Mortgage Shopping Considerations
Fixed vs Adjustible
- This is the very most basic thing to understand before all the others.
- A fixed rate mortgage has the same monthly payment for the term of the mortgage no matter what. The payment is determined up front by applying the interest rate to the loan balance. The only reason the apr will be different than the interest rate is that the apr will take into account the up front fees. Typically fixed rate mortgages come in 30 year and 15 year varieties but other durations are sometimes available as well.
- An adjustible rate mortgage has an initial period where the rate can't change followed by a period where the rate can change with the changes typically tied to some kind of index. They are typically named with the upfront fixed period followed by the frequency the changes can occur. For example a '5/1' will have a fixed rate for 5 years followed by the potential of a rate change every 1 year after that. They usually have a duration of 30 years total (though there are some exceptions to that rule). The apr isn't nearly as useful for them because calculating it requires making an asumption about what interest rates will look like in the future. They will also typically have rate caps which will limit how much the interest rate can rise or fall both in any given adjustment period and also over the life of the loan.
Adjustible Mortgages and the Financial Crisis
- There is a bit of conventional wisdom out there that goes like this: "Responsible people always go with 30 year fixed rate mortgages. An adjustible rate mortgage is like a ticking time bomb waiting to bankrupt you and everyone else in a repeat of the 2009 financial crisis."
- There is some truth to the claim that adjustible mortgages helped further the financial crisis. The way it typically looked was that peoples' payments were adjusting up at the same time as their home value had gone down so much that they couldn't refinance into some new loan. So while they had planned to never pay the higher payments (via refinance), they found themselves stuck with payments they couldn't afford and not cushion of savings to help
- There are two things wrong here: 1. If you can't reasonably afford the higher payments on the adjustible mortgage either via excess monthly income or savings, then getting one is an irresponsible thing to do (even if you can get approved) 2. When home values are plummeting to some degree whatever mortgage you're in will look bad...people underwater on 30 year loans also couldn't refinance and plenty of them defaulted too
Advanced Fixed vs Adjustible
- It will always be the case that the interest rate for an adjustible mortgage will be lower than that of a fixed mortgage of the same size and duration. The reason is that a 30 year mortage is riskier for the lender because it might get stuck with 30 years of low rates if rates go up whereas the adjustible mortage is riskier for the borrower because if rates go up the cost of the mortgage will go up
- A good way to look at this discrepancy is to pretend that you are buying an insurance policy. In other words your borrowed money is subject to interest rate risk (just like your house is subject to fire risk and your car is subjec to accident risk). As with other risks you might be willing to spend of some money to mitigate that risk.
- The thing to do with insurance policies (from a financial standpoint) is typically to decide whether you can afford to have the bad thing happen to you. If you can afford it then forgoing the insurance is ok (because the insurance company will always know the risk of it better than you and will make money over all their customers). If you can't afford for the bad thing to happen then you need to buy the insurance. This is a nasty paradox because usually people looking at adjustible rate mortgages are looking at them exactly because they can't afford a fixed rate mortgage. Those people are being irresponsible and should probably stick to houses that they can afford based on the 30 year mortage cost.
- Suppose for a second though that you have enough income for all the mortgage types (including an up-adjusted rate on an adjustible mortgage). If you get a $500K loan at 4% (on a 30 year fixed) your total interest for the first 5 years will be $95,459. The same scenario with a 5/1 at 2.75% would cost $64,949. So you would have paid $30,510 for the privilege of not worrying about whether your payment would go up
- Also it's worth noting that average person lives in a house for 7 years before moving. So if you're an average person, there's a pretty good chance you wasted that $30K given that even if your payment went up you were just going be moving in 2 years.
Buying vs Refinancing
- When you're buying a house you have a ticking clock. That's the key. You've probably committed to closing the transaction within 30 days or so. The mortgage underwriters of the world won't allow you to have two loans open for underwriting at two different places at the same time. So whoever you do business with had better be able to get you closed within your closing window.
- So if you're buying a house. First do business with people who are responsive and call you back. Try to put some pressure on them to finish something on time. For example before you choose your house, tell them you need a preapproval letter in an hour to show someone. See if they can do it. If there's any question about how responsive they are, get someone else. If they don't have the best rate, don't worry too much before you can just refinance it right away. Be sure not to pay any fees (go with a higher interest rate) and be completely sure there is no pre-payment penalty.
- If you're refinancing your loan, remember that you have all the time in the world. Shop thoroughly. Find the best rate with the lowest fees. If people you're doing business with are annoying or unresponsive, just tell them to get lost and shop a bit more.
Non Standard Types of Adjustible Mortgages (Mostly the 5/5)
- Nearly everyone has a 5/1 for sale. Most folks have a 7/1. Many have 3/1s. 10/1s and 1/1s are out there. We think of these as standard because in the worst case interest rate scenario they're going to go bad on you pretty quickly when they can adjust every year.
- Recently some credit unions have been pushing adjustible loans that adjust less frequently. The most prominent is the 5/5 but there are also 15/15s and 7/23s and probably some others out there.
- These are nice because while they can still adjust upwards, it takes them much longer to get to a rate which is really going to hurt you.
- Specifically for the 5/5, watch two things: the Breakeven Point and the Initial Discount.
- The Breakeven Point with a 30 year loan for the worst case scenario is the first thing to look at. Your thinking will probably look something like: "In the first five years I save tens of thousands of dollars (over the thirty year), the second five years I'm close to even or maybe it costs me a bit, in the third five years I give back my tens of thousands of dollars, and after that it's just as bad as a 5/1". The breakeven point (the point at which the total interest paid would be the same for the two kinds of loans) might be year 13 or so. Remember though that that the average person moves after 7 years. So if your breakeven is in year 13, you're not taking such a huge risk. The 5/1 breakeven might be closer to year 7 or 8. Also you're only looking at the worst interest rate scenario. If rates don't do sky high you also win
- The Initial Discount is the gimmick by which credit unions get the rate on the 5/5 to match or be very close to the rate on the 5/1. It's a bit subtle and this example represents a typical case but not all cases so read the fine print. The way it works is the 5/1 is at 2.75% and if rates don't change at all in year 6 it will still be at 2.75% (and so on). The 5/5 is ostensibly also at 2.75% (in the advertisements), but if you read the fine print you learn it's actually at 3.25% and that you get an initial discount of .5% so it looks like it's same price. The key is that in year 6 if rates are unchanged you'll still adjust up (to 3.25%). This gimmick probably doesn't outweigh the other benefits of the loan, but if you find someone who isn't doing it that way consider doing business with them instead
Credit Union Membership Requirements
- The laws governing credit unions say that a given institution has to only do business with some set of interest groups. This a relic of annoying banking industry lobbyists, but the long and short of it is that they aren't allowed to say "everyone is welcome come in and do business" and have to instead say something like "Welcome to Thumbs Federal Credit Union serving all the needs of people with thumbs everywhere...if you don't have any thumbs, then get the heck out"
- On this site we've decided to divide them into National Credit Unions and Reqional Credit Unions
- National Credit Unions are those that effectively are open to everyone. They will typically have on their list of interest groups some non-profit that is completely trivial for you to join. A popular one is the "Financial Fitness Association". Joining is free or maybe takes a donation of five or ten dollars and then you're in.
- Regional Credit Unions actually take their affilitaions seriously and will say "open only to residents of our city or county" or "employees of our company" or something like that. Some of these will probably have still have loopholes where you can get in, but you have to track them down and talk to them. Some of them might actually be impossible to join if you aren't in their interest group
- Separate from the requirements to join, some of the smaller ones don't have mortgage licenses in all states (we've called these out as Regional Credit unions in our database), so you could get excluded that way too
Credit Unions vs Banks vs Mortgage Brokers (and Zillow)
- It's helpful to understand what happens to your mortgage after it's issued. Most mortgages get agregated into mortgage backed securites which are then sold to investors. The companies who do this aggregation (in combination with government agencies like Fannie Mae and Freddie Mac) effectively set rules for most mortgages because in order to be in one of their pools, a given mortgage must meet some minimum set of criteria regarding things like Debt-To-Income ratio or credit score or size
- The impact of this is that most people out there are actually selling you the same mortgage. The only difference is how much of the commision they're keeping for themselves and how large their origination fees are. So while a site like Zillow is really useful for finding the best deal amongst the brokers it has signed up, you have to realize that all the brokers are essentially selling the same thing, so you can't expect that big of variance
- The main reason we focus on credit unions here is that many of the bigger ones are actually make loans on their own. They use customer assets to fund them and they don't sell them to be agregrated into mortgage backed securities. This means they can set their own rules. They might actually have a substantially better rate and they might have wildly different requirements for things like DTI or credit score
- So if you're really shopping you have to look at all the loans from many different credit unions or order to figure out if a given bank or broker really has a good deal or not.
How To Choose Which People to do Business With
- At the first sign of a lack of integrity, Run
- The first time your aren't called back in a timely manner, Run
- If you get those two things right you'll probably do ok