Which Mortgage Is Right? - The New York Times

Which Mortgage Is Right? - The New York Times:

By BOB TEDESCHI
Published: July 20, 2006

Industry executives say most homebuyers continue to gravitate toward fixed loans and conventional adjustable-rate mortgages (or ARM’s), but given the heady prices in the real estate market, many speculators and some homebuyers are also rushing toward so-called 80/20’s (also referred to as a “piggyback” loan, or “no money down” loan), and five-year interest-only loans.


Illustration by Andy Rash

30-Year FixedIn the late 1990s, as many as 70 percent of all mortgages were 30-year fixed loans, where the first payment is identical to the last. It is an understandable statistic, perhaps, given what many of those homeowners lived through in the high-interest environment of the 70’s and 80’s.But as of 2006, that figure had dropped to about 40 percent, according to Anthony Hsieh, president of LendingTree.com, which connects mortgage applicants to lenders and brokers.

One reason is that in the recent housing boom, as housing prices rose and interest rates dropped, consumers were less willing, or able, to lock themselves into more expensive fixed-rate loans.Mr. Hsieh said long-term, fixed-rate mortgages still appeal to a healthy number of consumers who know they will stay in their homes, and who would rather avoid the anxiety that accompanies interest rate fluctuations. But tastes are clearly shifting, he said.“In the previous generation, every house was pretty much the same, and people lived in it for 30 years and at the end they had a mortgage-burning party,”

Mr. Hsieh said. “Now, particularly young, first-time buyers have no intention of staying put for 30 years. They want the opportunity to step up into a different home.”One choice for these buyers is shorter-term fixed rate loan, of 10, 15 or 20 years, which buffers the homeowner from interest rate fluctuations while accelerating the amortization process.

Such loans are popular among those who have the money to make monthly payments that are significantly higher than 30-year loans at the same rate, and who wish to quickly free themselves of a mortgage burden or diminish their overall interest costs.Adjustable-Rate Mortgages, or ARM’sFor less risk-averse borrowers, ARM’s are the loan of choice.

These mortgages typically carry the initial interest rate for a set period — usually between one month and 10 years — after which time the rate fluctuates according to changes in various interest rate indexes. Some indexes are well-known, like the Prime Rate, while others less highly publicized, like the 11th District Cost of Funds Index.

No matter the index, banks limit the interest rate adjustments in two ways. First, a rate change cannot exceed a set amount – usually 1 or 2 percent – from the previous rate. Second, banks set a cap on the interest rate, typically 5 or 6 percent above the initial rate.The chief benefit of ARM’s, of course, is that they carry lower interest rates than fixed rate loans.

That benefit can be significantly expanded with so-called option ARM’s, which have shot to popularity in recent years. As Mr. Hsieh said, option ARM’s are “almost like a giant credit card, where the principle never reduces.”Option ARM terms typically start with an interest rate of 2 percent for the first few months. Each month thereafter you can choose from three payment options.

The first is to pay the prevailing interest rate – say 6 percent, plus a share of the principle (based on a 30-year amortization schedule).

The second is to pay only the 6 percent interest.

The third is to stay with the 2 percent rate, which means the loan is accruing significant interest monthly.Should borrowers choose the third option, the terms are reset when the debt reaches a set amount greater than the original loan (usually between 7 and 15 percent).

Then, the loan reverts to a 30-year fixed loan, with principle-and-interest payments each month.“This is good for people who are self-employed, or have seasonal income, because you can pay as much as you want or as little as 2 percent,” Mr. Hsieh said. “But it’s not designed for consumers who can’t afford the home unless they’re making a 2 percent payment, because you end up owing a lot more than you borrowed.”

Nonetheless, Mr. Hsieh said, some option-ARM borrowers take the chance. “Whether it’s right or wrong nobody’s certain, but consumers are a lot more tolerant of risk than before,” he said.
80/20 MortgagesThe 80/20 is so named because consumers actually take out two mortgages – one for 80 percent of the home’s value, and the other for the remaining 20 percent.

The first mortgage typically has a payoff requirement after two or three years, which in practical terms means borrowers must refinance the home at that point.

The 80/20 mortgage rose to popularity, Mr. Hsieh said, starting in about 2003, mostly in response to demand among “young working professionals with good income and credit, but very little savings.”Because of the structure of the loan, 80/20 borrowers are betting that the home’s value appreciates enough that they can pay off both loans at the time of the refinancing, and realize additional equity from the new appraisal.

If the home’s value appreciates, the homeowner may re-finance to a longer-term loan.Interest-Only LoansAnother comparatively risky, and increasingly popular, product is the interest-only mortgage, where the buyer pays no principle, typically for 5 or 10 years.

Beyond that, the interest rate fluctuates to the prevailing short-term rate and borrowers start repaying principle on an accelerated basis.Mr. Hsieh said these loans are popular among homebuyers who simply cannot afford a big monthly payment, and who are betting that their homes accumulate in value during the interest-only portion of the loan.

If that happens, they can refinance after five years, using the home’s increased equity as the basis for a loan with better terms.If the home’s value stays flat, though, the homeowner has essentially paid rent on the property for five years. And if the home’s value decreases during that time and the owner sells because he cannot afford a monthly payment that includes principle, he faces a big loss.