Want a More Flexible Mortgage? Think Small

Gary Lewis, president and CEO of the Bank of Internet USA, had an unusual request from a potential borrower: a $400,000 loan that would completely pay off his home in five years.

No problem.

"That doesn't fit into any cookie cutter loan that's out there. It was like a five-year, $400,000 car loan," explained Lewis. "His monthly payment was $20,000, but it was a great loan that was lower than the rate on a 30-year fixed mortgage. This guy couldn't get a loan anywhere."

Bank of Internet USA was able to make the loan because it is a portfolio lender, which means it keeps loans it makes instead of reselling them on the secondary market.

Usually, banks bundle loans together in the form of securities, reselling them to raise capital to make more loans and help hedge risks associated with default. But in order to securitize loans and sell them to buyers like Fannie Mae ( FNM) and Freddie Mac ( FRM), the loans involved must be standardized. As a result, the wide majority of loans sold on the secondary market are plain-vanilla 30-year fixed-rate and one-year adjustable-rate mortgages. Since most portfolio lenders resell every loan they make, few were flexible enough to create that five-year, $400,000 car loan.

Sounds great. What's the rub? Homeowners must be willing to pin their mortgage to adjustible rates, since that's how these lenders make money. While these rates are competitive, they may be a bit higher than fixed rates -- you pay for flexibility. But borrowers with special requests, bigger loans and/or shorter time frames to stay in their homes should consider portfolio lenders.

Part Lender, Part Contortionist

"The biggest advantage for any portfolio lender is that we do not have to follow the Fannie Mae and Freddie Mac guidelines," Lewis says. "We can make exceptions that other lenders can't."

Every aspect of the loan process is negotiable, from the private mortgage insurance required on a small down payment, to the points and fees paid in closing. Borrowers can dodge refinancing costs, create personalized loans and avoid mind-numbing paperwork.

Portfolio lenders are FDIC insured, there's no risk of losing your money if the bank goes belly up. And because they have their own lending standards, qualifying for a loan may be less stringent.

"Our processing is a lot different because we don't need 50 pieces of paper to get you into a loan. We don't use minimum credit scores. And there's no transfer of escrow, which means people aren't confused about making payments to the right party," says Tom Laird, senior vice president for Hudson City Bancorp.

Thornburg Mortgage ( TMA), a publicly traded REIT lender, and other portfolio lenders have used this flexibility to provide loan-modification programs, which allow customers to switch loans without having to perform all the paperwork associated with refinancing. Under Thornburg's program, borrowers can pay a flat fee of $1,000 once a year to switch into a new product with just a few signatures.

"There's no need to refinance. There are no application fees. And no need for a new appraisal. We just switch your rate," says Larry Goldstone, CEO of Thornburg Mortgage.

The advantages can add up, especially for those with large loans. Let's say you have 26 years and $700,000 remaining on one-year ARM at 4%. Now that you're certain you love the home, you'd like to lock in a low rate and want to switch into a 5-1 ARM, which has a fixed rate of 5.125% for the first five years and varies after that.

Under Thornburg's loan-modification program, all you have to do is fill out a simple form, pay $1,000 and you've got a new loan with 26 years left on it. But in a standard refinancing, not only will you have to fill out cumbersome forms, you'll pay more money to do it and restart with a new 30-year mortgage.

Although you may be able to find a no-cost refinancing, you'll still have to pay to get a new title insurance policy. Every lender is different, but standard refinancing costs are usually 2% of the total loan -- in this case, $14,000.

"A loan modification is like a no-cost refinancing, only you don't re-extend the terms of your loan," says Keith Gumbinger, vice president at HSH Associates. "A $1,000 flat fee might not be so bad if you've got a huge loan."

The Fixed-Rate Dilemma

Because portfolio lenders assume all the risk on their loans, they need to guarantee that they're always profitable. As a result, the vast majority of portfolio loans are ARMs, which have a constant profit margin pegged to a variable rate. With the rates on 30-year fixed mortgages down below 6.5%, you're choosing flexibility over an unprecedented rate opportunity.

"If you have a short time horizon to stay in your home, an ARM might work out," says Gumbinger. "But you're bypassing the opportunity to get the lowest rates in 35 years."

And because portfolio lenders rely heavily on ARMs, there's no telling whether that loan modification will give you that much of an advantage down the road. After all, once ARM rates start rising, they'll jump across the board, leaving borrowers stuck in an undesirable loan if they plan to stay in that home for a long period of time.

Portfolio lenders can be tough to find, too. "They're a real small bunch because we're in a fixed-rate environment and most of them make ARMs," says Gumbinger. "Going back years ago, when there were lots of midsized thrifts, these banks did most of the portfolio lending. Now they're gone."

Who It's Best For

Generally speaking, standard lenders are fine for most people who're in the market for standard loans. But people who have trouble getting loans or have extremely large loan amounts may want to track down a portfolio lender to negotiate better loan terms.

"Someone who lived off a large trust fund came in and wanted a loan, but didn't have the income needed to fund it," said Lewis. "Because the income-to-debt ratio wasn't there, no one else could make the loan, despite the fact he had assets to back it up. It fell outside the market, but not ours."

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