Like two weights on a seesaw, every time mortgage interest rates ratchet up a notch, home buyers’ spirits seem to sink a bit lower.
This phenomenon makes sense when you consider that even a quarter-point rise in interest rates can easily mean $50 or more in monthly mortgage payments. “Interest rates are one of the scariest things you have to deal with when buying a home,” observes Allyn Wilcox Rawling, an agent at Mitchell Bros., a division of Koenig & Strey in Evanston.
Buyers get spooked by the specter of rising rates, fearing that the home they want may have become unaffordable. But that anxiety can be unfounded because lenders, real estate agents and others connected with the home-buying process have devised ways for buyers to cope with higher rates.
Adjustable-rate mortgages, mortgage locks and negotiating with home sellers to have them “buy down” rates or make other concessions can help buyers make a limbo-like slip under today’s higher mortgage interest rates.
Courting buyers
Higher interest rates have cut the volume of refinancings and, as a result, “mortgage lenders are highly competitive and looking for business, ” says Dru Bergman, executive director of the DuPage Homeownership Center. “In a sense, it is a buyer’s market. You really have to shop around because you might find a better interest rate or a lending program that suits you.”
Meg Priestley saw the competition between lenders when she put in a contract to buy an Evanston condominium late last year. “I don’t know how they knew I had put in a bid,” says Priestley, “but I had lenders calling me to explain their programs.”
And indeed, one of the callers offered a better loan program than Priestley had been able to find when she had been loan shopping before putting in her bid. “In addition to a slightly better rate than I found, this lender offered a 75-day lock on the rate at no charge. Most locks are just 60 days, and I wanted the extra time.”
In a rising rate environment, having a lender offer a “lock-in” is especially important. As the name implies, a lock-in means that the rate in effect on the day you apply for the loan will be the rate you receive when you close, or the funds are disbursed. As Priestley found, lenders are fiddling with lock-in arrangements to attract borrowers.
Chris Mallinckrodt, principal of First Security Mortgage in Oak Brook, a mortgage brokerage, observes: “There’s been a growth in `lock and shop’ programs. You can get pre-approved for a loan and lock in a rate, then get 30 days to look for a house, and 45 days after that to close.”
Home buyers building new homes often need an extended lock program, says Mallinckrodt, whereby rates are guaranteed for up to nine months. “Builders often now want buyers to take out an extended lock so that it is certain the buyer can qualify for the loan by the time the house is ready,” she explains.
Grayslake resident Peter Bauer is glad he took out a six-month extended lock last July. When he closed on his newly built home late last November, the rate on his mortgage was slightly less than the going rate. To get the extended lock, Bauer paid half a point, or one half of 1 percent, of the mortgage loan amount he wanted upfront, but was credited that amount when he closed. “These extended locks are a good idea,” says Bauer, “but you should read all of the fine print and really shop around. Some of the programs don’t credit you back the upfront fee at closing. You should also be aware that you can forfeit the fee if you do not go ahead and close within the lock period.”
Making adjustments
While lock-ins are a way for borrowers to enjoy today’s rates before they move higher, mortgage lenders have basically been keeping the loan market perking by offering an array of adjustable rate mortgages, or ARMs. Unlike a fixed-rate loan, where the interest rate never fluctuates and payments are the same from month to month, in an ARM the rate changes according to terms agreed to by the borrower and the lender.
Because of the comfort of the predictable payments, home buyers traditionally favor fixed-rate loans. However, ARMs carry a lower interest rate, at least initially, and borrowers favor that route when rates rise. “We did about 70 percent of our loan volume in ARMs during 1994,” says Craig Hesselberg, loan officer with American Home Finance in Palatine.
Blending the best of the fixed-rate and adjustable products, lenders now offer ARMs that don’t adjust until after the third year, the fifth, seventh or even the 10th year. The traditional ARM adjusts once every year, according to a specified index, such as rates on one-year U.S. Treasury bills. The one-year ARM usually carries a lower initial interest rate than ARMs with fixed rates for the first several years.
For instance, in mid-February one-year adjustables carried interest rates of about 7.25 percent with zero points, and the three-year ARM was about 8.25 percent, also with zero points. A conventional 30-year fixed mortgage was about 9.25 percent with zero points. (Paying points upfront also helps lower the interest rate, more on that later.)
Despite the higher starting rates, says Hesselberg, many borrowers opt for an ARM where the rate is fixed for the first few years, because they want the certainty that they can afford their monthly mortgage payments, at least in the short run.
Most adjustables can rise as much as two percentage points per year, warns Bergman of the DuPage Homeownership Center. “You should really understand how the rate on these loans can go either up or down, and be aware of the consumer safeguards,” she warns. “Ask you lender to run some worst-case scenarios.”
And though the initial rate may be temptingly low on the one-year adjustable loan, borrowers usually must qualify for the loan at 2 percentage points above that rate, or the steepest possible rise at the first adjustment. (Though your initial rate may be 6.75 percent, for instance, you would have to be able to afford 8.75 percent to qualify for the loan.)
That’s so borrowers won’t be unable to afford payments if the rate goes up, Hesselberg explains. “The only time a lender will qualify you at the first-year rate is if you are making a down payment which is 25 percent or more of the purchase price of the property you’re buying,” he adds.
Qualifying rules
In fact, the way lenders decide whether or not to grant a loan to a borrower underscores why interest rate increases have such an impact on home buyers.
The standard rule of thumb is that no more than 28 percent of your gross, or before tax, monthly income can go to your mortgage payment, which also usually includes taxes and homeowner insurance, and that no more than 36 percent of your gross income can be taken up with the sum of your regular debt payments-your mortgage, car payment, alimony, etc. On a $100,000 mortgage at 8 percent, the payments are $734 monthly, excluding taxes and insurance. If the rate rises just 1 point, to 9 percent, payments jump to $805. That means you’d have to be making almost $3,000 a month to afford the loan at 9 percent, but just about $2,650 to afford the same loan at 8 percent.
“Anytime rates go up, some people are going to be priced out of the market,” notes David Berson, chief economist for the Federal National Mortgage Association, or Fannie Mae.
To increase chances of being qualified, borrowers should pay off as many credit cards as possible, advises Hesselberg. And it isn’t a good time to buy a car before you apply for a mortgage, because a car payment will limit the amount of mortgage loan you can qualify for.
In fact, notes Patricia Cunningham, consumer affairs manager of the state Office of the Commissioner of Savings and Residential Finance, you should even close out credit cards that you have but don’t use. “Lenders will look at all of your credit cards, and even though there may be a zero balance, they see a potential for a lot of monthly debt.”
Sales job
Buyers struggling to afford the home they want at today’s rates needn’t just look at mortgage financing options. In a rising rate environment, homes typically sell more slowly, and sellers may be more motivated to help buyers find a way to purchase.
“You can negotiate anything when you’re buying a home,” notes Don Giarrante, manager of the Koenig & Strey realty office in Libertyville. Just as you can ask a seller to leave a chandelier or kitchen curtains, buyers stretching to afford a loan can ask sellers to make concessions such as paying the first year of real estate taxes, or pre-paying condo association dues for a year, notes Giarrante.
Another technique is to have the seller “buy down” the loan. This means that you as the buyer will offer to pay more for the home than you otherwise would, but by paying more, your monthly mortgage bill is initially less in a buydown situation.
Reed Brunzell, loan officer with Windsor Mortgage, Northbrook, explains: “A `two-one buydown’ is the most common program. That means that the seller chips in points in order to allow the buyer to have a lower interest rate the first year of the loan and a somewhat lower interest rate the second.
“For example,” continues Brunzell, “on a $200,000 loan at 9.25 percent, you would pay about $18,500 per year in interest. But if the seller chips in 3 points, or $6,000, at closing, the lender can reduce the interest rate by 2 percentage points the first year, saving the borrower $4,000 in interest, or about $333 a month. The second year, the rate is reduced by 1 (percentage point), and the buyer saves $2,000 in annual interest. The buyer may not have been able to afford the house at a price of $245,000 with a 9.25 percent loan, but he can afford the house by paying more-$251,000-and having the seller pay points for a buydown.”
Lenders, however, will qualify borrowers at the second-year rate in a buydown situation, says Brunzell.
Kevin Hunt of Century 21-Triad in Chicago, adds: “Once sellers understand that they have the points that they are giving the buyer built into the price, they are usually amenable to a buydown program.”
