Beginner's Information: August 2007 Archives

Got a search engine hit for



do I make a big down payment on a home or should make a lump sum payment after the mortgage



It's very hard to construct a scenario where using it as "purchase money" doesn't come out ahead. Not to say it can't be done, but it's highly unusual.



Here's the basic rule: You're allowed tax deductibility of the acquisition indebtedness, amortized, plus up to a $100,000 Home Equity Loan. For many years, the universal practice has been to deduct all of the interest on a "cash out" loan even though it's not permitted by a strict reading of the rules. That is now changing, and the IRS has served notice that they are going to be scrutinizing mortgage indebtedness to compare it to acquisition indebtedness, and disallowing anything over what they figure is the amortized amount of purchase indebtedness. For example, if you originally bought your property for $120,000 in 1991, and your original loans totaled $108,000, sixteen years later you might persuade the IRS that your deductible balance is about $85,000, as ten percent loans were common then. But if your property is now worth $500,000 and you've "cashed out" to $400,000, the IRS is likely to prove supremely skeptical of that deduction.



The other reason not to use your down payment money for a down payment is to save it for repairs and upgrades. There's only so many places that the money might possibly come from, and your own pocket heads the list. Cash back from the seller not disclosed to the lender is fraud, and if you do disclose cash back to the lender, you've defeated the only rational purpose for it, because they will treat the purchase price as being the official price less the cash back. You're not legally getting any extra net cash from the seller. Period. If you put the money down and then try to refinance it out, the refinance becomes a "cash out" refinance - the least favorable of the three types of real estate loan. Unless the rates have gone down or your equity situation has improved, you'll get better rates on a purchase money loan, not to mention not spending the second set of closing costs for the refinance because you only did the purchase money loan. So if you need the money for repairs or to make the property livable, you're probably going to want to keep it in your checking account rather than using it as a down payment.



On the other hand, the search question postulates that you'll use the money to pay down what you owe, whether immediately at purchase or later on. After you put the money down, you'll have an improved equity situation, which means that you are likely to get a better price on the loan - a better rate-cost trade-off if you put the money down. Not guaranteed, but it is highly likely. If it's the difference between 100% financing and 99% financing, most lenders treat 99% financing the same as 100%. But if it's the difference between 100% financing and 95% financing, you're likely to get a better loan, or more likely a better set of two loans. Which means you either spent less in costs, got a better rate, or some trade-off of the two. Less money spent equals more money in your pocket, or more money for the down payment, which translates as more equity. Better rate means lowered cost of interest. The fact that it's on less money also means lowered minimum payments, although you shouldn't be shopping loans based upon payment. More importantly, you don't pay interest on money you don't owe. If your balance is $10,000 lower on a 6% loan, that's $600 less interest per year - $50 real savings per month.



If for some reason you want to pay extra, and you're holding on to the money so your minimum payment will be higher, don't. Most loans allow you to pay at least a certain amount extra, and if you're one of those unfortunates with a "first dollar" prepayment penalty, I have to ask, "Why?" There are sometimes reasons to accept a so called "80 percent" pre-payment penalty. There's never a reason to accept a "first dollar" penalty. Not to mention that your lump sum will get hit with the penalty anyway, where if you used it as a down payment, it wouldn't.



Finally, I should note that there are arguments against paying off your mortgage faster. Paying extra on your mortgage does sabotage the gain you get from leverage. You could typically take the money and invest elsewhere at a higher rate of return. Psychologically, however, there's a peace of mind to be had from not owing money, or not owing so much money. The only sane way to define wealth is by how long you could live a lifestyle comfortable to you if you stopped working right now, and if you don't owe as much money, that time frame that determines your real wealth is obviously longer.



The point is this: There are arguments to be made on both sides, and the circumstances can be altered by the specifics of your situation. My default conclusion remains that if your mind is made up that you're using a certain amount of money to reduce debt on the property, either from necessity or because you want to, then you might as well use it in the form of purchase money down payment.



Caveat Emptor


Games Lenders Play, Part II

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Here's another advertisement that I've gotten in the mail:





"Pick a Pay, Any Pay!' The Revolutionary Option ARM!"



"Start rates as low as 1%!"



Loan amount $100,000 Payment $321.64

$200,000 $643.28

$300,000 $964.92

$400,000 $1286.56



Could this help save you money?





Let's see, given the real rate on these, there is negative amortization of about $500 to start with per month on the $300,000 loan, compounded over the three years the pre-payment penalty is in effect. Cost me $19,000 to "save" this money - even if the underlying rate doesn't rise. Not counting what it costs to do the loan. Or I refinance out of it and pay a pre-payment penalty of about $9200.



Doesn't matter the friendly sounding name you give it. An option ARM is a Pick-a-pay is a negative amortization loan.



What this guy (in this case) is hoping is that you'll be so enticed by this "low payment" that you won't ask questions. These are easy loans to sell to people who don't understand them, and impossible to those who do unless you're the person it's really designed for. Indeed, many prospective clients do not want the problems with this loan explained to them. It's like they've chosen to be insulated from reality for a time.



But this is no surgical anaesthetic. Most folks are going to want to be homeowners for the rest of their lives, and unless your income has increased commensurate with your loan balance (and prospective interest rate increases) I guarantee you that the pain will go on for quite a long time after the time of "affordable low payments". I'd rather not shoot myself in the foot in the first place.





You could also lower your monthly payments. Free yourself from high interest rate credit cards and debts with a loan that could reduce your monthly payments by hundreds of dollars and leave you with enough cash to buy a car, remodel, or pay property taxes. And don't forget that mortgage interest is usually tax deductible. So you could save more at tax time.





This is all true - and only a part of the story. Remember that the easiest way to lie is to tell the truth - just not all of it. What they're selling you is the seductive "cash now - pay later". This was how you probably got into the situation they're talking about. What most people do is then take the money out and spend it, and then when the payments get to be too much, refinance again. What are you going to do when the overall payments get larger (again) next time. What are you going to do when there's no more equity? What are you going to do when you can't afford the payments?



The consolidation refinance can be a real financial lifesaver, if you do it right, have a plan, stick to it, and pay everything off, or at least pay your mortgage down below where it was before you go acquiring more debt. Fiscal responsibility is not what they're selling here.





You've earned a 30-day break from payments!





By rolling it into your mortgage, where you pay points and fees on it and the loan provider gets a bigger commmission because of it. There is no such thing as a free lunch! You'll be better off if you stop looking for it. The bank is never going to give you one day that is free from interest, much less thirty. And because you don't make a payment now, you will be paying more later. Probably much more.



You're probably going to see a lot of recurring themes when I do these quasi-fiskings. That's because the lenders and real estate agents and everybody else keeps advertising the same misleading nonsense over and over and over again, they just say it in slightly different ways. As far as I am concerned, anybody who sends out one of these ridiculous things deserves to have their name engraved on my personal blacklist of people I will never do business with. I hope for your sake that you feel the same way.



Caveat Emptor


Games Lenders Play, Part I

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I was a little shy of ideas of stuff I wanted to write about, and too lazy to finish my research on some stuff I'm working on. But: I get the same junkmail and spam most of you folks do. They don't know who I am when they send it out. It's just that I know what's going on behind the scenes with this stuff.



So I thought I'd get out my calculator and deconstruct what's going on with the advertisements I've gotten in the mail over the last day or two.



The first one starts with "30 year fixed rate 5.125% (APR 5.42)" Well, computing that out, it converts to 10,100 of nonexcludable fees on a $300,000 loan (UPDATE: actually, I discovered later in light fine print that the APR is based on a loan amount of $359,650, the so called "maximum conforming" loan at the time, which means the imputed number of points are slightly higher). This works out to 2.71 points, assuming they get it done for the same $1700 or so of non-excludable fees everyone else has (Title, Escrow and appraisal charges are excluded from APR computation). I had that rate at 2.25 discount points at the time, so they're making about half a point extra if there's no prepayment penalty. So if there's no prepayment penalty that's not a bad loan, except that I called and found out there's a five year prepayment penalty on it. That's a good healthy (or unhealthy, depending upon your point of view) cha-ching of about two and a half or three points to the loan provider. Not to mention that the postcard was "old and the rates are higher now" according to the voice on the phone I talked to at the time, "so you should start the loan now before the rates go higher." The lowest rate they could do as we were talking? 5.375, which I could do for 0.75 discount points as I was talking to them - giving them as a loan provider almost two points in their pocket without the 2.5 to 3 points for a five year pre-payment penalty.



Then, after a faint dotted line designed to be overlooked, they tell you all about payments. $250,000 is $632.14 per month, $300,000 is $758.57 per month, etcetera. Going over to the calculator (even though I can tell you what's going on without it), I get a negative interest rate when I punch in thirty year amortization. I shouldn't need to explain to adults that something is wrong with that picture. Well, what's likely going on is that this is a forty year amortization, and indeed, when I punch in a forty year amortization I get an interest rate of 1%. So on top of being on a forty year amortization, the payments they are quoting are on a negative amortization loan. It is neither on the same rate nor term as the previously talked about loan. And that's the purpose of that thin dotted line that's designed to be missed. They want you to think payment B is connected to loan A, when in fact they are talking about a completely different loan. And indeed I can find that in small, very light print on the other side of the card, under some darker print about about $1000 "Best price guarantee." Voice on the phone explained that, "If you close and subsequently prove you qualify for a better rate with someone else, we'll pay you $1000." Well, first off, if they pay you $1000 to make three points on the loan, they are still $8000 plus to the good, and if I were the sort to be giving that sort of guarantee I'd have no problem wriggling out of it on any of several fronts. And if you refinance or sell within five years, you're out over $7600 in prepayment penalty. Since 95% of all clients sell or refinance within five years, if you've got to have the 5.125% rate, statistically you're better off paying somebody honest one point of origination as well as the lender discount points for no prepayment penalty. One point of origination works out to a little over $3000 on a $300,000 loan. This is less than the difference between the loan they advertised and the loan they theoretically had when I called the day after I got the card.



But the rate is voodoo magic to most people. Theoretically, you've got to be able to understand some mathematics to graduate high school, or at least be able to figure out how to get numbers out of a calculator. Nonetheless, what most people "buy" loans on is payment. This is well known factual information to everyone in the real estate industry. Very few people ever call saying, "Give me that rate." What most customers want is the payment. And when the advertising apparently links the cheap payment on a negative amortization loan to the "Thirty year fixed rate of 5.125%", most companies are doing what I call "lying by association". Most clients want to believe that the one goes with the other and that the listed item is a pretty good bargain, when in fact I have shown that not only do they have nothing to do within each other, but also that they are both the sort of loan I would wish my worst enemy in the loan business would get for some enemy of civilization like Chairman Mao. Then when Chairman Mao gets a lawyer (and enemies of civilization never have a problem getting competent lawyers), I get to watch the whole thing blow up on both of them from safe on the sidelines.



Oh, and this postcard also talks about "skip one or maybe 2 payments." As I cover in the second through seventh paragraphs of this article, you never really skip any payments, EVER. You can either pay them out of pocket or roll them into the costs of the loan. Anybody who represents otherwise is lying, with malice aforethought, unless they're going to whip out a checkbook and pay it out of their pocket. How likely do you think that is?



To avoid this trap: First, don't "buy" loans based upon payment. Second, get (or find) a calculator and use it, or even learn to do the calculations yourself. Third, ask the prospective loan provider the hard questions, and make sure that the question they answer is the one that you asked. Fourth, Shop Shop Shop around for a loan. And apply for a backup loan. Finally, always realize that with the kind of money loan providers make from loans, they will promise anything to get you to call, do anything to get you to sign up, and even though they never have any intention of actually delivering what's on the MLDS

there is little chance of you being able to get any kind of legal satisfaction from them.



Caveat Emptor

A mortgage is basically pledging an asset that you own as collateral for a debt. If you default on the debt, the lender takes your property. When you're talking about real estate in the state of California (and many others), this is generally accomplished by use of a Deed of Trust. There are three parties to a Deed of Trust: the trustor, trustee, and beneficiary.



The Trustor is the entity getting the loan.



The Beneficiary is the entity making the loan.



The Trustee is the entity which has the legal responsibility of standing in the middle and making sure the rules are followed. When the loan is paid off, they should make certain a Reconveyance is completed and sent to the trustor so they can prove it was paid off. If the beneficiary is not being paid, they are the ones who actually perform the work of the foreclosure.



One thing to keep in mind during all discussions of real estate and real estate loans is that the amounts of money involved are usually large - the equivalent of somebody's salary for several years on every transaction. The temptation to fudge the numbers or even outright lie to get a better deal, or to get a deal at all, is strong. Many people don't think they're really doing anything wrong by fudging things a bit, but this is FRAUD. Serious felony level FRAUD. Fraud, and attempted fraud are widespread. There are low-lifes out there who make a very high-class living at it (for a while). Every lender has to devote a large amount of resources to determining that each individual transaction is not being conducted fraudulently. To fail to do so would be to fail in their jobs to protect their stockholders and investors. I can, and probably will, tell stories about the most common sorts. But the reason everything in every real estate transaction is gone over with such a fine-toothed comb that adds thousands of dollars to the cost of the transaction is that people lie. Every hoop that anybody is asked to jump through has a reason why it exists, and often that is because somebody, usually MANY somebodies, have committed FRAUD based upon that particular point.



One of the conditions I must attach, implicitly or explicitly, to every quote for services, is that this is based upon the condition that you are telling me the truth, the whole truth, nothing but the truth, and are being honest and forthright in your presentation of the facts without trying to hide anything and are specifically calling my attention to anything that you suspect may be a problem. And because the list of what is relevant information is long, complex, and conditional upon factors that are often opaque to non-professionals, sometimes, people quite honestly don't realize that something is a fly in the ointment so they don't mention it. I, or any other professional practitioner, have no way of knowing that said fly exists unless you, the client, tell me about it. Therefore what I tell you initially does not account for said fly. This is not unethical, it is just a due to the fact that I don't have all of the relevant information.



When you're talking about residential real estate loans there are basically two absolute requirements as to the nature of the collateral. The first is land - land as in real estate. A partial, fractional, or partial ownership of a common interest in land (as in a condominium) are each sufficient unto the task. A rented space to park your mobile home is not.



To that real estate, there must be permanently attached in a way so as to prohibit removal, or at least make it an extended project, a residence in which people can live. We're all familiar with you basic site-built house. Personally, I'm a big believer in the virtues of manufactured housing. To paraphrase Robert A. Heinlein in precisely this context, imagine a car for which all the parts are brought individually to your home and assembled on site with ordinary portable tools in an environment which was not specifically designed to facilitate said assembly. How much would you expect to pay, and how would you expect it to perform? The correct answers are "A LOT more than for your house", and "not very well, in terms of either reliability, speed, or economy."



Nonetheless, when a lender looks at a house that's been moved to the site, they see one that can be moved away from the site as well, and they are skeptical because so many people have done precisely this. Furthermore, the way that residential real estate is valued is somewhat arcane. The lot itself may be worth $400,000 here in California because it has $150,000 of improvements on it in the form of a three-bedroom house on it, but take away that three-bedroom home, and the lot may be only worth a fraction of the amount. So they loan you money based upon a $550,000 value of the combination as it sits. Some time later, you back your truck up to the house and cart it off, and then default on the loan, leaving the bank a lot that may only get a value at sale of $80,000. Now imagine yourself as the bank employee who made the loan. How do you explain this to your boss? Over the years, many bank employees have had to explain this to their bosses, all the way up the chain of command to CEOs explaining to investors and stockholders. Lenders know that most people are honest - but they've got a duty to make sure you are among the honest ones. And if you subsequently lose your job and can't pay your mortgage, might you not be tempted to back the truck up and haul the house off somewhere if you could so the bank can't take it? There are good substantial reasons why many lenders won't approach manufactured housing as residential real estate, and the ones who do treat it as such charge higher than standard rates, and place further limitations on lending.



I've been personally eyeing a beautiful manufactured home that more than meets my family's needs, is in the middle of the area I want to live in, and is priced more than $100,000 lower than comparable sized and lower quality site built homes on smaller lots. Yet there is a reason for that lower price. It's not like that owner just decided to list it for $150,000 less than he could get. The home carries many higher costs. If I buy that home, I am going to be paying for it in the form of higher loan costs every month, and higher loan fees every time I refinance until I sell it, and fewer people able to buy the home when and if I do sell it as a result of loan constraints, and a I can expect lower eventual sales price as a consequence - which is the situation that owner is in right now. I have reluctantly decided that those costs outweigh the benefits. My decision is regretful, but until somebody comes up with a procedure that banks agree makes manufactured housing equal in every way to site built in their eyes, it is also firm.



Caveat Emptor.



(And I must say that if somebody comes up with such a procedure, you will be a gazillionaire, and deserve every last penny and then some. I hereby publicly forswear all claims of compensation for the idea of such a procedure. If you can make it work and it makes you rich, I won't ask for a penny, although any contribution you care to make voluntarily will be happily accepted. I just want to be able to say you got the idea from me, as part of my contribution to a better world)



This sentence is a textbook illustration of the most effective way to lie. Tell the truth, but not all of it. Not that I'm trying to coach habitual liars, but I am going to deconstruct this astoundingly dishonest claim that I keep encountering. It's mostly used by less ethical loan officers trying to persuade someone not to shop around.



At the bottom-most level, all mortgage money does come from basically the same place. It's all investors looking for a return on their money in a historically well secured market where they are somewhat protected from taking a loss.



What happens to it after that, and whose hands it goes through, matters a lot. Just like saying all water comes from the ocean doesn't mean it's all drinkable, just because all mortgage money comes from investors doesn't mean it's all equal. The lender and loan officer make a huge difference.



Consumers cannot, in broad, go directly to mortgage investors and request a loan. Most of the investors wouldn't know how to do loans if it bit them. They don't have the actuaries, the underwriters, the tools, and the networks to get the best value for their money. That's where the lenders come in.



I'm not going to get into all the details of CMOs and MBSes- Collateralized Mortgage Obligations and Mortgage Backed Securities - how they are sold, how to price them, yada yada yada. It's something I am not involved in, and I don't really need to know as much as I do. Even when I was financial planner, the nuts and bolts just aren't that important to most investment portfolios. Two important things to note: The higher the interest rate, the better the price the lender will get from the investors, and the lower the rate, the lower the price. The higher the default and loss rates is expected to be, the lower the price, and the lower the default and loss rates are expected to be, the higher the price. Default and loss rates translate to "How tough are the underwriting standards?" Low interest rates at a lender usually means very tough underwriting, and fewer people qualify. High interest rates means relatively easy underwriting, and more people qualify.



What you really going on here is that the banks - the lenders - are the middlemen putting investors and consumers together. For this, they get paid. They get paid enough to pay for all those fancy offices and the executives' salaries and everything else the bank might have. Mortgage lending is big business. Lest it sound like I'm saying the fact they get paid is a bad thing, it's not. It makes the market far more efficient, as most individual investors can't afford an entire mortgage all at once, and individual borrowers would have a daunting problem in finding investors willing to lend money at a decent rate in their situation.



Each individual lender tries to hit a certain market segment. It works like branding in the consumer world, in that there are clients they are aiming at, and ones who are incidental to their business. Lending is a risk-based business, and the higher the risk to the lender, the higher the rate. What will happen the vast majority of the time with the vast majority of lenders is that they will sell the loans, whether or not they retain servicing rights. In other words, just because you have a loan with bank A doesn't mean they'll keep it. It is very rare for a lender to keep the loan. Even if they retain servicing (for which they get paid - and they're not even risking any money!), so that you keep sending that lender your payment, they don't hold the actual loan. Some lenders are interested in A paper, whether conforming with Fannie Mae and Freddie Mac, or nonconforming but to essentially the same standards. These loans are fairly uniform and highly commoditized, but lenders put their own stamps on them. One bank might have incredibly tight standards, but offer lower rates. They will have a record of fewer defaults, practically zero losses, and get a better price on their loan packages in the bond market. Another bank might be somewhat looser in their standards, and so not do as well on selling the loans, and they will charge a higher price, in the form of interest rate, in order to compensate.



This phenomenon expands out progressively farther in the A minus, Alt A, and subprime lending worlds. A paper has noticeable differences between lenders, while subprime's targets vary from the not quite A paper to those who specialize in the ugly loans to people with 501 credit scores, and even some lenders that will accept a borrower with only one FICO score at the 500 level. Almost all of them have their own niche, or niches, that they will underwrite to, trying for a mix of rates to borrower and underwriting standards for approval that results in fewer of their loans defaulting, and thus the ability to command a premium price in the bond market over and above what mostly equivalent lenders will give.



Below subprime is hard money. It's called hard money because before they fund your loan, they are recruiting individual lenders and syndicates who will hold your loan for as long as you have it. This is why hard money is typically multiple points up front, interest rates of thirteen percent and up, and three year hard prepayment penalties, as well as only going to about sixty-five or seventy percent of the property value at most. Without the lenders, every loan would be hard money.



No lender has the capability of running programs that are good fits for everyone. Some of them have a few dozen, some have only ten or twelve. This sounds like a lot, but it isn't. Every single loan type is a different program. Just to cover the most standard loan types for their market is usually between twenty and thirty. I can point to lenders with twenty-five or more different Option ARM programs.



This is where brokers come in. There's an old saying about how "If the only tool you have is a hammer, pretty soon all the problems start looking like nails." You walk into a direct lender's office, and they has a couple dozen programs focused on one segment of the market. You're not an ideal fit for any of their loan programs, but so long as you can qualify for any of them, they are going to keep your business rather than refer you to someone else. They're hammering nails, never mind that your problem is a threaded bolt. They get you pounded into the board. Yes, you get a loan, but you could qualify for a better one if you wandered into a different lender's office.



Brokers have lenders wandering into their offices. Lenders who will give the brokers better deals than they give their own loan officers, because they're not paying for the broker's expenses, and the broker knows better than to be a captive audience. The fact is that brokers are usually capable of getting a deal that's enough better that they can pay their expenses and salaries, still have profit left over, and nonetheless offer the client a deal enough better than the lender's own branches as to be worth the trip. Brokers also shop multiple lenders, looking for a better fit. If you're a top of the line A paper borrower, someone that any major bank has a good program for, the broker can still get you a better loan, but maybe only by an eighth to a quarter of a point. On a $300,000 loan, that's $375 to $750 in cost at the same rate for the exact same loan. If you're in a marginal A paper situation, the difference made is liable to be that you qualify A paper with a broker who knows where to shop, where you'd likely have to go subprime, with inferior options and a prepayment penalty, by walking into a bank office. You get into subprime situations, and I have seen pricing spreads of two and a half percent on the interest rate between the best lender for a given loan, and the rest of the pack. You can physically go to twenty or fifty different banks, fill out an application and furnish paperwork in each - or you can go to a broker.



The point is that no lender is both offering low rates and loose underwriting. As everything else having to do with money, it's always a trade off. The lenders charge higher interest rates, they get a better price for their loans. The lenders underwrite to tougher standards so they will have fewer defaults, and practically zero losses, they get a better price for their loans. The lenders need a certain margin to keep their owners happy, and a certain margin to keep investors happy, and neither one of those in the business of giving away money for less than it is worth.



The ideal thing for a given borrower is not an easy loan. Unless you're so high up on the ladder of borrowers (credit score, equity in the property, lots of documented income) that you'll qualify for anything easily. The ideal loan, where you get the best tradeoff of rate and cost, is to find the loan where you just barely scrape through the underwriting process. With average loan amounts in California being about $400,000 now, chances are that any extra time and effort you spend will be handsomely rewarded when you compute the hourly costs and payoffs.



So you see the partial truth of the title statement, and the utter falsehood. All mortgage money pretty much does start out in the same place. Nonetheless, what happens to it after that, before it gets to the consumer, renders the statement "All mortgage money comes from the same place" incredibly dishonest.



Caveat Emptor.

Just like Mohandas Gandhi and Genghis Khan and Attila the Hun were all human beings, lenders are all companies that make money by lending money to people who want it.



That's about the limit of the truth in that statement.



Lenders do, by and large, get their money to lend from the bond market. But not all lenders get their money from the same part of the bond market. Some get the money from low-risk tolerance folks looking for security, and willing to accept comparatively low rates. Some get the money from high risk tolerance folks looking for more return for their risk. Within each band, there are various grades and toughnesses of underwriting. A lender with tough underwriting will have a very low default rate, and practically zero losses. A lender with more relaxed underwriting will have more defaults, and higher losses, meaning they must charge higher rates of interest in order to offer the investors the same return on their money.



I have literally just finished pricing a $600,000 loan for a client with top notch credit and oodles of income (he's putting $800k down). Even A paper and with the yield curve essentially flat, I got variations of three eighths of a percent on where their par rate was. Every single one of them had significant differences in how steep the points/yield spread curve was (if you need these terms explained this is a good place). For one lender it was "offsheet pricing" below their lowest listed rate. This lender is more interested in low cost loans, and they take it for granted that folks will not be in their loans very long. This lender is appropriate for those who are likely to refinance within a few years. For another lender, it was "offsheet pricing" above their listed sheet prices. This lender specializes in low rates that cost multiple points, so they can market lower payments. For those few people who really won't sell or refinance for fifteen years, these are superior loans.



Which do you think is really better for the average client? Well, let's evaluate a 6.5 percent 30 year fixed rate loan that costs literally zero (I get paid out of yield spread, while rebating enough to the customer to cover all their costs), with a 5.875% 30 year fixed rate loan that costs $3400 plus two points. I always seem to be computing $270,000 loans here, but since this was "jumbo" pricing and a $270,000 loan is "conforming", which carries lower rates, I'll run through both.



The 6.5 percent loan is zero cost to the client. Nothing out of pocket, nothing added to the loan balance. Gross Loan Amount: $270,000. The 5.875% loan cost 1.875 points in addition to $3400 in closing costs. Gross loan amount $278,625. You have added $8625 to your mortgage balance to save yourself $98.40 per month. You theoretically are ahead after 88 months (7 years, 4 months), but not really even then.



Every so often I get a question that asks why they can't have A for the price of B. The answer is the same as the reason why you can't have a Rolls Royce for the price of a Yugo. Another funny thing about Rolls Royces is how expensive they are to maintain. A middle class person with a Rolls better plan on living in it. The funnier thing is, your friends, family and neighbors can't even see you in it, so there is no point in a "Rolls Royce" home loan except for utility, and if it's not paying for itself, then there is no utility (or negative utility, i.e. something you don't want), and therefore, money wasted.



Now, let's crank the loans through five years - longer than 95 percent plus of all borrowers keep their loans, according to federal statistics - and see which is really better for most borrowers. The 5.875% loan makes monthly payments of $1648.17. Over five years - 60 payments - they pay $98,890 and pay their balance down to $258,869. Total principal paid: $19,756. Actual progress on the loan (amount owed less than $270,000): $11,131. Interest paid: $79134, which assuming a 30 percent combined tax rate, saves you $23,740 on your taxes.



Now let's look at that 6.50 percent loan that didn't add a penny to your balance. Monthly payments of $1706.58, total over five years $102,395. Looking pretty awful, so far, right? But your total amount owed is now only $252,750. Total principal paid: $17,250. But this same number is also the actual progress! Interest paid $85,145, and assuming 30 percent combined tax rate, same as above, it gives you a tax savings of $25,543.



Now let's consider where you are after five years.



With the 5.875% loan, you saved $3505 on payments. But you also owe $6118 more, and the 6.5 percent loan saved you $1803 more on your taxes. Furthermore, if you've learned your lesson and rates are as low when you refinance or sell (6.5 percent on your next loan), it's going to cost you $397.67 per year from now on for that extra $6118 you owe! Net cost: $4416 plus nearly $400 more per year for as long as you have a home loan. Assuming that's "only" 25 years, your total cost is $14,358. I never spent so much money to save a little for a little while!



Now, let's consider that $600,000 loan in the same context. After all, the pricing really applies there (conforming rates are lower). Appraisal costs a little more, and so does title and escrow, for jumbo loans on million dollar houses. Let's say $3700 in costs. Your new 5.875% loan would be for $615,236 (disregarding rounding). Payment $3639.35, which over 5 years goes to $218,361 in payments. Crank it through 60 payments, and you've paid the loan down to $571,612. Principal paid $43,388, actual progress $28,388. Total Interest paid, $174,973, which assuming a combined 40% tax rate (higher income to qualify!) gives you a tax savings of $69,989.



At 6.50 percent, the payment on a $600,000 loan is $3792.40. Times 60 payments is $227,544. Crank the loan through those 60 payments, and you've paid the loan down to $561,666. Principal paid and actual progress made: $38,344. Total interest paid $189,209, which at the same combined 40% rate is a tax savings of $75,684.



With the 5.875% loan, you saved $9183 in payments. Yay! However, you owe $9946 more, paid $5695 more in taxes, and on your next loan, assuming it's at 6.5 percent, you pay $646.49 per year in additional interest. Total cost is $6458 plus $646 per year for as long as you have a home loan, which assuming that's 25 years equates to a total of $22,620!



Which of these two loans and lenders is better for you? Well, if you're going to stay 15 years or more and never refinance, the lender who wants to give you the 5.875% loan. That rate wasn't even available from the 6.5 percent lender. On the other hand, if you're like the vast majority of the population that refinances or sells within five years (for whatever reason) you really want the 6.5 percent loan whether you knew it before now or not, which also was not available from the 5.875 percent lender.



The billboards advertising rates aren't going to tell you cost, of course. They're trying to lure clients who don't know any better, and often they're playing games with the loan type as well. But when the rate spread between the rate their selling and APR is over 3 tenths of a percent, you know they're building a blortload of costs into it. Keep in mind that the examples I used were almost two full points, and they were each only about a 0.25% spread between rate and APR. You are never going to recover those costs in the time before you refinance. The lender who offers you 6.5 percent for zero cost is probably offering you a better loan.



Now, there were lenders targeting the markets between these two lenders, some that overlapped the whole market, and even another lender specializing in rates even lower and with higher pricing. Keep in mind that this article was limited to A paper 30 year fixed rate loans, which are limited in what they can possibly accept by Fannie Mae and Freddie Mac rules. Once you get out of the A paper market and especially down into sub-prime lenders, the diversity between offerings really multiplies, as the differences they are permitted in target market cover all parts of the spectrum. Some wholesalers walk into my office with the words, "Got any ugly sub-prime today?" Other sub-prime wholesalers ask me about "people that could be A paper but are willing to accept a prepayment penalty to get a lower rate" (I don't use those much). Some want short term borrowers, and their niche is the 2/28. Some want the thirty year fixed with a prepayment penalty. The ones who ask me about negative amortization loans, I throw out of my office but they're selling them somewhere. A lot of somewheres, judging from the evidence that they were 40 percent of purchase money loans here locally last year.



So lenders are not all the same. Indeed, every single one of them is different, and you need to shop enough different ones to find the program that's right for you, and ask lots of questions every time. Just asking about rate is not going to make you happy, as I hope I have just demonstrated. If you walk into their office, they're not going to tell you that you're not the client they're really looking for unless they just don't have any loans at all that you qualify for (and if you're in this category, do not blindly accept any recommendations they make. Most places, they're sending you to the place that pays the most for the referral, not the lowest cost provider).



Caveat Emptor.


from an email:



On a related note, I hope you might have some advice for us. My husband and I just sold our condo. But we are NOT buying at the moment. Instead we are renting. (Not sure where we are going to be 6 months out and buying does not sound like a good idea until we are settled again.) So we are spending a small part of the profit off the sale on retiring the only credit card debt we still have and putting the rest in a money market to earn interest until we can use it as a down payment on our next house.



However, with no credit card debt and no mortgage (and one car loan that will be paid off in about a year) I am afraid that by the time we buy a house, we won't be considered good credit risks because of not having loans we are paying on.



We DO have a credit card that we put some charges on and pay off every month. Is that enough? Or is there something else we should be doing now to make sure we remain credit-worthy for a mortgage loan?



We will be renting an apartment. Does that show up on the credit report?





In general you want to have two open lines of credit to have a credit score. This doesn't mean that you necessarily have to have a balance on either of those lines of credit.



What you're doing seems fine and like a good idea. It's a rough market; I probably wouldn't buy right now unless I knew I was going to stay (or keep it) five years or more. In general, rent does not show up on a mortgage provider's credit report. It probably will not count as an open line of credit.



The card you use, which I gather is what you use to maintain credit, needs to be an actual credit card, which appears to be the case. If it is a debit card, it doesn't count as a line of credit to determine whether you have two open lines of credit or not. If it is indeed a credit card, you've got one existing line of credit that you've had for a while. Keep it open, keep paying it off every month. This helps your credit score even if you never carry a balance.



However, instead of closing the (other) credit card you have a balance on, may I suggest that you simply pay it off but keep it open? Unless it has a yearly charge just for having it, it costs you nothing to keep it in your safe at home. This gives you one open line of credit, and because you've had it for a while, this is better than a new line of credit (length of possession of open lines is one factor determining credit scores, and over five years is best). You might want to use it once per six months or so just so they don't think you've canceled. As long as it's a regular credit card where if you pay it off within the grace period there is no interest charge, and that's your second open line of credit.



You also currently have a installment payment operative, which is fine as long as you keep paying it on time. Depending upon how much you're getting in interest on the money market, it may behoove you to ask for a payoff. If the money market is getting two percent taxable and you're paying five on the installment debt (not tax deductible), you may wish to consider paying it off. On the other hand, if either of the two above cards is a debit card, this is your second line of credit, so keep it open long enough to get something else.



I live in San Diego, which has several big credit unions, and I've had good experiences having my clients apply for credit cards with most of them (they're also a decent source for second mortgages and home equity lines of credit - that's where they're set up to compete best - but first mortgages I can usually beat them blindfolded, because it's not where they're set up to shine). There are also any number of available offers on the internet, but check out the fine print carefully. Credit Unions may not be absolutely the best credit cards available, but they tend to be shorter on the Gotcha! provisions.



(Internet searches for credit unions in Los Angeles turn up fifty or more; in the Bay area a similar number. You need to do your due diligence and you may not be eligible to join most, but I've found it worth doing as opposed to doing business with the major banks and credit card companies that advertise like mad. The money to advertise doesn't come from nowhere.)



This should help you make informed choices as to what to do given your current situation to maintain two open lines of credit and a good credit score. Please let me know if this does not answer all of your questions or if you have any further questions.



Caveat Emptor.

Copyright 2005-2017 Dan Melson. All Rights Reserved

 



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