Conventional Mortgages

A conventional loan is one that is not guaranteed or insured by the federal government under the Veterans Administration (VA) or the Federal Housing Administration (FHA), or the Rural Housing Service (RHS) of the U.S. Department of Agriculture.  About 35-50% of mortgages, depending on market conditions and consumer trends, are conventional mortgages,   which mean the underlying terms and conditions meet the funding criteria of Fannie Mae and Freddie Mac. In other words, Fannie Mae and Freddie Mac guarantee or purchase 35-50% of all mortgages.

At one point in our history, conventional loans were the only mortgage loans available and they were all made by local lenders such as banks, savings and loans, and credit unions. They kept and serviced these loans in their own portfolio until they were either paid in full or foreclosed on.

In the late 1930's, a secondary market was created which allowed these local lenders to sell their loans, getting the full payment much more quickly allowing the local lenders to reinvest those funds into new mortgages. This secondary market greatly increased the availability of mortgages.  The servicing lender that purchased the loan will collect payments from the borrower. Today it is very common for lenders to sell their loans to the secondary market.

Conventional loans may be "conforming" and "non-conforming". Conforming loans follow the terms and conditions set by Fannie Mae and Freddie Mac and do not exceed $417,000. Non-conforming loans don't meet Fannie Mae or Freddie Mac qualifications, but are also considered conventional.  Due to the changes in the market in the last year, there are very few non-conforming loans being offered.

Another category of loans, jumbo loans (greater than $417,001), falls outside of Fannie Mae eligibility but is also considered conventional. A jumbo loan is a loan above the maximum loan amount established by Fannie or Freddie and they usually have a higher interest rate. 

Choices to Make

Term

Conventional mortgages have various repayment terms to select from.  The most common repayment term is a 30 year term.  Following that is a 15 year term. Of course the shorter term will reduce the interest paid over the life of the loan.  The following terms are available: 

                   50 Year  ~  40 Year  ~  30 Year  ~  20 Year  ~  15 Year  ~  10 Year

Not all lenders offer each of the terms, so check with your loan offer to discuss which terms are offered by each specific lender.

Fixed vs. Adjustable

Which is the better mortgage option for you: fixed or adjustable?

The low initial cost of adjustable-rate mortgages (ARMs) can be very tempting to home buyers, yet they carry a great deal of uncertainty. Fixed-rate mortgages (FRM) offer rate and payment security, but they can be more expensive.

Here are some pros and cons of ARMs and FRMs.

ARM Advantages

·         Feature lower rates and payments early on in the loan term. Because lenders can use the lower payment when qualifying borrowers, borrowers can purchase larger homes than they otherwise could buy.

·         Allow borrowers to take advantage of falling rates without refinancing. Instead of having to pay a whole new set of closing costs and fees, ARM borrowers just sit back and watch their rates fall.

·         Help borrowers save and invest more money. Someone who has a payment that's $100 less with an ARM than with a FRM for a couple of years can save that money and earn more off it in a higher-yielding investment.

·         Offer a cheap way for borrowers who don't plan on living in one place for very long to buy a house.

ARM Disadvantages

·         Rates and payments can rise significantly over the life of the loan. A 6 percent ARM can end up at 11 percent in just three years if rates rise.

·         A borrower's initial low rate will adjust to a level higher than the going fixed-rate level in almost every case even if rates in the economy as a whole don't change. That's because ARMs have initial fixed rates that are set artificially low.

·         The first adjustment can be a doozy because some annual caps don't apply to the initial change. Someone with an annual cap of 2 percent and a lifetime cap of 6 percent could theoretically see the rate shoot from 6 percent to 12 percent, 12 months after closing if rates in the overall economy skyrocket.

·         ARMs are difficult to understand. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused or trapped by shady mortgage companies.

·         On certain ARMs, called negative amortization loans, borrowers can end up owing more money than they did at closing. That's because the payments on these loans are set so low (to make the loans even more affordable) they only cover part of the interest due. Any additional amount due gets rolled into the principal balance.

FRM Advantages

·         Rates and payments remain constant. There won't be any surprises even if inflation surges out of control and mortgage rates head to 20 percent.

·         Stability makes budgeting easier. People can manage their money with more certainty because their housing outlays don't change.

·         Simple to understand, so they're good for first-time buyers who wouldn't know a 7/1 ARM with 2/6 caps if it hit them over the head.

FRM Disadvantages

·         To take advantage of falling rates, FRM holders have to refinance. That means a few thousand dollars in closing costs, another trip to the title company's office and several hours spent digging up tax forms, bank statements, etc.

·         Can be too expensive for some borrowers, especially in high-rate environments, because there is no early-on payment and rate break

·         Are virtually identical from lender to lender. While lenders keep many ARMs on their books, most financial institutions sell their FRMs into the secondary market. As a result, ARMs can be customized for individual borrowers, while most FRMs can't.

All of these things should factor into your decision between a fixed-rate mortgage and an adjustable one. But there are other important questions to answer when deciding which loan is better for you:

1. How long do you plan on staying in the home?
If you're only going to be living in the house a few years, it would make sense to take the lower-rate ARM, especially if you can get a reasonably priced 3/1 or 5/1 ARM. Your payment and rate will be low and you can build up more savings for a bigger home down the road. Plus, you'll never be exposed to huge rate adjustments because you'll be moving out before the adjustable rate period begins.

2. How frequently does the ARM adjust, and when is the adjustment made?
After the initial fixed period, most ARMs adjust every year on the anniversary of the mortgage. The new rate is actually set about 45 days before the anniversary, based on the specified index. But some adjust as frequently as every month. If that's too much volatility for you, go with a FRM.

3. What's the interest rate environment like?
When rates are relatively high, ARMs make sense because their lower initial rates allow borrowers to still reap the benefits of homeownership. The chances are fairly good that rates will fall down the road too, meaning borrowers will have a decent chance of getting lower payments even if they don't refinance. When rates are relatively low, however, FRMs make more sense. After all, 7 percent is a great rate to borrow money at for 30 years!

4. Could you still afford your monthly payment if interest rates rise significantly?
On a $150,000, 1-year adjustable-rate mortgage with 2/6 caps, your 5.75 percent ARM could end up at 11.75 percent.

Down Payment

Most conventional loans now require at least 5% down payment.  Based on your credit score you may be required to put 10% or even 20% down.  The higher the down payment, the better interest rate you will receive.  Lenders have more risk when less is put down so they charge a higher interest rate.  In certain situations we can use a second mortgage in conjunction with a first mortgage; this would eliminate the need for Private Mortgage Insurance (PMI).  PMI is required on any mortgage that the loan exceeds 80% of the purchase price.  The PMI protects the lender in the event of default on the mortgage; it offers no coverage to the borrower personally.

A borrower can request a lender drop their PMI when the loan to value equals 80%, the lender must drop it at 78%.  Recently PMI has been made a deductible expense as long as you earn under $100,000 Adjusted Gross Income (consult a tax professional).  The deductibility makes PMI much more attractive to borrowers since at least it can possibly be a Federal Tax Deduction. 

We discuss in great detail the structure of each loan with our borrowers.  Since everyone’s needs are different, there is no cookie cutter approach to meet everyone’s goals.  This is why our Loan Officers take a great deal of time in structuring the loan to meet the best financial objectives of the borrower.  We have a Financial Planner who can meet with borrowers and provide advice regarding which account to move money from the cover the required don payment and closing costs.