One thing that I’ve been getting a lot of requests about as a Manchester mortgage advice consultant is the ongoing mortgage mess in the US. I wrote a bit about it a while ago, explaining what was going on. But since then, I’ve gotten a lot of people asking me to explain various things about how mortgages work, and what kinds
of trouble people have gotten into.
The basic idea of a mortgage is very simple. You want to buy a house, but you don’t have enough money to buy it up front. So you borrow money to pay for it. A
mortgage is a loan that provides you with money to purchase a house, using the
house itself as the collateral for the loan – so that if you can’t pay back the
loan, the lender is allow to confiscate and sell the house in order to
recover their money.
The mortgage loan is paid back monthly. Normal mortgages are set up using a
simple mathematical structure. You choose a term for the mortgage –
typically 15 or 30 years. The lender chooses an interest rate to charge you. Then
you work out a monthly payment where, if you make the same payment every month,
after the term is over, you’ve the interest rate on the outstanding balance of the
loan each year, and you’ve also payed off everything that you borrowed.
There’s a fairly simple formula. Suppose that you want to borrow P dollars. You want to make a total of n payments. The interest is charged at a rate
of i percent interest per payment period. Then your payment per period can
be given by an amortization equation:
Payment = P ×(n/1-((1 / 1+i)n))
So, if you took out a mortgage at 5% on $100,000, with monthly payments,
and interest charged monthly, then your payment would be 100,000 × (0.004 / (1 – (1/1.004)360)), or roughly $525.
Now, I’m going to get lazy. There are a ton of amortization calculators
around the net; the one that I used calculates based on interest
charged yearly, so the end-result is a tiny bit different – $536 per month, rather than $525. But just that difference should drive home an important fact: even seemingly trivial differences in the exact terms of a mortgage can make
a big deal.
Using the bank’s amortization calculator (I used one on fidelity.com),
on the $100,000 mortgage at 5%, yearly. You’d pay $536.83 per month.
At the end of the year, you would have paid $6442. $4966 of that would have been
interest, and $1476 would have been actually paying back the money that you
borrowed. The part of the payment that is paying back the money you borrowed is
called principal. (You might think that the interest the first year
should be 5% of $100,000; but the interest is always payed on the outstanding
balance, so each month as you pay it down, you’re reducing the amount borrowed. So
you don’t end up paying 5% of the full mortgage value the first year.) The second
year, you again pay $6442, but now you only pay $4891 in interest. And so on,
until the 30th year of the mortgage, when you pay less than $200 in interest.
When you own a house with a mortgage, you can think of it as you and
the bank co-owning your house. You really own part of it – the difference
between the price you could get by selling the house, and the amount of money
you still owe to the bank. The value of the part of the house that you really
own is called your equity. Your equity is equivalent to
the sum of your downpayment on the house, plus any change in the value
of house since you bought it, plus however much of the principal of the loan
you’ve paid back.
The monetary value of owning a home comes from equity. If you’re paying
rent, you’re giving money to the owner of a house, and you’ll never get any of
it back. With a house, you can often get back your equity when you
sell the house. So if the value of the house never changes, you get back part of your monthly payment when you sell the house; if the value of the house increases,
then you can think of it as having earned income on your principal.
Fancy (or Crazy) Mortgages
That’s a simple mortgage. Things in the real world get a lot more complicated. One of the complications is something called an adjustable rate mortgage (ARM). In an ARM, the interest rate changes. Depending on your contract with the mortgage company, the interest rate on the loan can change at certain intervals. Each time the interest rate changes, it’s called a reset. Each
reset, the outstanding balance stays the same, and the monthly repayments
are recalculated using the new interest rate, the outstanding balance, and the number of months left on the mortgage. Suppose that in the $100,000 example, there was a reset after 5 years, which raised the interest rate to 7%. At that point, the outstanding balance would be 91,829. With 300 months left on the mortgage, the
new monthly payment would jump to $649. Altering the interest rate by 2%
changed the monthly payment by about 17%. Small changes in the interest rate
can translate into very big changes in the payment!
Depending on your ARM, you can see multiple resets, creating a huge
change in payments. One of the standard tricks during the great mortgage
mess in the last few years was something called a teaser rate: basically, a bank would offer you a mortgage with an initial interest rate that was incredibly low – some teasers went as low as 1.2% for the first two years. But once they start resetting, they reset to the current standard interest rates, not
the low teaser rate. So people who fell for teasers could see their mortgage rate change from 1.2% to 8% over the span of a couple of resets. In terms of
payments on a 30 year, $100,000 mortgage, that’s changing the payment from $331
at the start, to $617 after resetting to 7% four years into the mortgage.
You can see from this that taking an ARM could be an incredibly
stupid idea. If you only plan to live in the house for 3 years, and the loan
doesn’t reset for three years, then the teaser rate could be a very good deal. But
if you didn’t think it through, you could be royally screwed. An awful lot of
people took ARMs when they really shouldn’t have – some because the banks
refused to offer them anything else; some because they were talked into it
by a fast-talking salesman; and some because they were just plain stupid.
But it gets much worse than that. After along conversation with some folks at Irenas Xero bookkeeper in North Shore, I learned that, A lot of people took
what’s called an interest-only mortgage. That’s not really
a mortgage. The idea is that the bank loans you a bunch of money to buy a house, and every year, you pay back just the interest. So in our example, that means
that every year, you pay the bank $5,000. The idea behind this is that
if the value of the house increases, then when you sell the house, you’ll
be able to pay back the loan and still come out ahead. This is what’s known
as a really bad idea. It was used by a lot of people to buy houses
that they really couldn’t afford. It doesn’t even save you that much – in our example, it saves you $1500 over the course of the year – just a little over $100/month.
But it gets dumber than that. A lot of the interest-only loans
were also adjustable-rate. So people were buying houses that they could
barely afford to make the interest payments on, under terms that allowed
the lender to change the interest rate by more than the difference between an interest-only loan and a normal mortgage!
But it gets dumber than that. There were people who wanted to buy
homes even further beyond their means. So they took what’s called a
negative amortization loan. In that, the bank charges you
a particular interest rate per year; you make payments to them that are
less than the interest rate that they’re charging. So the amount
that you owe to the lender is increasing. When the loan term is up,
you’re expected to pay back the outstanding balance – the original amount that you borrowed, plus the outstanding interest. The idea behind it is that if
the rate at which the debt is increasing is slower than the rate at which the value of the house is increasing, then you’ll still come out ahead when
you sell the house.
Another different but related kind of stupidity is something called
a HELOC, which stands for home equity line of credit. In a HELOC,
you’re taking out a loan secured by the equity you have in your home. In the
old days, HELOCs were called “second mortgages”, and were considered a last-resort
thing to do: if you were in serious financial trouble, you could take out a second mortgage to get some money.
Re-naming them as HELOCs is part of a rather obnoxious scheme. The idea is
that lenders portray HELOCs as “cashing in your equity”. They try to make it
look as if your house is a sort of ATM: you put money into it by paying off
the mortgage; you take money out of it by drawing on a HELOC. It’s presented
as a way of accessing your money.
The problem is, it’s not. It’s a loan, which uses the piece of your home that you own as collateral. And it’s often a really bad loan.
To give you an idea of just how foolish this has gotten, I recently saw
an article talking about how many people had used HELOCs to buy cars. If you
think of it as your money, that seems like it makes sense. You need
a car; you’ve got a bunch of money in equity on your home – why not use your
money to buy the car instead of taking out a loan? HELOC vendors have done their best to convince you to see it that way – that it’s just using your money.
The reason that that’s stupid is that HELOCs are loans. If you
compare the terms of the HELOC to the financing terms being offered by car
dealers, the HELOC is often absolutely horrible. Just for example, I looked
at the current rates. In Westchester county, where I live, there’s an ad in the paper for a Honda dealership offering 2% financing for people with good credit. The current HELOC rate for people with good credit is between 4.7% and 4.9% – more than double! And that 4.7% is a teaser rate: it’s variable, with the interest rate reseting weekly, with a maximum rate of 15%! The 4.7% rate is fixed for the first three months – and then it starts to reset weekly.
This is plenty long, so I’ll stop here. Next part will be about
how banks handle mortgages, and what can go wrong.