Mortgage Planning ABC

My how things have changed over the past 12 months. Let’s take a very quick look at some highlights that will be applicable to you.

The Good

Mortgage rates are spectacular. The 30-year fixed is in the low 6’s, lower than last year and two years ago. The 5-year ARM is in the low 5’s, much lower than last year and two years ago. On top of that, with the temporary conforming loan limit increases, rates on loans greater than $417,000 and up to $729,500 are only about quarter of a point higher (about the same as historically). It’s a great time to refinance (if you can) and to buy a home (at least from a mortgage perspective).

The Bad

It’s much tougher to qualify. 100% financing is long past. Try 90% or, even better, 80% LTV–difficult, especially for those in homes than have declined even modestly in value. Sub-prime is long past. A mid-600 might get you a mortgage, but with a hit to the rate. Shoot for 720+ credit scores for the best rates. Full stated programs are long past. You’ll need to at least document assets. If everything looks excellent, you might get a pass on documenting income.

The Ugly

Is the credit crush over? Apparently, not by a long shot. IndyMac recently shut it’s mortgage doors, further reducing competition for mortgages. And Fannie Mae and Freddie Mac are having major capitalization problems. Cross your fingers, because we’ve still got a long road to stable mortgage markets.

Fannie Mae released the guidelines for conforming mortgages over $417,000 (called jumbo-conforming). The guidelines can be found here.

Highlights:

Full-documentation only
660+ credit score
Single unit homes only (no duplex, triplex, 4-unit)
45% maximum debt-to-income ratio
No cash-out refinancing
75% LTV maximum for refinances (70% for declining markets–most of Southern California)
90% LTV maximum for purchase - fixed rate (85% for declining markets–most of Southern California)
80% LTV maximum for purchase - adjustable rate (75% for declining markets–most of Southern California)

The short of it is that you must have very strong income, equity and credit to qualify. Perhaps disappointing to many, but not surprising. But because these loans compete with the jumbo market, I will say there is a potential for vanilla jumbo products to improve in terms of rate and guidelines, so we’ll certainly keep an eye on that.

HUD has now published the new conforming loan limits for 2008. You can lookup them up here. As far as I know, neither Fannie nor Freddie have adjusted their underwriting systems to allow the limits yet. Once they do, it will take a while longer for lenders to offer the new limits to customers. It remains to be seen how much higher the mortgage rate will be for loans that exceed the old limit.

Here’s a great article from Bloomberg describing how inflation fears are causing rates to rise. It also comments on future Fed action and the steepening of the yield curve.

It was a busy week for economists, policymakers, consumers and mortgage professionals.

We had a surprise .75% rate cut from the Fed.

We had the announcement of an economic stimulus package that included not only significant tax rebates, but a temporary increase in the conforming loan limits from $417,000 to $729,750 (a huge, huge win for Californians).

We also saw mortgage rates reach ultra-low levels, then spike off the bottom quicker than you can bat an eye. Take a look at 30-year fixed conforming rates from one wholesale lender:

• 1/22/08 AM 5.250% (Fed lowers Federal Funds target rate by .75%)
• 1/23/08 AM 5.000%
• 1/23/08 PM 5.125%
• 1/24/08 AM 5.500%
• 1/24/08 PM 5.625%
• 1/25/08 AM 5.625%

I’d like you to take two things away from this.

First, the Fed does not control mortgage rates — certainly not long-term mortgage rates, like the 30-year fixed.

Long-term rates are affected by economic outlook and inflation. They are forward looking. It has not been a secret that the U.S. economy is ailing. Long-term rates have declined the past few months in the face of this.

The Fed’s openness to aggressively cutting rates and the passing of the economic stimulus package is sure to help the economy. One analyst estimated it would add 0.8% to this year’s GDP. So it’s not surprising that long-term rates would rise on this news.

Where do rates go from here? Hard to predict for sure, but we do know that A (Fed cut) does not always lead to B (lower long-term mortgage rates). We also know that how your structure your mortgage is more important than trying to predict interest rates.

Second, have a reputable mortgage professional you can trust.

If you received a quote for a 30-year fixed mortgage for 5% on Wednesday morning and it turned into 5.625% by the next day, is it because you were bait and switched? Or is it because rates actually went up? You shouldn’t have to deal with that kind of stress.

And if you’re looking for a reputable mortgage professional you can trust, try this one here.

It’s amazing how quickly fear of inflation can be replaced by fear of recession.

In a surprise move, the FOMC lowered the Federal Funds Rate by .75%. That this happened before the FOMC’s regularly scheduled end-of-January meeting, combined with the size of the cut and the willingness to aggressively cut further, indicates how precarious the Fed views the economy at this time.

What does this mean for mortgage rates? Here’s an extremely popular post from last year: The Relationship Between Federal Funds Rate and Mortgage Rates.

Through the constant onslaught of dire news in the mortgage markets, did you notice that the average 30-year fixed-rate, conforming mortgage rate was 6.20% according to Freddie Mac?

Compare this with the average rates each year since 2000:

Not too bad!

Of course, lending guidelines are now more strict. It’s more difficult and more expensive to borrow more than 90% of the value of your home. Stated income loans are harder to come by. Poor credit will hurt your prospects for a reasonable loan. Negative amortization loans have less attractive terms and conditions. And jumbo loans are a little more expensive compared with conforming loans.

But if you have good credit, can document adequate income and don’t over-leverage your home, rates look better than last year and in the early 2000’s.

Did you get that? Good credit, adequate income, reasonable leverage. It makes sense, doesn’t it?

The most popular question asked of the average loan officer is “What’s your rate?” Good question, but it’s like asking a car salesman “How much is a car?”

My clients know that there are considerations more important than rate alone in achieving the optimal financial picture. Still, every loan has a rate, and I always tell my clients up front what that great rate is, as well as how to position themselves for future savings.

But what goes into quoting an interest rate? It is often a complex process that involves analyzing 10-20 different factors about the borrower’s financial situation, credit history, property and intentions.

Multiply this by the hundreds of potential lenders, each offering similar, but slightly different, loan products with their own loan qualification and interest rate pricing factors. Change the loan product, and we start over again. Today turns into tomorrow, and the rates change. Or maybe not.

In some cases, it’s not too complicated. But for the most part, behind the scenes, someone is squinting at thousands of tiny numbers on a stack of lender ratesheets or on a computer screen, to get you your best rate.

Understanding some of these factors can help you understand your interest rate and what we can do to lower it.

Loan Product. Before we can even talk about rate, we have to select a loan product. Common examples of loan products are the 30-year fixed, the 15-year fixed or the 5-year adjustable rate mortgage. Change the number of years, and you have some more examples.

Then there’s the option ARM I wrote about last month and the newer fixed-rate option ARMs that have come out. Lenders are always coming out with new loan products to meet your needs, and each loan product has its own set of base interest rates.

Credit. This is the single most important factor that you have control over (besides deciding to rent forever). I’ll be writing many articles on credit, but let me say the obvious. Borrowers with the best credit get the best interest rate.

There are many reasons for having a bad credit score and many very good programs for those with imperfect credit. There are also many ways to raise your credit score. Do so, and you can lower your interest rate.

Loan-to-Value. The next most important factor is called the loan-to-value ratio or LTV. It is the amount of the loan divided by the value of the property, expressed as a percentage, like 80% or 90% or 100%. The higher the LTV, the more interest you will pay. Why?

If you default on your mortgage, the lender will sell your property to pay off the loan (foreclosure). The fire sale nature of foreclosures and the added administrative expenses means sometimes only 70% of the property value is recovered. Also, the more you borrow, the higher your payments and the greater the risk of default. Higher LTV loans means higher risk for lenders and higher interest rates.

Points. Points represent an amount paid upfront on the loan. One point equals one percent of the loan amount. If you have the money to pay points, the loan’s interest rate is lower. If you anticipate keeping the mortgage for a longer period of time, paying points can make sense. No point mortgages may also be right for you, but the rate will be a bit higher.

Prepayment Penalty. Lenders use prepayment penalties discourage borrowers from refinancing their mortgage or selling their home for a certain number of years or face stiff financial penalties (commonly 6 months interest on 80% of the remaining loan balance).

They are more common, even mandatory, on lower credit mortgages. Sometimes you can buy out the penalty via a fee or in exchange for a slightly higher interest rate.

Can a prepayment penalty be good you? Maybe. In some cases, you can obtain a lower interest rate in exchange for having a prepayment penalty. If you are sure you won’t refinance or move for a number of years, it might be beneficial for you. But be careful, these penalties can easily add up to thousands of dollars.

There are occasions where prepayment penalty should always be avoided, such as when it locks you into certain large rate increases–for example a 3-year prepay on a 2-year adjustable rate mortgage.

Documentation Type. It used to be that to get a mortgage, you needed to provide the lender with the last two years of 1040 income tax returns and employer W2 statements, your recent paycheck stubs and the last three months of bank statements. This is called full documentation and assures the lender that the income and assets that you put on your application are true.

There are many reasons that borrowers are unable to provide this information. They may be self-employed in a newer business with tax and bank statements in less than perfect shape.

These borrowers may opt for a stated income loan where, simply, their income is stated with no verification required. Interest rates are higher, of course, to offset increased risk.

Occupancy. These days, many homeowners are multi-homeowners, owning second homes and income property. An owner-occupied home has the lowest risk of default because the borrower lives in it. A second home usually requires a higher interest rate and investment properties require even higher.

Loan Purpose. Often, a mortgage obtained for a purchase has a better interest rate than one for a refinance. The reason is a borrower who refinances their mortgage once has a higher chance of refinancing in the future. For a lender, having their loan refinanced means their money no longer earns interest.

Cash Out. A borrower who refinances and takes additional cash out (the mortgage amount increases) takes a small hit in rate because they are not just refinancing for better terms, but adding to their financial obligations (and risk of default) as well.

Escrows. Lenders provide a service called escrows (or impounds) where they create an account and collect extra payments from you to pay for your property tax and hazard insurance. Rather than paying two large lump sum tax payments during the year (December and April), it’s taken care of via your monthly payments.

That’s good if you have trouble saving your money for these payments, but bad if you’re on top of it and don’t like the bank holding onto your money interest free. Some lenders discourage not having escrows with a higher interest rate, preferring borrowers to have uniform monthly housing payments.

Other Factors. Interest-only mortgages may have higher rates since your loan balance is not being paid down. Condo financing may be more expensive because often there is less pride of ownership. High-rise condo financing may increase your rate since there is often a higher incidence of rental condos, reducing resale value. Some lenders reduce the interest rate for larger loan amounts (borrow more and save!). Some lender do the opposite and increase the rate (more loans and smaller amounts means better diversification for them). Typically, a borrowers debt-to-income ratio (DTI) is used to determine how much money can be borrowed. Some banks now let you increase that ratio and borrow a bit more for an interest rate premium.

We could go on and on from here; as I said, all lenders are different. But these are the most common factors that will affect your interest rate.

The next time you see a rate, find out what you are getting and understand what conditions need to be met to get that rate. Give me a call and I’ll gladly decipher for you and help you find the best mortgage for your unique situation.

The Core Personal Consumption Expenditures (PCE) Index rose by 1.8% in August versus a year ago. Core PCE measures price changes in consumer goods and services, excluding volatile food and energy components.

This is the third consecutive month that year-over-year Core PCE growth has come in under 2%, significant because the Fed considers 1-2% to be it’s target zone for inflation.

Inflation erodes the value of money and causes long-term interest rates to rise. Low inflation is like a ceiling for long-term interest rates.

Low inflation also gives the Fed a green light to lower short-term rates (Federal Funds Rate) to support economic growth, if necessary.

But low short-term rates increase consumer and business spending and can cause inflation to rise, and you know what that means, right? (See above)

The takeaway is that we should expect long-term mortgage rates in general to remain low, but move up and down in a range, as it normally does.

More worthwhile than watching rates all day long is to engage in some solid mortgage planning. Contact me if you’d like to see how improving your credit, optimizing your cash flow and taxes and selecting the right mortgage product at the right time can nicely improve your financial picture!

Jonathan Clements has an excellent article in the Wall Street Journal today about what to do with your personal finances if you are worried about a recession.

One of the key items is setting up a home-equity line of credit (HELOC) as an emergency source of funds, and I am reminded of an article I wrote in November of last year about accessing home equity, which I’ve provided a few paragraphs from here.

A HELOC is terrific because:
(1) it is a revolving credit account, so you can save it for a rainy day
(2) if you are using it, the interest expense is generally tax deductible (please consult your tax advisor), making it a cheaper source of credit than most other unsecured debt
(3) many HELOC have a fixed-rate feature, allowing you to lock in a rate for a number of years

Just a year ago, the concept of using a HELOC as an insurance policy for cash wasn’t as interesting because it was relatively easy to get a HELOC or refinance your home, even if you didn’t have a job or great credit.

Today, especially with falling home prices, an unexpected layoff and/or a missed mortgage payment likely closes your doors to a home loan, at least to one with reasonable rates.

I have some no closing cost HELOCs with great rates for those of you looking for some peace of mind. Just contact me.

Here’s my November 2006 article:

Over the past several years, many fortunate homeowners experienced huge gains in equity as home prices skyrocketed. In less than five years (since the beginning of 2002), the median sales price of a home in California has more than doubled, increasing over $300,000 in price.

How does a homeowner access this equity? You could sell your home, but for most people, that isn’t going to cut it. Where are you going to live? If you are keeping your house, the only way to get at the equity in it is to borrow against it.

In this month’s article, I’m going to discuss three ways to borrow against your home’s equity, how to determine which way is best and when using your home equity is a very good thing.

Cash-Out Refinance

In a cash-out refinance, your old mortgage is paid off with a larger, new mortgage. The difference between the old balance and the new balance is the “cash out” and is money sent to you.

When interest rates were falling several years ago, it was a boon to homeowners who were simultaneously seeing large increases in their home equity. They could refinance their mortgage, take some cash out, get a lower interest rate and get a lower payment.

These days, the story is a bit different. If you have, say, a 5.25% 30-year fixed mortgage, you aren’t going to be able to refinance it at the same rate. While still low by historical standards, rates are a bit higher today, so it’s important to understand the full costs of using a cash-out refinance.

Scenario A. Let’s assume your current balance is $300,000 on the 5.25% mortgage ($1,312.50 interest per month). You need $75,000, and I help you obtain a new $375,000 mortgage at 6% ($1,875.00 interest per month). The $75,000 does not cost just 6% because you end up paying more interest on the original $300,000. You pay an additional $562.50 per month on $75,000 cash out, equivalent to a 9% interest rate.

Scenario B. If your current mortgage has a 5.75% rate ($1,437.50 interest per month) and you cash-out refinance to a 6% loan, the $75,000 costs an additional $437.50 per month, or a 7% equivalent interest rate. You need to use these equivalent rates to compare to other options.

Home Equity Loan

Another way to access your equity is using a home equity loan, which is a traditional second mortgage. The home equity loan has a fixed loan amount, a fixed interest rate and is amortized over a set number of years, similar to your first mortgage. You continue to make payments on the first mortgage and also make payments on the second.

Home equity loans have slightly higher interest rates than first mortgages because, in the case of foreclosure, the debt is second in priority to the first mortgage, which means greater risk for the home equity lender. If you have good credit and decent equity in your home, you should expect to get a rate somewhere in the neighborhood of 7% today.

Compared to Scenario A, above, the home equity loan is more economical (7% versus 9%). Compared to Scenario B, the home equity loan costs about the same (both 7%). Your particular scenario will be different because of your particular current loan, the amount of cash needed, and the rates you can get on the refinance and the home equity loan (I will be glad to help you with this).

Home Equity Line Of Credit

A second kind of second mortgage is the home equity line of credit, or HELOC. It’s a bit like a credit card in that it is a revolving line of credit that you can use, pay down and use again.

If you have good credit and decent equity in your home you can get a HELOC with a rate at prime (currently 8.25%) or less. Compared to Scenario A, the HELOC is a less expensive way to draw on your home’s equity than the cash-out refinance, but it is more expensive to Scenario B. Your situation will, of course, vary.

The primary benefits of a HELOC are that you don’t have to use (and hence pay interest on) the entire credit line, and the monthly payments are typically lower because minimum payments are interest-only for the first 10 or 15 years.

The primary drawback of a HELOC is that it has a variable interest rate, usually tied to the prime rate. Many HELOC holders saw their interest rates rise seemingly without end during the Fed’s 17 straight rate increases.

HELOC with Fixed-Rate Lock

Recently, lenders have been offering HELOCs that incorporate the fixed-rate feature of home equity loans. You may lock part of the credit line at a fixed rate and amortization period and do this several times over the life of the HELOC. It’s like being able to create your own home equity loans inside of your HELOC, just by writing a check.

The rate for a lock will depend on the amortization period you choose, with a longer period having a slightly higher rate, but lower payments. One nice program has a feature where you can lock for an interest-only period, giving you the lowest monthly payments. Another excellent program is a prime -.25% HELOC that you can currently lock at 6.99% over 5 years, perfect for buying a car.

And, should interest rates decline, you can unlock the lock and go back to paying the variable rate.

Using Your Home Equity

A home loan is one of the lowest cost loans available because mortgage interest is tax deductible for most people (call me or check with your tax advisor for specifics). A home equity loan at 7% is equivalent to borrowing a 4.55% for a homeowner with a 35% marginal tax rate. By contrast, credit card rates can be 18% or higher, and auto loans average around 8%. Consolidating higher-rate, non-tax deductible debt into a mortgage will save you money.

Tax-advantaged investments, such as 401(k)s, IRAs and educational plans are often overlooked by homeowners. The Federal Reserve Bank of Chicago concluded in a recent study that many borrowers making prepayments to their mortgage rather 401(k) contributions are “making the wrong choice.”

You can contribute up to $4,000 a year (so can your spouse) to a Roth IRA. Because its earnings are tax-free, you compare its investment return with your mortgage’s after-tax interest rate. In the 7% home equity loan example, if you can earn more than 4.55% on your Roth IRA, it will be the better investment.

Coverdell ESAs and 529 plans are similar. Like the Roth IRA, the earnings on these educational savings plans are tax-free. If you have kids, taking full advantage of these savings plans may be a better bet than paying down your mortgage.

Are you taking full advantage of your employer’s 401(k) contribution match? The match is free money that should not be thrown away. Beyond that the tax deferred earnings may also surpass the after-tax rate on your mortgage.

What about investing in the stock market? There are two reasons to be careful here. Because stock market gains are taxable, you have to reduce the earnings by your tax rate to make a comparison. Also, stock investments are inherently risky, especially if made for the short-term. Weigh that against a 100% certain return on paying down your mortgage.

How about money for a business? Businesses tend to be risky, too. But many people make a living running their businesses and borrowing may be a necessity. You situation may find using your home’s equity a perfect vehicle for financing your business.

Finally, your home’s equity may serve as an insurance policy against the loss of a job or an emergency situation where money is needed. In this case, a HELOC is a perfect choice. Credit that is unused in a HELOC does not cost you interest, but it is always available when the time comes. Waiting to open a HELOC until after an emergency is risky: if you lose your job, it will be very difficult to get the loan and you will pay a higher interest. The time it takes to process the loan may also play a factor.

If you are interested in seeing whether your home equity can help you save money, just give me a ring. I do not advocate plunging yourself in debt or mortgaging yourself to 100% of your home’s value for high stakes poker games. But if money is needed or there are clear cut ways to improve your financial position, I will give you some very good options.