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IF YOU HAVE INTERNET ACCESS and are shopping for a loan, there are a host of commercial web sites that want your business. One of my favorite mortgage web sites is The Mortgage Professor’s Web Site at www.mtgprofessor.com, which is friendly and consumer-oriented.
Jack Guttentag, who is a real Professor of Finance Emeritus, has designed over two dozen calculators for helping consumers make common loan choices. The site also includes his many well-written articles about choosing a loan, working with lenders and mortgage brokers and using the Internet for loan shopping. Professor Guttentag explains how to avoid mortgage scams and predatory lending pitfalls, and describes how honest “upfront” mortgage brokers work.
The following is a brief discussion of real estate loans, with a list of the most common types of loans in use today.
The Real Estate Loan Formula
A real estate loan is based on a mathematical formula which is easy to run on a financial calculator, but too complicated to figure out on paper, even if you paid attention in algebra class. If you want to see how the loan formula works, you can use a calculator with financial functions.
The five main elements of the loan formula are the same as the five keys on a financial calculator. These are the term, the interest rate, the principal, the final value and the payment. The five elements in the loan formula are mathematically interrelated. When you change one element, this alters one or more other elements in surprising and unexpected ways. The time value of money is a powerful concept. It allows the borrower to go into debt just as effectively as it helps the investor build wealth.
For example, if you want to make lower monthly payments, you can do one (or all) of four things – increase the term of the loan, lower the interest rate, lower the principal amount or reserve a final payment at the end of the loan term.
Term
The standard term for a residential mortgage is 30 years, with the 15 year loan a close second in popularity. Loan terms of 10, 20, 25 and 40 year terms are less common, but not unheard of.
Interest Rate
The mortgage interest rate is usually expressed as the annual percentage rate or APR. Interest rates for 30-year home mortgages normally ride a few notches above the interest rates for 30-year treasury bonds, called “long bonds,” which serve as a national benchmark for mortgage interest rates. Bond interest rates normally rise and fall with the rate of inflation, and generally run in counterpoint to the stock market. A strong stock market, healthy economy and low inflation usually means low mortgage interest rates. When you apply for a loan, most lenders will allow you to “lock in” an interest rate for a period of time, usually 30 to 60 days.
Principal
The principal is the total amount being financed. When you buy a house, this is the purchase price minus the down payment. However, the principal can also include a variety of closing costs, also called settlement costs. These include fees for loan origination, document preparation, escrow, title insurance, credit reporting, document recording, pest inspection, appraisals, surveys, commissions, legal fees, insurance and property taxes. Some dishonest lenders and mortgage brokers might also try to include a variety of “junk fees” which you shouldn’t have to pay.
Closing costs are always negotiable. There are no hard and fast rules about these fees or about who pays them. Congress passed the Real Estate Settlement Procedures Act (RESPA) in 1974, which requires the lender to provide a good faith estimate of closing (settlement) costs within three business days from the date of the loan application. Lenders are also required to provide the borrower with a “truth-in-lending” statement which discloses the annual percentage rate (APR) of the loan.
Lenders often use a term called points to describe the loan origination fee, which can be one of the major closing costs. One point is equal to one percent of the loan amount. Points become part of the principal which has to be repaid over the term of the loan. Borrowers can often decrease or “buy down” the interest rate by paying more points.
Final Value
The final value at the end of a conventional mortgage term is usually zero, meaning the loan has been paid in full. However, some loans call for a balloon payment at the end, where the borrower has to pay a lump sum. When sellers finance a real estate loan, they often make it a short-term loan with a balloon payment at the end, giving the buyer time to establish good credit and refinance with a conventional loan.
Payment
Once you know the term, interest rate, principal and final value, you can calculate the monthly payment. This is an important number because it determines whether or not you can afford to pay back the loan.
Types of Real Estate Loans
There are an incredible variety of real estate loans on the market today. Although confusing, the loans have been designed to accommodate the different needs of borrowers. The following is a list of the basic types of real estate loans.
Amortized Loan – This is the modern mortgage loan, were the borrower makes equal monthly payments which are part principal and part interest. The payments start with a larger proportion of interest at the beginning of the loan term and gradually shift to a larger proportion of principal toward the end of the payment series.
Adjustable Rate Mortgage (ARM) – The adjustable rate mortgage (ARM) now makes up about half of all new real estate loans. With an ARM, the interest rate changes throughout the term of the loan, and the monthly payments can go up or down accordingly. The interest rate is the sum of an index rate and a margin. Common index rates are the prime rate, the 11th District Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR) and various Treasury Bill and Certificate of Deposit rates. The margin is set by the lender and does not change. ARMs come with lifetime interest rate caps, and usually an annual cap. Some ARMs offer reduced initial rates.
Hybrid Mortgage – Hybrid mortgages start out as ARMs and are convertible to fixed rate loans, and vice versa.
Second Mortgage – An additional mortgage which is in second position or subordinate to the first mortgage. These are often called home equity loans or home equity lines of credit.
Conforming Loan – A loan which conforms to the purchase requirements of the two major secondary mortgage market lenders (Fannie Mae and Freddie Mac).
Jumbo Loan – A non-conforming mortgage which does not meet the purchase requirements of Fannie and Freddie because it is too large.
Wraparound Loan – In this arrangement, a buyer purchases the property with the seller’s existing loan still in effect. The seller continues to make payments on the original loan and the buyer obtains a new loan which “wraps around” the first loan.
Short-Term Loan – A loan with term of 5 years or less, usually with a higher interest rate than a conventional mortgage.
Cash-Out Refinancing – This is a new loan which replaces an old loan, giving the borrower extra cash out of the deal.
Bridge (Interim or Swing) Loan – A bridge or interim loan is a short-term loan which spans the gap between two other loans. Bridge loans are often used by buyers between the closing dates of a home purchase and a home sale.
Construction Loan – A construction loan is generally a short-term, higher interest loan, where the lender advances money in stages as the construction progresses.
Take-Out Loan – This is a conventional loan which replaces or “takes out” another loan, such as a construction or bridge loan.
Reverse Mortgage – Designed for senior citizens who are equity-rich and cash-poor, reverse mortgages give the homeowner a lifetime fixed monthly retirement income. When the homeowner dies, the residence is sold, the loan is paid off and any leftover cash goes to the heirs. The homeowner may also decide to sell the house and receive the leftover cash. Reverse mortgages can provide real benefits, but their image has been tarnished by predatory lenders who have scammed unsuspecting seniors with huge up-front loan fees.
Term (Straight) Loan – The term, or straight loan was widely used prior to the Great Depression of the 1930s. Borrowers paid the interest in a lump sum at the end of each year. The principal was due at the end of the loan period, which could be as short as one to five years.
Interest-Only Loan – Common prior to the 1930s, interest-only loans do not include the repayment of any principal for a given time period. The borrower pays only the interest while the loan balance remains unchanged. Some home equity lines of credit are set up as interest-only loans for a given time period (such as 5 years) and then convert to conventional amortized loans.
Balloon (Partially-Amortized) Mortgage – This is a short-term loan with a final or balloon payment due at the end of the term. Monthly payments are usually calculated over a 30-year period. Borrowers often refinance the loan before the term is up to avoid making the balloon payment.
Budget Loan – The budget loan includes the standard housing costs, which are the principal, interest, real estate taxes and insurance (PITI for short). This helps some borrowers budget for these expenses.
Package Loan – A package loan is a budget loan which includes personal property, such as appliances.
Purchase Money Loan – This is a loan financed by the seller.
Open End Loan – This is a type of home equity loan or second mortgage which provides a line of credit.
Blanket Loan – A blanket loan involves more than one property offered as collateral.
Graduated Payment Mortgage (GPM) – The graduated payment mortgage offers monthly payments which start out low and gradually increase. During the early series of payments the principal may actually increase, which is a process called negative amortization.
Installment Sale – A type of seller financing which combines an interest-only loan with principal payments paid in installments over two or more tax years. The seller benefits by deferring profit tax and the buyer benefits by deferring payments on the principal.
No-Interest (Islamic) Loan – Some lenders have developed certain types of no-interest loans to meet the needs of Islamic buyers, whose religious beliefs forbid charging interest.
Simple (Daily) Interest loan – A complicated type of loan which requires that payments be made exactly on the same date each month.
Shared Appreciation Mortgage (SAM) – In this type of loan, the lender gives the borrower a lower interest rate in exchange for a 30 to 60 percent share of the property’s future appreciation. The more appreciation the borrower agrees to share with the lender, the lower the interest rate. SAMs are making a comeback in some areas because of rising home prices and mortgage rates.
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