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As a first-time homebuyer, the choice of where to plant your long-term roots can be overwhelming. My own commitment issues were further taxed by the variety of funding options. This guide outlines the defining features of the different options and gives pointers to navigating the choice.
Mortgage types are differentiated by the timing of capital repayment and the basis of calculating interest. Knowing how these two features are impacted by future changes in financial circumstances and the economic environment, the informed buyer can choose a financing option that meets her needs.
Although most buyers will settle on only one financing instrument, understanding the full spectrum of asset financing options minimizes the chance of overlooking the best deal. Also, considering alternatives will cue the investor who needs to refinance in the face of changing personal financial circumstances or the overall economic climate.
The Basic Features of a Mortgage
A mortgage is a long-term (greater than five years) loan issued to a buyer who wishes to secure a long-term real estate asset. In exchange, the buyer agrees to make scheduled periodic payments, at the end of which the lender would have received her capital with some appreciation, generally in the form of interest.
Typically, the asset being bought is pledged as collateral in the event that the borrower defaults (fails to stick to the repayment schedule). When this occurs, the lender takes possession of the property through a process called foreclosure. Foreclosed properties are sold, with the proceeds used to settle the outstanding debt.
The qualifying borrower has to demonstrate creditworthiness (the likelihood that she will adhere to the repayment terms) and may be required to make a down payment. This assessment is referred to as underwriting.
Through a process of credit vetting, borrowers who are deemed to have a chance of defaulting (not strictly meeting the repayment terms) are charged a risk premium, usually in the form of a higher interest rate.
Below we survey the different types of mortgage a borrower can expect to encounter.
Capital Repayment Mortgages
These are the standard variety of mortgages and come in fixed and variable rate flavors (see below). In a capital repayment mortgage, each periodic (usually monthly) repayment goes towards paying both the capital borrowed (hence the name) and the interest accruing on the loan.
Since the interest is calculated based on the remaining capital and accrued interest outstanding, it is to the borrower’s advantage to pay more than the required payment, as such excess payment – known as prepayment – will erode the value of the outstanding capital due.
In effect, this will shorten the life of the mortgage. In some cases, lenders apply penalties for prepayments that exceed a certain level.
Interest-Only Mortgages
These mortgages, which have declined in popularity, require that the borrower pay only interest over the course of the life of the mortgage, paying off the capital at the end of the term. Ideally, the borrower would then maintain a separate investment account to save for the capital due.
Two factors have contributed to the declining popularity of the arrangement. Firstly, there is the risk of the property outperforming the investment account, in which case, not enough money would have been saved to cover the end-of-term obligation, leaving the borrower scrambling for refinancing and at risk of default.
Secondly, these schemes do not work very well in low inflation environments. Over a period of high inflation, the “real” value of the loan declines steadily so that repayment is not an onerous undertaking for the buyer.
This does not happen in such low inflation environments as have been seen in America and Japan over the last thirty years.
Fixed-Rate Mortgages
In fixed-rate mortgages, the interest rate does not change over a specified period, usually five to ten years. This provides insurance against rising interest rates and inflation, allowing for more accurate estate planning.
On the downside, buyers with these mortgages will not benefit from declining interest rates, as they are committed to the same monthly repayment.
At the culmination of the fixed period, the mortgage is adjusted to the issuing bank’s variable rate (see next paragraph). Some borrowers might consider this a trigger to refinance – seeking to buy out their mortgage with a new fix-rate one. The costs associated could prohibit this.
Variable/Adjustable-Rate Mortgages (ARMs)
Banks cover their daily shortfall by borrowing from a Central Bank, which charges a reference rate that varies from time to time. By varying this rate, the Central Bank controls price volatility and overall stability in the economy through the financial markets.
The banks, in turn, cover themselves by passing on the variability to the clients. This is why most mortgages are variable rates, meaning that their interest rate hovers in tandem with the Central Bank’s fluctuation of the reference rate.
Unless a fixed rate is specifically requested, mortgages are standardly issued with a floating rate. At the time of issue, this rate will be slightly lower than the corresponding fixed rate – a device through which the issuing banks insure themselves against interest rate volatility.
The risk to variable-rate borrowers is that an interest rate spike (or series of such) may push their repayment beyond levels of affordability.
Hybrid ARMS
Hybrid ARMS are a cross between fixed rate and variable rate mortgages. These instruments have a rate that is fixed for a specified initial period over the life of the mortgage. After that, at regular intervals, the rate is adjusted up or down, according to a specified formula linked to a reference index.
In some cases, it is useful to think of a Hybrid ARM as a fixed-rate mortgage in which the level is periodically revisited to adjust for medium changes to the economic environment. In others, the instrument is more like a variable rate mortgage with an initial fixed grace period.
Hybrid ARMs are usually capped to limit rate escalation. They are quoted as a rate followed by two integers, e.g., “3% 5/25” or “ 2.5% 2/1”. The rate is the initial fixed interest rate on the mortgage. The first integer indicates the number of years over which the initial rate remains fixed.
The second integer may indicate the period over which the rate floats (as in the first example – 25 years) or the reset frequency (annual, in the second example).
Some Federal agencies are involved in the backing of mortgages in their sectors of interest. We list the bigger five here:
Veterans Administration Loans
Serving personnel of the United States Armed Forces may apply for a certificate of eligibility for a VA loan. This mortgage equips them to get VA backing for a mortgage on a primary residence for themselves, a spouse, or dependent (in the case of serving members).
VA loans are subject to size limits set by the Veterans Administration. Borrowers buying properties under the limit qualify for low-to-no down-payments. Exceeding the limit triggers a higher down payment and requirement for the borrower to purchase private mortgage insurance (PMI).
FHA Loans
To encourage homeownership, the Federal Housing Administration guarantees loans issued by qualifying issuers. The criteria have been adjusted to permit a broader pool of primary homeowners, with down payment requirements linked directly to credit scores.
The overall low down payment requirements and down-weighting of historic defaults make this an attractive option for newly financially stable buyers.
US Department of Agriculture Loans
Buyers in rural and suburban areas may qualify for loans backed by the USDA. These set income limits, have low down payment requirements and generally tend to favor lower-income purchases of rural real estate in demarcated areas.
The credit criteria vary from area to area, and overall, are not as strict as prohibitive as the federally backed urban equivalents.
203(k) Loans
These instruments are designed to accommodate buyers of a primary home that needs extensive repair. Because of the anticipated construction costs, the value of the loan exceeds the purchase price of the property.
Qualifying criteria encourage new owners, and the higher interest rate reflects not only the higher risk profile of the owners but also the resale risk associated with an unfinished home that re-enters the market early.
In practice, an escrow account is created to house the money remaining after the seller has been paid the payment consideration.
Building contractors are paid from the escrow after completing work on the property, and a six-month time limit is placed on the construction. Non-primary residences and investment properties are excluded from this arrangement.
Fannie Mae offers a HomeStyle Loan for the same market. This product has the features of a conventional mortgage (so no cash-out and escrow), but the borrower gets the liquidity benefit through a very low down payment requirement – freeing up cash for the moving/renovation costs.
Conforming & Jumbo Loans
The government housing promotion agencies Fannie Mae and Freddie Mac provide guidelines for the required income and down payment for aspiring borrowers. The Federal Housing Finance Administration FHFA stipulates limits on the size of loan amounts, given income and credit scores of applicants.
Together, these guidelines and limits seek to limit the risk of default. The Government Sponsored Entities that provide loan guarantees (covering issuers in the case of default) do not protect mortgages issued outside of the conformance limits.
A conforming conventional loan is a conventional mortgage that conforms to the Federal Agency guidelines. In contrast, Jumbo Loans exceed the limits laid down.
Accordingly, they attract a higher interest rate as the lenders seek to cushion themselves against the increased risk of default without the backing of a federal guarantee.
Piggyback Loans
These are effectively partial loans on the down payment required. A typical scenario involves a buyer who does not have the 20% required down payment and signals to her lender that she wishes to cover it with a piggyback loan.
The lender would refer her to a second lender, who then issues a portion of the required amount, leaving the borrower with a smaller net down payment.
An example is the 80/10/10 structure, where the mortgage lender provides 80% of the property’s value, the second lender provides 10%, leaving the buyer with only a 10% cash down payment. 75/15/10 is another common structure, with the same net payment requirement for the buyer and higher participation by the piggyback lender.
Buy-to-Let Mortgages
These mortgages target investors looking to buy a property to let it. Rather than a conventional mortgage, these investors are given interest-only debt, with higher required down payments.
As a result, they capitalize on the spread between the residential rate and their borrowing rate, getting an enhanced return on the appreciation of the underlying property (which they will have to sell or refinance at the termination of the agreement).
The high down payments and explicit exclusion by banks preclude this as a funding instrument for residential buyers.
Help-to-Buy Mortgages
In these schemes, the government assists (usually first-time) buyers who struggle to meet the deposit requirements on their mortgages. This mortgage takes the form of an ancillary loan, covering a part of the deposit.
Because of their assistance nature, these schemes usually put a cap (upper limit) on the price of the underlying property. They may also be red-lined – making them off-limits to property purchases in areas deemed affluent. Variations restricted to new builds have also been seen.
In London, the scheme has been sweetened to include a 0% interest accrual over the first five years, with incremental interest over the remainder. A shared-ownership variety helps tenants in housing associations to buy equity in their house, paying rent on the remainder, and with an option to buy fully in the future.
Tracker Mortgages
These mortgages are designed to explicitly track an economic variable – usually the lending rate of the Central Bank in the territory of origin. They can be regarded as a more transparent version of adjustable-rate mortgages, in that the issuing lender’s discretion to vary the rate is explicitly obviated.
They are flexible in that the borrower may target a reference rate that more closely matches her liability profile.
Typically, the rate would be quoted as a specified number of basis points (parts of a percent) above the reference rate, e.g., “Fed fund Rate = 0.5%”.
Discount Rate Mortgages
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As the name suggests, the mortgages offer a discount to the prevailing reference rate. Their popularity has been limited by the suspicion that they are prone to use as marketing gimmicks.
The mortgage works by offering the borrower an interest rate lower than a reference market rate. This discount will be in place for a stipulated period, implying that the periodic repayments over that time will be reduced.
A problem is that in the event of a drop in the reference market rate, the issuer is under no obligation to drop the discount rate. This means that ordinary market moves can erode the bargain before its stipulated expiry. It has also ceased to be generally true that discount rates are the cheapest in their class at the outset.
Capped Rate Mortgages
These are variable-rate mortgages with a ceiling rate. The borrower’s interest rate fluctuates but is not allowed to rise above the stipulated cap rate. This allows peace of mind that rising rates will not put the borrower out of pocket. At the same time, the borrower benefits from drops in the interest rate.
In effect, the borrow has taken a standard variable rate mortgage and bought interest rate insurance. This reflects a problem for unsophisticated users buying such instruments. The starting rate of a capped mortgage is higher than that for a corresponding uncapped product, reflecting the embedded insurance.
Deciding whether the insurance has been overpriced is a difficult calculation, generally beyond the ken of even sophisticated buyers.
Cash Back Mortgages
These mortgages lend more than the value of the property, offering the borrower cash that usually is needed to defray moving/resettlement costs. Effectively, the borrower is taking out two loans – one to finance the house and a second personal loan.
Accordingly, the repayment rates of these loans are usually higher than vanilla mortgages, as they are effectively the weighted average of a mortgage rate and an unsecured personal loan rate – the latter of which is higher than the former.
Expect the rate offered to be even higher than the expected average, as issuers usually expect to attract cash-hungry borrowers.
Offset Mortgages / Access Bonds
Offset mortgages cater to buyers with savings that they do not want to commit to real estate. When the savings are invested in qualifying long-term interest-bearing products, they may be entered into an offset mortgage.
In this case, the borrower’s interest payment is calculated on the capital balance of the mortgage, less the nominal value of the savings account. This caters to investors who have the financial wherewithal to make a prepayment on their mortgage but prefer the asset diversification that a split between property and liquid savings allows.
Offset mortgages are economically equivalent to access bonds. These are mortgages in which the borrowers who prepay their debt can withdraw funds equal to the prepaid amount from their account.
In some cases, and at the lender’s discretion after conducting underwriting, the money advanced might exceed the value of the prepaid amount.
In both cases, the borrower should consider the cost-adjusted interest rate differential, as this would impact the net return. Entering an offset would likely be a poor decision when the savings attract a higher return than the mortgage repayment rate.
Flexible Mortgages
Fully flexible mortgages give the borrower wide latitude in her conduct over the course of the loan. The payment schedule acts as a guide, and the borrower is free to prepay, withdraw prepaid amounts, and take payment holidays during times of stress without triggering a default.
These mortgages fit buyers whose source of income is subject to wide variability that defies confident prediction at the time of mortgage origination.
Care should be taken to not over-accrue interest on account of numerous or sustained payment holidays. The initial rates of these mortgages are higher than corresponding conventional mortgages. This higher cost may not be worth the value of the flexibility.
Chattel Mortgages
Chattel loans are designed to cover movable property like mobile homes and manufactured homes, in which the buyer pays for the residential asset but not the land. They can also be used to cover heavy equipment.
The mortgages usually have a shorter repayment period and unique risk management features. Usually, they require registration of the underlying asset in a registry akin to the Deeds Office. Consistent with their risk, they carry a higher interest rate and are generally unsuitable for buyers of fixed property.
Home Equity Loans and Reverse Mortgages
Both these products allow homeowners to capitalize on the equity of their homes. Home Equity Loans are the general form of a loan secured against property already in possession of the borrower.
Reverse mortgages were designed for homeowners over the age of 62. A popular version of this instrument is the Home Equity Conversion Mortgage (HECM), insured by the Federal Government.
This allows retirement age homeowners to borrow against a portion of the value of their home – the home equity. It is tailored around the liquidity profiles of retirees and does not require repayment before the death or sale of the underlying property.
Guarantor / Family Assisted Mortgages
These loans are crafted to assist those who struggle to front the deposit for an expensive property or whose credit score is low.
In a guarantor mortgage, a third party with property and a passable credit score provide supplementary loan collateral in the form of a property. The guarantor then agrees to fulfill the borrower’s repayment commitments in the case(s) where default occurs.
In a family-assisted mortgage, a family member effectively lends money to the borrower to cover a shortfall in the required deposit.
How this differs from an outright loan is that instead of making a direct payment to the buyer/borrower, the family member deposits the funds into an interest-bearing account under the lender’s control.
The money, and its interest, are returned to the family member if, after a stipulated period, the borrower meets a specified repayment threshold.
In both arrangements, the buyer and the guarantor/relative risk losing their collateralized assets in the case of a joint default.
Islamic Mortgages
Fastidious Muslims may observe their religion’s Sharia code of ethics, which prevents the levying of interest. Accordingly, Muslim finance has developed property finance plans that preclude interest. They involve variations of a theme: the funding bank buys the property and enters an agreement with the buyer to rent it from the bank.
Part of the rental payment is recorded as a down payment on the house, and after a specified period, the buyer will be left with a residual amount, on payment of which full ownership of the house transfers to her.
Three popular versions are Ijara, Musharaka and Murabaha. The first two instantiate the scheme described above and differ principally in the proportionality of transfer over time to the buyer.
In the Murabaha model, the financing is characterized as the bank buying the property for its own account and then on-selling it at a marked-up price, lending the buyer’s purchase consideration free of interest.
How to Navigate the Options
With so much apparent choice, a decision might be hard to make. At every step, a qualified financial advisor should be consulted, as the long-term costs of an early misstep could be onerous.
A skilled advisor might also help understand the pricing, which – especially for non-standard mortgages – can be more complex than a first view suggests. Overall, there are three things to consider.
Choosing a Lender
With financialization, there has been an increase in the number of mortgage lenders. Guarding against predatory and unethical practices is as important as shopping for price. Be sure to consult with consumer advocates, who may know the profiles and past conduct of your candidate lenders.
Choosing a Mortgage Type
As the discussion above has shown, the bewildering pack of options can make for a tough choice. It is worth laboring through all the available options as a small difference can accrue into a large opportunity (or cost) over the long life of a typical mortgage.
Decisions While Invested
Changes in the economic environment, as well as your personal circumstances, necessitate that you periodically review the fitness of your funding instrument. A fixed-rate might have locked you far out of a cycle of declining rates.
Too many payment holidays might have lengthened your required repayment horizon. In general, it pays to ask if your mortgage’s parameters still reflect the best repayment profile for you. If not, the time may be ripe for a switch.
We have taken a tour of the mortgage universe. While financial innovation has created a range of options, the array of choices should not dazzle the careful buyer. Remembering the main characteristics that define the types is key.
By understanding the broad differences between different types of mortgage, the diligent buyer can home in on a product that meets her needs. And secure funding for the home of her dreams.
References:
Time Magazine: Types of Mortgages
The Mortgage Reports: Complete Guide to Building a House
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