The Mortgage Reports Blog

The Math Is Changing For Fixed Rate Vs. Adjustable Rate Comparisons

After running neck-and-neck throughout the first three quarters of 2007, interest rates are now diverging for fixed-rate and adjustable-rate mortgages.

At present, 3-year, 5-year and 7-year ARMs are now between a quarter and a half percent lower than 30-year fixed-rate mortgages for conforming home loan products. 

This equates to a savings of roughly $30 per $100,000 borrowed per month.

If you're in a 30-year fixed mortgage right now and aren't sure if that product fits your long- and short-term financial goals, check with your mortgage planner for an evaluation.  A well-structured ARM could be a real money-saver.

(Image courtesy: Bankrate.com)

HELOC or HELOAN? It May Be Too Soon To Tell.

Okay, so you've seen me use this sort of graphic before. 

Published by the Federal Reserve Bank of Cleveland, this Fed Funds Rate Future chart is an analysis of what action market players think the Fed will take at its next meeting.  The Fed next meeting is a two-day affair beginning October 30.

The Fed Funds Rate matters to regular people like you and me because it is used to calculate Prime Rate, the rate on which credit card interest rates and Home Equity Lines of Credit rates are based. 

Prime Rate had been 8.250% from June 2006 until September 2007's Fed meeting after which the rate dropped to 7.750%.

According to the chart above, prior to the Fed's September meeting, traders placed an 80 percent expectation that the Fed Funds Rate would be lower in October that it is right now.  The odds of the FFR being 4.500% points were roughly 60 percent (as represented by the blue line) and the odds of it being 4.250% were roughly 20 percent (as represented by the white line).

Today, the probabilities look much different. 

• 25 percent chance that the Fed Funds Rate will drop 25 basis points to 4.500%
• 5 percent chance that the Fed Funds Rate will drop by 50 basis points to 4.250%
• 70 percent chance the Fed Funds Rate will remain at 4.750%

We track this chart because can help borrowers make decisions about whether a Home Equity Line of Credit is preferable to a Home Equity Loan.  HELOCs are adjustable rate loans based on Prime Rate; HELOANs are fixed rate loans.  If the probability that Prime Rate will fall is very high, a HELOC becomes more attractive to a borrower.

All things equal, HELOANs tend to be priced 0.250-0.500% lower than HELOCs but carry higher payments.  HELOANs amortize whereas HELOCs only require interest payments each month.

There is currently a 0% chance that the Fed will choose to raise the Fed Funds Rate.  This means that is highly likely that Prime Rate will remain at 7.750% through at least December 11, the date of the Fed's next meeting.

How The Demise of Second Mortgages Is Bringing PMI Back In Vogue

Suddenly, Private Mortgage Insurance is back in vogue.  If only by default. 

Since 2002, many homeowners have financed a portion of their homes using second mortgages.  It wasn't well-publicized, but these "piggyback" loans that helped people finance 85%, 90%, 95% or 100% of their home's value were really sub-prime loans, reflecting the greater risk in lending over 80% on a home's value.

With the demise of sub-prime lending, so went many lending sources for home equity loans.  As mortgage guidelines tighten, home equity loans are becoming either (1) scarce, (2) expensive, or (3) both.

The higher costs are one reason why PMI is once again a viable option for homeowners with less than 20% equity in their homes.

We've talked about the "quick snap back to 2002".  Well, that we're even talking about PMI at all is one more supporting argument.  Check out this Bankrate.com article from that year.  Despite its age, some salient points are raised.

Even as second mortgages increase in rate, PMI payments still tend to be slightly higher than its piggyback counterparts.  The Tax Relief and Health Care Act of 2006 narrows that gap, however, using tax deductibility.  The act grants itemized deductions for some private mortgage insurance (PMI) and government mortgage insurance (MIP) expense premiums paid in 2007.

For all loans originated in the 2007 calendar year, mortgage insurance is tax-deductible provided that two tests are met:

1. The homeowner's household income is $100,000 or less in 2007
2. The home loan is for a primary or secondary residence

For households earning more than $100,000, the deduction is phased out to the tune of 10% per $1,000 of additional income until it reaches 0% at $110,000.  So, if a single person earns $90,000 in 2007 and buys a home using MI, the MI expenses are tax-deductible in 2007. 

However, there's a catch!  Because the tax code is due to expire December 31, 2007, there is no guarantee that the MI will be tax-deductible in 2008.  As always, talk with your tax professional about how tax deductions work and whether you qualify for a PMI deduction. 

Because mortgage guidelines continue to shrink and second mortgages grow more scarce, PMI is expected to grow in popularity.  When it does, the graphic/poll above will shift, too. 

(Image courtesy: LendingTree.com)

Why LIBOR Will Not Impact Your Adjustable Rate Mortgage This Year

LIBOR (Lie'-boor): 1. The variable in most people's "What's my mortgage adjusting to" mortgage rate formula; 2. Media darling now that writers are wondering from where the next big mortgage problem will originate.

Despite what you may hear in the news, LIBOR's rapid ascent will not have a major bearing on your adjustable-rate mortgage and your ability to repay your lender-- at least not this year.  That's because all adjustable-rate mortgages have very clear rules by which they can adjust.  Those rules can provide you with protection against market conditions just like the ones we're facing now.

For an ARM, the formula to determine the new, adjusted mortgage rate is (LIBOR) + (some constant) = (New Mortgage Rate) where some constant is equal to any one of the following:

• Conforming loan: 2.250-2.750%
• Alt-A or Portfolio loan: 1.500-3.500%
• Sub-prime loan: 4.999-8.999%

But, not that it matters.

The press is talking a lot about LIBOR right now and you may be getting nervous.  There's no need to because most articles are leaving out the most important condition of an ARM's adjustment calculation -- the Adjustment Cap. 

The Adjustment Cap defines the rate by which your mortgage can move up or down when annual (or semi-annual) adjustment is calculated.

Stated differently:  Your mortgage rate doesn't just change willy-nilly -- it follows very clearly defined rules.  Your rate cannot adjust too high too fast, or move too low too fast.  We can presume that this was put in place to protect the bank in the event of falling rates, but when rates rise, homeowners like you get the benefit.

So, what it is your adjustment?  If you have your old loan papers, dig them up and you'll find out.  If you can't understand your closing papers (or don't want to), scan and email them to me and I'll take a look at it for you.

If you don't have your papers (or don't feel like looking it up), you can assume that your Adjustment Cap is 2.000%.  That's because for many conforming and Alt-A 5-year ARMs originated in 2002, the rate adjustment cap was set to be 2.000% at the point of first adjustment; for 3-year ARMs originated in 2004, the adjustment cap was set to be 2.000%. 

During the fixed rate portion of those 5- and 3-year ARMs, LIBOR is up roughly 4.000%.  But, like I said -- it doesn't really matter.

The most that the ARM can adjust is 2.000%, regardless of LIBOR. 

In a real life example:

• Current ARM: 4.250% 3-year LIBOR ARM, adjusts 09/2007
• Adjustment Formula: LIBOR (5.750%) + CONSTANT (2.250%) = 8.000%
• Actual Adjustment: 6.250% because 8.000% exceeds the 2.000% cap

So, no need to panic about LIBOR.  Despite what the newspapers say.  As always, the news talks in broad terms and isn't specifically addressing you.

Source
1 Year LIBOR -- Rate, Definitions, & Historical Graph
MoneyCafe.com

Vacation Reruns: WaPo Gets It All Wrong About 30-Year Mortgages

I am on vacation, but that doesn't mean you should have be deprived of good reading.  I am re-posting some of my favorites from the past few months on auto-pilot this week.  New material will resume Tuesday, April 17, 2007.

Original post: WaPo Gets It All Wrong About 30-Year Mortgages

Original date: October 2, 2006

Excerpt:

This is why 30-year fixed mortgages are so much more expensive than shorter-term adjustable rate mortgages.  It's a lot easier to predict how the economy will move over the next 3 years, or 5 years, or 10 years.  With an ARM, the bank's time risk is less so the rates are less, too. 

Some homeowners will gladly accept a higher interest rate for the certainty of knowing their rate will never change, but just like the banks take on a huge risk in trying to predict the economy over 30 years, so does the homeowner! 

For many people, having a 30-year fixed mortgage is like buying an insurance policy for way more coverage than necessary.  By sharing in some of the time risk with the bank, the homeowner can get a lower rate and lower monthly payments.

Enjoy the reruns.  I'll be back soon.

So, Your Government Wants To Legislate Against The Interest Only Loan?

If governments see fit to curb the use of interest only mortgages, I propose a solution for mortgage borrowers everywhere.

The 100-year mortgage.

Using the 100-year mortgage, your payment on every $100,000 borrowed will be just $1.26 higher than it's corresponding interest only payment.

Yes, this post is somewhat tongue-in-cheek.

UPDATE: Sellsius already posted on this, like, three weeks ago.  But, I will not be stopped from taking my rightful place as a mortgage industry visionary.  Behold: the 101-year mortgage.

Following Up On The 15-Year Mortgage As A Sucker's Bet

A year ago, I called the 15-year fixed mortgage a "sucker's bet" in one of my most popular posts ever.

There was a fair amount of debate around the subject and some of you posted legitimate economic discourse on the subject.  It made me feel good about my audience, actually.  What is a "safe" investment anyway?  In what investment vehicles can returns be maximized?  How do tax deductions apply, or not apply, to certain Americans.

There were a ton of interesting comments.

Only one person, however, went so far as to create a spreadsheet to uncover the heart of debate.  Using pure mathematics, an Air Force veteran in Virginia dissected the argument and drew the most logical conclusion of anyone.

Thank you, Dave Goodridge.

Dave put his dual degree in economics and electrical engineering to work in building an Excel spreadsheet.  You can download the file and test your own scenarios with the usual caveats and qualifiers (i.e. borrower itemizes his interest tax deductions, interest payments are within the bounds of the top marginal tax bracket, invested refunds are paid into a 100% tax-deferred account).

In the end, it appears that the better of the options -- 15-year fixed versus 30-year fixed -- comes down to the likely investment return on the payment delta.

Dave made a terrific case that it's not the 15-year mortgage that's for suckers -- it's the failure to manage your own mortgage and finances that is. 

If we can learn anything from Dave, it's that math never goes out of fashion and to always question what you read.

Tired of Sub-Prime News Yet?

Well, it's the story three years in the making.  Hope you're not bored by it yet.

The latest chatter in markets is how rising sub-prime mortgage defaults will create additional home supply via the foreclosure process, thus kicking the housing market's rebound clear in the shins.

Weak housing leads to weak spending and the U.S. economic engine starts to sputter.

Look, folks.  The sub-prime story is everywhere and there's a lot of talk on both sides of the aisle. 

The truth is that there are more questions than there are answers right now, and it will take months (or years?) to find out just how big of an impact the sudden sub-prime market implosion will have on housing and on lending standards.

My advice is free, so take it for what it's worth, but current sub-prime borrowers with adjustable-rate mortgages should call their mortgage lenders and ask about remortgaging the home into a fixed rate mortgage while products are still available. 

Think of it like playing from the deep sand. Sometimes, you're better off playing it safe by taking a drop.  It's better to lose one stroke and get a good lie than to risk two or more shots in hopes of a look at the green.

Metaphor over. 

Yes, by switching to a 30-year fixed mortgage, the monthly payment will be higher.  But at least you can go to bed each night and know what your worst-case payment scenario is going to be for the next 30 years. 

Your payment will never be worse than it is on the day you close.

Meanwhile, if credit profile your improves over the next several months or years, you can always remortgage into a different home loan with more favorable terms.  But, at that point, it will be a choice for you -- you won't have to do anything.  Your mortgage, remember, is a fixed-rate mortgage and your payments are unchanging.

Which is Better: 30-Year Fixed or 5-Year ARM

After speaking at length with a client about "how much house can I afford", she asked a fairly common question that I thought could be addressed in public.

"What's better?  The 30-year fixed mortgage or the 5-year ARM?"

It's a fair question.  The answer comes from my Econ 004 professor (whose name escapes me):

"Like all things in economics, the answer is: 'It depends.'"

In other words, there is no right answer about "which is better".  It all depends on a homeowner's individual preference and their short- and long-term financial goals.

People who consider themselves to be "conservative" often default to the 30-year fixed mortgage because they believe it's the "conservative mortgage".  People in this category tend to place a premium on the emotional security of knowing that their mortgage will never change. 

There is nothing more calming for some people than the knowledge that their mortgage payment will not change for 30 years when their home is paid in full. 

I call this the "Sleep at Night" factor.

The major downside to the 30-year fixed, however, is that it puts the lender is in a terribly risky position.  The concept is called Time Risk.  The bank thinks, "30 years is a long time to tie up our money and what mortgage rates move higher in the future?  We committing to offering this low rate today!"

For this reason, 30-year fixed mortgages are usually much more expensive than shorter-term adjustable rate mortgages.  Lenders increase the long-term fixed mortgage interest rates to compensate themselves for the future risk of committing to an interest rate today.

Instead of defaulting to a 30-year fixed mortgage, a "conservative" homeowner should look at their overall financial picture and make realistic assumptions about their timeline for living in the house. 

If the moving trucks are scheduled to come back in 6 years, there is no real reason to pay extra to the lender for 30 years of Time Risk.  The Sleep at Night factor can be very expensive over time. 

The alternative is an adjustable rate mortgage.

With ARMs, the lender locks your interest rate for a period of time that may be as short as 6-months and as long and 10 years.  After that time period is over, the mortgage rate will adjust according to current market conditions. 

This way, the bank's Time Risk is dramatically reduced and when a bank's risk is reduced, their rates generally reduce, too.

So, like I said, the answer to the question of "which is better" depends on the homeowner's circumstances.  In an optimal scenario, a homeowner passes on as little Time Risk to the lender as possible without losing the emotional certainty of being able to get a good night's sleep.

(Image courtesy of Silicon Chip)

Comparing Principal Paydown Schedules For 30-Year, 40-Year, and 50-Year Mortgages

In reference to 50-year mortgages, here is a quick amortization schedule comparing 30-year, 40-year and 50-year mortgages.

• After 30 years, a 30-year mortgage term is paid in full
• After 30 years, a 40-year mortgage term has 57% of the original borrowed amount remaining
• After 30 years, a 50-year mortgage term has 81% of the original borrowed amount remaining

Of course, it's not all bad news for longer-term mortgages. 

Because a greater percentage of payment is going towards mortgage interest, tax deductibility is highest for holders of 50-year mortgages over the first 30 years, followed by holders of 40-year mortgages, and then 30-year mortgage holders.

(Image courtesy: Mint.com)

Increases To Prime Rate Spell Doom For First Lien HELOCs

Oh boy, oh boy.  The cost of credit is going up (again).

The Fed is widely expected to raise its benchmark Fed Funds Rate to 3.75% today and that's bad news if you have a "first lien HELOC", a popular mortgage product popular from 2003.

First lien HELOCs are lines of credit that serve as a primary mortgage.

When Prime Rate was 4.000%, first lien HELOCs were an attractive mortgage product for a certain class of homeowners.  They provided the flexibility of a traditional home equity line of credit, and the low cost of a Prime Rate-based loan.

At 6.750%, Prime Rate is no longer "low cost".

Holders of first lien HELOCs would be well-served to remortgage into a new loan with lower monthly carrying costs -- maybe a 3-year ARM with interest only options, or something different depending on the overall financial picture.

Regardless, with long-term mortgage rates sitting below Prime Rate, the first lien HELOC is a mortgage product whose time appears to have passed.  And you don't have to be a Harvard student to figure that out.