Which Mortgage is Right for You
Someone in the market for a new home, planning to sell a present one or seeking investment property, should be aware of the new mortgage plans available. Most of these represent a departure from traditional mortgages, can involve more risk for the buyer and are frequently tied to changes in the market. However, they also may feature lower interest rates and allow more buyers to qualify. Be sure to shop carefully for the right plan for you.
The buyer takes over the seller’s original, below-market rate mortgage. Sometimes the buyer wishes to assume an existing loan due to impaired credit.
The monthly payments are lower. However, this may be prohibited if a “due on sale” clause is found in the original mortgage. This is not contained in most new fixed rate mortgages, but older documents frequently permit this assumption.
Monthly payments are based on a fixed interest rate,
usually short term. Payments may
cover interest only with principal due in full at the term’s end.
This offers low monthly payments, but possibly, very little equity until the loan is fully paid. When due, the loan must be paid off or refinanced, which normally involves closing costs again. Refinancing poses high risks if rates rise.
A balloon mortgage is a relatively short-term note that usually does not provide for guaranteed refinancing. Balloon mortgages have a series of equal monthly payments and then a large final payment. Although there is usually a fixed interest rate, the payments may be for interest only. The unpaid balance (frequently the original amount borrowed) matures in a short period, usually within five years.
If you cannot make the final payment, you may have to refinance or sell the property. Some lenders guarantee refinancing when the balloon payment is due, although they do not guarantee a certain interest rate. Without this guarantee, you may be forced to go through the entire lending procedure again, including the payment of closing costs and front-end charges.
A developer (or third party) provides an interest subsidy that lowers monthly payments during the life or portion of the loan. It can have a fixed or flexible interest rate.
This offers a break from higher payments during early years. It enables a buyer with a lower income level to qualify. With flexible rate mortgage, payments may jump substantially at the end of the subsidy.
The seller pays an amount up front to the lender. This amount is put into escrow and is used to partially subsidize the borrower’s payments for the period of the buy-down. To make sure of the deductions, where applicable, establish that you, and not the seller, paid the points. Otherwise, the lender may simply deduct the points from the loan amount, which means the immediate deduction of the full amount will be lost.
FIXED RATE MORTGAGE
This traditional mortgage instrument with a fixed interest rate, usually long term, has equal payments of principal and interest until the debt is paid in full.
This mortgage offers stability and long term advantages. Interest rates may be higher than other types of financing. New fixed rate mortgages are rarely assumable.
The most common Fixed Rate Mortgages are 15 year and 30 year terms.
ADJUSTABLE RATE MORTGAGE (ARM)
Interest rate changes are based on a financial index, resulting in possible changes in monthly payments, loan term and/or principal. Some plans have rate or payment caps.
The starting interest rate is slightly below market, but payments can increase sharply and frequently if the index increases. Payment caps prevent wide fluctuations in payments, but may cause negative amortization where the mortgage balance actually increases. Rate caps can limit the amount which total debt can expand.
An Adjustable Rate Mortgage, also known as a flexible rate mortgage, provides an interest adjustment at given intervals ranging from six months to five years. Usually, these rates are tied to some index that is readily available, verifiable and beyond the control of the lending institution, for example, the Federal Home Loan Bank Board index, based on T-bills.
Lenders tend to offer adjustable rate mortgages at rates 1% to 2% below fixed rate mortgages. However, they also tend to require borrowers to have more equity in the property than in fixed rate mortgages. If interest rates rise, you may pay more interest than stated in your original mortgage. Some ARMs provide payment or interest rate ceilings.
Recent ARM Mortgage contracts now have prepayment penalties if the loan is paid off early, usually within the first 2 to 3 years.
125% OVER EQUITY MORTGAGES
This type of mortgage is built on the tradition Fixed Rate or ARM mortgage with the main difference being that you are borrowing 25% more than the value or cost of the home.
WARNING! Normally you cannot deduct all the interest on this type of loan on your tax return. Please consult your tax advisor.
NO DOCUMENT MORTGAGE
This really is not a type of mortgage but our goal is to educate so we include it. A No Document Mortgage is a mortgage where you put down a larger than normal amount of equity, 40% or more of the value or purchase price of the house. For this larger down payment the bank or mortgage broker will waive most document requirements such as copies of past tax returns etc.
GRADUATED PAYMENT MORTGAGE (GPM)
Lower initial monthly payments rise gradually (usually over five to 10 years), then level off for the duration of the term. It may include flexible interest rate, with additional payment changes possible if index changes.
It is easier to qualify for this type of mortgage. It features negative amortization. The buyer’s income must be able to keep pace with scheduled payment increases. With a flexible rate, payment increases beyond the graduated payments can result in additional negative amortization.
This mortgage may be especially attractive if you are buying a home for the first time and expect your income to rise in the future. This loan has monthly payments that are smaller during the early years of the mortgage but gradually increase during the first five to 10 years and then level off. The interest rate is usually fixed.
The drawback is that you will find yourself taking longer than expected to build equity in the home since the early payments usually do not cover interest. During later years, the difference is made up by larger payments. To counter balance this effect, the lender may require a somewhat larger down payment.
GROWING EQUITY MORTGAGE (GEM)
This is a fixed rate instrument with an increasing payment schedule. The increases are applied to the principal.
It permits rapid payoff of debt because the payment increases will reduce the principal. The buyer’s income must be able to keep up with payment increases.
This mortgage carries a fixed interest rate, like a traditional mortgage, except there are monthly payment increases (based on specified indexes) applied totally to principal. These increases cause the principal to be paid much faster than normal, usually within 15 years, thereby increasing home equity that much faster.
The GEM is beneficial if your income keeps pace with the increasing payments, and since the loan is paid earlier, you may be able to save up to one-half the interest cost of a conventional mortgage. Consequently, however, the plan does not offer as much in long-term interest tax deductions.
SHARED APPRECIATION MORTGAGE (SAM)
This mortgage features a below-market interest rate and lower monthly payments, in exchange for relinquishing a share of profits when the property is sold on or before a specific date. There are many variations on this plan.
If the home appreciates greatly, the total cost of the loan jumps. If the home fails to appreciate, a projected increase in value may still be due, requiring refinancing at possibly higher rates.
In a SAM, monthly payments are relatively low and the borrower pays a relatively low interest rate. SAMs require sharing with the lender a set percentage of the home’s appreciation (normally 30-50%).
Under some SAM agreements you may be liable for the dollar amount of the property’s appreciation, even if you do not sell the property at the agreed upon date. Unless you have the cash, you may be forced to sell the property. Also, if property values remain constant or decrease, you may still be liable for an additional amount of interest.
RENEGOTIABLE RATE MORTGAGE (Rollover)
The interest rate and monthly payments are constant for several years; changes are possible thereafter.
The less frequent changes in interest rate offer some stability of payment schedule.
The seller retains the original mortgage. No transfer of title takes place until the loan or contract is fully paid. Interest Rates on Land Contracts tend to be 1% to 2% higher than standard Fixed Rate Mortgages.
Normally, there is no equity until the contract is fully paid. The buyer has few protections from conflicts.
However the seller is acting as a bank, therefore your credit rating or other problems may not enter the transaction.
Land Contract is a popular financing method for land
as many banks will not lend money to buy raw land.
RENT WITH OPTION
The renter pays an “option fee” for the right to purchase property at a specified time and agreed upon price. The rent may or may not be applied to the sale price.
This enables the renter to buy time to obtain a down payment and decide whether to purchase. It also locks in the price during inflationary times. Failure to take the option, however, means the loss of the option fee and rental payments. It is important to read the contract very carefully since some permit the Landlord to re-sell the property without notice and the equity is lost.
REVERSE ANNUITY MORTGAGE (Equity Conversion)
The borrower owns a mortgage free property and needs income. The lender makes monthly payments to the borrower, using property as collateral the mortgage balance grows.
This mortgage can provide homeowners needed cash. At the end of the term, the borrower must have the money available to avoid selling the property or refinancing.
The seller provides all or part of the financing with a first or second mortgage.
This may offer a below-market interest rate. It also may have a balloon payment requiring full payment in a few years or refinance at market rates that could sharply increase.
The seller keeps the original low rate mortgage. The buyer makes payment to the seller, who forwards a portion to the lender holding the original mortgage. A Wraparound offers a lower effective interest rate on the total transaction.
The lender may call in the old mortgage and require payment of a higher rate. If the buyer defaults, the seller must then take legal action to collect debt.
PRE-PAID INTEREST (POINTS)
This normally cannot be taken for tax purposes in the year paid but must be spread out over the repayment period. However, prepaid interest points may differ from normal interest. They may be deductible in the first year if the payment of points is an established practice in the area where the loan was obtained, if the number of points paid is also in accordance with local practice and if the points were for an initial purchase, or as a result of refinancing in order to pay for remodeling. Deductibility applies only to points paid in connection with a principal residence.
ZERO RATE AND LOW RATE MORTGAGE
Appears to be completely or almost interest free. A large down payment and one time finance charge is required. The loan is then repaid in fixed monthly payments over a short term.
This method permits quick ownership. It may not lower the total cost because of a possible increased sales price, and it does not offer long-term interest tax deductions.
If you are trying to finance the purchase of a new home, you will find a number of alternatives available in addition to the conventional fixed rate mortgage.
These are just some thoughts to consider. Your tax advisor and attorney can provide more detailed information and should be consulted before any action is taken. A careful reading and understanding of the specific loan agreement is essential prior to committing yourself to loan fees or assuming the liability.
Tax Disclaimer: To ensure compliance with IRS Rules, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
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Wink Tax Services / Wink Inc.