Credit and Debt Management

1. Credit and Debt Management

2. Student Learning Objective • Compare and contrast the advantages and disadvantages of various mortgages

3. Mortgage A contract, signed by a borrower when a home loan is made, that gives the lender the right to take possession of the property if the borrower fails to pay off, or defaults on, the loan.

4. Home loans are available from several types of lenders • Thrift institutions • Commercial banks • Mortgage companies • Credit unions.

5. Fees • A home loan often involves many fees, such as loan origination or underwriting fees, broker fees, and settlement (or closing costs). Every lender or broker should be able to give you an estimate of its fees. • Many of these fees are negotiable. Some fees are paid when you apply for a loan (such as application and appraisal fees), and others are paid at closing. • In some cases, you can borrow the money needed to pay these fees, but doing so will increase your loan amount and total costs.

6. Points Points are fees paid to the lender or broker for the loan and are often linked to the interest rate; usually the more points you pay, the lower the rate.

7. Down Payments and Private Mortgage Insurance • Some lenders require 20 percent of the home’s purchase price as a down payment. However, many lenders now offer loans that require less than 20 percent down — sometimes as little as 5 percent on conventional loans. If a 20 percent down payment is not made, lenders usually require the homebuyer topurchase private mortgage insurance (PMI) to protect the lender in case the homebuyer fails to pay. • When government-assisted programs like FHA (Federal Housing Administration), VA (Veterans Administration), or Rural Development Services are available, the down payment requirements may be substantially smaller.

8. Escrow The holding of money or documents by a neutral third party before closing on a property. It can also be an account held by the lender (or servicer) into which a homeowner pays money for taxes and insurance.

9. Annual percentage rate (APR) The cost of credit expressed as a yearly rate. For closed-end credit, such as car loans or mortgages, the APR includes the interest rate, points, broker fees, and certain other credit charges that the borrower is required to pay.

10. Interest rate The price paid for borrowing money, usually stated in percentages and as an annual rate.

11. Loan origination fees Fees charged by the lender for processing a loan; often expressed as a percentage of the loan amount.

12. Lock-in A written agreement guaranteeing a homebuyer a specific interest rate on a home loan provided that the loan is closed within a certain period, such as 60 or 90 days. Often the agreement also specifies the number of points to be paid at closing.

13. Points • One point is equal to 1 percent of the principal amount of a mortgage loan. For example, if a mortgage is $200,000, one point equals $2,000. • Lenders frequently charge points in both fixed-rate and adjustable-rate mortgages to cover loan origination costs or to provide additional compensation to the lender or broker. • Points are paid usually on the loan closing date and may be paid by the borrower or the home seller, or split between the two parties. • In some cases, the money needed to pay points can be borrowed, but increases the loan amount and the total costs.

14. Private mortgage insurance (PMI) • Protects the lender against a loss if a borrower defaults on the loan. • It is a payment usually required of a borrower for loans in which a down payment is less than 20 percent of the sales price or, in a refinancing, when the amount financed is greater than 80 percent of the appraised value. • When you acquire 20 percent equity in your home, PMI is cancelled. Depending on the size of your mortgage and down payment, these premiums can add $100 to $200 per month or more to your payments.

15. Settlement (or Closing) costs • Fees paid at a loan closing. May include application fees; title examination, abstract of title, title insurance, and property survey fees; fees for preparing deeds, mortgages, and settlement documents; attorneys’ fees; recording fees; estimated costs of taxes and insurance; and notary, appraisal, and credit report fees. • Under the Real Estate Settlement Procedures Act, the borrower receives a “good faith” estimate of closing costs within three days of application. The good faith estimate lists each expected cost either as an amount or a range.

16. Link • mortgage worksheet • youtube

17. An ARM is a loan with an interest rate that changes. ARMs may start with lower monthly payments than fixed-rate mortgages, but keep in mind the following: 1. Your monthly payments could change. They could go up— sometimes by a lot—even if interest rates don’t go up. 2. Your payments may not go down much, or at all—even if interest rates go down. 3. You could end up owing more money than you borrowed—even if you make all your payments on time. 4. If you want to convert your ARM to a fixed-rate mortgage, you might not be able to.

18. Adjustable-rate mortgage (ARM) • A mortgage that does not have a fixed interest rate. The rate changes during the life of the loan based on movements in an index rate, such as the rate for Treasury securities or the Cost of Funds Index. • ARMs usually offer a lower initial interest rate than fixed-rate loans. The interest rate fluctuates over the life of the loan based on market conditions, but the loan agreement generally sets maximum and minimum rates. • When interest rates increase, generally your loan payments increase; when interest rates decrease, your monthly payments may decrease.

19. Hybrid ARMs • Hybrid ARMs often are advertised as 3/1 or 5/1 ARMs—you might also see ads for 7/1 or 10/1 ARMs. These loans are a mix— or a hybrid—of a fixed-rate period and an adjustable-rate period. • The interest rate is fixed for the first few years of these loans—for example, for five years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example), until the loan is paid off. In the case of 3/1, 5/1, 7/1 or 10/1 ARMs: • The first number tells you how long the fixed interest-rate period will be, and • The second number tells you how often the rate will adjust after the initial period.

20. Interest-only ARMs • An interest-only (I-O) ARM payment plan allows you to pay only the interest for a specified number of years, typically for three to 10 years. This allows you to have smaller monthly payments for a period. • After that, your monthly payment will increase—even if interest rates stay the same—because you must start paying back the principal as well as the interest each month. • For some I-O loans, the interest rate adjusts during the I-O period as well.

21. If you take out a 30-year mortgage loan with a five-year I-O payment period, you can pay only interest for five years and then you must pay both the principal and interest over the next 25 years. • Because you begin to pay back the principal, your payments increase after year five, even if the rate stays the same. • Keep in mind that the longer the I-O period, the higher your monthly payments will be after the I-O period ends.

22. Payment-option ARMs • A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options each month. The options typically include the following: • A traditional payment of principal and interest, which reduces the amount you owe on your mortgage. These payments are based on a set loan term, such as a 15-, 30-, or 40-year payment schedule. • An interest-only payment, which pays the interest but does not reduce the amount you owe on your mortgage as you make your payments.

23. Conventional loans Mortgage loans other than those insured or guaranteed by a government agency such as the FHA (Federal Housing Administration), the VA (Veterans Administration), or the Rural Development Services (formerly known as the Farmers Home Administration or FmHA).

24. Consumer cautions • Many lenders offer more than one type of ARM. Some lenders offer an ARM with an initial rate that is lower than their fully indexed ARM rate (that is, lower than the sum of the index plus the margin). • Such rates—called discounted rates, start rates, or teaser rates—are often combined with large initial loan fees, sometimes called points, and with higher rates after the initial discounted rate expires.

25. Payment shock Payment shock may occur if your mortgage payment rises sharply at a rate adjustment. Let’s see what would happen in the second year if the rate on your discounted 4% ARM were to rise to the 6% fully indexed rate.

28. Negative amortization—When you owe more money than you borrowed • Negative amortization means that the amount you owe increases even when you make all your required payments on time. • It occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage—meaning the unpaid interest is added to the principal on your mortgage and you will owe more than you originally borrowed. • This can happen because you are making only minimum payments on a payment-option mortgage or because your loan has a payment cap.

29. Prepayment penalties and conversion Prepayment penalties If you get an ARM, you may decide later that you don’t want to risk any increases in the interest rate and payment amount. When you are considering an ARM, ask for information about any extra fees you would have to pay if you pay off the loan early by refinancing or selling your home, and whether you would be able to convert your ARM to a fixed-rate mortgage.

30. Conversion fees • Your agreement with the lender may include a clause that lets you convert the ARM to a fixed-rate mortgage at designated times. • When you convert, the new rate is generally set using a formula given in your loan documents.

31. Types of Mortgage Pros and Cons Fixed-rate mortgage • No surprises • The interest rate stays the same over the entire term, usually 15, 20 or 30 years. • If interest rates fall, you could be stuck paying a higher rate.

32. Adjustable-rate (ARM) or variable-rate mortgage • Usually offers a lower initial rate of interest than fixed-rate loans. • After an initial period, rates fluctuate over the life of the loan • When interest rates rise, generally so do your loan payments.

33. FHA (Federal Housing Administration) loan • Allows buyers who may not qualify for a home loan to obtain one Low down payment. • The size of your loan may be limited.

34. VA loan • Guaranteed loans for eligible veterans, active duty personnel and surviving spouses • Offers competitive rates, low or no down payments. • The size of your loan may be limited.

35. Balloon mortgage • Usually a fixed rate loan with relatively low payments for a fixed period. • After an initial period, the entire balance of the loan is due immediately This type of loan may be risky for some borrowers.

36. Interest-only • Borrower pays only the interest on the loan, in monthly payments, for a fixed term. • After an initial period, the balance of the loan is due. • This could mean much higher payments, paying a lump sum or refinancing.

37. Reverse mortgage • Allows seniors to convert equity in their homes to cash; you don't have to pay back the loan and interest as long as you live in the house. • Subject to aggressive lending practices and false advertising promises, particularly by lenders that prey on seniors. Check to make sure the loan is Federally insured.

38. BUYING A HOME • Get prices on other homes. Knowing the price of other homes in a neighborhood will help you avoid paying too much. • Have the property inspected. Use a licensed home inspector to inspect the property carefully before you agree to buy it. • Check to see if a particular home requires you to pay any ongoing homeowners association or condo fees.

39. When shopping for a home mortgage, make sure you obtain all of the relevant information: • Check the rates for 15-year, 20-year, and 30-year mortgages. You may be able to save thousands of dollars in interest charges by getting the shortest-term mortgage you can afford. • Ask for details on the same loan amount, loan term, and type of loan from multiple lenders so you can compare the information. Be sure to get the APR, which takes into account not only the interest rate, but also points, broker fees, and other credit charges expressed as a yearly rate.

40. Ask whether the rate is fixed or adjustable. The interest rate on adjustable-rate mortgages (ARMs) can vary a great deal over the lifetime of the mortgage. • If a loan has an adjustable rate, ask when and how the rate and loan payment can change. • Find out how much of a down payment is required.