National Public Accountant, The (Nov 27, 05:32 AM) Editor's Note: Most people generally agree that real estate is one of the best ways to develop personal wealth. However, many first- time and potential homebuyers lack information about the best way to finance a new home and the types of financing available. This article provides some simple explanations and comparisons to help NSA members answer queries from their clients.
Before going into an explanation of the different types of mortgages, practitioners should make sure that their clients understand the meaning of certain terms. The following real-estate terms should be part of any home buyer's glossary:
Loan Terminology
Adjustable Rate Mortgage (ARM). An ARM is a type of loan in which an initial interest rate is given for a fixed period of years (3, 5, 7 or 10). After that, the interest rates may vary (i.e., will be adjusted), based on a specific index, such as 30-year Treasury bills or Cost of Funds Index. Usually, an ARM can be adjusted no more than two percent in one year with a maximum of six percent over the term of the loan. Thus, if the initial rate for the ARM was 4 percent and if interest rates rise, the ARM can go as high as 10 percent.
When this article was written, the interest rate for a 3-year ARM was 37 7/8 percent, a 5-year ARM was 4 3/4 percent, and a 7-year ARM was 4 7/8 percent. Homebuyers usually are required to give a 20 percent down payment, but lenders will agree to loans with down payments as low as 3 percent. In these cases, private mortgage insurance (PMI) is required to protect the investment. This, of course, increases the homebuyer's monthly payment.
Conventional Mortgage. This is the most popular type of home financing. These loans are not insured by the VA and FHA (explained below) and can be for 10, 15, 20, 25 or 30 years. The most common loan period is 30 years.
A conforming conventional mortgage is one that goes up to $322,700. Rates for such a loan are around 5 1/2 percent at present. A non-conforming or jumbo conventional mortgage is one that exceeds $322,700. Rates for such loans are currently in the vicinity of 5 5/8 percent. The down payment requirements are similar to ARMs, as described above.
FHA Insured Mortgage. These loans, available through banks and other lenders, are insured-that is, backed by the Federal Housing Administration. These loans can be as high as around $300,000 and they appeal to individuals who may have trouble qualifying for a conforming mortgage. These loans have low down payment requirements.
VA Insured Mortgage. VA loans are similar to FHA loans except that they are available to veterans. Like FHA loans, the maximum is around $300,000. They also have low down payments. Interest rates are competitive with conventional mortgage rates.
Guidance for the Potential Owner
Practitioners can help dispel myths or preconceived notions about house hunting, particularly:
* Potential homeowners think that they can't afford to own because the payments are too high. The truth is that if one can afford to rent, he/she can afford to buy.
* Clients often think that they cannot get a mortgage due to credit problems or because they do not have enough cash for a down payment. The truth is that there are programs for everyone.
* Individuals usually think of their homes as places to live. The right approach would be to look at a home as an investment.
* Individuals think that if they buy directly from the owner, they will get the house cheaper. Sellers usually don't pass the commission on to the buyer by selling at a lower price. The main reason that they are selling without an agent is to make a greater profit for themselves.
* Buyers often assume that a house purchased in a good neighborhood will appreciate in value faster than a house purchased in a lower class neighborhood. The better plan is to evaluate neighborhoods by their relative house prices and the benefits of living there.
Potential homeowners are looking for basically one thing, namely, the best loan at the cheapest cost. The problem is to define "best" because "best" is a relative term. What is best depends on a number of factors. One has to consider circumstances in addition to goals and objectives.
In our opinion, the following three key issues actually determine the type of mortgage loan potential homeowners will obtain:
1) If one is interested in saving money on a mortgage (that is, paying the least amount of interest over time), the homebuyer may opt for a type of mortgage other than an ARM or conventional mortgage with a fixed monthly payment.
2) The size of the down payment is another consideration. Buyers may have to settle for a particular type of mortgage because they can only afford a small down payment.
Table 1
Table 2
3) A buyer's crcditworthiness is another consideration. If buyers have credit problems, they may not be able to obtain a loan with a very favorable rate.
Circumstances determine the type of loan that a potential homebuyer should seek. Cash flow is the key. Many buyers merely worry about qualifying for a loan and will do whatever it takes to qualify for a particular program. The cost of interest over the long- term is of little concern to them. Rather there is a "live for today- worry about the short-term" attitude. Very few homebuyers do the long-term arithmetic.
Comparison of Mortgages
Following are several examples of the ramifications of the long- term math, comparing a 51/1 percent 30-year conventional mortgage to 3% percent 3-year; 4% percent 5-year, and 4% percent 7-year adjustable rate mortgages.
As Table 1 illustrates, a homeowner choosing an ARM would have a positive cash flow (savings of $2,950.56) in the first three years. This savings is fine, but it is not that substantial. Furthermore, assuming that the fixed rate averaged 51/4 percent over the next 27 years, which is only 1/4 percent more than the 30-year conventional rate of 5% percent, the total savings in interest would only be $478.54. In the above example, the differential between the 3-year ARM and 30-year conventional mortgage was 1 3/8 percent and the conventional rate for the next 27 years was only 1/4 percent higher on average than the 51/4 percent 30-year conventional rate. Thus for all intents and purposes, this was a break-even situation.
However, the numbers change dramatically if, for example, the conventional rate for the next 27 years was 1/2 percent higher on average than the initial conventional rate, Table 2 provides an illustration of this difference.
As one can see, the interest paid over the long-term with a 3- year ARM is $4,206.33 more than if the homeowner started with a 5% percent 30-year conventional mortgage. This is assuming only a % percent change in the conventional interest rate on average over the 27-year period.
Table 3 shows that, again, for the 3-year ARM, there would be a savings in interest charges during the first 5 years. However, the amount of $2,484.68 is hardly substantial. Over the life of the loan, the 30-year conventional loan would cost $ 1,070.19 less. This assumes only a % percent differential between the 5% percent 30- year conventional mortgage rate and the rate at the time of conversion from the ARM to a conventional mortgage.
The findings in the scenario in Table 4 are remarkably different. Over the life of the mortgage, the 30-year conventional mortgage is $5,192.19 cheaper.
Let's compare a 7-year ARM to a 30-year conventional mortgage.
Again, Table 5 shows that during the period of the ARM there is an interest savings of $2,598.28, but over the life of the loan, the ARM costs $436.64 more than the 5 1/4 percent 30-year conventional mortgage.
Table 6 is consistent with the other examples. During the first 7 years, the ARM yields an interest savings of $2,598.28, but over the life of the loan, the ARM costs $3,995.16 more.
Studying these comparisons, we can conclude that homebuyers do not elect to finance their homes via an ARM because this is cheaper than a conventional mortgage. The ARM enables the buyer to achieve a lower initial monthly payment in order to qualify for the size loan that the buyer is requesting from the bank or mortgage lender. Mortgage lenders look at the ability of the borrower to pay-i.e., meet the monthly payment-based on the homebuyer's cash inflow. Mortgage lenders have several industry ratios that they employ. To make the ratios work, homebuyers try to obtain the lowest monthly outlay.
Of course, the above comparisons would be greater in absolute terms if one obtained a $200,000 or $300,000 loan. However, even with the larger loans, the differences aren't that dramatic over the life of the loan. Ignoring cash flow considerations for the moment, the deciding factor is a forecast on the way interest rates will fluctuate in the future. It certainly appears better to lock into a lower rate for the long term, particularly in the present period where interest rates are the lowest that they have been in decades.
Bi-Weekly vs Monthly Payments
If one really wants to achieve interest savings over the life of the loan, the authors suggest entering into a bi-weekly payment plan. Assuming cash flow is not a consideration, we recommend that practitioners advise their clients to arrange with the lender to pay their loan back on a bi-weekly basis. An automatic deduction, for example, can be arranged with the lender or an agent for the lender. Every two weeks a payment is made. Table 7 illustrates the inte\rest savings for a typical homebuyer.
The advantage of this program is significant. Specifically, the homebuyer will accelerate paying off the loan. In effect, a 30-year mortgage would be paid off in 25 years, achieving a savings of $18,898.87 in interest.
Table 3
Table 4
Table 5
Table 6
Table 7
Conclusion
Many homebuyers have little concern about the cost of the loan over time, namely, the amount of interest that they will ultimately pay. They feel "if conditions change, we will re-finance." Practitioners have an obligation to educate their clients so that they will make the decision that is right for them in the long run.
Clients often ask, "What type of mortgage loan should we obtain?" Your answer to that question should be "It depends on your goals and objectives."
Frank Grippo, MBA, CPA, CPE, is an Associate Professor of Accounting at William Paterson University, Wayne, NJ. Joel Siegel, PhD, CPA, is a Professor of Accounting at Queens College, NY.
Copyright National Society of Public Accountants Nov 2003
