Mortgage Deals—Too Good to be True?
Buying a house is a big commitment, both financially and emotionally. When you take the plunge into home ownership, the last thing you want to do is fall prey to lending practices that could jeopardize your mortgage—the loan you secure in order to purchase your home.
Lending companies often offer special arrangements advertised as ways to save you money that in truth don’t save you money at all. In fact, many of these “special” deals can cost you money in the long run.
One prime example is mortgages with no closing costs. Closing costs are a big part of the upfront money you must pay to buy a house. While they don’t cost as much as a down payment, they also don’t contribute toward the cost of the home or property. And according to the Department of Housing and Urban Development (HUD), closing costs average $3,000 for a $100,000 sale. This is money out of your pocket that doesn’t count toward your purchase price.
Removing these costs should be a great deal, right? Not necessarily. Since the banks and lenders make much of their profit through closing costs, they’ll have to make up that money somewhere else in your agreement. The other way banks make money on mortgages is through the interest charged on the loan. So if you don’t have to pay closing costs, chances are good that the bank will be offering a higher interest rate—often considerably higher.
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What’s the big deal, though? You’re going to pay interest, anyway, so what difference will a couple of percentage points make? A great deal of difference, as it turns out. Consider the following example, provided by Kristin Arnold.
If you borrow $200,000 for a 30-year mortgage at 6.5%, you’ll pay out $255,000 in interest over the term of the loan. At 7%—an increase of only a half a percent—that amount rises to $279,000. That half a percent cost you $24,000—all to save you the $6,000 in up-front closing costs.
Private Mortgage Insurance—Adding to the Bill
Another cash sinkhole that can appear on your mortgage payment is Private Mortgage Insurance, or PMI. PMI is insurance placed on your mortgage to protect the lender in case you default on the loan. This insurance is required by the bank. There are, however, some ways to avoid paying it.
PMI is only required if your initial down payment for the house is less than 20% of the house’s appraised value. So the most straightforward way to avoid PMI is simply to make a 20% down payment. PMI won’t be required for the loan, and thus will be eliminated as a concern.
But what if you don’t have enough money on hand to pay 20% up front? One popular way to get around this is to actually take out two loans for the purchase. If you can make a 10% down payment, take out a loan for another 10% and apply this toward the down payment. You will effectively have paid 20%, and PMI won’t be required. This is commonly referred to as an 80-10-10 mortgage. You could also do an 80-5-15, if you only have enough cash to make a 5% down payment.
While this option is popular, it’s not necessarily the best idea. Typically, the interest rate on the second loan will be higher than that on the first, so be sure to ask questions and read all the fine print. Do the math, as well—you might find out you’ll end up paying more in interest than you would have if you’d made the initial, higher down payment.
An additional tip regarding PMI is to be aware that you can pay your loan down and then have the PMI removed after you’ve met the appropriate requirements.
Watch Out for the Yield Spread
Still another hidden cost is the yield spread. This is the difference between the interest rate you qualify for and the interest rate you end up actually paying.
Why would you pay a higher interest rate than you can qualify for? The usual answer is because your mortgage broker wants to make some money on the sale. Brokers are paid yield spread premiums by lenders if they bring in loans at slightly higher interest rates. While this might seem like a scam, it’s generally considered a legitimate way of doing business, though some special interest groups beg to differ.
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Is there a way to avoid a yield spread? Not necessarily. Even dealing directly with the lender, without a mortgage broker in the middle, might not keep you from paying a slightly higher interest rate than you qualify for. The best way to handle the issue of the yield spread is to shop around. Compare fees between brokers, and between different lenders. This comparison shopping will help you determine what constitutes a reasonable yield spread and what is too extreme.
Inflated yield spread premiums are included in almost all subprime mortgage loans. So, as with any business venture, read your contracts carefully before you sign them, and be sure you know exactly what you’re paying for.