7-21-06
The Homebuyer’s Vocabulary List – 2
Part of what makes buying a home particularly daunting for us is the vast new set of terms and acronyms we are forced to digest in order to stay on top of the whole process. This issue’s article will focus on clarifying some of the jargon and phraseology which is often heard but often misunderstood when buying a home. [Note: This is our second journey into home buying vocab; if you missed the first one, you can catch it here.]
Prepay
When you ask your “homeowner friends” (that’s what I used to call them anyway) for advice, most of them will probably tell you to avoid any prepayment penalties. While that advice is usually good it isn’t always. Either way, what are they talking about?
A prepayment penalty, also called a “prepay,” is a fee charged by the lender if the property owner wishes to repay part or all of his or her loan in advance of the regular schedule. This prepayment typically includes selling the property or refinancing the mortgage, anything that would terminate your relationship with your current lender. Prepayment penalties usually range from two to three percent and usually have a time limit, i.e. you would only pay the prepay penalty if you sold or refinanced within the first, say, three years of the mortgage agreement.
So why do some homeowners have a prepay attached to their mortgage? Well, in some cases, it might make sense. You can occasionally secure a slightly lower rate by agreeing to a prepay. For example, your rate might be lowered by one-quarter point if you agree not to pay off your mortgage within the first three years of the agreement. If you are certain you will be remaining in the property for at least five, this move might make good financial sense. Second, sometimes homeowners do not have a choice. If you have less-than-great credit or a recent bankruptcy or other issues, you might need to go with a “sub-prime” lender; “sub-prime” loans often require a prepay. Finally, some homeowners might not even realize that there is a prepayment penalty attached to their mortgage, either because their loan officer didn’t tell them or because the officer wasn’t aware of it. For this reason, always check with your loan officer to see if there is a prepayment penalty included in your mortgage.
Lock
The lock or rate lock is a lender’s promise to hold a certain interest rate for you, for a given number of days, while your loan application is processed. From the day you initially apply for your mortgage, the interest rates quoted to you may stay the same, decrease, or increase. The lock offers you a way to ensure that what you shop for is what you get.
Rate locks may be offered for up to 60 days, with longer locks sometimes available, but perhaps requiring an additional fee. It is important to check with your loan officer regarding your lock expiration to make sure the closing date specified by the contract falls comfortably into the lock period. Similarly, if you need to push your closing date, the lock might expire and you might lose that rate, so be sure to check with your loan officer before agreeing to move your closing date!
Interest Only
Some of those “homeowner friends” of yours might also suggest you take a look at “going interest-only.” As we know, a standard monthly mortgage payment consists of principal and interest. As you might suspect, a mortgage is interest only (IO) if the scheduled monthly mortgage payment – the payment the borrower is required to make – consists entirely of interest on the loan. You will most likely have a slightly higher rate and the option to pay interest usually only lasts for a specified period, usually 5 to 10 years. Borrowers have the right to pay more than interest if they want.
For example, a 30-year fixed rate mortgage of $100,000 at 7 percent has a monthly payment of $665.30, which consists of $583.30 of interest and $82.00 of principal. The interest-only payment would, of course, be $583.30; there is no payment to principal.
Why go interest only? The most common reason is financial flexibility. A concern of many first-time homebuyers is keeping their new home payment as close as possible to their current home payment, i.e. rent. Going interest only may enable you to accomplish that goal.
ARM
ARM is an acronym for Adjustable Rate Mortgage. As its name implies, an Adjustable Rate Mortgage or ARM is one in which the rate changes (adjusts) on a specified schedule after an initial “fixed” period. That initial period can be anywhere from one month to 10 years; the shorter the time span, the lower the rate. Over that initial fixed period, you will enjoy a rate that is better than the standard 30 year fixed rate mortgage.
But what happens after that initial time period ends and your mortgage rate begins to adjust? The amount of the rate change (referred to as an adjustment) will be determined by a mathematical formula based on a particular index, the most common being the 1-Year U.S. Treasury Bill or the Cost of Funds Index (COFI). Most adjustable rate mortgages have a lifetime rate cap (also called a ceiling), which limits the amount the interest rate of the loan can increase over the life of your loan. Most adjustable rate mortgages also have a periodic rate cap, which limits the amount of the rate increase for each adjustment. The lender typically will adjust your ARM rate upward by a maximum of 2 percentage points a year (that’s the periodic cap), and a max of 6 percent over the entire loan period (that’s the lifetime cap).
For example, a five-year ARM that starts out at, say, 6.25 percent can increase to 8.25 percent in the sixth year, to 10.25 percent in the seventh year, and to 12.25 percent in the eighth year. Kinda scary, but if you are certain you will be selling or refinancing within five years, an ARM might be able to save you an arm and a leg (ok, that was bad, but you get the point).
As always, if you have any questions, even if you already are a homeowner, feel free to call or e-mail me anytime. Please send me any comments or suggestions about this column, and let me know if there are topics you would like to see discussed.
Mike McNamara has been an actor in Chicago for the past eight years in theatre, commercials, television and film. Mike is also a Loan Officer with West America Mortgage Company. He can be reached anytime at 773/398-0021 or McNamara310@aol.com. Special thanks to Jim Morley, Assistant Vice President of West America Mortgage Company (and Chicago theatre actor) for contributing to this article. Jim can be reached at 773/594-9777 or at JMorley@wamc.com.