Fixed rate, Balloon, ARM and Hybrid Loans

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One of the things that always seems to be aiming to confuse mortgage consumers is advertising based upon whether the loan is fixed rate, and for how long.

First, I need to acquaint you with two concepts: amortization and term. The term of the loan is nothing more than how long the loan lasts. How many months or years from the time the documents are signed until it is done. At the end of the term, the loan is over. In some cases, the payoff schedule (or amortization) will not pay the loan off in this amount of time, leaving you with a balance which you must pay off at that time. When this happens, it is known as a "balloon payment."

Amortization is the payoff schedule. In other words, if the term was long enough (it isn't always) how long would it take you to pay the loan off with these payments?

There are four basic types of home loans out there. The first is the "true" fixed rate loan, the second is the "true" ARM, or Adjustable Rate Mortgage, the third is the hybrid, which starts out fixed but switches to adjustable, and finally, the Balloon.

"True" Fixed rate loans have the interest rate fixed for the entire life of the loan. Loan term of a true fixed rate loan is always the same as amortization period. Until you pay it off or refinance, the rate never changes. They are most commonly fixed for thirty years, but are fairly common in fifteen year variety, and widely available in 25, 20, and even 10 year variants, and the 40 year loan is one of those things lenders bring in and out of availability depending upon how badly they need it to sell loans. The shorter the period, the lower the rate will be in comparison to other loans available at the same time, but the higher the payment, as you have to get the entire principal paid off in a much shorter period of time. I seem to always use a $270,000 loan amount, so let us consider that. Making and holding a few background constraints constant, when I originally wrote this the rates from a random lender for a thirty year fixed rate loan was 6.25% at par (no points, no rebate). The 20 was 6.125, the 15 year 5.75. The 15 sounds like a better deal, right? But where the payment on the 30 year fixed rate loan was $1662.43, the payment on the 20 year fixed rate loan was $1953.88, and the payment on the 15 year loan was $2242.11 So you may not be able to afford the payment on the 15 year loan. (This particular lender didn't have 25 or 10 year loans.)

Some thirty year fixed rate loans are available with interest only for a certain period, usually five years, and then they amortize over the last 25 years of the period. Some people do this because they expect a raise in their income over the next few years, and some just do it for cash flow reasons, planning to sell or refinance before the end of the fifth year. Using the example in the preceding paragraph, this would have you making a monthly payment of $1406.25 for the first five years, then $1781.11 for the last twenty-five.

If there is a pre-payment penalty on a thirty year fixed rate loan, it is typically in effect for five years. Considering that over 50% of everybody will refinance or sell within two years, and over 95 percent within five, this is an awfully long time for a pre-payment penalty to be in effect. Practically everyone with a five year pre-payment penalty is going to end up paying it.

"True" Adjustable Rate Mortgages, or ARM loans, are adjustable from day one. The interest rate is, from the time the loan starts, always based upon an underlying rate or index, plus a specified margin. There is no fixed period whatsoever on a "true" ARM. This makes them in general hard to sell, because people cannot plan their mortgage payments, and except for the Negative Amortization loans sold on the basis of a temporarily low payment, these loans have always been very rare.

(If someone offers you a rate that appears way below market rates, like 1%, they are offering you a Negative Amortization loan. The 1% is a "nominal" or "in name only" rate, the real rate on these is month to month variable from the start based upon an underlying index, making this a "true" ARM.)

If there is a prepayment penalty on a "true" ARM, it must therefore be for a longer period than the fixed period, which is zero. You are taking a risk that you will have to pay a pre-payment penalty because the rate did something that you did not anticipate, and you may not be able to afford the payments if the rates change but the penalty is still in effect.

Rate adjustments on ARMs can be monthly, quarterly, biannually, or annually, with monthly being most common, including for every Negative Amortization loan I've ever seen.

The third category is the hybrid loan. Hybrids are often called Adjustable Rate Mortgages, and most loan officers are really talking about hybrids when they discuss ARMs. You should ask if uncertain, but in general, everybody from the lender on down calls them ARMs (I myself almost always call them ARMs), but when you get down to the technical details, they are a hybrid. Hybrids start out fixed rate for a given period, then become adjustable. The overall term of the loan is usually thirty years, but the forty is more likely to be available for hybrid ARMs than for fixed rate. Unlike Balloons, if you like what they adjust to, you are welcome to keep hybrids for as long as they fit your needs. There is no requirement to refinance a hybrid after the fixed period.

Hybrids are widely available with 2, 3, 5, 7 and 10 year initial fixed rate periods, and they may also be available "interest only" for the period of fixed rate at a slightly higher interest rate. Two years fixed is typically a subprime loan, and while five and seven and ten year fixed periods are available from some subprime lenders, they are more commonly "A paper" loans. Three is common both subprime and "A paper". Once they begin adjusting, "A paper" typically (not always!) adjusts once per year, while every hybrid subprime I've ever seen adjusts every six months.

WARNING: I often see hybrid loans advertised and quoted as "fixed" rate loans, and you find the fact that they are hybrid ARMs buried in the fine print somewhere. Yes, they are "fixed rate" for X number of years. But this is fundamentally dishonest advertising. This is one of the reasons I keep saying that any time you see the words "Fixed rate," you should immediately ask the question "How long is the rate fixed for?" Please go ahead and ask, for your own protection. Ethical loan officers know that people get sold a bill of goods on this point every day, and so they're not offended. And you don't want to do business with the unethical ones, right?

Now, I am a huge fan of hybrid loans myself. When I originally wrote this, I went so far as to say that I would never have a thirty year fixed rate loan on my own home unless the rates do something economically unprecedented. Well, that has now changed due to the stringency of qualification requirements and how people's economic circumstances can change to make it impossible to qualify for a new loan. You get a lower interest rate because you're not paying for an insurance policy that the rate won't change for thirty years, without jacking up the minimum payment to something you may not be able to afford. Most people voluntarily abandon their thirty year interest rate insurance policy (also known as "Thirty year fixed rate loan") within about two years anyway. So why would I want to spend the money for that policy in the first place, when I'm likely to only use two or three or five of those years?

Nonetheless, particularly with subprime loans, you need to be careful. I have seen precisely one subprime loan in my life without a pre-payment penalty, and I've seen a lot of loans (at least thousands, maybe tens of thousands - I wasn't counting at the time - where your average real estate agent has seen maybe a few dozen, and your average bank loan officer maybe a few hundred). Many loan providers, even "A Paper" loan providers will stick you with a three or five year pre-payment penalty on a two year fixed rate loan. Why? Because it increases their commission. So if you take one of these loans, you will have a period of time when you don't know what the rate will be doing, but if you refinance or sell during that period, you will have to pay your lender several thousand extra dollars. This puts many people on the horns of a dilemma - whether to keep making payments they can't afford, or pay the pre-payment penalty. The bank wins either way.

One final point about hybrid loans. Once they adjust, they all adjust to the same rate plus the same margin. Unless you need the lower payment to qualify for the loan, it makes no sense to pay three points to buy the rate down on a five year hybrid ARM (or anything else) when it takes eight to ten years to recover the cost of your points. Why? Because you'll never get the money back! When the rate adjusts on the loan you paid three points for (IF you keep it that long), it goes to the same rate as the loan where they would have paid all of your closing costs. Judging by the evidence, most people don't understand this.

The final category of loan that I'm going to discuss here is the Balloon. This is a loan where the amortization is longer than the term. So if the amortization is thirty years, you make payments "as if" it were a thirty year loan, but since the actual term of the loan is shorter, you will have to sell, refinance, or somehow make extra payments to pay it off before the loan term expires. The thing I don't understand is that Balloon rates are typically higher than the comparable hybrid ARM, despite the fact that you either have to come up with a large chunk of cash at the end or sell or refinance prior to that. This makes them a less attractive loan. Furthermore, pre-payment penalties are every bit as common. Balloons are widely available in five and seven year terms with thirty year amortization, and I've seen three and ten, as well. Probably the most common "balloon" loan, though, is for those who do a fixed rate second mortgage, where the best loan available is usually a thirty year amortization with a fifteen year balloon. Since over half of everybody has refinanced within two years anyway, and 95 percent within five, the fact that it's got a fifteen year balloon payment just doesn't affect a whole lot of people, and it shouldn't scare anyone off.

WARNING!: I have seen Balloon Loans mis-advertised in the same way as I talked about with hybrid ARMS a few paragraphs ago. I regard this as even more misleading than advertising hybrid's as fixed. Unfortunately, many states do not have good regulations on rate advertising, and in many others, enforcement is lax. When a loan provider advertises, the entire game is to get you to call, and then control what you see and what you learn from that point on. Your best protection from this is to talk to other loan providers. Shop around, compare offers, tell them all about each others' offers. If something is not real, or it has a nasty gotcha!, if you talk to enough people, somebody will likely tell you about it. If you only talk to one person, you're at their mercy. Even if you somehow ask the right question to discover the gotcha!, the people who do this have long practice in distracting you, or answering another question that somehow seems similar enough that you let it go.

Caveat Emptor



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About this Entry

This page contains a single entry by Dan Melson published on November 6, 2014 7:00 AM.

Mortgage Rate, Points, and Closing Costs was the previous entry in this blog.

Pocket Listings: Out of Sight, Out of Mind is the next entry in this blog.

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