As banks and mortgage companies look to subvert unpredictable interest rates and a sluggish economy, they`ve turned to a variety of financing and marketing strategies to draw new home buyers their way. It has wrought a virtual bonanza of options for buyers, but also means that deciding on a financing scheme can be as onerous as finding the house of your dreams.
While many will discover that the age-old, 30-year fixed-rate mortgage is still king of the banking hill, other financial shoppers will find that clinging to balloon mortgages and other creative financing options can carry them to the heights of home ownership. It`s all a matter of what you really want from your mortgage.
”When interest rates rise, then people look to creative financing to give them increased purchasing power,” said Brian Israel, marketing manager for Harris Trust and Savings` retail mortgage division. ”We try to warn people, however, that there`s no free lunch there. Sometimes it`s not best to get into the biggest possible house at the earliest possible time.
”After all, once the contract is signed, the Realtor and the banker disappear. The responsibility is on the homeowner to know what their creative option means and how it can affect the ownership of their home.”
The balloon bursts
Many eager home buyers during the late 1970s and early 1980s neglected such warnings, plunging head-first into a market flush with some of the same types of creative solutions that are again being offered today. To those buyers, the idea of foreclosure conjured distant visions of family farmers in the country. Little did they imagine that their tidy suburban cottage was an equally prime target.
”The people who signed contracts on balloon mortgages 10 years ago were optimistic that they would be out of the house within the right time frame to avoid the huge balloon payment,” said Israel. ”But we moved into a period of volatile (interest) rates and after three or five years they were faced with the prospect of paying off the entire loan or refinancing at enormously higher rates.
”Or, as happened a lot, they couldn`t afford either and lost their homes.”
Balloon mortgages, which are generally set at a fixed rate half a percentage point or more below 30-year mortgage rates, give owners the benefits of lower monthly payments over the short term. However, they are set for repayment much faster than standard 15-, 20- or 30-year fixed-rate mortgages-usually seven years-and that means owners must either sell the home to pay off the loan or refinance at new, sometimes higher rates.
Fair warning
While it`s an option fraught with danger for those who either neglect or don`t understand the terms of the agreement, the balloon has come back into vogue as more consumers become educated and bankers look to entice customers with a broader range of affordable financial products.
”The resurfacing of the balloon as a popular option is as much a marketing revolution as anything else,” Israel said. ”The risks are the same as they ever were, but people have heard the horror stories and now know what they are getting into. But as fixed rates creep up, people don`t want to worry about adjustable rate mortgages and so (the balloon) represents an option to get a little more home without the year-to-year risk.”
For many first-time buyers who expect to stay no longer than seven years in their first home, the balloon is an attractive financing option, many bankers and loan officers said. It offers lower monthly payments because of its lower interest rate, which, in turn, allows buyers to afford more house.
”It is an especially popular product with first-time buyers,” said Bob McDonald, president of Centurion Financial, a mortgage banking company in Deerfield. ”In fact, they see the balloon as a very conservative option instead of a risk. There is no adjustment in the interest rate for seven years and the expectation is that they will be out of that house by then anyway.
”A lot of the balloons that were marketed in the past were for one, three and five years. But we`ve found that those time frames are too short. With the seven-year option that is now basically standard, owners can get a leg up on moving to a better second home while not being forced out of the first too soon.
”There`s certainly more flexibility now than ever.”
Popular alternatives
While stock in balloon mortgages has gone up, up and away during the last year, other new financial products have received just as warm a welcome. Among them, the 7-23 (also known as the seven-year extendable mortgage) has proven to be one of the most popular.
First initiated by the Federal National Mortgage Association (Fannie Mae) five months ago, the 7-23 mortgage offers a fixed rate for seven years at one- quarter to three-eighths of a percentage point below comparable 30-year fixed-rate loans. At the end of that seven-year period, the interest may jump dramatically, based on the index being used to compute the then current market rate.
However, if the rate increase is 5 percent or less, based on the index, or if interest rates fall below the rate established in the original agreement, homeowners can lock in at that new rate for the remaining 23 years of the mortgage for a simple $250 fee-with no additional finance charges.
”You don`t have the (typical) balloon on the 7-23; it`s more of a circuit breaker,” said McDonald. ”For a nominal sum of money, you are able to effect a refinance without the problems incurred with a balloon.”
If the rate jumps, however, homeowners are faced with many of the same consequences they might encounter with a seven-year balloon: They are forced to either refinance at a much higher rate, sell and pay off the mortgage or, in the worst case, lose the home to foreclosure. Therein lies the risk of the 7-23.
”With this type of loan, there are three possible results after seven years,” says McDonald: ”Your interest rate can be the same, lower or higher. And in two of the three cases, the owner comes out ahead. That`s what has made this so popular.
When it pays
Most of the bankers we talked to said the best time to enter into a 7-23 is when you can save at least a quarter of a point over the rate being offered for the 30-year fixed equivalent. If the difference in the rates is less than that, the interest savings are negligible and can`t compete with the long-term security offered by the 30-year option, they said.
Another recently popular option, tied to the more traditional 15- and 30- year fixed rate mortgages, is a bi-weekly payment program. It offers faster-paced equity growth than the usual monthly payment program, but requires an extra month`s worth of mortgage payments over the course of each year-26 half-payments, versus 12 full payments. Still, the bonus is that by writing these extra checks each year, the buyer pays less interest over the life of the loan.
And as with all of the new and reborn non-traditional financing alternatives, the best weapon against being forced to sell, or worse, is to know exactly what is expected in the worst-case scenario. Being prepared means never being surprised.
”One of the things that I dislike is that some of the components of these new types of loans are camouflaged,” Israel said. ”Thorough prequalification and a searching of goals are the most important steps-that is, understanding things like indexes and what your options are.
”The benchmark that people should set as they explore the new financial products is: Do you have a sense that your banker is taking an interest in your future or are they just selling you a product?
”It`s not always cheapest to get the lowest monthly payment. Some people just look for the K mart option and they wind up paying for it later.”
