Understanding Home Loans

photo: Jeremy Brooks

Let’s say you’re ready to take advantage of low (and possibly rising) home loan rates and buy a little chunk of something to call your own.

Just three years ago, walking into the bank was like walking into the video store. You could go with Duplicity (a pay-option adjustable-rate mortgage) or Where the Wild Things Are(subprime). Home prices were going Up, and no one had any idea that we’d all end up in The Hurt Locker, and yes, I will now stop. Sorry.

Not any more. “In terms of product available, it’s very old-school at this point,” says Frank Ruzicka, a mortgage banker at Cornerstone Mortgage, Inc., in St. Louis. “Gone are the crazy things. You don’t see the pay-option ARMs anymore. You’re not doing subprime lending anymore.”

So what’s left? Here’s what you’re likely to find today.

Conventional fixed-rate mortgages

“The one product that is constant and still available everywhere is the traditional 30-year fixed-rate mortgage,” says Keith Gumbinger, VP at HSH Associates, which analyzes the lending market. “Thirty-year, 20-year, 15-year, still available in the marketplace. Those probably will never go anywhere.”

These are the safest, most boring loans around. To get one, you’ll need a good credit score–at least 680, according to Ruzicka, and a down payment. If you live in an area that saw major carnage in the housing market, that down payment will be at least 10 percent, and perhaps as much as 20 percent. In less exciting markets, like Ruzicka’s St. Louis, you can get away with 5 percent.

As always, if you put down less than 20 percent, you will be required to purchase private mortgage insurance, which adds a small chunk to your monthly payment until you hit 20 percent equity. Long gone are the “piggyback loans” that would let you duck this requirement. (If you don’t know what a piggyback loan is, trust me, you’re better off not knowing.)

Advantages: Fixed payment throughout the life of the loan; available everywhere.

Disadvantages: Need great credit to qualify; higher interest rates, on average, than adjustable-rate loans.

Adjustable-rate mortgages

ARMs have a bad reputation, but they’re actually a whole family of loans, and only some members of the family are bad apples. Those apples have rotted away now, and we’re left with mainly 5/1 and 7/1 ARMs (the good ones).
Both numbers are in years. The first refers to the length of the introductory interest rate period. So, if you get a 5/1 ARM advertised at 3.5 percent, you’ll pay a low rate for the first five years. After this, your interest rate will adjust every year for remaining 25 years of the mortgage. With a fixed-rate mortgage, your bank takes the risk that interest rates will rise over the course of the loan. With an ARM, you take the risk.

Exotic types of ARMs got people into a lot of trouble during the housing bubble. “ARMs were making up as much as about 40% of the marketplace in 2006,” says Gumbinger. That’s now down to about 6%. But plain-vanilla ARMs aren’t so dangerous: in fact, they’re the standard form of mortgage in that plain-vanilla country known as Canada.

Advantages: Low introductory rate; lower interest overall, on average, than fixed-rate loans; generally lower closing costs; good for buyers who plan to move within five years.

Disadvantages: Buyers tend to forget that the rate is going to adjust; high interest rates could send payments sky-high.

Government-insured (FHA and VA) mortgages

Who’s the biggest mortgage lender in the US? That would be Uncle Sam.
Buyers who would have been served by subprime lending–and many buyers with good credit, for that matter–are qualifying for loans insured by the Federal Housing Administration or Veterans Administration. Youneed a FICO score of 620 and a 3.5 percent down payment.

FHA lending is huge. Only 2% of the market in 2006, it has now surged to over 35%. The government wants a vibrant housing market and is putting its money where its mouth is. (Did you know the governmenthad a mouth? Its name is Rahm Emanuel. Sorry, political humor.)

“If you can’t scrape together tens of thousands of dollars for a down payment,” says Gumbinger, “you’re probably going to end up over in the FHA program, where you generally don’t need to.”

The FHA does have its own qualification standards. You can’t be carrying too much personal debt. You can’t take a huge loan; the maximum amount varies by county, and you can look up your maximum at the HUDwebsite. If you want to buy a condo, the building has to be FHA-qualified.

Advantages: Low down payment; low interest rate; available to buyers with good-but-not-great credit.
Disadvantages: Maximum loan amount tends to be lower than a conventional loan; must meet government qualifications; condo buildings may not be FHA-qualified.

Jumbo loans

Want to borrow more than the $417,000 maximum of a conforming loan? If you’re in a high-priced market, the FHA might lend you more than that. Most likely, though, you’ll be looking at a jumbo loan.
”Jumbos are definitely available,” says Gumbinger, “and the price of private market jumbo money is nearing historical lows.”

The catch–and you knew there had to be one, right?–is that you have to be Mr. or Ms. Clean to get one. That means at least FICO 720 (740 is better), a 20% down payment (even more in some markets), a reasonable debt-to-income ratio, and plenty of documentation.

If you think you can qualify, be sure to shop around. Jumbo loans vary a lot more in price (that is, points and interest rate)–even within the same city–than conforming or FHA loans. “Don’t assume that the first or even the second price you find is necessarily the only price you’ll find,” says Gumbinger.
Advantages: It’s a big pile of money, and rates are currently low.
Disadvantages: Rates and costs vary; tough to qualify.

What you won’t find

Subprime loans. “If you’re not dealing with at least a credit score of 680, you need to be going FHA,” says Ruzicka, “and if you don’t have a credit score of at least 620, you need to go to a credit repair place and get your credit straightened up. Because there really isn’t much of an option below 620.”

Option ARMs and interest-only ARMs. Want to see the principal on your loan go up over time instead of down? Me neither. “Pay-option ARMs have disappeared from the landscape,” says Gumbinger.

If you want excitement, go rent a movie, because you won’t find it in the home loan market. Isn’t that reassuring?
Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.