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Mortgage Blog

Jul 26

The Fully Amortizing Mortgage With Equal Monthly Payments: An Under-Appreciated (and Often Misunderstood) Blessing

The standard mortgage contract in the US today calls for full repayment of the balance over the term with equal monthly payments of principal and interest. For example, a $100,000 loan at 6% for 30 years has a monthly payment of $599.56. That payment, if made every month, will pay off the loan in 30 years. I will save space by calling a fully amortizing mortgage with equal monthly payments a FAM.

Under-Appreciation

The great virtue of the FAM is budgetary convenience for the borrower, plus the prospect of full payoff at the end of the term. It is underappreciated by those who have not considered the alternatives.

One alternative, which was very common during the 1920s, was for borrowers to pay interest only until the end of the term, at which point they had to pay the entire balance. If they could not refinance, which was frequently the case during the depression of the 1930s, the alternative was foreclosure -- until the creation of the Home Owners Loan Corporation (HOLC), which bailed out many distressed borrowers.

Another way to pay off the balance by the end of the term is to pay interest plus equal monthly principal payments. For a long time, this was the method used in New Zealand. In my example, this would require a principal payment of $100,000/360, or $277.78 a month. In the first month, interest would be $500, making the total payment $777.78, as compared to $599.56 on the FAM. While the payment using this approach would decline over time, the borrower's ability to afford a given-priced house would be reduced, which is why New Zealand ultimately replaced it with the FAM.

The FAM was developed and used by our early building societies, which were mutual institutions that later evolved into savings and loan associations. In 1934, the newly-created FHA declared that all FHA-insured mortgages had to be FAMs. Within a few years, the FAM had become the standard for the industry.

Misunderstandings: The Conspiracy Theorists

The feature of a FAM that generates misunderstanding is that the composition of the monthly payment between interest and principal changes over time. In the early years, the payment is mostly interest while in the later years it is mostly principal. This has given rise to the allegation that the way lenders charge interest is both unfair and self-serving – possibly even sinister. The following statement is typical.

"All mortgages are front end loaded, meaning you're paying off the interest first. So during all of those first years, you aren't paying down the principle. Instead, you're buying the banker a new Mercedes...Your 6% mortgage is really costing you upwards of 60% or more!"

This is nonsense, but it is widely believed nonsense. Interest payments in the early years are larger because the loan balances on which the interest is calculated are larger. On the 6% $100,000 loan, the interest payment in month 1 is $500 because the borrower owes $100,000, in month 253 the interest payment is $250 because at that point the borrower is owed only $50,000. The lender is earning the same annual rate of 6% in month 1 and month 253.

If large interest payments in the early years really generated additional profits for lenders, they would prefer 30-year to 15-year mortgages, because interest payments on the 30 are higher in the early years and don't decline as rapidly. They should therefore charge higher rates on 15s. In fact, they charge lower rates on 15s.

Mortgage lenders have enough to answer for without saddling them with a charge that is wholly bogus.

Misunderstandings: Borrowers With Multiple Mortgages

Borrowers with more than one mortgage who are deciding how they should allocate their extra payments, sometimes go astray for the same reason.

"I am coming into a large sum of money that I intend to use to pay down my mortgage balances. I have a first mortgage at 4.5% and a second mortgage at 6%, but the second is more recent and a smaller part of the payment goes to principal. Am I thinking correctly that I will save more interest by paying down the first mortgage?"

This is a perfect illustration of the old adage that a little bit of knowledge can be a dangerous thing. Borrowers who don't understand how FAMs work assume correctly that you pay down the highest rate loan first. It is only borrowers who are aware of how the mortgage payment is divided between interest and principal who mistakenly believe that they will do better directing their extra payment toward the mortgage on which the principal payment is the highest. The mistake is in not realizing that 100% of extra payments are always allocated to principal.

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Jul 19

Can You Afford That House? How Much House Can You Afford?

The house purchase season is now in full swing, and many wannabe purchasers are wondering whether or not they can afford the price quoted on the house they would like to buy. Alternatively, they may not have started their house shopping and may be wondering what price range they should be exploring.

The availability of mortgage financing is obviously a critical feature of the affordability equation, and it is quite different today than when I addressed the issue before the financial crisis. Interest rates are lower for borrowers with good credentials, which may increase the amounts they can afford to pay. However, rates are not necessarily lower for borrowers with less-than-stellar credentials, and more borrowers today are unable to qualify at all. In particular, the income used to qualify would-be purchasers today is not the income they believe they have but the income that they can document, which could be much lower.

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Jun 14

Craziness In Today's Mortgage Market

Some time ago, I pointed out that mortgage lenders today can make a loan with only 3% down to a borrower with a steady job but a credit score of only 570, and have it insured by FHA. But lenders can't or won't accommodate a self-employed physician who can't adequately document enough income, even if the physician can put 30% down and has a credit score of 800! Considering that the likelihood of default is at least ten times higher on the first mortgage, this is insane.

The insanity is best viewed in the broader context of how the current market differs from the one we had before the financial crisis. Some types of borrowers do better in the current market while others such as the physician mentioned above, fare much worse.

How Borrowers Have Fared Depends Heavily on Their Risk Status

1. Transactions Viewed as Low-Risk: The market is even more receptive to this group than it was before the crisis. Loans are as readily available to them today as they were before the crisis, but the rates are lower. These borrowers are better off now.

2. Transactions Viewed as Moderate-Risk: Loans are available in the current market, but the rate spread between moderate risk and low risk transactions is larger than it was before the crisis. Hence, these borrowers don't enjoy the full benefit of the unusually low market rates.

3. Transactions Viewed as High-Risk: Loans that were available before the crisis at premium rates, are not available today at any rates. These borrowers are shut out of the market altogether.

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May 3

Navigating the Mortgage Pricing Maze

Why did Jones pay more for her mortgage than Smith? One possible reason is that her mortgage had features that increase risk to the lender, who charged a higher price to compensate. I call these "risk factors." Potential borrowers ought to know what they are, how much of a rate penalty they will be charged when the risk factor is present, and whether or not there is any way to eliminate or reduce the penalty. That is the subject of this article.

Risk Factors and Their Measurement

The major risk factors are:

1. The borrower's credit score is below some critical level, usually 740-760.

2. The property will be rented rather than occupied by the borrower.

3. If a refinance, the borrower is withdrawing cash.

4. The ratio of loan amount to property value is greater than 75-80%.

5. The property is other than a single-family home.

6. The borrower wants to avoid the escrow requirement.

The effect of these risk factors is measured by comparing interest rates with and without the factor on transactions that are otherwise identical. The rates cited below cover "conforming" loans that are eligible for purchase by Fannie Mae and Freddie Mac, and have been adjusted to include all loan fees. They were obtained by shopping for a 30-year fixed-rate mortgage, the most widely used of the various mortgage types, at several different lenders adjustment lists.

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Apr 11

How Does a Separating Couple Separate Themselves From Their House?

If a couple is not married when they purchase a house, the possibility of a future split looms large, and they should agree before the purchase on how the house will be handled when it occurs. This article assumes that the couple is married, they own a home, and they made no provision beforehand on how it would be managed if they split. When they married, deciding on how they would divide the house if they split was not on their agenda. Nonetheless, the issues that arise with a split are the same whether the split is anticipated beforehand or not. The difference is that agreement is much easier and less costly if done beforehand when the relationship is warm.

Selling the House Is the Way to a Quick and Clean Break

The only issue is deciding how the proceeds are to be divided, although this can be quite contentious when it is not agreed upon beforehand. Unless the couple can agree to accept the judgment of a neutral third party, it will have to be delegated to lawyers to negotiate, at which points the costs begin to mount.

One approach a third party could use is to divide the net proceeds according to each party's contribution to the equity in the house when it is sold. Suppose, for example, that the couple paid $100,000 for a house, took a mortgage of $80,000, paid $20,000 down plus $3000 in settlement costs, and sells it after 5 years when the loan balance is $74,000. Total contributions of the parties to equity in the house at the time of sale consist of $23,000 in cash at purchase, plus $6,000 in reducing the loan balance. If one party contributed 60% of the cash and paid 40% of the expenses, that party's share of net proceeds would be [.6(23,000) + .4(6,000)]/ 29,000, or 56%.

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