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When buying a home or refinancing, it pays to conform

By Philip van Doorn - sbup

With all the dreadful news and market action on banks home and abroad over the past few days, we need to remember that life goes on, and it’s possible to find some benefit in the current environment.

With the federal funds target rate lowered on Dec. 16 to a floating range between 0% and 0.25% and prime to 3.25%, mortgage rates have dropped dramatically over the past month. As expected, this and the freefall of home prices in areas like California have led to an increase in mortgage applications for home purchases.

Refinancing activity has picked up as well. However, with so many people “upside down,” or owning mortgages that exceed the market values of their homes, refinancing isn’t an option for everyone.

According to the Mortgage Bankers Association survey for the week of Jan. 15, mortgage application volume increased 96% from the previous week and 52% from the same week a year earlier.  

On Wednesday, sbup’s composite index for 30-year fixed-rate mortgages was 5.15% and 4.88% for a 15-year fixed.  

The variable rate indexes were considerably higher. It’s best to stay away from variable-rate loans anyway because of the additional risk if rates increase. There’s considerable risk of a drawn-out, painful increase in interest rates at some point, since the federal government is borrowing so much money to bail out banks and other companies, as well as to stimulate the economy while tax revenues are declining.

Some readers will remember the tough remedies for inflation, including high double-digit rates in the early ’80s. You could be in for some real trouble if you have a variable-rate mortgage going into one of those periods. Of course, your loan officer or mortgage broker may have an incentive to persuade you to take an adjustable rate mortgage. You’ve been warned.

The composite rates are gathered by RateWatch, sbup’s sister company. Banks, thrifts and credit unions are asked to provide rates for “conforming” mortgages of $175,000.

What is a conforming mortgage and why should I care?

All that matters is getting the best rate, right?

Actually, it’s not that simple, and learning a few things about the secondary market for mortgages can help you get a competitive rate and possibly make it easier to sell your home down the line.

Banks love to sell fixed-rate mortgages. Not only do they usually make a small profit if they quickly sell new loans, they remove the interest-rate risk from their books. If a small community bank is holding a portfolio of mortgages with rates averaging 6% while entering a period of double-digit short-term rates, their earnings could be wiped out.

The easiest way for banks to make and quickly sell mortgages is through Fannie Mae (FNM) and Freddie Mac (FRE). While they were placed under conservatorship by the Treasury in September, the mortgage giants are still operating, providing underwriting guidance to banks and other lenders, and purchasing loans.

Mortgage loans that conform to Fannie and Freddie’s requirements and are eligible for sale tend to have the lowest rates.

There are many factors that Fannie and Freddie underwriting guidelines consider when determining whether a loan is eligible for purchase. The easiest one to consider is the single-family mortgage-loan limit.

During 2006, 2007 and part of 2008, the conforming loan limit was $417,000. Loans with higher balances, known as “jumbo mortgages,” had much higher rates. Of course, in areas such as the suburbs of New York City, this was a complete joke, as it was very difficult to find a house whose price was low enough to qualify for a conforming loan.  

This problem was addressed by the Economic Recovery Act of 2008, which changed the definition of a conforming loan. There are now a “general” set of limits and a “high-cost” set for the lower 48 states, D.C. and Puerto Rico, and a different set for Alaska, Guam, Hawaii and the U.S. Virgin Islands.

The basic sets of limits for Fannie Mae can be reviewed here. The limits for high-cost areas vary, and you can review the limits for specific areas of the country by downloading the Loan Limit Lookup Table available on the top right of the page.

This information can help you consider how expensive a home you may target, if you are looking to get the lowest possible mortgage rate. Of course, you can also make sure your loan conforms to the limit by making a larger down payment.

There are many other factors considered by Fannie and Freddie in determining whether a loan is eligible for purchase (and therefore a preferred rate), and since all are considered when a loan is underwritten, no benchmarks are set in stone.  

There is generally a requirement for the loan-to-value ratio to be 80% of the home value or less, otherwise you will need to pay monthly private mortgage insurance (PMI) premiums. PMI is a complete waste for the borrower, since it only protects the lender, Fannie or Freddie.

Debt-to-income ratios are also considered. For example, a good rule of thumb is that the mortgage payment shouldn’t be higher than 33% of your gross monthly income, and the total of all your monthly credit payments shouldn’t exceed 40% of your monthly gross income.

It is also rare for Fannie and Freddie loans to be extended to borrowers with credit scores below 620. Generally, Fannie and Freddie will charge fees to banks to purchase loans made to borrowers with lower credit scores. These fees are passed on to the borrower.  

Finally, Fannie and Freddie also have guidelines against purchasing loans collateralized by homes in under-developed areas, homes that don’t conform to most of the other homes in an area, etc. So if you are considering being the first one to buy a home in a new development or buying the biggest house (by far) on the block, it’s best to have a detailed discussion with your lender first.

Consider the Loan Term

While 30-year mortgages are the most common, many people take 15-year mortgages.  Not only will the mortgage be paid off 15 years earlier, but the rate is likely to be lower. And while you might not stay in the home 15 years, whenever you sell, your equity percentage will be higher.

Here’s an example using sbup’s Wednesday composite index of 4.88% for conforming 15-year fixed-mortgage loans, compared to 5.15% for 30-year fixed.  

If we look at a $200,000 mortgage, the monthly principal and interest payments for a 15-year mortgage would be $1,569, and the interest over the life of the loan would amount to $82,440.

On the other hand, monthly payments for the 30-year loan would only be $1,092, but the interest over the life of the loan would total a whopping $193,137, more than double that of the 15-year loan.

As you can see, taking a shorter-term mortgage will save you an amazing amount of interest over the life of the loan. Of course, the sacrifice of paying an extra $477 per month in this example may be too much.  If so, consider a 20- or 25-year mortgage. Many people don't realize they are not locked into selecting from 15- or 30-year mortgages.

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