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How Adjustable Rate
Mortgages Work?
During the last decade, Adjustable Rate Mortgages (ARMs) have
increased in popularity among consumers. These days, few homeowners
(especially first−time buyers) remain in their homes for more than
seven years. In this case, it often makes sense to get an adjustable
rate mortgage with a lower rate, especially one with a 5−year or
7−year fixed portion, since they won't have the loan long enough to
be concerned about rate fluctuation.
Adjustable Rate Mortgages have three main features: Margin, Index,
and Caps. The Margin is the fixed portion of the adjustable rate. It
remains the same for the duration of the loan. The Index is the
variable portion. This is what makes an ARM adjustable. Margin +
Index = Interest Rate. It's important to understand that there are
many different indices: The 11th District Cost of Funds (COFI), the
Monthly Treasury Average (MTA), The One Year Treasury Bill, the Six
Month Libor, etc. Each index has its own strengths and weaknesses;
some are slow moving, others are more aggressive. The third and
final component of Adjustable Rate Mortgages is Caps. Caps limit how
much the rate can fluctuate over time. Annual Caps limit changes to
the annual rate, whereas Life Caps provide a worst case scenario
over the life of the loan.
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What is Negative
Amortization?
A
negative amortization loan is an adjustable rate mortgage that
allows the consumer to tap into home “equity” by offering several
monthly payment options. Up to an additional 25% of the original
loan amount is available to the borrower. This flexibility works
well for consumers who have seasonal income or want more control
over their cash flow. However, the borrower must have some degree of
financial discipline.
Each
month, the borrower will choose to make a fully amortized payment,
an interest−only payment, or a low introductory rate payment. A
fully amortized payment is larger, and includes payment toward
principal + interest. The interest−only payment is lower, but no
part of that mortgage payment goes toward the principal. The
borrower is simply keeping their head above water. The third option
is where negative amortization comes into play. If the consumer
chooses to make the low introductory rate payment, the interest is
not sufficiently covered for that month.
The
balance of interest owed is then tacked back on to the principal,
thus increasing the mortgage debt. Smart consumers can use these
payment options to their advantage, but should have a full
understanding of how adjustable loans work. They should also know
that once the maximum loan amount has been reached, the lender will
immediately increase the payment amount to the fully amortized rate.
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What Are
Points and When Should You Pay Them?
Points are up−front fees paid to
obtain a better interest rate on a loan. One point equals one
percent of the loan amount. A lower interest rate may result in a
lower monthly payment, but it is important to consider how long you
intend to be in the loan, and to compare current rates to historical
market trends.
If you take out a $300,000 mortgage
and decide to pay one point, this translates into an up−front
closing cost of $3,000. Paying a point up front saves $100 a month
but it will take 30 months to recuperate the cost of that point. If
you decide to refinance or sell the home before the 30−month mark,
your money is lost. In this case, you would benefit financially by
remaining in the home longer than the 30 months.
Rates run in cycles. When rates are
at historical lows, it is sensible to pay points if you plan to live
in the home for an extended period of time. It is unlikely that
rates will go down; hence, there will be no need to refinance. When
rates are up, there is a strong likelihood that they will come down.
This is no time to pay points. The chances of refinancing in the
future are extremely high, and you will likely not be in the loan
long enough to recuperate the cost of the points.
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What Is a Prepayment
Penalty?
A prepayment penalty is a fee charged
to borrowers that make full payment on their mortgage, or pay off a
substantial portion (generally anything exceeding 20% of the total
loan amount), ahead of schedule. This is a clause written into some
contracts to protect the lender's book of business in exchange for
providing a lower interest rate, or for providing financing to a
high−risk borrower. Prepayment penalties vary with different
lenders, but generally apply to a one, two, three, or five year
period of time.
This fee can be expressed as either a
specific number of months' interest or a percentage of the
outstanding balance. A 'hard' prepayment penalty applies to either
the refinance or the sale of a property. A contract written with a
'soft' prepayment penalty permits the borrower to sell their
property without incurring a penalty, but does restrict refinancing
for a set period of time.
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What Is Title Insurance?
Title insurance is a policy that is
usually issued by a title company to protect the lender against
something that might have happened in the past, rather than
something that might occur in the future. In essence, an extensive
search of public records is conducted by the title company to
validate who has held title to the property in the past.
The lender wants to know if there are
any liens, judgments or easements on the property that they should
be aware of. But title insurance also guards against hidden risks or
unknown factors that might cause an encumbrance at some point in the
future, such as unknown heirs, forged deeds or wills, misinterpreted
wills, false impersonation of the true owner of the property, deeds
signed over by persons of unsound mind, or defects in the recording
of past titles.
Title insurance covers the cost of
the title search, and any legal fees that may result from any
dispute over past property ownership. It is required by the lender
and paid for by the buyer. The smart home buyer will also purchase
title insurance to protect their own interests. This is a one−time
premium that protects the buyer or their heirs, as long as they
retain an interest in the property.
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What Constitutes Closing
Costs?
Closing costs are expenses that cover
fees associated with the transfer of property ownership, fees paid
to state and local governments, and the costs of obtaining a
mortgage loan. Some of these fees are negotiable, and could be paid
by either the buyer or the seller. Some costs are one−time fees
(non−recurring closing costs, such as title search, termite
inspection, appraisal, etc.); while other fees such as homeowner's
insurance or property taxes are things you will expect to continue
to pay on a regular basis as a homeowner.
As part of the loan selection
process, your mortgage consultant should be giving you some idea of
how much money you should have in reserve to cover your end of these
costs. The Real Estate Settlement Procedures Act (RESPA) requires
the lender to provide you with a Good Faith Estimate within three
days of the submission of your loan application.
RESPA also states that as a
home buyer, you have the legal right to request a copy of the HUD−1
Settlement Statement 24 hours before your closing is scheduled. The
HUD−1 clearly defines all closing costs, including those that are to
be paid by the buyer and the seller. It's a good idea to have both
of these forms before your closing so you can compare the estimated
costs to the actual costs before you finalize your transaction.
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What are the Pros and Cons of a Bi−Weekly Mortgage Program?
When a borrower enters into a
contract to make bi−weekly payments on their mortgage, the
amortization schedule is accelerated. For example, with a 30−year
amortization schedule, the borrower makes 12 payments per year. In a
bi−weekly arrangement, the borrower makes 26 'half' payments, which
allows the loan to be paid off in 22.8 years instead of 30 years.
It's the same as making 13 monthly
payments. This ultimately saves the borrower thousands of dollars in
interest rate fees. However, bear in mind that bi−weekly programs
usually have some type of setup, transaction, and maintenance fees
associated with them. A custodian manages the bi−weekly payments in
a trust account (and also makes a profit on the interest accrued
there). Because the lender really doesn't accept partial payments,
this middle man is still making monthly payments to the lender on
some type of pre−payment schedule.
It is important to know that the same
results can be achieved without hiring an outside company to do
this. As long as your loan program carries no pre−payment penalty,
pre−payments can be made on a monthly or annual basis to shorten the
loan term to save money on interest or remove PMI charges on loans
that have less than a 20% down payment. The borrower simply needs to
indicate the extra payment is being made toward the principal
balance, and have the discipline to make these extra payments as
scheduled.
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What is the Difference Between Pre−Qualification and Pre−Approval?
Pre−qualification is the first step in obtaining mortgage financing.
A potential borrower answers a few questions to provide the loan
consultant with a quick snapshot of the borrower's income, existing
debt, accumulated savings and whether or not there is a co−borrower.
Signature(s) allow the loan consultant to run a credit report and
begin to determine what loans are good candidates for this
particular client. However, there are literally thousands of loan
programs available. It is important for the loan professional to
know the long−term financial objectives of the prospective
homeowner.
Pre−approval is a written documentation that proves the borrower has
full support of a lender. It means the form 1003 Uniform Residential
Loan Application has been completed and reviewed by an underwriter.
Based on the borrower's income, debt ratio and savings, the
underwriter will provide a dollar amount this borrower is eligible
for. Now the borrower has the convenience of shopping for a home in
the price range agreed upon by the lender.
Pre−approval allows potential homeowners to shop as cash buyers, and
that means negotiating power. The seller will take an offer from a
pre−approved shopper much more seriously.
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What are the Most Commonly Made Mistakes in Buying or Refinancing a
House?
If
you're like most people, purchasing a home is the biggest investment
you'll ever make. If you're considering buying a home, you're likely
aware of the complexity of the endeavor. Because of the numerous
factors to consider when purchasing a home, it's important to
prepare as best you can. Some common home-buying principles and
caveats are presented here for your consideration. By keeping them
in mind, you'll help create a successful and more enjoyable
experience. These Top Ten lists are by no means exhaustive. Since
your home could cost you 25 to 40 percent of your gross income, it's
important to conduct research, ask questions and study the process
carefully.
1. Buying a home Looking for a home
without being pre-approved. As a potential buyer competing for a
property, you'll have a better chance of getting your offer accepted
by being as prepared as possible. Consider this hierarchy of
preparedness:
Neither pre-qualified nor
pre-approved Pre-qualified Pre-approved
The benefits available at each level
can be easily understood when viewed from the seller's perspective.
Imagine you're a seller in receipt of multiple offers to purchase
your property. A complete stranger (buyer) is asking you to take
your property off the market for at least the next two to three
weeks while they apply for a loan. As the seller, lets consider the
type of buyer you'd prefer to deal with.
Neither pre-qualified nor
pre-approved This buyer provides no evidence that they can afford to
purchase your property. You may wonder how serious they are since
they're not at least pre-qualified. Pre-qualified This buyer has met
with a mortgage broker (or lender) and discussed their situation.
The buyer has informed the broker regarding their income, expenses,
assets and liabilities. The broker may also have seen their credit
report. The buyer provided you with a letter from the broker stating
an opinion of what the buyer can afford. Pre-approved This buyer has
provided a broker written evidence of income, expenses, assets,
liabilities and credit. All information has been verified by a
lender. As a result, much of the paperwork for this buyer's loan has
been completed. This buyer will probably be able to close quickly.
They provide you with a letter (pre-approval certificate) from the
lender. You're as certain as possible that this buyer can close.
As a potential buyer, you can see
that being pre-approved will give you the best chance of getting
your offer accepted. This is critical in a competitive situation.
2. Making verbal agreements. If
you're asked to sign a document containing instructions contrary to
your verbal agreements--don't! For example, the seller verbally
agrees to include the washing machine in the sale, but the written
purchase contract excludes it. The written contract will override
the verbal contract. More importantly, your state may require that
contracts for the sale of real property be in writing. Do not expect
oral agreements to be enforceable.
3. Choosing a lender just because
they have the lowest rate. While the rate is important, consider the
total cost of your loan including the APR , loan fees, discount and
origination points. When receiving a quote from a lender or broker,
insist that the discount points (charged by the lender to reduce the
interest rate) be distinguished from origination points (charged for
services rendered in originating the loan).
The cost of the mortgage, however,
shouldn't be your only criterion. Have confidence that the company
you select is reputable and will deliver the loan with the terms and
costs they promised. If in the final hours of the transaction you
determine that the lender has suddenly increased their profit margin
at your expense, you won't have time to start again with a different
lender. Ask family and friends for referrals. Interview prospective
mortgage companies.
4. Not receiving a Good Faith
Estimate. Within three business days after the broker or lender
receives your loan application, you must receive a written statement
of fees associated with the transaction. This is both the law and
the best way to determine what you'll pay for your loan. Bring the
Good Faith Estimate (GFE) with you when you sign loan documents. You
should not be expected to pay fees which are substantially different
from those contained in your GFE.
5. Not getting a rate lock in
writing. When a mortgage company tells you they have locked your
rate, get a written statement detailing the interest rate, the
length of the rate lock, and program details.
6. Using a dual agent, i.e., an agent
who represents the buyer and the seller in the same transaction.
Buyers and sellers have opposing interests. Sellers want to receive
the highest price, buyers want to pay the lowest price. In the
standard real estate transaction, the seller pays the real estate
commission. When an agent represents both buyer and seller, the
agent can tend to negotiate more vigorously on behalf of the seller.
As a buyer, you're better off having an agent representing you
exclusively. The only time you should consider a dual agent is when
you get a price break. In that case, proceed cautiously and do your
homework!
7. Buying a home without professional
inspections. Unless you're buying a new home with warranties on most
equipment, it's highly recommended that you get property, roof and
termite inspections. This way you'll know what you are buying.
Inspection reports are great negotiating tools when asking the
seller to make needed repairs. When a professional inspector
recommends that certain repairs be done, the seller is more likely
to agree to do them.
If the seller agrees to make repairs,
have your inspector verify that they are done prior to close of
escrow. Do not assume that everything was done as promised.
8. Not shopping for home insurance
until you are ready to close. Start shopping for insurance as soon
as you have an accepted offer. Many buyers wait until the last
minute to get insurance and do not have time to shop around.
9. Signing documents without reading
them. Whenever possible, review in advance the documents you'll be
signing. (Even though some specifics of your transaction may not be
known early in the transaction, the documents you'll sign are
standard forms and are available for review.) It's unlikely that
you'll have sufficient time to read all the documents during the
closing appointment.
10. Not allowing for delays in the
transaction. In a perfect world, all real estate transactions close
on time. In the world we live in, transactions are often delayed a
week or more. Suppose you asked your landlord to terminate your
lease the day your purchase transaction was scheduled to close. A
day or two before your scheduled closing date, you discover your
transaction is delayed a week. In a perfect world, no one is
inconvenienced and your landlord is willing to work with you. More
likely, however, your landlord is inconvenienced and angry. Will you
be thrown out? Will you have to find interim housing for a week or
more? The eviction process takes a little time, so the Sheriff won't
immediately remove you, but this type of stress-producing episode
can be avoided. How? Terminate your lease one week after your real
estate transaction is scheduled to close. That way, if there is a
delay in closing your transaction, you have some leeway. This
approach might cost a little more, then again, it might not.
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