The interest rate is, of course, the stated interest rate on the loan you’re taking from the bank.  The APR, however, is more comprehensive because it includes many of the up-front costs of your mortgage.  These additional fees taken into account usually include loan origination fees, and underwriting fees.  The idea is to give you a better idea of the actual “interest” you’ll be paying once the extra costs are taken into consideration.  The bigger the spread between APR and the interest rate, the more those upfront fees are raising the effective cost of your mortgage.  That’s why banks are required to display this rate – so they can’t advertise a lowball interest rate and hide the fees that you’ll be charged.

Discount points that you pay up front can account for large differences between the APR and the stated interest rate.  A point represents 1% of the loan amount paid up front.  Because the lender gets a portion of his interest income straightaway, he is willing to lower the interest rate they you will pay over the life of the loan.  This, in turn, lowers your monthly payment, which is why discount points seem so attractive.  Whether or not paying points is worth it to you depends on the difference it will make in your monthly payment, and how long you plan to stay in the home you’re buying.  Figure up the monthly mortgage payment both with and without the points being paid.  Then compare the two amounts to find out how much you’re saving each month thanks to the points.  Divide that monthly savings by the amount you’re paying for the points to find out how many months it will take to break even.  If you think that you might not be in the house at that time, the points aren’t worth it.

Private Mortgage Insurance, or PMI, can also cause the APR to be higher than the interest rate.  Your lender will require PMI if your down payment is a small percentage of the loan, usually less than twenty percent of the value of the home you’re buying.

While the APR can provide a useful comparison between lenders to get an idea of the true cost of your mortgage, it has its limits.  Every financial institution, for example, figures APR differently; not all of them include the same upfront costs.  So a quick comparison between APR numbers isn’t enough – ask the lending institution what costs are included.  You should also get a good faith estimate from a prospective lender of the closing costs.  Also know that the APR is a much more meaningful comparison figure on a fixed rate loan than on an adjustable rate mortgage, because an ARM’s rate can change – and so will your costs.

Of course, your payment has two components:  principal, or the original amount that you borrowed, and interest.  If it’s a fixed rate of interest, that rate is applied to the principal each month to determine the interest portion of your payment.  The rest is principal.  This is how your payment is the same from month to month, but the interest and principal portions of the payment change each time.

If you’ve had your mortgage for a while, you might have gotten a statement showing your principal balance and been shocked that the principal has been reduced only slightly, despite a year or so of faithful payments.  But, if you consider how interest is calculated, this makes sense.  As was noted earlier, interest is applied to the principal balance to come up with the interest component of your payment, with the rest going to principal.  So, at the beginning of a fixed-rate mortgage, that interest is the bulk of that fixed payment amount, with a minimal amount going to principal.  This also ensures that the lender makes back his interest while you are still paying down the principal balance of your loan.  As time goes on, however, the share of each payment attributed to principal gets larger and larger, and this is how your loan gets paid off.  At the end of the loan amortization, virtually the entire payment is principal.

You can speed up this process a little by adding a little extra in each payment to go to principal, signing up for a pre-payment program, or just sending in an extra payment or two every year.

Most monthly house payments aren’t just principal and interest, however.  You have taxes and various insurance policies to pay, and these tend to be rolled into your payment by the bank.  That’s why you might see an “escrow” component to your payment.  The bank figures up the total amount that it expects to need for the coming year’s homeowners insurance and property taxes, then divides that amount by the total mortgage payments for the year.  When the homeowners’ insurance and tax bills come due, they go to the mortgage company, who pays them for you using the escrow that has accumulated.

You might also see an amount for PMI, or Private Mortgage Insurance, on your mortgage statement.  PMI is required if the amount of your mortgage loan is comparatively high versus the fair value of your home.  In other words, you have very little equity built up in your home.  PMI usually applies if the down payment you make is a small percentage of the actual mortgage.  So, the PMI is an insurance policy that ensures the lender will be protected in the event you default on your mortgage.  Once you’ve made enough payments to accumulate enough equity, the PMI policy should be canceled automatically – but since a lender can always make a mistake, check regularly to ensure that you are still required to pay for it.

One more important note:  If you have an adjustable rate mortgage, or ARM, understand that the interest rate can change – sometimes significantly – making for a major change in the amount of your payment.  Know what kind of mortgage you have and, if it’s an ARM, understand how high the interest rate can go, and how often it can change

A mortgage can seemed complicated, but hopefully your monthly mortgage statement is now demystified.  Check your statements regularly, and don’t be afraid to ask questions about anything you don’t understand.  A home is your life’s biggest investment, and you should know where every penny of that payment is going.

Application Fee – The fee charged by your bank or lender to apply for a loan, generally intended to cover initial processing costs and a credit check.

Loan Origination Fee – Another fee charged by your bank or lender (sometimes called an underwriting, administration, or processing fee) designed to cover the costs of processing and evaluating a loan for you, such as legal costs, notary fees, and overhead.

Title Search Fees – A fee paid to research the property to ensure there are no other claims against it that would interfere with your ownership.

Title Insurance Fees – Title insurance guards against an error in the title search; should a previously-undiscovered problem rear its head, this policy protects the lender.  If you want to protect yourself, you’ll also need an owner’s title insurance policy.

Appraisal Fees – Any lender is going to require an appraisal to ensure that you’re paying a fair price for your new home.

Points – A point is 1% of the loan amount.  A lender may offer you a lower interest rate if you pay points up front.  Like mortgage interest, points are tax-deductible in the year you pay them.

Home Inspection Fees – Your lender may require you to get a home inspection to check for major structural or other damage, water quality, pests, etc.  Even if it’s not required, a home inspection is a good idea for your peace of mind.

Prepaid Interest – This is the interest that will build up, or accrue, on your mortgage until your first scheduled mortgage payment.  The lender will want this up front.

Private Mortgage Insurance (PMI) – If your down payment is less than 20% of your home’s value, the lender may want you to purchase PMI to cover its losses in case you fail to make the payments.  Once you’ve built up enough equity and have established a good payment history, these payments will stop.

Flood Determination Fee – A fee the lender may charge to determine if your home is in a flood zone, and if you’ll need to buy flood insurance.

Homeowners’ Insurance – The insurance policy that protects against fire, natural disasters (other than floods), and other hazards that can damage your home.

Escrow (or reserve) funds – You may be asked to pony up money at closing to put in an escrow account to cover property taxes, insurance, and other costs.  Even if you don’t pay this at closing, part of your monthly mortgage payment will probably go toward escrow.   When the bills for taxes and insurance come due, the lender takes the money out of escrow and pays them for you.

Property Survey Costs – This is a fee to obtain an accurate, legal survey of the exact location of the property you’re buying to ensure that you are getting exactly the land you’re paying for.

Bundled Fees – Some lenders may offer some, but not all, of the fees listed above as part of a package deal.  That’s fine as long as you understand exactly what’s included, and what you’ll still have to pay at closing.

While the existence of so many fees can be shocking, there’s good news.  A good faith estimate will give you an idea of what’s you’ll be expected to pay.  Ask your lender for this estimate and an itemized list as early in the process as possible.  If there are any fees listed you don’t understand, ask for an explanation.  Also realize that many fees, especially application and processing fees, are negotiable.  Ask your lender to reduce or waive these fees; alternatively, the seller may be willing to pay them.  Don’t be afraid to ask – after all, this is the biggest purchase you’ll ever make.

The refinance boom of the early 2000′s saw the rise of a number of non-conventional mortgage options for homeowners. For most borrowers these mortgages are not the best option. However, depending on your situation, you may benefit from one of these non-conventional loans. One of the simplest, but most often misunderstood is the balloon mortgage.

Traditional Mortgage

It’s best to understand a balloon mortgage in comparison to a traditional mortgage. A traditional, 30-year fixed mortgage is structured in a way that at the end of the 30-year term, the loan will be completely paid off. A percentage of each payment you make on such a loan goes to interest and a percentage goes toward the principal.  That’s pretty simple to understand and is the most popular mortgage type because of its stability and simplicity.

Balloon Mortgage

The balloon mortgage is very similar except for a few key differences. First of all, you pay a smaller payment each month than you would on an equivalent term conventional loan. That seems like a good thing and is what entices many borrowers who take on this loan to do so. To understand it completely we have to ask, “Why would the lender let you pay a smaller payment on such a loan?” Well, it’s because they get it all back in the end, which brings us to the second difference between the two mortgage types.

Although you make a smaller payment each month on a balloon mortgage, that extra amount that you’re not paying all comes due in one single month at the very end of the term. What does that mean? Well, let me lay out an example.

A Balloon Example

Let’s say you get a balloon mortgage and your monthly payment is $1200, however, because it’s a balloon that monthly payment of $1200 will not pay off the loan in 30 years. So, if you managed to get a 30-year balloon, you pay your $1200 per month for 359 months. That very last month, month #360, the entire loan becomes due. In many cases that means you have to come up with $10-, 20-, $30 thousand dollars or more for that final payment. So now you’re wondering why on earth anyone would take a balloon mortgage if they have to make a big lump sum payment at the end, right?

What Good is a Balloon Mortgage?

Although it does seem crazy at first glance that anyone would want to take on a loan that has a final payment in the tens of thousands of dollars, it does make sense if you plan on selling the home before the end of 30 years for example and you would prefer to have more cash in your pocket each month than build equity in the home. Then, when you sell the home you just pay off the mortgage like you normally would (assuming you have the equity required).

So, in practice, a balloon mortgage is very much like an interest-only loan and is geared toward freeing up monthly cash flow rather than building equity in the home. It’s certainly not the best loan for everyone, nor, perhaps for most people, but it is useful under the right circumstances for the right people.

Now, you’re probably thinking, “why understand the reasoning behind paying off your mortgage, its simple, to reduce your debt, pay less interest, and be safe from the potential of losing your home if you lose your job.” Well, it seems simple, but in many cases, the numbers work out in favor of not paying off your mortgage. How can we explain, then, the overwhelming support in favor of paying off a mortgage that may actually be helping most homeowners in the first place? To do that, we need to understand the reasons behind the wave of excitement over becoming mortgage free as well as the numbers that show whether or not becoming mortgage free is something that will benefit you.

Why Pay Off Your Mortgage?

For most Americans, there are three main reasons for paying off their mortgages:

1. A mortgage is a debt, and debts are risky by nature.
2. A mortgage is an expense, and paying off your mortgage cuts out a large monthly expense.
3. Because of the length of time it takes to pay off a mortgage, most homeowners will pay an enormous amount of interest over the life of their loans.

Let’s examine these one at a time…

A Mortgage is a Debt, and Debts are Risky by Nature

The Two Major Risks Associated with Mortgages:

1. If some major negative financial event occurs in your life, such as a job loss or major illness, you run the risk of being unable to make your mortgage payments and the bank could foreclose on the property.
2. For borrowers with interest rates that may adjust during the life of the loan, when caught in a real estate market downturn, you run the risk of not being able to refinance if your home’s value, and hence available equity, drops significantly. If your interest rate adjusts to a point that you cannot afford to make payments without refinancing, you may have to sell or the bank will foreclose on the property.

A Mortgage is Expensive, So Paying Off Your Mortgage Cuts Out a Large Monthly Expense

This is pretty simple, the more money you have, the more freedom you have to do what you want. For most Americans, paying off their mortgages will relieve them of their largest monthly expense, giving them more freedom to do what they want.

Also, income generally drops at retirement when workers begin living off pensions, social security, savings, etc. Having the mortgage expense eliminated by that time frees up a large expense.

Mortgage Interest Is Expensive

Since the term of a mortgage is generally around 30 years or more, you can expect to pay an enormous amount of interest over that time. In fact, on a $200,000 mortgage, at 6%, over 30 years you’ll pay over $231,000 in interest…more than the property even cost to begin with!¹

Getting that mortgage paid off quickly certainly helps save interest. Even as little as $100 extra per month in the above example would save almost $50,000¹.

Why Not Pay Off Your Mortgage?

Now let’s reexamine the reasons why homeowners want to pay off their mortgages and see why you may not want to pay it off.

Debt Allows You to Leverage Other People’s Money

Debt always carries some risk with it, but debt is the only way to leverage the often-talked-about principal of “Other People’s Money.” If you have $100,000 in cash to invest, at 6% per year you’ll reap $6,000 in gains. Now, if you have $100,000 cash to invest and you add to that $100,000 of someone else’s money in the form of debt, you can reap $12,000 in gains the first year with the same $100,000 of your own money. By taking on debt, in this case, you double your cash on cash return from 6% to 12%. As long as you’re paying less interest on the money borrowed than you’re making from the investment, you come out ahead.

Bank Make Money with Arbitrage, and So Can You

Arbitrage, with regard to mortgages and investments, is a concept that refers to borrowing money at a lower rate than you can make from it through investment. For example, if I can borrow money at 6% and invest it at 8%, I have a 2% positive gain on that money. If my $200,000 mortgage at 6% costs $1,199 per month, and, instead of making an extra $100 payment each month on the mortgage, I invest that $100 at 8%, I can gain $8 per month, as opposed to the $6 per month I would save by applying that money to my mortgage at 6%.

Mortgage Interest is Expensive, But You Have to Consider the Bottom Line

Sure, making an extra principal payment of $100 per month in the above example would save $50,000 in interest charges over the life of the loan, but by investing that extra $100 per month at 8% for those same 30 years, I can make almost $150,000. That would give me enough to pay the extra $50,000 in interest on the mortgage and still have almost $100,000 left over.²

Mortgage Ideas to Consider Beforehand

Opportunity Cost

Whether or not you should pay off your mortgage depends on a number of factors, and you really have to do the math to find out if it’s in your best interest. When considering the options, always keep in mind a key term…Opportunity Cost.

Opportunity Cost is defined by Investopedia.com as:

“The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.”

And…

“The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% – 2%).”

Whatever you do with your money, there is always an opportunity cost. Instead of spending $5 a day no a Starbucks latte, you could just invest that $5 a day. $5 a day at 8% over 30 years is around $225,000. So, you could say the opportunity cost of 30 years-worth of daily Starbucks lattes is $225,000, even though, over those 30 years you’d actually spend only $54,000 at Starbucks. Over 30 years you could spend $54,000 at Starbucks and have nothing to show for it, or you could spend that same $54,000 over 30 years on an investment and have $225,000 to show for it. That’s opportunity cost.

So, before you decide to pay off your mortgage, you need to calculate the opportunity cost of doing so. Find out what else you could do with the money you’d put toward paying off your mortgage and run the numbers.

Acceptable Risk

A large portion of your decision for or against paying off your mortgage will lie in the level of risk you personally find acceptable. Here are some of the risks you should consider…

The Type of Mortgage

If you’re on a 30 year fixed rate mortgage and are debating whether or not you should put extra money toward payoff, or invest, this won’t be a factor for you….either way, your mortgage rate and payment are going to be fixed for the life of the loan.

If, however, you’re on any type of loan without a fixed interest rate, you need to consider the fact that your interest rate will fluctuate. The calculations can get pretty complex at this point, but a simple technique you can use is to run the numbers 3 times. The first run, assume your interest will pretty much stay the same. For the second calculation, assume the interest rate will hit its cap (most adjustable rate mortgages have an interest rate cap); this is your worst-case scenario. Finally, run the numbers assuming the interest rate will hit its floor (most adjustable rate mortgages also have an interest rate floor); this is your best case scenario.
Now, if you want the numbers to be really accurate, you need to factor in any projected refinance costs. For example, if you’re on a 30-year fixed, interest-only mortgage, and plan to make interest only payments and invest the difference, keep in mind that the interest-only feature on most of those mortgages are only available for 10-15 years, after which point you have to start making principal and interest payments; in other words, the payment will go up significantly if you don’t refinance. So you’ll need to factor the cost of refinancing every 10-15 years into your calculations.

Investment Options

You should also consider the investment options available to you and their associated risks. In the examples above I used 8% for the investment rate. A question you need to answer is, can you even find an 8% investment, and if you do, can you realistically expect that return to at least remain stable over the life of the investment? For example, the S&P 500 has averaged just over a 9% gain per year over the past 30 years, so 8% is certainly a reasonable estimate of what you could expect, but some people lose money investing, and others make quite a bit more than 8%; it all depends on your knowledge, experience, ability, etc. Only you can make the call as to whether or not you can pull investment returns that will outweigh your mortgage costs.

Market Conditions

Real Estate is, always has been, and always will be a highly cyclical industry; meaning there are a lot of ups and downs and those ups and downs are more pronounced than other industries. You need to have an understanding of your own personal understanding of the Real Estate market. Will you be able to see a bear market before it arrives? During a bear market, will you be able to recognize when the market’s bottomed out? And during a bull market, will you be able to recognize when it’s reached its peak? You don’t have to be Warren Buffet to recognize these things, especially since markets don’t usually turn on a dime. If you keep your eyes and ears open and you’ve provided yourself enough of a safety margin, you should be able to prevent major market swings from damaging your plan.

On the other hand, you need to be able to recognize when this is completely outside of your ability. Only you know yourself well enough to make the call. If you don’t think you can predict market conditions before they have a major impact on your plan, increase your safety margin. You can do this any number of ways, one of the best is to ensure you always have some equity in the property. It’s much more risky to hold a 95% LTV mortgage than one at 60% LTV. Your ability and knowledge of Real Estate and market trends will determine how much of a down payment, in this case, you’d need to make in order to lessen your risk to an acceptable level.

Methods to Pay Off Your Mortgage

So now that you’ve gotten this far and you’re still thinking about paying off your mortgage, here are some of the most common ways to make that happen.

Bi-Weekly Payments

Our bi-weekly payment calculator can show you the benefits of a bi-weekly payment plan. On a bi-weekly payment plan, instead of making one payment per month, you make two. The amount of your monthly payments don’t change, instead, the benefit lies in the fact that making 12 monthly payments of $1,000 totals $12,000 a year, whereas making bi-weekly payments of $500 means that you’ll make 26 payments of $500 each year, which totals $13,000.
The reason for the difference lies in the fact that there are 52 weeks per year and 12 months per year. Bi-weekly payments will have you making 26 payments per year, and monthly payments will have you making 12 payments per year. Since bi-weekly payments are half what monthly payments would be on the same mortgage, you end up making the equivalent of one extra monthly payment each year on a bi-weekly plan.

Extra Payments

You may not want to commit to a bi-weekly plan, so instead you can opt to make extra payments whenever you have some extra cash. Our Loan Length Calculator can show you the effect of making extra payments on your mortgage.

Mortgage Terms Less than 30 Years

By far the most common fixed-rate mortgage term is 30 years, but you can opt for a 10, 15, or 20 year fixed rate mortgage. Our mortgage payment calculator can show you the difference in payment amounts with various term lengths.

Mortgage Acceleration Plans

Mortgage acceleration plans are becoming more and more popular these days. One such plan is called the Money Merge Account. We won’t go into the details of these plans here, but many people find them useful. Before looking into them, you should know that there is some debate over whether they are truly beneficial to homeowners, but we’ll leave that up to you to decide.

Investment as a Means to Paying Off Your Mortgage

You should also know that there is a middle ground between paying off your mortgage and investing your extra cash; you can do a combination of the two. If you’re keen on the idea of being mortgage free, instead of making extra principal payments, you can invest that extra cash until it reaches a certain amount, at which point you can either pay off a chunk of your mortgage with the investment proceeds and do it again, or simply wait until the amount in your investment account(s) equals your mortgage amount and pay it off entirely. Obviously, the same investment risks described above are a factor in this option, but it is commonly used as a method to early mortgage payoff.

Conclusion

Ultimately, it is quite possible to build wealth without ever paying off your mortgage. If you chose to not pay off your mortgage, you can certainly have more money in the long run. However, the decision should be examined carefully using all of the information we’ve gone over in this article. If your main goal is to eliminate risk, or come as close as possible to eliminate risk, you’ll want to pay off your mortgage as fast as you can. On the other hand, if you’re someone that can accept a level of risk, no matter how small, investment alternatives should be looked at and your personal level of acceptable risk should be factored in.
Our mortgage and financial calculator section has some great calculators that can help you on your way to calculating what’s best for you.

Sources:

1. Calculated using the Free Debt Calculator
2. Based on $0 starting balance, compounded monthly

After You Sign the Papers

We’ve covered the mortgage process a bit in the past, but we’ll give you a quick refresher here. In many cases, soon after a borrower signs his or her loan documents the loan is sold to investors on the secondary mortgage market. This happens more often than most people realize, in fact, even if you’ve got a loan with a major company like Wells Fargo or Bank of America, those lenders may still opt to sell the loan to investors.

When Mortgages Are Sold

Now, when mortgages are sold, generally they’re split into two major parts.

First is the actual mortgage itself, which is bundled with a bunch of other mortgages and sold to an investor in the form of bonds or some other investment vehicle. When you make a payment to the company servicing your loan (covered in the next paragraph), that company takes a small percentage and pays the rest to the investor. So, while you’re making monthly payments, the investor is receiving them, after the servicing company takes its cut.

The second part of the mortgage that is sold are the servicing rights. This is the portion that, if you’ve ever had a mortgage, you’re more familiar with (more so than you probably think at least). Servicing rights grant a company the right to handle, well, the servicing of your mortgage. Whatever company you’re making payments to is the company that holds the servicing rights to your mortgage. That company takes a small cut, usually around 0.25%-0.5%¹ of the monthly payment in return for handling all the administrative tasks that come with servicing your loan, like sending out statements, collecting past due payments, etc… After that, the rest of the monthly payment is sent to the investor who bought the investment vehicle your loan is bundled into.²

What If Your Original Lender Goes Bankrupt?

If the lender who you got the loan through originally goes bankrupt, you may not even know about it. If that lender sold off both the mortgage and its servicing rights, you wouldn’t even be making payments to them anymore. They’ve essentially taken themselves out of the loop entirely this way.

Some of the larger companies will keep the servicing rights and sell off just the mortgage as an investment vehicle. If your lender goes bankrupt after this happens, the lender will be forced to liquidate its assets, in other words, it has to sell the servicing rights to someone else. Since we’re talking bankruptcy here, those servicing rights will generally sell at a discount and, in many cases, people/companies will be fighting tooth and nail to get to purchase those servicing rights. Once a deal is struck, the biggest change you’ll notice is that the company you send payments to will change. Most homeowners have had their mortgage servicing rights sold at one point, although it doesn’t always mean their lenders went bankrupt.

What If the Servicing Company Goes Bankrupt?

If your original lender sells off both the mortgage, as well as its servicing rights, you’ll have to start making payments to the new servicing company. Now, what if that company goes bankrupt? Same as above…that company will be forced to liquidate its assets, of which your mortgage servicing rights are one of those assets, and those rights will be sold at a discount to another company or investor, at which point you’ll have to start making payments to yet another new company.

What If the Investor Who Bought Your Mortgage Goes Bankrupt?

Now that we’ve covered the servicing side of things, what if the investor who bought the actual mortgage itself, as some sort of investment vehicle, goes bankrupt? Well, that’s just like if you bought some stock in a company and then you had to declare bankruptcy; you might sell the stock to someone else, or you might lose it in a lawsuit, either way, the company who’s stock you own isn’t really going to be affected. Likewise, if the investor who bought your mortgage goes bankrupt, you likely won’t even know about it.

Will the Terms of the Mortgage Change?

No. No matter what happens, no matter how many times your loan is sold or how many companies holding it go bankrupt, the terms of your mortgage will never change. Now, you may have to start making payments to a new company, and that can be a bit of a hassle, especially if it happens several times, but your 5.5% 30-year fixed (or whatever) will stay a 5.5% 30-year fixed.

Why All This Buying and Selling Mumbo Jumbo?

So, the question still remains, why are there all these companies that handle these different aspects of your mortgage? Aren’t they all middle-men jacking up the cost you ultimately pay for your home? Well, no, and we don’t want to leave you hanging, but that’s a topic for the next article here at Truthful Lending.

Also, if you haven’t seen our brand new Debt Free Calculator, take a look.

Sources:

1. New York Times
2. Mortgage News Daily
3. MSNBC
4. Bloomberg News

When you do decide that it may be the right time to buy a house, this article should help you make a more informed decision.

Rate of return

It’s a common belief that real estate is one of the greatest investments you can make, however, over time, real estate under-performs the S&P 500 in the Rate of Return category. On the other hand, you’re going to pay for a place to live one way or another, so if you can buy a house for near the cost to rent, you can come out ahead.

The economy

Wouldn’t it be great if the mortgage payment on a home was the same as the cost to rent a similar property in the same area? Of course it would, if that were always the case, we’d all be homeowners, but it’s not. Property values swing just like the prices on any other market, much more so in recent years. The idea is if your mortgage payment on a house is going to be significantly more than it would cost to rent that same house, it’s probably not the right time to buy.

Also pay attention to what’s happening in the housing market in your area. Have prices been shooting sky high for several years? If so, they’re unlikely to continue on that path for much longer. On the other hand, if prices have been dropping like crazy for a while, it may be the right time to buy.

Costs you may have overlooked

When considering the affordability of a property, keep in mind the fact that the mortgage isn’t all you have to pay each month. In addition to that, you’ll pay homeowner’s insurance, property taxes, and depending on where you live, flood or hurricane insurance. Insurance costs vary depending on where you live, areas prone to natural disasters like coastal Florida are going to have significantly higher costs associated with homeowner’s insurance.

Property taxes are also often overlooked, and in some areas, that’s a big mistake. Because of high property values in California, you might pay $600 per month or more in state property tax alone. That’s a blunder you don’t want to make.

As if that wasn’t enough already, right? Well, you also have the maintenance and utility costs of owning a home. Maintenance is something you’ve probably never paid if you’ve always been a renter, but you can expect to spend 1% of the total purchase price of your home on maintenance each year, that could be $2,000-$3,000.

I’m sure you paid utilities as a renter, but keep in mind that a bigger palace means a bigger utility bill.

Down Payment and Fees

While this is just another cost, its a big one so we feel it deserves its own section. Conventional wisdom says you need a 20% down payment, but if you have great credit you can have as little as 0-5% down payment, depending on the purchase price. Even so, if you’re looking at a $300,000 property, a 5% down payment is $15,000…that’s a hefty chunk of change.

That’s not all, you’ll also pay around anywhere from 1-3% on the mortgage amount in closing costs that are in addition to the down payment. That’s another $3,000 – $9,000 on a $300,000 property.

Can you get approved?

One more question you need to ask yourself is can you even get approved for a mortgage? That’s a tough question to answer in an easy way, but take a look at your credit score, if it’s in the low 600′s or even lower, you may find it tough to qualify for a mortgage.

If you’re unsure, contact a bank or broker and see what they have to say.

No Income, No Asset (NINA)

This is just like it sounds…no income or asset documentation required. Sounds great, right? Well, these type of loans aren’t very common, especially in today’s market.

I didn’t state it explicitly in the last doc type article, but the different doc types represent different levels of risk for the lender, and, as a result, the more relaxed the documentation requirement for a given loan, the higher the interest rate will be. The NINA doc type, all things being equal, represents a significant risk for the lender, since there is no way to verify whether the borrower has the means to afford a given property at all. The borrower’s employment is verified, but neither the income amount or liquid assets are even reported on the Mortgage Application.

Since the NINA doc type represents a relatively high risk for a lender, these types of loans generally require a number of compensating factors. For instance, these loans are usually reserved for borrowers with very high credit scores, a large amount of equity in their homes, and many times they cannot be first time home-buyers.

This doc type is only second to No Doc in the level of risk it poses to the bank. Interest rates will generally be higher on this doc type than all but No Doc, and other loan qualification requirements will be much more strict.

No Doc

No Doc is very similar to the NINA doc type, with one small difference…No Doc means no income, asset, or employment documentation whatsoever, whereas NINA does not require income and asset documentation, but does require verification of two years of employment in the same field. Other qualification requirements will be very strict.

This doc type carries the most risk for the bank out of those we’ve covered and generally offers the highest interest rates.

No Ratio

The No Ratio doc type requires all the same income and asset documentation as a Full Doc loan, but where this loan differs is in the fact that there is no Debt-to-Income ratio (DTI) limit. So, whereas a borrower may be turned down for a Full Doc loan if his or her DTI is over 50% or so, with a No Ratio loan, the bank won’t even take DTI into consideration. Obviously, this type of loan presents certain risks to the bank, and because of this, there must be compensating factors like good credit, low LTV, etc, before one could expect an approval on this doc type.l

Between NINA, No Doc, and No Ratio, No Ratio definitely represents the least amount of risk on the part of the bank. The fact that assets are considered as a qualification requirement differentiates the No Ratio doc type from the others covered in this article. Nonetheless, it’s still a risky loan and interest rates and qualification requirements will generally be higher with this doc type than the more common doc types covered here.

Doc Type Breakdown and Usage

As with any loan through any lender, a given lender is going to have specific requirements for each doc type that may deviate slightly from the explanations here…that’s ok. Keep in mind, these are general standards and the specifics of a given loan are usually going to change from lender to lender. In the spirit of presenting all these details in an easy to understand format, here a side-by-side comparison of the three doc types covered in this article [Click on the chart to view larger image].

Perhaps the main reason nobody has anything good to say about these loans nowadays is because so many average homeowners took them when they’re actually beneficial to only a select group of people. Unfortunately, the way banks and brokers pushed Option ARMs over the past several years gave most of these homeowners the impression that they’re an all-around great loan, when nothing could be further from the truth.

Who Benefits from the Option ARM?

Before we cover the situations in which this type of loan could be beneficial, I should start off by saying that Option ARMs are a niche product, a relatively complicated loan program that can only benefit select groups of people; anyone not part of one of those select groups shouldn’t even consider an Option ARM.

Option ARMs are great loans for the following groups, but only if the conditions are right:

1. Commissioned Workers: Option ARMs offer the borrower the option of making an extremely low minimum payment if need be. Homeowners with salary jobs may not see a huge benefit to this, but homeowners who are paid a large chunk of their incomes in the form of commission may find the minimum payment option quite convenient. As someone who’s worked for 100% commission, I can attest to the fact that income can fluctuate quite a bit from month to month at such a job. One month you may bring in $20,000, the next month $0. When your income fluctuates so much it’s nice to have the option to vary your expenses, something Option ARMs can offer.
2. Real Estate Flippers: Investors who buy a house with the goal of fixing it up and flipping it for a profit need access to as much cash to spend on upgrades as possible. The Option ARM’s minimum payment can help them free up a bit more cash that they wouldn’t have had otherwise. Sure they’re deferring interest, but when you’re making 20-30% profit on every dollar you spend, deferring 7% worth of interest isn’t a big deal. These days, however, Option ARMs are tough to get without making a down payment on the purchase, something many investors prefer not to do.
3. Savvy Investors looking to free up some cash: I say “savvy” because it’s important that the borrower understand how an Option ARM functions and is able to calculate a benefit of investing the extra cash freed up by the minimum payment. This really isn’t the best approach for the average homeowner, not even for the casual investor; you really have to understand the numbers or pay someone who does, because when investments come into play, calculating Option ARM benefits can get pretty hairy. Assuming the investor understands the intricacies involved, he or she may benefit from extra cash afforded by the minimum payment should a great investment opportunity suddenly pop up.

Rate and Prepayment Penalty Determine Benefit

The three groups of people above are certainly great candidates for an Option ARM, but that doesn’t mean its the best loan for all of them all the time. Option ARM interest rates can vary quite a bit and, obviously, the higher the interest rate, the less the benefit for all three groups above. A low rate is absolutely essential with an Option ARM. In spite of what the mainstream media says, you can get an Option ARM at a descent interest rate, but the main reason brokers have pushed Option ARMs in the past is because they pay out major points in the form of YSP (a rebate paid by the bank to the broker). However, this huge rebate (usually around 3 pts, or 3% of the loan amount) requires a higher interest rate and longer prepayment term. Since many homeowners in Option ARMs today only got them because of the low minimum payment, the actual interest rate was usually overlooked, so brokers could get away with hiking the rate up to 9% or so to get a bigger rebate.

Also, an Option ARM with no prepayment penalty doesn’t pay nearly the rebate on the same loan with a 3 year prepayment penalty, and again since borrowers, in the past, were usually focused on the mouth watering minimum payment, brokers could get away with throwing on a 3-year prepayment penalty. I’ve seen Option ARMs put $30,000+ into the brokers pocket before he’s even charged the borrower a dime, but only with a 2+ year prepayment penalty and a high interest rate.

These days, a low risk borrower can get an Option ARM rate as low as 6.5% or so and no prepayment penalty, which is very comparable to 30-year fixed rates, but with greater flexibility when used correctly.

The Option ARM spread like the plague when it was first introduced around 2001, but it’s really a specialized, niche product that requires a complete understanding of it’s inner workings to prove beneficial. If you think you may benefit from an Option ARM, or you just want to learn a bit more about the inner workings, our next article will cover some of the terms all homeowners should understand when considering an Option ARM.

As previously mentioned, ARM stands for Adjustable Rate Mortgage. So it makes sense that the interest rate on this type of loan is adjustable, but it’s a bit more complicated than that. Let’s come back to this in a minute, in the mean time, what does the Option in Option ARM mean? The reason this mortgage type is known as an Option ARM is because it offers the borrower four different payment options each month; now, there are some Option ARMs offering only three payment options, but by far the majority offer four. We’ll start with the fourth option and work our way backwards to the first, which is the meat and potatoes, so to speak, of the Option ARM.

Payment Option Four – 15 Year Amortization

The fourth payment option is the largest of the four, and covers principal and interest, amortized over 15 years. 15-year amortization means that the payment is large enough that it will pay off the loan in 15 years; so, for instance, a 15 year amortized loan will call for a larger payment than a 30 year amortized loan, which will call for a larger payment than a 40 year amortized loan, and so on.

Payment Option Three – 30 Year Amortization

The same applies here as with option four, the only difference is that this option is amortized over 30 years; in other words, if a borrower were to make this payment consistently, the loan would pay off in 30 years.

Payment Option Two – Interest Only

Option two offers the borrower the opportunity to pay only the interest on the loan. With this option, no principal is paid and the mortgage balance never decreases. This payment will always be lower than the 30 year amortized payment – option three – because the 30 year amortized payment includes interest and principal.

Payment Option One – Minimum Payment

Option one is generally referred to as the minimum payment. Now you may be thinking, “What could be lower than interest only?” The simple answer is nothing; the interest is how the bank gets paid, and it will get paid; it’s just a question of when the bank gets paid. Similar to the way we can say a 30-year mortgage is amortized over 30 years, we can say an Option ARM minimum payment is negatively amortized. What this means is that, instead of the principal balance decreasing as it does on a 30-year amortized loan, the principal balance actually increases.

The reason for this is simple; the minimum payment is less than the interest-only payment, or less than the interest that is actually owed to the bank each month. Should a borrower opt to pay the minimum payment, the remaining interest owed is tacked onto the principal balance. This sounds complicated, but it’s really not…time for a little easy math.

If Suzie Homeowner has an Option ARM with a 30-year amortized payment of, say, $2,000, she might also have an interest-only payment of $1,750. On such an Option ARM, Suzie Homeowner might have a minimum payment around $625. If Suzie opts to make the minimum payment this month of $625, the remaining interest charges will be added to the principal balance; so if the interest charges this month are $1,750, and she pays $625, then $1,125 is added to the principal balance ($1,750 – $625 = $1,125). The interest that is tacked onto the principal is also known as deferred interest, because it doesn’t have to be paid now, but it will have to be paid some time down the road.

So Why Not Just Make The Minimum Payment Forever?

It’d be really nice if you could make the minimum payment forever, but banks set limits on the amount of interest that can be deferred. When one of these limits is reached, the loan recasts, meaning the minimum payment option is taken away, and the monthly payments are recalculated based on the current loan amount at the time of the recast.

Option ARM Recast Limits

The first limit represents the maximum time period before the Option ARM recasts, and is generally set at 60 months, or 5 years; at the end of month 60, no matter what payments the borrower has been making, the loan will recast.

The next limit caps the balance of the mortgage anywhere from 110-120% of the original loan amount. So, if Suzie Homeowner has a $300,000 mortgage and makes the minimum payments, deferring interest in the amount of $1,125 each month, the balance of the mortgage will increase to $330,000, 110% of the original balance, in just under 27 months. If her bank’s cap is 110%, her loan will recast at this point; likewise, if her bank’s cap is 120%, her loan will recast in month 53.

The important thing to note about recast limits is that the loan will recast when the first of any limit is reached. So, if Suzie makes minimum payments some months and interest-only payments other months, even though it may take longer than 60 months to reach her cap of 110-120%, her loan will recast at 60 months because it’s the lesser of the two limits.

The Trouble With Option ARMs

Now that we’ve got an understanding of Option ARMs, let’s go over the major problem with these loans. As mentioned earlier, when the loan recasts, the minimum payment option is taken away and the monthly payment is recalculated so that it will pay off in 30 years. The problem with this is what’s known as payment shock; if a borrower is used to making the minimum payment, and the loan recasts, the new minimum payment is usually interest-only and is, usually, more than double the amount of the old, negatively amortized minimum payment. To add to this, if the balance has gone up, when the new 30-year payment is calculated, it’s going to be more than the old 30-year payment. In cases like these, the minimum payment on an Option ARM can sometimes triple in one month. This obviously comes as a shock to borrowers who don’t completely understand how Option ARMs work, and one more little hiccup could make the situation even worse.

The Prepayment Penalty

Prepayment penalties on Option ARMs generally range from 0 to 3 years. A major problem arises when, because the borrower makes mostly minimum payments, the loan reaches its cap of 110-120% of the original balance before the prepayment penalty expires. In this case the borrower is forced to either pay the prepayment penalty or face triple the monthly minimum payment. Most banks watch out for this nowadays and won’t fund such a loan to begin with, but that wasn’t the case only a year ago.

The “ARM” in Option ARM

As if things weren’t complicated enough, Option ARMs also have an adjustable interest rate. Option ARMs are linked to a given index, such as the LIBOR, MTA, or COFI; these indexes fluctuate with market conditions. When the linked index goes up, the rate of the Option ARM goes up, when the index falls, so does the Option ARMs interest rate. Adjustable rates aren’t necessarily a bad thing, but they do represent a greater risk than fixed rates.

Option ARMs are obviously complicated creatures and need to be dealt with carefully. In spite of all the bad press and potential pitfalls, these loans can be beneficial. The benefits of Option ARMs will be the topic of the next article, so stay tuned.

When I price out a loan scenario with my lenders, they always ask, “What’s the doc type?” The answer to that question will be a factor in determining the borrower’s interest rate on a particular loan. The doc type refers to the method by which we verify, or document, the borrower’s income and assets for the purpose of a loan qualification/approval. The different doc types vary in their levels of risk to the lender and, as such, usually lead to different interest rates for any given loan program.

Important Terms

You didn’t think vocabulary class was over after grade school, did you? These are some terms we’re going to have to understand in order to follow along.

Verification of Employment (VOE) -

This is a document sent (usually faxed) to a borrower’s current employer, which he or she will fill out and return to the lender for the purpose of confirming that the borrower has been employed there for at least two years. It may not be necessary for the employer to confirm length of employment under certain doc types.

Cash Reserves(Assets) -

Also known as liquid reserves, this refers to the amount of the borrower’s assets that are considered liquid by the lender. This includes, but is not limited to: checking, savings, stocks, 401(k), IRA, or money market account. Generally, cash reserves will include anything you are able to access within a week or so if need be, even if there is a penalty for early withdrawal, such as with a 401(k).

For the purpose of qualifying for a loan, cash reserves are considered in months and are calculated based on the combined payments of loan principal, interest, property taxes, and homeowner’s insurance for the new loan.So, if a borrower has $20,000 in a 401(k), and, under the new loan, principal, interest, taxes and insurance payments total $3,500 per month, take $20,000 divided by $3,500 and you find that borrower has 5.7 months of cash reserves.

Seasoned Assets -

Most lenders have a requirement that the cash reserves/assets have at least two months seasoning, or two months in the same account.

PITI -

Acronym for Principal, Interest, Taxes, and Insurance. This is the combined monthly payment that a lender will consider housing expenses. Incidentally, for the purpose of loan qualification, PITI under the new loan is what’s important, not the current loan. Also, if the new loan will be interest-only, PITI is replaced with ITI (Interest, Taxes, and Insurance) for most qualification requirements.

Full Doc

A full doc loan, also known as going full doc, or full documentation, is a loan that requires two years worth of income verification as well as seasoned assets. We’ll get into seasoned assets in a bit, for now lets focus on income documentation. Thinking of it as a full doc loan is slightly misleading; it’s better to think of the doc types in terms of pricing, as I can usually do any given loan program on a variety of doc types. So, instead of a full doc loan, think of it as full doc pricing.

Most lenders require two years worth of income documentation in the same field, preferably at the same job. This is usually in the form of the past two years’ tax returns (W2s), the past two months’ pay stubs, and a VOE (see terms above). If a borrower has not been employed with the current company for at least two years, but can document two years of employment in the current field, the lender will usually accept that. So, if a borrower has been an administrative assistant at his or her current company for only a year, but was also an administrative assistant at another company prior to the current one, that borrower should be fine.

As far as assets go, the lender will usually want to see the most recent two periods’ bank statements confirming 6 months worth of cash reserves. I mentioned the term seasoned assets above, which means the assets must have been sitting in the same account for at least two months; this is why you shouldn’t transfer money around when you’re about to refinance or purchase a home.

Stated Doc

This is usually referred to as going stated, or simply, stated. There are several types of stated loans, but the most common two are Stated Income/Stated Assets (SISA), and Stated Income/Verified Assets (SIVA). If you’ve ever heard the term “Liar Loans,” stated loans are what that term refers to due to the fact that stated income means just that, stated, and people get away with stating just about any income they want that will allow the borrower to qualify for the loan, as long as it’s within reason (i.e. Stating a $10,000 per month income for a waiter just won’t fly). It is illegal to overstate income, but these types of loans have been so popular in the past because it’s nearly impossible to enforce that.

SISA

requires that the income and assets be stated on the loan application, but they are not verified in any way. Two years of employment in the same field, however, is verified with a VOE, the only difference is the employer is not required to note income on the VOE.

SIVA

requires that the income be stated on the loan application, but the assets are verified just the same as full doc, and two years of employment in the same field is verified with a VOE, but again, the employer is not required to note income on the VOE.

A common error is calculating cash reserves based on the current loan’s PITI; this is a mistake, when calculating cash reserve requirements for the purpose of qualifying for a new loan, the PITI under the new loan is what’s important. So, if the borrower wants to pay principal and interest on the new loan, and PITI under the new loan will be $3,500, in order to meet the standard 6 months cash reserves requirement, the borrower will need to have $21,000 in seasoned cash reserves. Here’s the breakdown of that calculation:

New Principal and Interest Payment = $2,900/month
Property Taxes = $400/month
Homeowner’s Insurance = $200/month
PITI = ($2,900 + $400 + $200) = $3,500/month
6 Months Cash Reserves = (# of Months) * (Monthly PITI) = (6 months ) * ($3,500/month) = $21,000

Other Mortgage Doc Types

There are several other, less common, doc types that we’ll cover in the next article. These include the No Income/No Asset (NINA), No Doc, and No Ratio doc types, so stay tuned.

I remember going on my 6th grade class trip to Canada and being amazed at the differences in price on just about everything. That was way back before I was the savvy market analyst I am now (I guess that depends on who you ask) and knew about exchange rates and the fact that different currencies are actually worth more (or less) than others.

I remember finding a video game I wanted to buy in the U.S. at a Canadian mall for $70. “This Canada place is pretty pricey,” I thought; that same video game was only $50 back in the states. I came to find out that $70 Canadian was about the same as $40 USD at the time; well that was it, I had to have it.

Unfortunately for you would-be cross-border shoppers, you can’t find that sort of bargain these days in Canada. Why? Because the U.S. Dollar, over the past several years, has been losing quite a bit of ground against just about every other currency out there. Take a look at this chart showing the exchange rate from USD to CAD over the past 4 years…

As you can see, back in ’03 the US Dollar could fetch about $1.60 Canadian. The tables have turned and the Canadian Dollar is, in fact, worth more now than the US Dollar; these days the US Dollar will only fetch $0.98 Canadian. So, as you can see, there’s no longer any point in going to Canada…ok, maybe for hockey.

So what does this have to do with you? Well, when the U.S. Dollar loses ground against the rest of the world’s currencies, you have inflation; and inflation, as we know, is a very bad thing for mortgage rates. Inflation is, basically, a measure of the change of a dollars purchasing power, and when you live in a global economy, global purchasing power is a part of that equation as well.

Yet another reason why I don’t foresee mortgage rates coming down anytime in the near future (or even the next several years for that matter).

So Many Economic Factors, Not Enough Time

Probably the major cause of most of the misinformation, or more accurately, incomplete information, is that there simply isn’t enough time in the day to take into account all the different factors that go into explanations and predictions of market conditions, so commentators focus on what they think is important and neglect to mention other things.

In our last article we indicated that mortgage rates dropped as a result of the Fed rate cut on Tuesday. That’s true, but I feel I need to clarify a few things. I’ve taken some snapshots of a rate sheet I receive from one of my lenders every day. The first is from Monday, before the rate cut, the second is from Tuesday, after the rate cut.

Monday 9/17/07

Tuesday 9/18/07

You’ll notice at the top of each image is the pricing for a 6.125% 30-year conforming loan with no adjustments. On Monday, 30-day lock pricing paid a rebate of -0.057%, whereas on Tuesday, the same rate paid a rebate of -0.184% (larger rebate = better pricing).

But now look what happened to rates from Wed – Fri.

Wednesday 9/19/07

Friday 9/21/07

So rates at this particular lender dropped on Tuesday, dropped even further on Wednesday and went back up by Friday. Now, here’s where the real confusion comes in, I have lenders releasing rates that have come down since Tuesday and other lenders releasing higher rates since Tuesday, it completely depends on the lender.

U.S. Average 30-Year Conforming Surveys

It’s important to keep in mind that when commentators mention rates, nine times out of ten they’re talking about the U.S. Average 30-year conforming rates from a particular survey. The problem with this is that you live in one city within one state, so national average rates need to be taken with a grain of salt. Additionally, each commentator is likely quoting a different survey of national mortgage rates. In the left sidebar you’ll notice we have the results of Freddie Mac’s Weekly Primary Mortgage Market Survey; that chart will be different from Bankrate’s Mortgage Trend Index, which will be different from every other survey out there.

The Financial News Media Is Like A Gossip Column

The vast majority of market information from news sources is grossly exaggerated or presented out of context. I read an article on Bankrate’s website yesterday that said rates have gone up 1/8% from last week. Well, if you’re a California homeowner that sounds like the signal to either get mad at your broker for not locking your rate, or to hold off on refinancing for a bit, but wait, look at these rates from last Thursday (that’s as far back as I’ve kept ratesheets):

Thursday 9/13/07

For a homeowner with a $400,000 mortgage, the rate change from last Thursday to this Friday represents an extra cost of $148 and no change in interest rate. I’ve seen higher fluctuations when Kevin Federline comes to town.

Well, the Fed Funds rate doesn’t directly affect mortgage rates, but mortgage rates are down since last week, so let’s examine exactly what happened, and why it may or may not last.

In simple terms, mortgage rates dropped because investors were pleased at the Fed’s decision to lower the Fed Funds rate, when investors are happy and confident in the US Economy, mortgage rates will generally go down, and that’s exactly what happened on Tuesday.

On the other hand, low interest rates can lead to inflation if the Fed doesn’t remain vigilant. The Fed Funds rate is only a target interest rate; in other words, the Fed doesn’t just come out of its meeting and say, “Let the Fed Funds rate be 4.75%,” and it just happens. The Federal Funds Rate is the rate at which banks lend money to each other, usually overnight, in order to ensure each is meeting the cash reserves it’s required to maintain. If one bank has more than it needs, it lends money to a bank that doesn’t have enough; the rate these banks charge each other is called the Federal Funds Rate. To drive the Fed Funds rate down, the Federal Reserve, in a roundabout way, pumps cash into the banking system. If banks have more cash, there is less demand for interbank borrowing, which leads to a drop in the Fed Funds rate.

Ideally, the cash the Fed pumps into the banking system will be just enough to keep the economy balanced. If the Fed pumps too much money in, banks find themselves with a bit of a surplus, which finds its way into the pockets of you and me. If everyone has more money, they spend more, which means higher demand for products and services, which leads to higher prices for products and services, which is called inflation. So the Federal Reserve has a real balancing act to play in the US economy.

If inflation starts to increase, mortgage rates will rise again simply because investors will demand a higher rate of return to counter inflation. So, while the Interest rate drop will spur the economy in the short term, what happens in the long term is anyone’s guess.

[youtube]http://www.youtube.com/watch?v=0YNyn1XGyWg[/youtube]

Well, the short answer is that the Fed doesn’t have much to do with long-term Mortgage interest rates. The Fed controls only one interest rate, the Fed Funds Rate; however, several other interest rates are based on the Fed Funds Rate, so, indirectly, the Fed controls these as well. The most important of these to consumers is the Prime Rate.

The Fed Funds Rate is the rate at which banks loan money to each other; banks make money by charging a premium on this rate when they lend money to consumers. The Prime rate is currently set about 3% above the Fed Funds Rate and is defined by the Wall Street Journal as “The base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks.” Credit cards and Home Equity Lines of Credit are based on the prime rate, which currently hovers around 8.25%. Long-term mortgage interest rates, on the other hand, are set more like stocks and bonds.

Most people assume that when they get a 30-year fixed rate mortgage, the lender they chose holds that loan until it’s refinanced or paid off; either that or the lender sells the loan to another lender soon after funding. This is only partially true and is misleading if you’re wondering about interest rates. The lender to whom you are making payments holds the servicing rights for your loan, but they don’t actually own the loan itself. What does this mean? Well, the lender gets paid to handle the customer service side of the loan, the only side you’re involved with.

Soon after your loan funds, the lender sells the ownership rights to your loan to one of two semi-private, government backed corporations, Fannie Mae or Freddie Mac. These two corporations package your loan with a bunch of others and sell them on the bond market to private investors in the form of Mortgage Backed Securities; to understand the concept, think of Mortgage Backed Securities as company stock sold on the stock market. Stocks represent an ownership interest in a company, whereas Mortgage Backed Securities represent an ownership interest in a group of mortgages. The investors that purchase your mortgage get paid from your mortgage interest payments. Since the interest you pay on a mortgage goes to these private investors, it makes sense that if there is high demand from these investors for Mortgage Backed Securities, interest rates will go down.

I’ll tell a brief story to illustrate this concept further. A couple years ago I was interested in going to a big 3-day music festival down in Tennessee. The tickets went on sale for around $175 a piece, but they sold out in seconds. After they sold out, the only way you could purchase them was on eBay for around $250 a piece. They went up in price because demand was so high; people wanted those tickets, and they were willing to pay a lot more than face value for them. It’s Economics 101; Supply and Demand.

The same thing happens with mortgages. When a lot of private investors want mortgages, it costs more for the investors to purchase them. But when investors are being paid on the interest collected on a mortgage, the lower the interest rate, the worse it is for the investor. So if there are a ton of investors out there buying mortgages, the lender says, “Hey, Mr. private investor, I know you want to make 8% or more on this investment, but there are a million of you out there willing to make only 5.5%, so if you don’t take it for 5.5% I’ll sell it to someone who will.” So mortgage interest rates are now 5.5%. But what happens if there are no investors willing to make only 5.5% on their investment? The lender has to raise the rates to encourage more investment; now rates rise to, say, 6.5% and more investors are willing to purchase mortgages at that rate of return.

So when mortgage rates rise, it’s because, for a multitude of reasons, investors would rather put their money somewhere else. To encourage the investors to purchase your mortgage, rates go up, and vice versa.

To sum up, the Fed only controls the Fed Funds rate, which has little to do with long-term mortgage interest rates. The private investors purchasing your mortgage are driven more by long-term economic indicators.

The private investors purchasing Mortgage Backed Securities are just like you and me; in fact, there’s nothing stopping you from purchasing Mortgage Backed Securities, other than the fact that they’re usually pretty pricey. One of the major factors that affect mortgage interest rates is inflation. If you were interested in investing $10,000, you’d want to maximize your return on that investment. If you knew that inflation was on the rise, you’d want more of a return because if inflation goes up, your $10,000 is worth less. If a company wants your $10,000 investment, they’re going to have to offer you a higher rate of return to make it worth your while. And like I explained above, a higher rate of return on Mortgage Backed Securities = higher Mortgage Interest Rates for homeowners.