NEW YORK (MainStreet) — All mortgages are not created equal, so reading the fine print before you agree to a long-term commitment is crucial.
Mortgage lenders now have become “very risk averse” since the financial crisis and are doing everything “pretty much by the book,” said Greg McBride, the chief financial analyst for Bankrate.com, a New York-based personal finance content company. “The rules on the ability of a homeowner to be able to repay are stricter than ten years ago,” he said. “Niche products have gone back to niche borrowers.”
While lenders are offering fewer risky products such as interest only mortgages to run-of-the-mill consumers, there are still hidden fees and other deceptive practices to be wary of, said Jason van den Brand, CEO of Lenda, the San Francisco-based online mortgage company.
In 2013, the Consumer Finance Protection Bureau issued guidelines to protect consumers from the types of mortgages that contributed to the financial crash. In the past, lenders were approving mortgages that allowed consumers to borrow large sums of money without any documentation such as pay stubs and offered extremely low interest rates to lure people into buying homes.
“It also doesn't mean that the potential to get bad mortgage advice has been eliminated,” van den Brand said. “There aren't bad mortgage products, just bad advice and decisions.”
Here are the top seven things consumers should consider carefully.
Avoid paying discount points to lower the interest rate. In some instances, it’s simply not worth it to pay for discount points. Lenders give consumers an option to pay for discount points to lower their interest rate. Keep in mind that when you pay for the points, you either pay for them in cash or finance it in your mortgage, which increases the total loan amount.
If the house you are buying is your second home and you plan on living there for a longer period of time such as five years, then paying for the points might be worth it since you will “capture more interest savings,” he said. First-time home buyers who are unsure how long they want to live in the house may not recoup the cost of the points.
Some of the origination fees that lenders want you to pay are not necessary and can be negotiated. Examine origination fees which include things like processing, underwriting or application fees, which can add up quickly. These fees can be 1% or higher of the loan amount. On a $300,000 mortgage that is $3,000 and these fees are not necessary. “Make sure to shop around and find a lender that doesn't nickel and dime you with these kinds of fees,” he said.
Refrain from believing that "no cost" or "no fee" loans are free. These fees are typically connected to the interest rate. If the borrower pays fees to get a certain interest rate, they get to enjoy the lower rate over time. However, if the lender is paying for the fees, the interest rate the potential homeowner receives will be higher.
“No cost or no fee means that the lender is paying the fees associated with getting a certain interest rate,” van den Brand said. “This means that rate may be higher than if the borrower was paying for the settlement costs.”
Avoid choosing an adjustable rate mortgage or ARM when it makes more sense to select a fixed rate mortgage. Those low initial rates offered by ARMs are enticing, but they only make sense for homeowners who know that in less than ten years, they plan to upgrade to a large home, move to another neighborhood or relocate for work. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, which increases your monthly mortgage payment said David Reiss, a law professor at Brooklyn Law School.
While many homeowners gravitate toward a 30-year mortgage, younger owners “should seriously consider getting an ARM if they think that they might move sooner rather than later,” he said. If you are single and buying a one-bedroom condo, it is likely you could sell that condo and buy a house in the future. “That person might not want to pay for the long-term safety of a 30-year fixed rate mortgage and instead save money with a 7/1 ARM,” Reiss said.
Pay attention on how expensive private mortgage insurance or PMI can be. If you don’t have a large enough down payment of 20%, lenders tack on the insurance as a safety net for them so they lower the risk of default. PMI can cost as much as 1% of the loan value on an annual basis. On a $300,000 loan that's $1,500 to $3,000 extra dollars coming out of your pocket every year.
“This extra expense could end up being the difference between a mortgage payment fitting into your financial plan and making yourself strapped for cash,” van den Brand said. “If you build up equity in the home you can refinance the mortgage down the road to get rid of PMI except for FHA loans.”
Obtaining mortgages you don’t have the funds to pay for each month. Both interest-only mortgages and ones with maturities exceeding 30 years means you bought a house for which you can barely afford to make the monthly payments, said Peter Nigro, a finance professor at the Bryant University School of Business in Smithfield, R.I. These types of mortgages are not as prevalent as they were in the years ago preceding the financial crisis, but avoid loans where you can’t pay down the principal in a timely manner.
“Homeowners should be building equity,” he said. “If you need to take out an interest-only mortgage to afford a payment -- you bought a house you can't afford. If you have to amortize the loan balance over 40 years, you probably should not be buying the house.”
Avoid spending all the money you received in a home equity line of credit (HELOCs). With HELOCs, the first ten years, which are known as the draw period, the borrower has access to a line of credit where they can borrow and repay as needed. Only a minimum payment of interest-only is required then, but at the end of the ten-year period, the line of credit is no longer accessible and the outstanding balance then converts to the repayment term, where both principal and interest payments are made, typically over a 20-year period. Your monthly payments could easily double. A $30,000 balance at a current rate of 3.25%, the current prime rate, carries a minimum payment of $81.25. Once that same $30,000 balance recasts to a 20-year repayment schedule, the monthly payment more than doubles to $170.16.
“Some homeowners used the proceeds to purchase other items,” McBride said. “If they have made little progress in paying it down, then they are in for a rude awakening when the line of credit converts into an installment loan.”
--Written by Ellen Chang for MainStreet