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
What Documentation Requirements Should I Seek?
What Type of Mortgage Should I Select?
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
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.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
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
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.
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!
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
waive escrows, and to accept a prepayment penalty.
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.
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
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.
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.
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
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
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.
Fully Amortizing Monthly
Payment Per $100,000
Payment First 5 Years
Payment After 5 Yrs
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
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
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.
Interest Rate Reduction
Yield on Down Payment
25% to 30%
6.60% to 6.55%
20% to 25%
6.80% to 6.60%
15% to 20%
7.05% to 6.80%
10% to 15%
7.35% to 7.05%
5% to 10%
7.90% to 7.35%
0% to 5%
8.55% to 7.90%
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.
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.
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
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
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.
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.
If you barely qualify at today�s rates, lock as soon as
possible. You are in no position to risk an
increase in rates.
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.
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.
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.
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
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
Type of Documentation
Type of Borrower
Borrower can document
income for last 2 years as derived from one job or business, and such
income is sufficient to qualify.
Same but the borrower
is in a hurry. Ask for this, it does not cost anymore.
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.
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.
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