Help a Reader: New Mortgage

Here's an email I recently received from a reader:

I have a bit of dilemma I’m hoping readers can help me with.  I purchased a home at the end of 2008, with a rate of 4.75%.  I still owe PMI until I’ve reached 20% equity.  My area has not seen the worst of the economic downturn, but housing prices have taken quite a dip.

A local bank is offering to refinance with as little as 5% equity, and they would not require PMI.  They also have low (for my state) closing costs of $1,800.  They have one rate at 20% equity, a little higher at 15%, higher still at 10%, and the highest at 5%.  At this point I’ve paid the appraisal ($400), and can walk away if I choose.  I’m waiting to see what the valuation is, Zillow estimates 13% equity.

At 10+% equity, the rate would be 4.25%, so rate savings of .5% and no PMI would be worthwhile.  Where I could use some advice is the next part.

My friends have started talking about a "new" type of mortgage.  It's actually a line of credit that replaces your first mortgage (I only have 1).  But confusingly, it’s a still a mortgage product, and interest is tax deductible.  The explanation video is pretty clear, and they have a fairly good simulator on their site.

I never understood why, when paying a mortgage the principle is around  20% of my payment.  I take it they assume you're going to take the full term and bill you in advance for the interest you would owe.  With the line of credit, you only pay interest on the amount borrowed daily.  Pretty innovative, although you are giving up a low fixed rate for a variable rate.  That's about as much as I understand.

It’s difficult to know where to go from here.  The credit line can be for up to 75% of the house.  With its variable interest rate, that seems like a lot given I can lock in such a low rate right now.  A 50% line of credit and 50% traditional mortgage might make sense.  Or perhaps a traditional mortgage at 80% of equity and only using the line of credit to fill in the equity gap and avoid PMI makes more sense.  Or I could forget the line of credit altogether.  If I blend the products, I will pay 2 closing costs obviously.   I’m unsure of how to determine which is the best approach!  Unfortunately I’m not great at math either.

The initial motivation was to lock in a lower rate and get rid of PMI, reducing my payments.  I have a 791-833 credit score from the 3 agencies.  I am not able to pay extra toward the mortgage at this time, and I’d like to decide without assuming I will, but I plan to.

I appreciate any advice you can give.  Thanks!

What's your advice for him?

Comments

[Luis]

This is pretty easy, never trade a fixed mortgage for a variable one. Reason is that interest rates can jump more than 10% in a matter of days. Look at a graph of interest rates from the 80's and you will see clearly what happened before and what can happen any future day from now. Would this scenario be more costly than a PMI? You betcha!

[Kris @ Everyday Tips]

There is no way I would switch to a variable rate mortgage. At this point, there is only one way for mortgage rates to go, and that is UP. You don't have extra money to pay on the mortgage now, so you are looking at holding this mortgage for a long time.

I didn't even know it was possible to not pay PMI if you have less than 20 percent equity.

Remember, 4.75 is actually a pretty decent rate, you don't have to race to do anything. Plus, don't base all your decisions on what Zillow says, there data is not necessarily accurate.

[Strick]

"I never understood why, when paying a mortgage the principle is around 20% of my payment. I take it they assume you're going to take the full term and bill you in advance for the interest you would owe. With the line of credit, you only pay interest on the amount borrowed daily. Pretty innovative, although you are giving up a low fixed rate for a variable rate. That's about as much as I understand."

I don't know anything about the product but question if you've had it adequately explained. On a regualar mortgage, you are not pre-paying interesting but are only paying the interest accrued. The reason why its so much of your payment at the start is because your balance is at its highest point. As the balance is paid down more and more goes to principal as the interest on the balanace becomes smaller and the payment is structured to be level. You could always pay more on the principal on your own. To both pay more and keep a convienient even payment, you could go with a 15 year, but sounds like thats a stretch right now.

So without better info, its hard to think a variable rate would be wise.

[Matt]

If it is rather complicated then it probably is and you are missing something. This is how so many people got caught in the foreclosure mess. They got into mortgages they did not understand.

Forget the hokus pokus and go with a mortgage you understand.

If we did not have all these lending institutions figuring out ways to avoid PMI we would not be in the foreclosure mess we went through and are still currently in.

[evilhomer]

@Luis, that's a good point and I have certainly been looking at the early 80's in particular. But that seems to be a pretty spectacular occurrence, not seen since the great depression. While it's obviously a concern, the risk seems quite low. I'm trying to balance risk versus reward.

@Kris, I didn't know it was possible either. They tell me they can because they're a local community bank. You are correct about Zillow. Since I submitted the story I've received the appraisal and I have less than 5% equity.

@strick thank you for the explanation. Yes, a 15 year would be difficult at this time. Paying more was also FMF's suggestion, but if that's not possible, generating less interest via a daily rate of (balance minus current savings) achieves a similar effect, right? Although that assumes the variable rate remains reasonable.

@matt, that's a very good point. I'm certainly trying to become more informed before making a decision.

[Mark]

While I agree that a fixed-rate mortgage looks good at this point in interest-rate history, do not be scared off by the comment that interest rates can rise 10% in a matter of days. In the 1990's, I had a variable-rate mortgage, and it had caps - no more than 2% interest rate increase per year and max of either 6 or 10% over the life of the loan.

As for the line of credit - even if you only pay interest on the amount you owe that day, don't forget that you owe most of that principal EVERY day of the month for many years.

[Mike]

"...a "new" type of mortgage...The explanation video is pretty clear...I never understood why...Pretty innovative...That's about as much as I understand."

One of my personal investment principles is to avoid things which have primary adjectives of new or clever, and to never sign up for something that I can't explain clearly and concisely.

It's not that I'm real smart or that new or complicated things aren't viable financial tools but I'm not willing to make assumptions.

I'm also not saying that you don't understand what you're getting into. The language you use just doesn't carry much conviction.

[Bill]

First the advice to never get a variable mortgage is not correct, there are times when a floating rate loan is going to be a better choice. That being said it's unlikely to be a good choice for you, that mainly stems from the length over which you are borrowing, the low level of absolute rates, as well as the relative flatness of the yield curve. That's a fancy way of saying a floating rate loan doesn't save you as much versus a fixed rate loan as it has in the past.

Second, it is perfectly acceptable for a bank to give you a high LTV loan without PMI. Fannie Mae, Freddie Mac, and FHA all require PMI for high LTV loans and they are issuing the overwhelming majority of mortgages in the US these days. For that reason it is quite unusual to see a high LTV loan without PMI offered but there is no reason it couldn't be.

Thrid, the "new" type of mortgage you are referring to is not actually new or really unusual in any way. It is simply a HELOC, a home equity line of credit. The bank would approve you for some maximum amount of credit, 75% of your LTV in your case, and you would borrow some fraction of that. If you had no mortgage your might apply for the HELOC and then not draw out any money, simply holding it as an emergency source of cash. Or at the other extreme, your situation, you'd borrow the maximum right away to pay off your first mortgage.

It's important to realize that the HELOC has no magical properties that will save you interest. It's a very basic loan even simpler than a traditional 30 year fixed mortgage in my opinion. The savings you would get come from two places.

The first is the lower interest rate on your HELOC. That would disappear if interest rates were to rise substantially and you could get those savings from refi-ing into a lower rate fixed product also.

The second source of savings you get from using a HELOC to finance your home and the major selling point from anyone who promotes this strategy is from combining a cash savings account with your HELOC.

Think of it this way, you might have a 100k mortgage and a 25k emergency savings account. If you used a HELOC to finance instead of a traditional mortgage you could get a 100k maximum balance HELOC and only borrow 75k from it. Both of these situations are fundamentally equivalent. You have the same net worth, 75k (100k-25k) and you have access to 25k in cash. However in the first case you are paying 4.75% interest on the 100k mortgage and only earning .1% on the savings account. In the second case you are only paying your HELOC rate on the 75k balance. Conceptually you can now earn your HELOC interest rate on any cash accounts you own that you've combined with the HELOC.

That's a great deal, it's not hocus pocus, it's a real effect that can be very valuable. Before you rush into HELOC financing you need to realize that there are major risks to the strategy. As I mentioned briefly the HELOC interest rate is going to be variable so if interest rates were to go up substantially it could wipe out any savings you had obtained. Tt could even end up costing you more than a fixed rate loan in the long run. Second and just as scary is that your cash savings are now only accessible if the bank keeps your credit line open. If in our imaginary scenario you had a 125k home and got approved for a 100k HELOC you would need the full amount of that HELOC to remain open to access your 25k in savings. If home prices declined and your home was worth only 100k you'd be limited to 75k in total drawdowns and find your 25k savings were now inaccessible.

I think this is a wonderful strategy that should be used by more people. However, because of the two reasons I just listed I think it's appropriateness is going to always be limited to a rather small segment of the population. I don't think you fit in to that. I would recommend this strategy only when your borrowing horizon is relatively short (5-10 years perhaps?), the LTV you are depending on using is relatively low (50 LTV?), and the amount of cash savings you are going to be combining with the HELOC is relatively high (25% or more of the total HELOC balance). You don't seem to meet any of those criteria so I would advise you not to go this route.

[Tato]

I agree with Bill, in that this is not a new product and has been around. I know of some acquaintances that use this approach for paying down their mortgage, however, I am not sure what their thoughts are about the prorgam are now (it was five or so years ago that they had talked about the program, and that was in the hey day of the home appreciation).

I would be leary of doing this program, just due to the risk related to rising interest rates. I am guessing that rates will remain low for the next several years based on communications from the Fed that they will try to keep rates at current levels until the end of 2013, but who knows where interest rates are headed after that. Since I can't predict rates in the future, I want the protection that comees with a fixed mortgage rate until the home is paid off.

[evilhomer]

@mark another good point. I don't see the cap number, but the article below said it is (or was. the article is undated) 5% over the initial rate.

@mike I certainly appreciate your point. I'm not looking to jump into something I don't understand. I'm working to understand it.

You had me wondering how new is it? I found that it was offered 25 states by 2007, so it's still relatively new here. But "in Australia, more than one-third of homeowners use a mortgage accelerator program. In the U.K., it's about 25 percent."

@bill insightful response, I appreciate the clarity. You're right, the time horizon really concerns me. LTV is high, given my low equity. And my cash savings are ok for an emergency fund, but well below 25% of the total balance.

Although it's obviously similar, it's a bit different than a HELOC. The article I found when looking to reply to Mark gave some differences.

Here is the link if anyone's interested: https://origin.bankrate.com/brm/news/mortgages/20061102_equity_accelerator_mortgage_a1.asp

Thank you again for the comments.

[Nashville]

My opinion is to run away from any variable rate mortgage as fast as you can. With a variable rate loan, the bank has the control. With a fixed rate loan, you have the control.

In 1994, my wife and I had our house built with a 7.50% 30-year mortgage. In about 3 years I was able to begin adding extra money to the payments. In 2003 we refinanced to a 5.25% 15-year mortgage but kept paying the same or more monthly payments we were before. In December, 2009, we paid off our mortgage completely. 15 years from start top finish. It does take some income but mostly it takes discipline.

[Apex]

Bill's description of what this is, is pretty accurate.

It can save some people some money, but most people will save very little or even lose.

The biggest warning sign is that website. It's a misleading, over-hyped, marketing gimmick. No where in there do they really explain the details. No where do they mention the pitfalls. No where do they tell you that it's actually just a product that allows you to put more of your money into your mortgage faster and then take some of it back out later if you need to.

Instead they allow you to believe the product is doing some kind of magic or secret that until now as been hidden from people. Now they don't say that but this comment by the person asking the question is very enlightening:

"I never understood why, when paying a mortgage the principle is around 20% of my payment. I take it they assume you're going to take the full term and bill you in advance for the interest you would owe. With the line of credit, you only pay interest on the amount borrowed daily. Pretty innovative, although you are giving up a low fixed rate for a variable rate. That's about as much as I understand."

I am sorry to the question asker but this quotation shows that this product's marketing has tricked them. The reason you pay 20% or even as little as 10% of principle is because in one month's time your loan has accrued that much interest and you need to pay that all back. That's how amortization works. It is designed to have the loan paid off in 30 years with equal payments. If you wanted to have half of the payment be principle you can easily do that. It's called a 15 year mortgage. If you wanted 2/3 of the payment to be principle its called a 10 year mortgage. Ah but the payment is so high on those you say. Exactly. The interest on the first payment is the same in each of those products, to pay more principle you simply have to make a much higher payment so that after paying the large interest payment there is more left to go towards principle.

[Apex]

Part II

Now the people on that website people who claim to be paying off their house in 7-8 years are simply paying 2-3 times more toward the mortgage every month than they would normally pay on a traditional mortgage. They are doing exactly what I describe above. Paying down more principle with higher payments. There is simply no magic bullet to paying down a mortgage quickly other than one thing, making higher payments to pay down principle faster.

If you are saying right now that a 15 year is a bit of a stretch for you then you are saying you can't afford to pay much more towards principle which means this plan is going to save you very little.

Worse yet, for people who do not fully understand what it is, this system will allow them to get into trouble. How? Because you are allowed to make smaller payments if you need to. This is called reverse amortization. It means that the amount you pay doesn't even cover interest which means the amount you owe owe gets larger with each payment. Further more you could exactly pay nothing and extract money out just like you could on a HELOC. This could be used to justify all kinds of spending that you might not otherwise do and it will leave you with a huge unpaid balance on your mortgage. That is exactly what millions of people did in the 2000's and are now losing their homes. This product is only appropriate for people who truly understand it and who have strong discipline. And for most who do they likely don't even need it as a 10 or 15 year loan with an amazingly low fixed rate is probably far better.

As others have already said, when there is the promise of something new and way better you should expect it's likely not true. Mortgages have been around for more than half a century. There is no undiscovered magic in mortgages.

Don't use this product. There is not real benefit here for you, only potential trouble.

[evilhomer]

@nashville good point, especially with rates as low as they are currently.

@apex thanks. I appreciate your insight, not just in regard to this product, but all over FMF. When I first saw the site, I thought it was scam. It is marketed in a scammy way, but it's legitimate product. That being said, you're right. I think my time horizon is too far off, and my income insufficient to make this worthwhile. Too much risk for too little reward.

Thank you both, keep the comments coming!

[Bill]

I don't believe you are correct in your understanding of the product, the linked article from Bankrate says specifically that the product is simply a HELOC.

The "offset" mortgages that are popular in England are different. In that case you do have a 100k mortgage and a separate 25k savings account and the bank agrees to charge you interest on the net amount of the two. It is my understanding that these cannot exist in the US because of IRS regulations. The bank has to charge you and report the interest on the mortgage balance alone. This means the only way to replicate the "offset" account type structure is to use a HELOC. And that by necessity puts your savings at the mercy of your line of credit.

[jim]

I agree with Apex.

This kind of mortgage is often marketed as a 'money merge' account or referred to as 'the Australian method'. They may have high closing fees, they may require you to buy fancy software for thousands of dollars (that you don't really need) and they likely carry annual fees. They are almost always over hyped with glitzy and confusing marketing. They're almost always a bad choice.

They outright claim you can pay off your mortgage in 'half the time' and theres no possible way to pay off a loan in half the time of a 30 year term unless you're making extra principal payments.

[evilhomer]

@bill that's not quite right. It says "Homeowners could cobble together a payment plan similar to a mortgage accelerator on their own by taking out a conventional HELOC, but a mortgage product specifically structured for this approach to consumer finances has some advantages." The differences are subtle, but it's not quite the same.

It is talking about products that are legal in the U.S.(in at least 25 states).

@jim $4k closing costs, higher than the community bank, but fairly typical for my state. No software or fees that I'm aware of, but before contacting them, I contacted FMF. They may reveal those later.

I more wondered if I might pay the house off in 22 or 23 years rather than 30 with this method. I wouldn't expect 15.

Thanks again.

[Apex]

@homer,

You will not pay the loan off in 22 or 23 years with this method unless you make extra principle payments which you can easily do without this product. There is another trick product out there that convinces people they can pay their mortages off in 23 years by simply switching to paying a half payment twice a month rather than a full payment once a month. They imply repeatedly that the savings by paying interest down intra-month is huge. But that is simply not true. Paying a little interest a little early makes almost no difference. Paying twice a month probably shaves at most one monthly payment off a 30 year loan but probably closer to one half of a payment.

The trick is that the plan doesn't have you pay twice a month. Instead what you actually do is you pay bi-weekly. Which for most people seems like twice a month. But twice a month would result in 24 annual payments and bi-weekly is 26 annual payments because there are 4.5 weeks in a month not 4.

[Apex]

Part II

So in the end you end up making 13 full month payments every year instead of the 12 with a typical mortgage. And that one extra payment goes 100% to principle. And that extra principle pay down goes a long way.

So if you want to pay your mortgage down in 23 years I can tell you how to do so very easily. Once a year make a double payment. Or alternatively make your monthly payment 8% higher than the mortgage requires each month. If you do either of those you will pay off a 30 year mortgage in 23 years. Because that is exactly how the bi-weekly payment plan does it.

No amount of interest floating or other strange tactics can do that.

[Apex]

sorry to keep splitting the posts. I have no idea why but neither one of my posts were accepted in their original form so I just split them and then they post.

[evilhomer]

Good point again Apex. Thanks for the reply.

Appreciate everyone's comments. Thank you!

[Bill]

Not to beat a dead horse but I really think you are confused about the structure of the product. The Home Ownership Accelerator website you linked to clearly states it is a HELOC.

"Loan Type: First lien line of credit, adjustable rate, based on 1-month Libor index."

They are selling you a HELOC and calling it an "accelerator", you don't have to cobble anything together to reproduce this product on your own. The only thing thing they are actually doing for you is sweeping your checking account into the HELOC automatically. Any standard HELOC will allow you to make payments with checks, a debit card, or an online account. Any HELOC will allow you to deposit your regular check and pay down the balance.

The differences are not subtle they are nonexistent. My local credit union will let me take out a HELOC and open a checking account simultaneously and transfer cash between the two.

Selling a standard loan product using misleading language leads me to believe they are going to overcharge you. What is the rate they are quoting you?