5 -0.50 6.625 -0.875 6.75 -1.25 6.875 -1.5 Paying points is an investment. The return is the lower payment and faster balance reduction that results from the lower rate. The return is higher the longer you have the mortgage. Suppose, for example, you elected to pay 1 point to reduce the rate from 6.25% to 5.875%. Over 3 years you earn 6.5% on your investment, rising to 17.6 % over 4 years, 22.8% over 5 years, and 29% over 12 years or longer. I calculated these returns, as you can, using calculator 11c. A companion calculator, 11d, does the same for ARMs. Negative points are payments made by the lender to you for paying a higher rate. For example, the lender shown above will pay you 1.5 points for accepting a 6.875% rate rather than 6.25%. You can use the payments to defray settlement costs. This may be attractive if you are cash-short. Where points that you pay yield a higher return the longer you have the mortgage, points that you receive cost you more the longer you have the mortgage. Over 2.5 years, you will be paying 2.9% for this money, rising to 12.7% over 3 years and to 23.0% over 4 years. I have calculated returns from similar schedules covering a number of lenders and different types of mortgages. I found that in most cases, paying points is a good investment if you hold the mortgage 3 years, but in a few cases you have to hold it for 4 years. This holds for both FRMs and for ARMs with initial rate periods of 3 years or longer. Negative points are very costly unless you are out within 3 years. I also found that differences between lenders are large. One lender offered better deals buying down the rate on a 15-year FRM than on a 30, while another lender offered a better deal on a 30. This is why it is a good idea to know exactly how many points you want to pay (or receive) before you shop for a mortgage. Since lenders quote rates in even increments of .125% and points to odd decimals, the way to shop is to find the rate which most loan providers quote with about the number of points you want to pay, then select the lowest points offered at that rate. For example, if you want to pay about 2 points and you find that A offers 6% with 2.13 points, B offers 6% with 1.97 points, and C offers 6% with 2.25 points, you select B. Waive Escrows: Lenders generally require borrowers to include taxes and insurance premiums in their monthly mortgage payments, which are placed in escrow until the payment date when the amount due is paid by the lender. I welcomed the arrangement when I had a mortgage, because it simplified our budgeting and our life. It was a small price to pay, I felt, for the interest on the escrow account, earned by the lender rather than by me. Other borrowers feel differently, however, and want to control the payment of taxes and insurance themselves. This avoids the risk that the lender will screw it up, which happens occasionally and which can be a nightmare for the borrower. If you feel this way, the lender will usually let you waive the escrow requirement if you are making a down payment of 20% or more, or if you make a modest payment, usually � of a point � that�s $250 for each $100,000 of loan amount. Read How Can I Avoid Escrows? Prepayment Penalty: A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan entirely, you will pay a penalty. Prepayment penalties usually decline or disappear with the passage of time, seldom applying after the fifth year. For additional details, see Mortgage Prepayment Penalties. Borrowers in the sub-prime market are required to accept penalties, but for other borrowers it is an option that can be exercised to reduce the rate. If you are taking an FRM, have a long time horizon, and would prefer not to be bothered refinancing if interest rates go down, you are the perfect candidate to exchange a prepayment penalty for a lower rate. How Long a Term Should I Take? The term of a mortgage is the period used to calculate the mortgage payment. The longer the term, the lower the mortgage payment but the slower you pay down the balance. A mortgage that is interest-only for its entire life has the longest term possible � it never pays off.  In the 1920s, many mortgages were of this type, but IO mortgages today are IO for only the first 5 or 10 years. Term selection is an issue primarily on FRMs, which are available at terms ranging from 10 years to 40 years. While 15-year ARMs appear now and then, virtually all ARMs today are for 30 years. Selecting a term on an FRM should take account of the term structure of mortgage rates. Here is a typical structure in September, 2005. It assumes that everything else � the borrower�s credit, documentation, down payment, etc � are the same. Term Interest Rate Fully Amortizing Monthly Payment Per $100,000 Interest Only Payment First 5 Years Payment After 5 Yrs 40 Years 6.250% $567.74 $520.83 $587.08 30 6.000 599.56 500 644.31 25 6.000 644.30 500 716.44 20 5.875 709.24 489.58 837.12 15 5.625 823.74 468.75 1091.47 10 5.625 1091.47 468.75 1915.90 The 30 and 15 are the most popular by far, and the rate on the second is always well below that on the first. The rate on the 25 is usually the same as that on the 30, while the 20 will be a little lower, but closer to the 30 than to the 15. The 40 is always priced higher than the 30 while the 10 is usually priced about the same as the 15.   The selection process should start with the 15 because it is the best deal around for borrowers who can afford the payment. Most of those who can�t afford it opt for the 30 because the payment is substantially lower. If you have trouble even with the payment on the 30, an IO option on the 30 for the first 5 or 10 years would be less costly than the 40, and more effective in reducing the payment.  Typically there is no rate advantage in shortening the term from 30 to 25 years, or from 15 to 10. If you want to pay off sooner, you can opt for the shorter term, or you can take the longer term and make the payment of the shorter term.  For example, if you would like to pay off in 10 years and have the income to do it, one way is to take a 15 and make the payment of the 10. This gives you the flexibility of being able to revert back to the smaller payment on the 15 if necessary. Alternatively, you take the 10 which requires you to make the larger payment on the 10.   It depends on whether you prefer the flexibility offered by the 15, or the discipline imposed by the 10. The same principle applies in choosing between a 25 and a 30.  The 20-year term is for borrowers who want to pay off as soon as possible but can�t quite make the payment on the 15. IO�s are not available on 15s, so that is not an option.  Some borrowers who can make the payment on a 15 are persuaded to take a 30, or even a 40, in order to invest the difference in cash flow. I recommend this only for the few borrowers who have the iron discipline to allocate their income this way every month, and have access to exceptional investment opportunities. For example, if you take a 30 at 6% rather than a 15 at 5.625%, each month you must allocate to investments $224.18 of your income for every $100,000 of loan amount. Further, these investments must yield a return in excess of 6.375%, covering not only your 6% cost of funds but loss of the opportunity to borrow at .375% less. Few borrowers can do this without taking significant risks.  How Large a Down Payment Should I Make?  The down payment is the difference between the loan amount and the lower of sale price or appraised value. Many borrowers have no down payment decision to make because they don�t have the money for one. Their challenge is qualifying for a loan without a down payment, for which purpose excellent credit is critically important.  Borrowers with enough money to make a down payment, who are not sure exactly how much to put down, do have a decision to make. It is similar to the decision about whether or not to pay points, in that it is best viewed as an investment decision. You pay money now and receive a return in the future. It is a good decision if the return is high relative to other investment options.  There are important differences, however, between investing in points and investing in a larger down payment. One difference is in the amounts required. If you have surplus cash equal to 1% of the loan, you can earn a return of 20% or more by buying down the rate, provided you hold the mortgage for 5 years or longer. The same amount used to increase the down payment will only yield a return equal to the mortgage rate, or a little higher if you are also paying points, but well below the return on points.   To generate a higher yield from investment in a larger down payment, the investment must flip the loan into a lower mortgage insurance or interest rate category. Mortgage insurance premium categories, expressed in down payments, are generally 3-4.99%, 5-9.99%, 10-14.99%, and 15-19.99%. Where lenders pay for the mortgage insurance and price it in the rate, they use the same categories.   For example, if a borrower taking a 6% mortgage at zero points with mortgage insurance considers raising the down payment from 5% to 7%, the loan will remain in the 5-9.99% mortgage insurance premium category. The premium will remain the same, and the return on investment will be limited to the interest saved on the reduction in loan amount, which is 6%. If the borrower invests an additional 5% instead of 2%, however, the loan shifts into the 10-14.99% mortgage insurance premium category. Since the premium is lower, the return on investment rises to 11.6%. (This and all other returns are calculated over 5 years using calculator 12a.)  Occasionally, a borrower�s desired down payment results in a loan amount slightly above the conforming loan limit�the maximum size mortgage that can be purchased by Fannie Mae and Freddie Mac ($359,650 in 2005). In such case, an increase in down payment that drops the loan amount below the maximum would also reduce the interest rate. If the increase in down payment from 5% to 10% in the previous example not only reduced the mortgage insurance premium but also brought the loan amount below the conforming loan limit, the rate would drop from 6% to about 5.625%. In such case, the return on the investment in a larger down payment would rise from 11.6% to 17.9%.  When mortgage insurance is paid by the lender and incorporated in the interest rate, the return on an increment to the down payment that flips the loan into a lower rate category is highest when the initial down payment is low. This is seen most graphically in the sub-prime market where risk-based pricing is pervasive. The following schedule is taken from a price sheet of a sub-prime lender on September 9, 2005, and applies to 30-year FRMs made to borrowers with credit scores above 680.  Down Payment Increase Interest Rate Reduction Yield on Down Payment Increase 25% to 30% 6.60% to 6.55% 7.3% 20% to 25% 6.80% to 6.60% 9.8 15% to 20% 7.05% to 6.80% 11.1 10% to 15% 7.35% to 7.05% 12.3 5% to 10% 7.90% to 7.35% 17.4 0% to 5% 8.55% to 7.90% 20.3 Note that increasing the down payment from 25% to 30% reduced the interest rate only slightly, and the return on investment was only 7.3%. But an increase from 0% to 5% dropped the rate substantially, with a return on investment of 20.3%. All rates of return are calculated from calculator 12a. In sum, investment in a larger down payment earns a return on investment about equal to the mortgage rate unless it drops the loan amount into a lower mortgage insurance premium or interest rate category, or below the conforming loan limit. Usually, this requires a down payment increase of 5% of property value or more. In the sub-prime market, where borrowers pay for smaller down payments in the rate rather than in mortgage insurance premiums, the return on investment in a larger down payment is particularly high, especially when the down payment is low to start with. If I Put Less Than 20% Down, What Type of Mortgage Insurance Should I Select? Borrowers who make down payments of less than 20% are charged for the risk they impose on lenders. The charge can take three different forms: private mortgage insurance (PMI), lender provided mortgage insurance (LPMI), and a higher-rate second or �piggyback� mortgage. Borrowers often have a choice between two and sometimes all three. PMI: A premium is paid by the borrower to a mortgage insurance company selected by the lender. The premium covers the entire loan amount, is not tax deductible, and is in force until terminated. PMI can usually (not always) be terminated when the loan balance declines to 80% of current property value.  LPMI: The lender purchases insurance from a private mortgage insurance company, and passes the charge on to the borrower in a higher interest rate. The higher rate remains in force until the loan is paid off, but it is tax deductible. Piggybacks: The borrower takes out two mortgages, a first mortgage for 80% of property value, and a second mortgage for the balance of the funds needed. The second mortgage carries a higher rate, and it is tax deductible.  I frequently receive letters asking me whether LPMI will be less costly than PMI, or whether a piggyback will be less costly than LPMI or PMI. Unfortunately, the answer to these questions can vary from case to case � no general answer is possible. For example, assume that Henry is purchasing a $400,000 house and he can afford to put 3% down -- $12,000. If he finances the purchase with a 30-year fixed-rate mortgage (FRM) of $388,000 at 6% and pays for PMI, his annual premium is .96% of the loan balance, which in the first year amounts to $310.40. Over 10 years, his pre-tax total mortgage cost including all payments and lost interest at 3%, less balance reduction, amounts to $284,700. These costs and those cited below are derived from calculator 14b. If Henry takes the same mortgage but purchases LPMI instead of PMI, he avoids the mortgage insurance premium but pays a rate of, say, 6.525% instead of 6%. His total mortgage cost over 10 years is also $284,700. If Henry goes the piggyback route, he gets a first mortgage of $320,000 at 6% but must pay (say) 8.5% on the $68,000 second mortgage. In addition, he has to pay (say) .82 points on the first mortgage to cover the added processing expense. You guessed it, his total mortgage cost over 10 years is also $284,700.  Of course, they all came out the same because I juggled the assumptions to make them come out the same � in order to make a point. Since the assumptions are completely plausible, it is clear that any one of the three can have the lowest cost. For example, dropping the LPMI rate below 6.525% will lower the cost of that option, and dropping the cost of the piggyback below 8.5% will lower the cost of that option.   In a market setting, the different options are likely to be offered by different loan providers, in which case there can also be differences in points and other lender fees. These complicate the issue enormously if you are trying to sort it out in your head, but calculator 14b handles them with no problem. If I were designing the housing finance system from scratch, it would use LPMI alone. Three options for accomplishing the same objective complicate things unnecessarily. LPMI makes it easy for borrowers to shop, and provides maximum incentive to lenders to negotiate insurance prices with mortgage insurers. But so long as the system we have offers the three options, borrowers need to be able to figure out which option is best for them. None of them are best for everyone. How Long a Lock Period Do I Need, and When Should I Lock? Lock Period: The lock period is the period during which the lender guarantees the rate and points. If an FRM is locked at 5.50% and 1 point for 45-days, for example, the lender is committed to make the loan at that price anytime within the following 45 days. Locks for longer periods are priced a little higher. Expect to pay another 1/8 point for each additional 15 days. Lock Expiration: If the loan has not closed by the end of the lock period, it expires; the lender is no longer committed. If prices have not increased during the period, the lender will usually be willing to extend the lock for a small additional fee. If prices have increased, however, any lock extension will be at the new higher prices. This is a risk you want to avoid. How Long a Lock Period Do You Need? On a home purchase, select a period long enough to include the expected closing date. On a refinance, the lock period need be no longer than is necessary to process the loan, but this period depends on the loan provider. Discuss it with the broker or lender. Leave yourself with a 15-day buffer, just in case. When Should You Lock? If you barely qualify at today�s rates, lock as soon as possible. You are in no position to risk an increase in rates. If you are comfortable with the risk, you can delay the lock in order to take advantage of the decline in price as the lock period shortens. For example, if market rates don�t change, a 45-day price of 5.5% at 1 point 15 days later should become a 30-day price of 5.5% at 7/8 of a point. This assumes, however, that you receive an honest reading of the market price on the day you lock. You will if you are dealing with an internet lender who posts your price on the internet every day. You are also safe if you are dealing with an Upfront Mortgage Broker (UMB) who gives you the best wholesale price on the lock day. In other cases, you may or may not get an accurate reading. The loan provider who knows you are in too deep to back out may up the price a bit, so the 1/8 point will go in his pocket rather than in yours. With no independent check, the �market price� is what the loan provider says it is. On a purchase transaction, the cost of failure to close is usually high. If you can�t completely trust the loan provider, you should lock while there is still time to find a new one. On a refinance, a delay in closing is usually less costly, and those refinancing with new lenders have an additional option: they can rescind the deal within three business days after closing. In practice, this won�t protect against an avaricious loan provider unless the borrower makes clear that he knows how the game is played and is prepared to exercise his options if necessary. What Documentation Requirements Should I Seek? A lender�s "documentation requirements" stipulate a) the information about income, assets and employment that must be provided; b) whether and how this information will be used by the lender; and c) whether and how the information provided will be verified by the lender. Lenders usually offer multiple choices, from the most demanding called �full documentation�, to the least demanding called �no-docs�. The full range is shown in the table below. Because the risk to the lender rises as documentation requirements become less stringent, the price of the mortgage rises correspondingly. Type of Documentation Type of Borrower Full Borrower can document income for last 2 years as derived from one job or business, and such income is sufficient to qualify. Alternative Same but the borrower is in a hurry. Ask for this, it does not cost anymore. Stated Income Borrower has sufficient income to qualify but cannot fully document it because, e.g., it is business income, borrower changed job or was promoted, there are two incomes but only one is being used to qualify, etc. No Ratio Borrower�s income does not meet lender standards but borrower considers it adequate because he is accustomed to allocating a large percent of income to housing, has dependable family support, will shortly reduce expenses by paying down other debt, etc. Stated Income/Stated Assets Borrower cannot fully document assets ( as well as income), but expects to have enough from gifts, business income, cash-out refi, etc No Income/No Assets (NINA) Borrower with a job or business either does not have the income and assets to qualify, or does not wish to disclose them. Borrower might have substantial income-generating capacity, such as a physician moving to a new state, or substantial home equity. No Docs Same as NINA but borrower cannot document a job or business.   In general, borrowers receive better pricing the more documentation they provide, though providing documentation can be a hassle. Some borrowers have such a strong aversion to the hassle that they are willing to pay the price to avoid it. That�s OK so long as the decision is yours and not the loan provider�s. Occasionally they steer a borrower into less demanding documentation in order to make less work for themselves. That you don�t permit. Copyright Jack Guttentag 2005

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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