Qualify Then Buy

Anyone watching or reading the financial news over the last few weeks has seen a lot of angst and consternation over the state of the mortgage industry. In fact, one of the larger lenders in the US, American Home Mortgage, was forced to shut down operations recently. But why? What is happening, what does all this mean to you and most importantly… what should you be doing do right now to make sure you are protected?
Here’s the scoop.
Over the past several years, many loans were made to homeowners with somewhat non-traditional or “non-conforming” situations, be it a poor credit history, inability to document income, or any number of factors that do not fit within the traditional “box” for home loans. These loans are often called “Sub-Prime”, or “Alt-A”, meaning that they were somewhat riskier in nature than A credit, prime, or traditional loans. Another type of “non-conforming” home loan is one where the credit and income might be perfectly fine, but the loan amount is higher than $417K, which is the current maximum loan that can be done using pools of money from mortgage giants Fannie Mae (FNMA) and Freddie Mac (FHLMC). If the loan amount is higher, it can certainly be done - it’s called a “jumbo loan” - but the end

Investing in real estate used to be considered a “no brainer,” a can’t-miss investment.

But these days, this sure thing isn’t so sure. Home prices keep falling. Standard & Poor tracking shows prices down 7.7 percent nationally in November 2007.

The National Association of Realtors, or NAR, reports that sales of single-family homes were down by 13 percent in 2007, the biggest drop since a 17.7 plunge in 1982.

Representatives of the NAR say that this makes it the best buyer’s market in a long time. Prices are down, interest rates are near a 45-year low and the supply of houses is high.

But others argue that with the real estate market in a tailspin, it might be a very long time before prices rebound — making it a poor market at this time.

Even those who advocate real estate investing concede that you need the right circumstances before you take the plunge.

Who Should Buy a Home?

“Dual-income customers should definitely buy a home now,” says George Kaiser, vice president of banking operations for Northbrook Bank and Trust and West America Mortgage Co., its sister company. “People with assets in reserve and a credit score of at least 680 should buy as well. Anyone with a credit score less than that will have to verify their income.”

Renters who have stable jobs might find this a good time to try homeownership because of the lower prices, says Scott Rose of Coldwell Banker in Deerfield, Ill.

William Chu, senior mortgage loan consultant, American Chartered Bank, suggests it’s a particularly good time to look at the higher end properties if you can afford them because with the pool of buyers shrinking, upper market sellers are lowering their prices to attract a larger pool.

“So if you qualify, you could purchase a more expensive home at a much lower price than you could a few years ago,” he says.

However, as always, consumers need to shop intelligently, avoid risk and buy what they can afford.

Kaiser warns that potential homebuyers must not get in over their heads. They should feel comfortable with their mortgages and be confident they can handle the payments along with taxes and insurance.

Those with lower credit scores will find it a little tougher.

“If you have some credit challenges or less than 20 percent down, be prepared for higher interest rates due to risk-based lending,” says Rose.

Who Should Not Buy Now?

While prices are more attractive these days, not everyone should be in the market.

“There is no hard and fast rule that applies in all cases, whether it be a good market for real estate or a down market, such as we are currently experiencing,” says Valerie Anderson-Jones, CPA, JD, CVA at Kessler Orlean Silver & Co. PC. “Tax advantages can make the ownership of real estate quite appealing, but the decision whether or not to own a home should be based on many factors.

“The size of the down payment and resulting mortgage will play a large part in this decision, as well as the amount of any other assets and debt one currently has.”

Brent Kalka, Certified Funds Specialist, or CFS, and financial adviser at Mueller Financial Services Inc., Elgin, Ill., points out there are times a person or couple should not consider buying in this market.

“For example, if a retired couple is thinking of selling their home in order to downgrade and gets less than fair market value, they will lose more financially then what they gain by getting a good deal on a less expensive house and are better off financially by waiting until the market turns around.”

A second consumer who ought not consider changing residences is a homeowner who, prior to the market downturn, had 20 percent equity in their home and didn’t have private mortgage insurance, or PMI payments.

“With home values down,” he says “their equity has dropped, and they no longer would have the 20 percent down payment necessary in a lateral or upgrade purchase to avoid PMI, which can run anywhere from $50 to $150 per month.”

Kalka also believes that potential homebuyers should consider the fact that the real estate market could be no better or even worse a year from now, so they have to decide if they want to wait it out.

People whose jobs are shaky should wait until their situation is more secure.

“To buy on what you are making now if future income is not stable is asking for trouble,” Rose says.

Also, if you are experiencing a life change, such as an upcoming job transfer, getting married, planning to move geographically within the next two years or struggling financially, you should wait.

“People who are thinking of flipping a home should not buy,” says Walter Molony, spokesman for the National Association of Realtors.
“Housing is a long term investment, and if you’re only planning to be there for a year or two, keep renting.”

According to Karen L. DeRose, CFP, DeRose & Associates, Chicago, renovating and flipping homes is much harder today and not something she is recommending to any of her clients. She says several of her clients now have to sit on these properties and the gains they thought they would get have been eaten away by the decline in home prices.

People with heavy credit card debt should not consider buying now.
“They must clean up their credit first,” Chu says.

Should You Buy a Home in Foreclosure?

The Census Bureau reported that the number of vacant homes in 2007 climbed to 2.8 million from 2.07 million. This is the biggest one-year jump on record. What does that mean to potential homebuyers?

Although property is available, Marsha Schwartz, a broker associate from Coldwell Banker Residential Brokerage in Northbrook, Ill., and Rose believe that buying a home in foreclosure can be a challenge and not always a good deal. Sometimes the home has been neglected for a long time due to financial reversals. Be prepared to invest money in the property.

Before you purchase it, have a professional inspection done, even though most of the time the home is being sold “as is.” It also pays to research comparable prices to make sure the price of the foreclosure is significantly below values in the area.

“You can always buy a home in foreclosure, but it depends on how much the lender is willing to lose to get rid of the property,” Kaiser adds. “Sometimes you can get a good deal.”

Is Raw Land or Commercial Real Estate a Good Alternative Now?

“Now is a great time to acquire land, because when you look at the residential market, many homebuilders are looking to get their existing inventory off the books,” says Ben Reinberg, Alliance Equities LLC, headquartered in Chicago.

“However, if you are going to buy land, you must have the ability to hold that piece of land until you have an opportunity for the next cycle to come around.”

When purchasing land, investors should investigate if it has sewer and water, what type of zoning it has and what you can do with it as well as the location of the property. When buying a piece of land, lenders require 30 percent to 60 percent equity depending on where it’s located and what the selling price is.

Reinberg believes if you have the opportunity to purchase the land at a discount (less than it would have sold for three to five years ago), buy it.

“There will be opportunities to buy land within the next 12 to 18 months, especially if we go into a recession,” Reinberg says. “The market is correcting itself, and was very inflated. Now it’s adjusting.”

In addition, Reinberg expects the rental market to be strong compared to the condo market, so multifamily properties will be in strong demand as well.

But he does issue a word of caution. “Be careful what you buy in this down market. Due diligence is important, and if you are a novice you may want to hire a commercial real estate broker.”

Why Not Wait Until the Economy Turns Around?

When Alan Greenspan says that Adjustable Rate Mortgage (ARM) loans were a better choice than fixed rate mortgages, people start to pay attention. So if ARM loans could have saved homeowners very significant amounts of money, why have Fixed-Rate products been the overwhelming favorite? The answer could be in the borrower’s lack of understanding, experience, or perhaps it is unjustified fear.
Additionally, many loan professionals may not have adequately and articulately walked their customers through the pros and cons of an ARM loan. Once a borrower gains a better understanding of the proper way to make comparisons between loans that can adjust vs. those that are fixed, as well as the historical data, they may be much more open to selecting an ARM loan and reaping the benefits.

There are lots of ARM loans to choose from and the features can vary quite a bit. The time that an ARM will remain fixed before adjusting and the factors governing the future adjustments, including the maximum amount the rate can change are important points to consider.
The future adjustments are based on an index, so understanding what will cause the index to fluctuate as well as historical data on the index are both important to know. Let’s look at one popular type of ARM…a 5/1. This loan will remain fixed for the first five years but then adjust every year thereafter. A common misunderstanding that many consumers will have is that they feel they should only consider the
5/1 ARM if they plan to be in their home for five years or less. They often fail to recognize that the savings made in the first five years will offset future years of possible higher payments if the rate on the ARM increases. The best way to illustrate this is to look at a specific example. It is very common for the rate of a 5/1 ARM to be about 1% lower that the rate on a 30-year fixed loan. Assume the loan amount were $300,000. The 1% savings on the 5/1 ARM would save the borrower about $200 each month for the first 60 months (5 years). That would net them a hefty savings of $12,000 during that time. But most borrowers worry about what will happen after the initial period. If the $12,000 savings during the initial five years were just placed in a piggy bank, there would be enough funds there to draw upon to cover future worst case increases for the following 2-3 years. This assures the borrower of coming out ahead by selecting the 5/1 ARM for 7-8 years. Compare that to the average life of a mortgage loan, which is four years (because people will refinance or sell their home) and the odds become stacked in your favor that the ARM will save you money.

Let’s Get Creative
Another strategy that can be used for the above mentioned example is to take the $200 monthly savings and use it to reduce the balance on the mortgage. The pre-payment of principal will have an even greater effect because the borrower is now skipping down the amortization schedule and paying more principal and less interest on each subsequent payment. After the initial 60 payments made during the first five years, the borrower would have approximately $17,000 more equity in their home because of the reduced principal balance. Because the borrower has this extra $17,000 in equity, they would be better off with their 5/1 ARM for approximately 10 full years. This is true if rates moved higher after the initial five years…even in the worst-case rising rate scenario. And, it just so happens that the National Association of Realtors states that the average period of time that people sell their residence is every 10 years.

Another benefit when using the strategy of reducing the principal balance happens at the time of the initial adjustment. When an ARM loan adjusts, it essentially becomes a new loan where the payments are based upon the remaining years, the new interest rate and the remaining balance. Because the remaining balance is significantly lower when the savings are used to reduce principal, the payment can actually go down even if the interest rate adjusts higher.

I Am Not a Gambler
Many borrowers say they refuse to take a gamble on their selection of a mortgage product so they stick with a fixed rate. Well, like it or not, what ever their choice is, it’s a gamble. Selecting a fixed rate still means they are betting that, during the time they are obligated to pay the mortgage, the fixed will perform better than the ARM.
Either way, they are rolling the dice and making a bet. The only difference is they will know the result of the fixed payment. The key here is to get the odds to work in your favor. That is where understanding and guidance from the loan originator can be worth its weight in gold.

Back to The Future
They say a picture is worth a thousand words. The chart below may be worth thousands of dollars. Over the past 200-years, interest rates on the US 10-year Treasury Note have, for the most part, remained fairly tame. The average has been close to 6%, but many fear the chance of runaway double-digit rates. Rates have remained in the single digits for all except 8 of the 214 years shown below. The rampant inflation of the late 1970’s had to be reigned in. So rates were pushed higher during the 1980’s. The result…low inflation and rates over the years leading to the present time. The lesson learned by the Fed was to use an ounce of prevention instead of a pound of cure. In other words, the Fed acts quickly now to hike rates a little so that inflation will remain in check, which helps keep rates from running significantly higher. The sky-high rates of the early 1980’s will probably never be seen again.

The Federal Reserve has been on a rate cutting spree once more. Many mortgage applicants are calling their mortgage representative and expecting a lower interest rate. Others who have been waiting to refinance are puzzled as to why mortgage rates have not moved lower during the recent five Fed rate cuts. This is difficult to explain to consumers who have watched a 2.25% reduction by the Fed with very little benefit in mortgage rates.

Is a Fed rate cut really good news for mortgage rates? The facts may be surprising. The Fed can only control the Discount Rate and the Fed Funds Rate. This is very different from mortgage rates. A mortgage rate can be in effect for 30-years while a rate set by the Fed can change from one day to another.

It is often said history repeats itself. And if history is any teacher, we can learn from what happened to mortgage rates the last time the Federal Reserve was in a rate-cutting cycle.

The last time the Fed was in a lengthy rate cutting cycle was back in
2001 from January 3, 2001 to December 11, 2001. In the span of 11 months, they cut the Fed Funds rate 11 times with eight of those cuts by 50bp. This resulted in a total of 475bp or 4.75% in short-term interest rate cuts taking the Fed Funds Rate from 6.00% down to 1.75%.
Now most uninformed people would naturally think because the Fed cut rates by so much during this time that mortgage rates would follow suit and trend lower as well. Not so. Mortgage rates actually moved higher during this time of significant rate cuts because inflation, the arch enemy of bonds, gradually rose.

Now let’s take a look at what happened with the Fed’s most recent cutting cycle, the first since 2001. On September 18, 2007 the Fed cut the Fed Funds Rate by 50bp. The mortgage bond market briefly enjoyed a “knee-jerk” reaction to the Fed move by closing higher that day, but lost 140bp over the following two sessions. Then on October 31, 2007 the Fed lowered the Fed Funds rate by 25bp. The mortgage bond market responded by losing 78bp over the following five trading days. On December 11, 2007 the Fed once again lowered rates by 25bp and the mortgage bond market lost 88bp in the next three days. So far this year, the Fed delivered a surprise 75bp rate cut on January 22, 2008 and mortgage bonds lost a whopping 144bp in just 2 days. Eight days later and as widely expected, the Fed cut rates by 50bp. Within 13 days from that 50bp cut, mortgage bonds lost 269bp.