220 Week 5 F /For WIZARD KIM

CHAPTER 4 Fathoming the Fundamentals 65

Chapter 4

IN THIS CHAPTER

» Understanding the basic building blocks of mortgages

» Looking at mortgage terminology

» Finding out about prepayment penalties and private mortgage insurance

Fathoming the Fundamentals

Like brain surgeons, nuclear physicists, pizza makers, and all other highly skilled professionals, financial wizards have developed their own weird customs, practices, and terminology over the centuries. If you want to do business with financiers, knowing how to speak their language helps, because they rarely bother to speak yours. A steady diet of jumbo loan with points au gratin on the side and the infamous house specialty, prepayment penalty flambé, for des- sert leaves even the hardiest borrower intellectually constipated.

Worse, some unscrupulous lenders may use your fiscal ignorance to maneuver you into getting a loan that’s good for them but bad for you. Even though an assort- ment of loans may outwardly appear to be equally attractive, they’re usually not — not by a long shot.

The good news is that lending ain’t rocket science. This chapter explains what makes a loan tick and helps you speak the language of lending like a pro. (Chapter 5 takes you through the particulars of choosing the best loan for you.)

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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66 PART 2 Locating a Loan

Grasping Loan Basics: Principal, Interest, Term, and Amortization

Money isn’t magical. It’s a commodity or consumer product like HDTVs and toast- ers. Lending institutions such as banks, savings and loan associations (S & Ls), and credit unions get their raw material (money) in the form of deposits from millions of people just like you. Then they bundle your cash into neat little pack- ages called loans, which they sell to other folks who use the money to buy cars, college educations, and cottages. Lenders make their profit on the spread (differ- ential) between what they pay depositors to get money and what they charge bor- rowers to use the money until the lender is fully repaid.

All loans have the following four basic components:

» Principal: Even though both words are spelled and pronounced the same way, the principal we’re referring to isn’t that humorless old coot who ruled your high school with an iron fist. We’re talking about a sum of money owed as a debt: the dollar amount of the loot you borrow to acquire whatever it is that your heart desires.

» Interest: No linguistic confusion here — interest is what lenders charge you to use their product: money. It accumulates over time on the unpaid balance of money you borrowed (the outstanding principal) and is expressed as a percentage called the interest rate. For instance, you may be paying an interest rate of 19.8 percent or more on the unpaid balance of your credit card debt. (We recommend that you pay off credit card balances as soon as possible!)

Consumer interest for outstanding balances such as credit card debt and a car loan is not deductible on your federal or state income tax return. Interest paid on a home loan, conversely, can be used to reduce your state and federal income tax burdens. There’s a major difference in how you borrow money. Understanding these income tax write-off rules can save you big bucks.

» Term: All good things come to an end sooner or later. A loan’s term is the amount of time you’re given by a lender to repay money you borrow. Generally speaking, small loans have shorter terms than large loans. For instance, your friendly neighborhood credit union may give you only four years to pay back a $20,000 car loan. That very same lender will graciously fund a loan with a 30-year term so you have plenty of time to repay the $200,000 you borrow to buy your dream home.

Lenders allow more time to pay back large loans to make the monthly payments more affordable. For example, you’d spend $568 a month to repay a $100,000 loan with a 5.5 percent interest rate and a 30-year term. The same loan costs $818 a month with a 15-year term. Even though the 15-year loan’s

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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CHAPTER 4 Fathoming the Fundamentals 67

payment is $250 per month higher, you’d pay far less interest on it over the life of the loan:

$818/month × 180 months for a $100,000 loan repayment = $47,240 in interest over 15 years

versus

$568/month × 360 months for a $100,000 loan repayment = $104,480 interest over 30 years

Don’t let a seemingly low monthly payment (with a longer-term loan) fool you into paying a lot more interest over the long haul.

» Amortization: Amortization is an ominous word lenders use to describe the tedious process of liquidating a debt by making periodic installment payments throughout the loan’s term. Loans are amortized (repaid) with monthly payments consisting primarily of interest during the early years of the loan term and principal, which the lender uses to reduce the loan’s balance. If your loan is fully amortized, it will be repaid in full by the time you’ve made your final loan payment. You’ll gasp in astonishment and sadness when you read Appendix B and see with your own eyes how long it takes to repay half of the original loan amount.

Deciphering Mortgage Lingo Just for the heck of it, ask the next thousand people you meet what a mortgage is. Approximately 999 of them will tell you that it’s a loan used to buy a home.

Amazingly, every one of them is wrong. Common usage aside, a mortgage is not simply a loan. This section clarifies what a mortgage is and isn’t.

So . . . what’s a mortgage? Mortgage is a word lenders use to describe a formidable pile of legal documents you have to sign to get the money you need to buy or refinance real property. What’s real property? It’s dirt  — plain old terra firma and any improvements (homes, garages, cabanas, swimming pools, tool sheds, barns, or other buildings) perma- nently attached to the land.

Mortgages aren’t used only to facilitate home purchases. They’re used whenever people acquire any kind of real property, from vacant lots to commercial real estate such as shopping centers and the Empire State Building.

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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68 PART 2 Locating a Loan

In case you’re curious, anything that isn’t real property is classified as personal property. Moveable or impermanent possessions such as stoves, refrigerators, dishwashers, washers and dryers, window treatments, flooring, chandeliers, and fireplace screens are examples of personal property items that are frequently included in the sale of real property.

Mortgages encumber (burden) real property by making it security for the repay- ment of a debt. A first mortgage ever so logically describes the very first loan secured by a particular piece of property. The second loan secured by the same property is called a second mortgage, the third loan is a third mortgage, and so on. You may also hear lenders refer to a first mortgage as the senior mortgage. Any subsequent loans are called junior mortgages. Money imitates life.

This type of financial claim on real property is called a lien. Proper liens invariably have two integral parts:

» Promissory note: This note is the evidence of your debt, an IOU that specifies exactly how much money you borrowed as well as the terms and conditions under which you promise to repay it.

» Security instrument: If you don’t keep your promise, the security instrument gives your lender the right to take steps necessary to have your property sold to satisfy the outstanding balance of the debt. The legal process triggered by the security device is called foreclosure. We sincerely and fervently hope that the closest you ever get to foreclosure is reading about it in this book (see Chapter 14 for details).

From a lender’s perspective, each junior mortgage (subsequent mortgage after the first loan on the property) is increasingly risky, because in the event of a foreclo- sure, mortgages are paid off in order of their numerical priority (seniority). In plain English, the second mortgage lender doesn’t get one cent until the first mortgage lender has been paid in full. If a foreclosure sale doesn’t generate enough money to pay off the first mortgage, that’s tough luck for the second lender. Due to the added risk, lenders charge higher interest rates for junior mortgages.

How to scrutinize security instruments The security instrument used in your transaction can vary from one state to the next depending on where the property you’re financing is located. Mortgages and deeds of trust are the most common types of security instruments. Without fur- ther ado, we give you some important information about them.

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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CHAPTER 4 Fathoming the Fundamentals 69

Mortgages as security instruments As a legal concept, mortgages have been around centuries longer than deeds of trust, their relatively newfangled siblings. That’s why folks nearly always refer to real property loans as mortgages even if they live in one of the many states where a deed of trust is the dominant security instrument. The other states use mort- gages as security instruments.

The seniority of mortgages explains why they’re the prevalent security instru- ment in many states east of the Mississippi River, the first part of the country to be settled. Check with your real estate agent or lender to find out which kind of security instrument is used where your property is located.

Here’s how mortgages operate:

» Type of instrument: A mortgage is a written contract that specifies how your real property will be used as security for a loan without actually delivering possession of the property to your lender.

» Parties: A mortgage has two parties — the mortgagor (that’s you, the borrower) and the mortgagee (the lending institution). You don’t get a mortgage from the lender. On the contrary, you give the lender a mortgage on your property. In return, the mortgage holder (lender) loans you the money you need to purchase the property.

» Title: Title refers to the rights of ownership you have in the property. A mortgage requires no transfer of title. You keep full title to your property.

» Effect on title: The mortgage creates a lien against your property in favor of the lending institution. If you don’t repay your loan, the lender usually has to go to court to force payment of your debt by instituting a foreclosure lawsuit. If the judge approves the lender’s case against you, the lender is given permission to hold a foreclosure sale and sell your property to the highest bidder.

Deeds of trust as security instruments Mortgages and deeds of trust are both used for exactly the same purpose: They make real property security for money you borrow. However, mortgages and deeds of trust use significantly different methods to accomplish that same purpose. The following list highlights the features of a deed of trust:

» Type of instrument: The security given isn’t a written contract. It’s a special kind of deed called a trust deed.

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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70 PART 2 Locating a Loan

» Parties: The trust deed involves three parties: a trustor (you, the borrower), a beneficiary (the lender), and a trustee (a neutral third party such as a title insurance company or lawyer who won’t show any favoritism to you or the lender).

» Title: The trust deed conveys your property’s naked legal title to the trustee, who holds it in trust until you repay your loan. Don’t worry, dear reader; you retain possession of the property. Your lender holds the actual trust deed and note as evidence of the debt.

» Effect on title: Like a mortgage, a trust deed creates a lien against your property. Unlike a mortgage, however, the lender doesn’t have to go to court to foreclose on your property. In most states, the trustee has power of sale, which can be exercised if you don’t satisfy the terms and conditions of your loan. The lender simply gives the trustee written notice of your default and then asks the trustee to follow the foreclosure procedure specified by the deed of trust and state law. Most lenders prefer having their loans secured by a deed of trust. Why? Compared to a mortgage, the foreclosure process is much faster and less expensive.

For simplicity’s sake in this book, we use mortgage, deed of trust, and the loan you get to buy a home as interchangeable terms. You, however, must promise us that you’ll always remember the difference and who explained it to you!

Eyeing Classic Mortgage Jargon Duets Just because you can speak mortgage fluently doesn’t mean you’ll be able to com- municate with lenders. The following sections offer more essential loan jargon. Consider these dynamic duos: mortgage loan options such as fixed or adjustable rate, government or conventional, primary or secondary, conforming or jumbo, and long- or short-term.

Fixed or adjustable loans FRM, ARM, or whatever  — don’t let the alphabet soup of mortgages available today confuse you. No matter how complicated the names sound, all loans fall into one of the following basic classifications:

» Fixed: This type of loan either has an interest rate or a monthly payment that never changes. A fixed-rate mortgage (FRM) is just what it claims to be — a mortgage that keeps the same interest rate throughout the life of the loan.

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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CHAPTER 4 Fathoming the Fundamentals 71

Even though you have a fixed-rate mortgage, your monthly payment may vary if you have an impound account (for folks who put less than 20 percent cash down when purchasing their homes). In addition to the monthly loan pay- ment, some lenders collect additional money each month for the prorated monthly cost of property taxes and homeowners insurance. The extra money is put into an impound account by the lender, who uses it to pay the borrow- er’s property taxes and homeowners insurance premiums when they’re due. If either the property tax or the insurance premium happens to change (and they do typically increase annually), the borrower’s monthly payment is adjusted accordingly.

» Adjustable: Either the interest rate or the monthly payment or both interest rate and monthly payment change (adjust) with this kind of loan. The follow- ing are examples of adjustable mortgages:

• An adjustable-rate mortgage (ARM) is a loan whose interest rate can vary during the loan’s term.

• A hybrid loan merges an FRM and an ARM. The hybrid loan’s interest rate and monthly payment are fixed for a specific period of time, such as five years, and then the mortgage converts into an ARM for the remainder of the loan term.

Just because a mortgage’s monthly payment is fixed doesn’t mean the loan is a good one. For instance, some ARMs have monthly payments that don’t always change, even though the loan’s interest rate can change and increase. This can lead to negative amortization, an unpleasant situation where the loan balance increases every month, even though you faithfully make the monthly loan pay- ments. After the subprime crisis, few lenders offer negative amortization loans. You can find an in-depth analysis of ARMs and negative amortization in Chapter 5. For now, be advised that we strongly urge you to avoid loans that have the poten- tial for negative amortization.

Government or conventional loans Through either insuring or guaranteeing home loans by an agency of the federal government, Uncle Sam is a major player in the residential mortgage market. Such mortgages are called, you guessed it, government loans. The remaining residential mortgages originated in the United States are referred to as conventional loans.

Here’s a quick recap of government loans:

» Federal Housing Administration (FHA): The FHA was established in 1934 during the depths of the Great Depression to stimulate the U.S. housing market. It primarily helps low-to-moderate income folks get mortgages by

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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72 PART 2 Locating a Loan

issuing federal insurance against losses to lenders who make FHA loans. The FHA is not a moneylender. Borrowers must find an FHA-approved lender such as a credit union, bank, or other conventional lending institution willing to grant a mortgage that the FHA then insures. Not all commercial lenders choose to participate in FHA loan programs due to their complexities.

Depending on which county within the United States the home you want to buy is located, you may be able to get an FHA-insured loan of up to $636,150. The minimum loan amount under this program is $275,665 with a $636,150 maximum as of 2017. The loan limit varies based on the cost of housing in each area. (For current, up-to-date lending limits by area, visit the FHA Mortgage Limits web page at https://entp.hud.gov/idapp/html/hicostlook.cfm.)

» Department of Veterans Affairs (VA): Congress passed the Serviceman’s Readjustment Act, commonly known as the GI Bill of Rights, in 1944. One of its provisions enables the VA to help eligible people on active duty and veterans buy primary residences. Like the FHA, the VA has no money of its own. It guarantees loans granted by conventional lending institutions that participate in VA mortgage programs. This can be an excellent program if you qualify.

» U.S. Department of Agriculture (USDA): The USDA oversees the Rural Housing program. This is a popular program for owner-occupied homes outside metropolitan areas. The loans offer $0 down and affordable mortgage insurance. However, there are restrictions on location, income, and assets. If you qualify, this is usually your best $0 down option, besides a VA loan.

» Farmers Home Administration (FmHA): Like the FHA, VA, and USDA, the FmHA isn’t a direct lender. Despite its name, you don’t have to be a farmer to get a Farmers Home Administration loan. You do, however, have to buy a home in the sticks. The FmHA insures mortgages granted by participating lenders to qualified buyers who live in rural areas.

FHA, VA, and FmHA mortgages have more attractive features — little or no cash- down payments, long loan terms, no penalties if you repay your loan early, and lower interest rates — than conventional mortgages. However, these loans aren’t for everyone. Government loans are targeted for specific types of homebuyers, have maximum mortgage amounts established by Congress, and may require an inordinately long time to obtain loan approval and funding. In a desirable urban or hot market where homes generate multiple offers, buyers using government loans often lose out to people using conventional mortgages that can be funded quicker.

Primary or secondary mortgage market Lenders make loans directly to folks like you in what’s called the primary mortgage market. Few lending institutions keep mortgages they originate in vaults sur- rounded by heavily armed guards. Lenders sell most of their mortgages to pension

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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CHAPTER 4 Fathoming the Fundamentals 73

funds, insurance companies, and other private investors as well as certain gov- ernment agencies in the secondary mortgage market. Why do mortgage lenders sell mortgages they originate? They want to make a profit and to obtain more funds to lend.

Uncle Sam is an extremely important force in the secondary mortgage market through two federally chartered government organizations — the Federal National Mortgage Association (FNMA, or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, endearingly known as Freddie Mac). One of the primary missions of Fannie Mae and Freddie Mac is to stimulate residential housing con- struction and home purchases by pumping money into the secondary mortgage market.

Fannie Mae and Freddie Mac boost home purchases and construction by purchas- ing loans from conventional lenders and reselling them to private investors. These  government programs are far and away the two largest investors in U.S. mortgages.

These programs aren’t meant to subsidize rich folks. To that end, Congress estab- lishes upper limits on mortgages Fannie Mae and Freddie Mac are authorized to purchase. Table  4-1 shows the 2017 maximum mortgage amounts for one- to four-unit properties. Note: These are the general loan limits for most areas, but if you’re buying a property in a so-called “high-cost” area, the maximum mortgage amounts are 50 percent higher than those in Table 4-1.

Congress periodically readjusts these maximum mortgage amounts to reflect changes in the prevailing average price of property. Any good lender can fill you in on Fannie Mae’s and Freddie Mac’s current loan limits.

TABLE 4-1 2017 Fannie Mae and Freddie Mac Maximum Mortgage Amounts for One- to Four-Unit Properties

# of Units Continental U.S. Alaska, Hawaii, Guam & U.S. Virgin Islands

1 $424,100 $636,150

2 $543,000 $814,500

3 $656,350 $984,525

4 $815,650 $1,223,475

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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74 PART 2 Locating a Loan

Conforming or jumbo loans This delicious tidbit of information can save you big bucks: Conventional mort- gages that fall within Fannie Mae’s and Freddie Mac’s loan limits are referred to  as conforming loans. Mortgages that exceed the maximum permissible loan amounts are called jumbo loans or nonconforming loans.

When Congress passed the Economic Stimulus Act of 2008 (The Act), it also cre- ated a brand-new type of mortgage neatly notched between a conforming loan and a jumbo loan. We now have three tiers of mortgages:

» True conforming loans include loan amounts up to $424,100. These loans, also called traditional conforming loans, have the lowest interest rates.

» Jumbo conforming loans encompass loan amounts from $424,100 up to a maximum of $636,150 and are designed for high-cost areas (the precise amount varies by area). Some lenders call these conforming jumbos, super conforming, or jumbo light loans. Whatever. Loans of this size generally have interest rates anywhere from half a percent to a full percent (or more) higher than the true conforming loan.

» True jumbos are loans that exceed $636,150. As you’d expect, the largest loans are also the most expensive. Their interest rates usually run a full percent point or more above jumbo conforming loans.

Fannie Mae and Freddie Mac both imposed tougher qualifying standards on jumbo conforming loans than they have for true conforming loans. Some examples of these tougher standards: Jumbo conforming loans are limited to single-family dwellings, require that you have at least a 700 FICO score if your loan-to-value (LTV) ratio exceeds 75 percent (for Freddie Mac) or 80 percent (for Fannie Mae), and specify that monthly payments on your combined total debt can’t exceed 45 percent of your income.

Fannie’s and Freddie’s jumbo conforming loan programs were originally sched- uled to expire December 31, 2008, but Congress keeps extending them, and these programs are still in place as of 2017. Be sure to check with your lender regarding the current status of these loans.

You pay dearly for nonconformity. The higher the loan amount, the bigger the thud if your loan goes belly up. Reducing the loan-to-value ratio is one way lend- ers cut their risk. To that end, conventional lenders generally insist on more than the usual 20 percent down on jumbo loans. You’ll probably be required to make at least a 25 percent cash down payment. Interest rates on nonconforming fixed- rate mortgages generally run from 3⁄8 to ½ a percentage point higher than con- forming FRMs. When mortgage money is tight, the interest rate spread between

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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CHAPTER 4 Fathoming the Fundamentals 75

conforming and jumbo FRMs is higher; when mortgage money is plentiful, the spread decreases.

If you find yourself slightly over Fannie Mae’s and Freddie Mac’s limit for either true conforming loans or the jumbo conforming loans, don’t despair. You can either buy a slightly less expensive home or increase your cash down payment just enough to bring your mortgage amount under their loan limits or possibly use a small second mortgage. In Chapter  2, we include a lengthy list of financial resources you may be able to tap for additional cash.

Long-term or short-term mortgages Any loan that’s amortized more than 30 years is considered to be a long-term mortgage. Reversing that guideline, short-term mortgages are loans that must be repaid in less than 30 years. Wow. Definitions that actually make sense.

These standards harken back to less complicated times before the late 1970s when people could get any kind of mortgage they wanted as long as it was a 30-year, fixed-rate loan. Back then, choices for a short-term mortgage were nearly as limited. Homebuyers could have an FRM with either a 10- or 15-year term or a balloon loan with, for example, a 30-year amortization schedule and a 10-year due date. They made the same monthly principal and interest payments for ten years and then got hammered with a massive balloon payment to pay off the entire remaining loan balance. (The reality was that homeowners simply had to refi- nance the remaining loan balance through a new loan either with their current lender or another lender.)

The total interest charges on short-term mortgages are less than total interest paid for equally large long-term loans at the same interest rate because you’re borrowing the money for less time. Because a lender has less risk with a short- term loan, such loans usually have lower interest rates than comparable long-term mortgages. For instance, the interest rate on a conforming 15-year, fixed-rate mortgage is generally about ½ a percentage point lower than a comparable 30-year FRM.

In our prior example (see the section “Grasping Loan Basics: Principal, Interest, Term, and Amortization”), we say that you’d spend $568 a month to repay a $100,000 FRM with a 5.5 percent interest rate and a 30-year term. The same FRM with a 15-year term and 5.5 percent interest rate costs $818 a month. If that loan has a 5 percent interest rate, its payment would drop to $791 per month. The half- point interest rate cut saves you an additional $4,860 over the life of the loan ($818 – $791 = $27 per month × 180 months). Not too shabby!

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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76 PART 2 Locating a Loan

Even though short-term loans have lower interest rates than their long-term cousins, qualifying for a short-term loan is more difficult due to the higher monthly loan payments. Lenders generally don’t want you spending much more than 30 to 35 percent of your gross monthly income on mortgage payments. Even if you can qualify for a short-term loan, it may not be in your best interests (pun intended) to irrevocably lock yourself into the higher monthly payments. Will higher loan payments deplete the cash reserves you ought to maintain for emer- gencies? Can you afford higher loan payments and still accomplish all the other financial goals we cover in Chapter 1? We devote Chapter 12 to a stimulating anal- ysis of the pros and cons of paying off a mortgage more rapidly than is required by the lender.

Introducing the Punitive Ps Certain warnings are drilled into people until they become as reflexive as the way your leg convulsively jerks when a doctor hits your knee with that little pointy rubber hammer. Don’t stuff yourself on sweets just before sitting down to a good, healthy meal. Don’t forget to floss and brush your teeth. Don’t drink and drive. Think before you post something on social media! Other injurious hazards are more insidious. The following sections offer words to the wise about two of them related to mortgages.

Prepayment penalties Some lenders punish borrowers severely for repaying all or part of their conven- tional loan’s remaining principal balance before its due date. As punishment, they impose a charge known as a prepayment penalty. Prepayment penalties aren’t permitted on FHA, VA, USDA, and FmHA mortgages (see the earlier section, “Gov- ernment or convention loans,” for more information on these kinds of mortgages).

How much money are we talking about? That depends. Maximum permissible prepayment penalties vary widely from state to state, from one lender to the next  — and even from one loan to the next on mortgages offered by the same lending institution. Some lenders will waive the prepayment penalty if you get a new loan from them when you refinance your mortgage or if you’re forced to pay off the loan because you sell your house.

Less sympathetic souls force you to pay upward of 3 percent on your unpaid loan balance, which equals $3,000 on every $100,000 you prepay. Even less humane lenders may insist on a penalty equal to six month’s interest on your outstanding loan balance. If, for example, your mortgage’s interest rate is 8 percent per annum, you’d have to pay $4,000 per $100,000 of principal you repay early.

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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CHAPTER 4 Fathoming the Fundamentals 77

Now that we have your attention, here’s how to determine whether the lender can impose a prepayment penalty:

» Ask: Now that you know what to ask, don’t be shy. Look your loan officer right in the eye and specifically inquire whether the loan you’re considering has a prepayment penalty. If it does, we strongly urge you to keep looking until you find another equally wonderful mortgage without a prepayment penalty. Some lenders will be willing to negotiate and reduce or even eliminate the prepayment penalty — all you have to do is ask!

» Read: Even if the lender says the loan doesn’t have a prepayment penalty, don’t take chances. Verify that the mortgage doesn’t have a prepayment penalty clause by carefully reading the federal truth-in-lending disclosure you’ll receive from the lender soon after submitting your loan application. Even good lenders frequently don’t know the nuances of every single loan they offer.

» Read again: Check, double-check, and check again. You must scrutinize one last document to be sure that your loan doesn’t have a prepayment penalty — the promissory note. Read it with care. Make sure a prepayment penalty clause doesn’t somehow manage to mysteriously creep into your mortgage before you sign the final loan documents.

Some mortgages have soft prepayment penalties, which may be waived at the lend- er’s discretion if you sell an owner-occupied one- to four-unit property after you’ve owned the property at least one year. Soft prepayment penalties are infi- nitely preferable to hard prepayment penalties, which are always enforced without exception.

You may be tempted to get a loan with a prepayment penalty, because you’re abso- lutely certain that there’s no way you’ll ever pay it off early. Trust us when we say that circumstances have a way of changing when you least expect them to. Utterly unforeseen life changes force folks to sell property whether they want to or not. Divorce happens. People find their employer has transferred them to another state or worse — fired them! Folks pass away prematurely. Life happens.

You may decide, in your infinite wisdom, to get a mortgage that has a prepayment penalty. Fine. If your mom couldn’t make you eat your vegetables, how can we make you follow our sage advice? At least make sure that you completely under- stand the terms and conditions of your mortgage contract’s prepayment penalty clause regarding the following:

» The amount you can prepay without penalty: For instance, some lenders permit you to prepay up to 20 percent of your original loan amount or current loan balance without penalty each calendar year. Others impose a penalty

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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78 PART 2 Locating a Loan

from the very first dollar of any prepayment. The more you can prepay without penalty, the better.

» When you can prepay without penalty: You may be allowed to prepay a specific amount of money or percentage of your original loan balance quarterly without penalty. Other lenders let you prepay funds without penalty only once a year. The faster you can prepay without penalty, the better.

» The duration of prepayment penalty: Mortgages on owner-occupied residential property often specify that the prepayment penalty expires three to five years after loan origination. Other home mortgages have prepayment penalties over the full term of the loan. The faster the prepayment penalty vanishes, the better.

» The severity of prepayment penalty: Some prepayment penalties diminish in severity as the mortgage matures. You could, for example, be penalized 5 percent on any funds prepaid within one year of loan origination, 4 percent in the second year, 3 percent for the third year, and so on. Other mortgages impose the same vicious penalty as long as the prepayment clause is in effect. Declining penalties are better.

Can you tell we’re not big fans of prepayment penalties?

Private mortgage insurance (PMI) Mortgage insurance protects lenders from losses they may incur due to the dreaded double whammy of default and foreclosure. Uncle Sam provides the mortgage insurance on government loans (FHA, VA, USDA, and FmHA). Private insurance companies provide private mortgage insurance (PMI) on all other loans.

Who pays for this insurance? You, of course — if you want a conventional loan and can’t make at least a 20 percent cash down payment on the property you’re buying or refinancing. (If that doesn’t apply to you, school’s out. You have our permission to skip the rest of this chapter.)

“Wait a second,” you say. “That seems incredibly inequitable, even for lenders. I pay for the insurance, but my lender gets the proceeds? What’s in it for me?” A  loan. It’s the only way to get conventional financing with a low cash down payment. That’s the deal. Take it or leave.

Twenty percent is a magic number to institutional lenders. They made a fascinat- ing empirical discovery after suffering through years of expensive, unpleasant experiences with belly-flopped loans. At least a 20 percent down payment is nec- essary to protect their investment (the mortgage) if you cut and run on your loan. We know you’re wonderful and would never default on your mortgage. Unfortu- nately, lenders don’t know you nearly as well as we do.

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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CHAPTER 4 Fathoming the Fundamentals 79

Look at things from their perspective. Suppose that you put only 10 percent cash down. A severe recession occurs, and property values drop 15 percent. You lose your job because your business fails, and you can’t make your monthly loan pay- ments. The lender is forced to take your house away from you in a foreclosure action and sell it to satisfy your debt. Farfetched? Hardly. Read your local paper. Stranger things happen every day. Witness the jump in foreclosures in most areas in the years just before and after the 2008 financial crisis and recession.

After the poor, misunderstood lender involuntarily takes back your now vacant home, fixes it up to make it marketable, and pays the real estate commission, property transfer tax, and other customary expenses associated with the sale of your house, there won’t be nearly enough money left to pay off your loan. Your lender will lose his corporate shirt. If that scenario happens too often, the lender goes belly up.

You may be able to deduct your PMI premiums on your federal tax return. For loans that commenced after 2006, borrowers with an adjusted gross income (AGI) of up to $100,000 may deduct their PMI premiums as they do mortgage interest on IRS Form 1040, Schedule A. The deduction is phased out in 10 percent incre- ments for each $1,000 in increased income above $100,000. Above $109,000, PMI isn’t tax deductible.

What you’ll end up spending for PMI depends on the following factors:

» Type of loan: For example, ARMs generally have higher PMI premiums than FRMs. (The previous sentence would have been utterly unintelligible gibberish before you read this chapter. See how well you’ve mastered the lingo? We’re so proud of you.) If you don’t understand this sentence, check out the section “Eyeing Classic Mortgage Jargon Duets,” earlier in this chapter.

» Loan amount: Your PMI premium is partially based on a percentage of the loan amount — the more you borrow, the more you’ll pay for PMI.

» Loan-to-value (LTV) ratio: LTV ratio is the loan amount divided by the appraised value of the property you’re buying or refinancing. The higher the LTV ratio, the greater the risk of default to the lender and, hence, the higher your PMI premium.

» Credit Score: Your PMI premium is also partially based on your credit score. » The insurance company issuing your PMI: This is the least important factor

because PMI charges usually vary relatively little from one insurance provider to the next. It can’t hurt, however, to instruct your lender to shop around for the best deal.

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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80 PART 2 Locating a Loan

Even though PMI charges don’t usually vary much from one insurer to the next, the type of loan they insure and geographical areas of coverage can vary wildly. The late 2000s mortgage market problems made lenders more cautious. Ditto PMI insurers. MGIC (Mortgage Guaranty Insurance Corporation, the largest private mortgage insurer), Radian Group, and Genworth Financial (two other large insur- ers) are now much more selective about loans they’ll insure. Insurers are skittish now about property in distressed markets where values are declining and loans with less than 5 percent cash down. Your lender may have to shop around to find a PMI provider who’ll issue your policy.

PMI origination fees and monthly premiums change frequently. Check with your lender for specifics on PMI expenses for your loan.

PMI isn’t a permanent condition. You can discontinue it by proving you have at least 20 percent equity in your property. Equity is the difference between your home’s current market value and what you owe on it. The magic 20 percent can come from a variety of sources: an increase in property values; paying down your loan; improving the property by, for example, modernizing the kitchen or adding a second bathroom; or any combination of these factors. To remove PMI, your lender will no doubt insist that you have the property appraised (at your expense, of course) to establish its current market value. Spending a few hundred dollars for an appraisal that’ll save you hundreds or more a year in PMI expenses is a wise investment. (We also thoughtfully include a section in Chapter 6 about how you may be able to use 80-10-10 financing to avoid paying PMI.)

Griswold, R. S., Tyson, E., & Tyson, E. (2017). Mortgage management for dummies. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-04 20:27:27.

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