Other Mortgage Articles

October, 2005 - Which Loan is Best For Me?

As the competition in the lucrative mortgage market increases lenders are offering more niche market products, which target transactions outside the norm, to gain an edge on their competitors. This influx of specialized products creates wider loan availability to borrowers than ever before; increasing the possibility to each individual borrower that a product exists that really serves their needs perfectly. Obviously, these products present a a benefit to borrowers when applied to the proper situation. However, this same range of products that bring benefits to clients can also make a consumer’s head spin. Without careful consideration and good guidance a borrower could end up with a loan that simply does not suit their needs. With the dizzying array of loans available to choose from consumers are faced with a difficult choice when selecting which mortgage loan is right for them. A bad choice made on the loan program can cost a borrower immensely. What's worse, is that the problems can occur at either end of the spectrum, when a borrower or loan officer is too aggressive, or so careful that they cost themselves money.

Unfortunately, borrowers, whose misconception that price is the only factor, will often gravitate to inexperienced loan officers that promise low price and sometimes deliver this in the form of niche programs that do not fit the needs of their borrower. Although negative amortization loans, variable rate loans, prepayment penalties and loan discount points are all viable and beneficial options under the right circumstances they are often misused and misunderstood by borrowers and loan officers alike.

Problems with misuse of products are often made worse when a lender fails to ask key questions that could reveal huge benefits to the consumer. Conversely, there are times when a lender is suggesting the use of of niche market product that is not beneficial to the borrower, this could also cost the borrower money. Such oversights, when a borrower may unwittingly end up with a loan that does not truly meet their needs, can cost a borrower thousands over the life of a loan.

One very common example is when a borrower takes a fixed rate loan even though they do not plan to live in the home more than a few years. A variable rate loan fixed for five or seven years would carry a significantly lower rate, and in the specific case of this borrower, cost a lot less per month. Imagine the amount of money saved in just five years if the difference between a fixed rate loan and a variable fixed for five years saved only one hundred dollars: a borrower that moved to a new home after five years, who took the wrong loan would have lost six thousand dollars. All of this money would have been saved if the bank or broker had simply asked the borrower what their plans were and explained why a variable rate loan might have been a better fit in this case.

Taking a fixed or variable rate loan is not the only question or place where mistakes with regards to mortgage financing can be made. There are also many other mistakes that can cost consumers many thousands of dollars or even endanger the very ownership of their home. Loans such as pay option ARMs with the potential for negative amortization can be very good loans for someone with very good cash-flow, but for many homeowners this loan can be a major mistake. Recently, as costs to own homes increase proportionately faster than borrowers incomes, niche loans, like pay option ARMs, that were once unusual have become far more common. Pay option ARM loans, also described as “negative amortization loans” are complex and fit only a very specific type of customer's needs for long term financing. Unfortunately, there is nothing to prevent a bank or broker from making this loan for a client who is grossly unsuited for this loan type. To understand how this loan could be a bad choice for someone, who for example is on a fixed income, look no further than what this loan is and what it is capable of doing.

A pay option ARM mortgage is a variable rate loan with a fixed, graduated monthly payment schedule that starts with monthly payments approximately half as much as those of a normal thirty-year amortizing loan. Sounds great until you realize that in order to achieve this low payment the client must be willing to have a loan wherein the principal balance they owe will quite likely increase significantly and the monthly payments will also increase over the life of the loan.

The structure of this loan is why a Pay Option ARM loan is not for everyone. Each monthly statement from the lender offers the client the option of paying a minimal (scheduled payment) in which the principal is not reduced and the payment may also not be sufficient to cover interest due for that month; in such cases the unpaid interest gets added back to the principal balance. Hence, the term “negative amortization” which indicates that the principal balance is actually increasing.

Each monthly statement also offers options to pay higher payments, which if the borrower is able to pay one of these options, would prevent the loan from adding unpaid interest back to the principal. But, these options require significant payment increases to overcome the deficiency between the minimum payment and what is needed to amortize or at least keep the principal from increasing. The inherent danger is that the borrower's capacity to repay the loan is qualified off of the lowest payment option, thus creating the opportunity for borrowers that have no hope of affording any of the higher payment options to take pay option ARM loans anyway.

Simply put, these loans are best suited for self-employed people with very strong cash flow, or a client whose income will increase dramatically in just a few years, such as a doctor in their residency. However, not many people can predict with reasonable certainty that their income will increase dramatically in just a few years. For an unsuspecting senior citizen or anyone on a fixed income this loan is an unmitigated disaster.

The sad fact is that many people simply hear the things that sound good and ignore the downside until it becomes a painful reality. If the real estate market in a particular area takes a dip in value, people with increasing principal balances and declining property values could find themselves unable to even sell their homes because they owe a mortgage lender more than the home's market value. Albeit this may be a worst case scenario, but in an real estate market with an unsure future this could be a reality for many families.

Most consumers do not really understand how complex the mortgage market is. Lenders marketing to the public often oversimplify these complexities and to be fair, it’s probably impossible to make such a complicated subject clear to everyone. This means that no matter what laws are made to stop abuse or misuse, or what efforts are made by lenders to educate their employees and borrowers, there will be clients that end up with the wrong loan for their needs. Furthermore, extra caution will not suffice to avoid problems; one must actually research and learn what is best for themselves. A borrower can err just as easily on the side of caution as be too aggressive, as in the example of the borrower who paid a fixed rate for five years when a variable loan would have been the better choice for their long term plans. There is simply no substitute for working with honest mortgage industry professionals who put your specific needs first when helping you choose a program.