What You Need To Know About…Mortgages (Part I)
Author: Lew Wessel | Photographer: Photography By Anne
I hesitated to tackle this subject because, as we’ve all learned in a very painful way, the world’s economies almost imploded over the complications from residential mortgages. Who am I, a simple, humble small-town financial planner, to try to explain a topic that befuddled the likes of Alan Greenspan and virtually every hot-shot economist in the world? Well, the fact is, I’m not that humble. Furthermore, in my opinion, it wasn’t mortgages per se that screwed us all up; it was what was done with those mortgages AFTER they were signed by the homeowners and the mortgage originators.
A residential home mortgage—and that is the scope of this and next month’s articles—is, in reality, a very simple loan contract between two parties in which one party, the mortgage company (a bank, mortgage lender, private individual, etc.) promises to lend money to an individual or couple to buy a home (single family, apartment, etc.) The home is collateral for the loan, but the borrower also makes a personal promise to pay back the loan (MUCH more about this promise later on!).
So what went wrong with this simple deal? In a nutshell, the mortgage and all the decision factors surrounding it went from a two-party transaction (the bank-lender and the individual-borrower) to one in which the lender became a “loan originator” who never intended to keep the loan in its own account, but instead was incentivized to sell it to a consolidator who then packaged it along with other loans and sold slices of it to individuals and institutions all over the world. The main focus of the “lender” then shifted from evaluating the credit worthiness of the borrower to simply assuring that the mortgage was a marketable financial instrument. In fact, given the then-market’s unquestioned faith in the rise of real estate prices, virtually every loan was marketable and the job of the mortgage broker became MORE, MORE, MORE to meet the demand. Hence were born the bizarre loans of yesteryear made to borrowers who had absolutely no business getting a loan. These include the now infamous: “No Doc” loans (aka “liar loans”) in which no documentation of the borrower’s finances was required; “NINJA” loans in which loans were approved even though the borrower had No Income, No Job, and No Assets; and “Option Arms” (aka “Pick-A-Pay Loans”)in which the borrower had the option of paying an absurdly low rate, say 1.5 percent, instead of the market rate of say 7 percent with the difference being added to the balance of the mortgage balance. It’s not hard to see that declining real estate values would wreak havoc with these loans.
Today’s Mortgage Market
Today, the mortgage choices are fewer—and saner—but, unfortunately, the role of the lender is still mostly that of “loan originator,” with the job still being the ability to sell the loan to a third party. In most cases, this translates into making sure the mortgage “conforms” to the strict guidelines of the Federal National Mortgage Association (Fannie Mae) or Federal Residential Mortgage Association (Freddie Mac), which together control 70 percent of the residential mortgage market, according to a recent article in the Wall Street Journal. Thus, as will be discussed below, the mortgage process and related decisions are almost exclusively numbers driven; i.e. your credit score is infinitely more important to getting your mortgage approved than the fact that your banker has known you since birth (or is, in fact, your own mom).
As stated, Fannie Mae and Freddie Mac pretty much control the market, but they are limited to mortgages of $417,000 in Beaufort County. Other programs include US Department of Agriculture (off-island only), Federal Housing Administration (FHA) and Veterans Administration. The “Jumbo Loan” market for mortgages over $417,000 is strictly market driven, but the underwriting (or approval process) has also gotten much stricter and pretty much mirrors the requirement of Fannie Mae and Freddie Mac.
Rent vs. Buy
Most people first learn about mortgages in relation to the rent vs. buy decision. While dollars and cents are certainly a major part of the equation, your decision should also, in large part, focus on the less quantifiable commitment factor. Your commitment as a renter is pretty much limited to paying the rent during the term of the lease and to keeping your beer pong games under control. In terms of time, this commitment (the lease) is usually no longer than one year. Buying your home adds a whole new level to your relationship with your abode. As the owner, you are now your own landlord, and that requires you to fix any broken appliances, repaint any walls, deal with neighborhood nuisances, etc. Instead of a maximum of one year, your commitment should probably be no shorter than three to five years, considering the high transaction costs and sheer hassle of buying and selling a home. You need to weigh these negatives against the many positives of ownership, which include significantly more control over your personal domain, a chance to build equity (i.e. cash in from gains to the price of your home—it could happen!) and the peace of mind added by locking in a large part of your future living expenses, if you get a fixed mortgage.
Is now a good time to jump in and buy? I’ll stick my neck out enough to say that if you are currently a renter and have any thought at all of buying a home in the near term, today is probably a good day to start the process. The combination of highly discounted home prices and historically low interest rates we see today probably won’t get much better.
Qualifying For A Mortgage
If your name isn’t Penelope or Winthrop, you’ll probably need a mortgage in order to buy a home. The first question to ask is how much of a mortgage can you afford and/or do you want to take on. Mortgage bankers utilize several qualifying “debt to income” ratios, the most important one being the “back-end ratio,” or the ratio of your total debt payments (mortgage payments + car payments + credit card payments other consumer debt) to your total gross income. As an example, if your total debt payments were $1,000 per month and your salary was $4,000 per month, this ration would calculate to 25 percent. According to BankRate.com (a fabulous resource, by the way) a ratio of 36 percent is acceptable, although local sources tell me that up to 40 percent will work with even some possibility of success as high as 45 percent. Having said that, just because you CAN doesn’t mean you SHOULD. Forty percent of your gross income (i.e. income before taxes, medical insurance payments, savings, etc.) may be a bigger chunk of your income than you are willing to commit. Don’t make the mistake of buying a more expensive home and committing to a larger mortgage than you really want simply because your realtor and mortgage banker say you can.
Another critical mortgage qualification issue is, of course, your overall credit score. The one most used is commonly known as your FICO score. FICO stands for the Fair Isaac Corporation…and who made them king?! These days, your FICO score better be pretty darn good—at least in excess of 620, out of a possible 850—if you want to have any chance at all. The Wall Street Journal reported on January 31, 2010 that the average score for Fannie Mae and Freddie Mac loans has recently climbed to 760, compared to an average of 720 in 2008. Even if you do qualify, your FICO score will also have a significant impact on the interest rate you’ll pay on your loan. As an example, a borrower with a FICO score of 620 will pay about 3 percent more than someone with a score of 720.
Next month: The rest of what you need to know about Mortgages including fixed rate mortgages vs. ARMs, down payments, points and more.