RESIDENTIAL MORTGAGES 101
The first thing you want to realize is that there are several ways to finance your purchase. Most people assume you need to put 20% down, and that PMI (mortgage insurance charged when you put less than 20% down) is the devil. On one hand, it is annoying to pay about $100 a month for basically nothing. On the other hand, it is a small cost for increasing your leverage four-fold. Leverage is the key to real estate investment, and is what makes all these real estate millionaires possible. Instead of putting 20% down on one $200,000 house, or $40,000, you can put 5% down on FOUR $200,000 homes, which is the same $40,000. Now instead of seeing appreciation on $200,000 of real estate, you'll see the appreciation on $800,000 of real estate!

One of the most misunderstood concepts in real estate is residential mortgage products. I would estimate that less than one quarter of my clients really understand what kind of loan they are getting. This article will be an introduction to the basics of residential mortgages. While the concepts apply to primary residences, opinions and advice are given from a real estate investor's point of view. Any person that is serious about getting into real estate investment should spend a good amount of time educating themselves about the various loan products. It's one of the few factors a client has such direct control over in an investment.

Mortgages have only been widely available since the end of World War II. The "30 Year Fixed" loan was about the only thing going. Many years later, Adjustable Rate Mortgages (ARMs) became available, so we basically had two products out there. I recently read an advertisement that one mortgage company had over 700 different mortgage programs available. While the differences between some of these loans might be as small as the length a prepayment penalty, the point is that the residential mortgage products have come a long way since WWII, especially in the last five years.

KEEP IT SIMPLE
The way I look at these loans is to break them down into five key elements:

Duration: 30 years v. 15 years
Interest Rate: Fixed v. Adjustable
Amortization: Fully Amortized v. Interest Only v. Negative Amortization
Documentation: Full Documentation v. Stated v. No Documentation
Occupancy: Primary Resident v. Second/Vacation Home v. Non-Owner Occupied

If you get into the habit of looking at loans this way, you won't get confused when you hear about a 30 Year Fixed Interest Only loan. Many people think that a 30 Year Fixed loan automatically means that you will pay principal and interest so that the loan is fully paid off at the end of thirty years. While "30 Year Fixed" loans tend to be fully amortized, you can definitely get an Interest Only loan with a fixed interest rate.

DURATION
Most loans are typically done over thirty years. Thirty years was selected because by fully amortizing the payments over thirty years, you to pay some of the principal from the beginning. This principal reduction is enough to start making a dent in the principal amount so that about 19 years into the loan you're paying half principal and half interest. If you were to amortize a loan over 40 years, the compound interest formulas result in a much lower principal reduction, and you end up paying almost the same amount each month, just for a longer period of time. To shorten a fully amortized loan up to 15 years, you have to pay a considerable higher amount each month (but you end up paying considerably less interest over the life of the loan.

INTEREST RATE
A fixed interest rate is what most people think of because that was basically the only loan our parents and grandparents could get, so we are accustomed to them. Adjustable Rate Mortgages, on the other hand, are fixed for a period of time, and then the interest rate can go up or down. In the recent past, most ARMs have been adjusted once a year, but many of the newer ARMs adjust monthly. The periodic adjustment is typically capped (very often at +/- 2% a year), and the maximum interest rate is typically capped at 6% above the initial interest rate.

ARMs are typically discussed as 3/1 ARMs, 5/1 ARMs, 7/1 ARMs, and 2/28s. A 5/1 ARM, perhaps the most popular of the ARMs, means that it is a fixed interest rate for five years, and after that, it adjusts each year (indicated by the 1 in the 5/1). If it is a 5/6 ARM, it would be fixed for five years, and then adjustable every six months. The 2/28 is an unusual name, as it means the interest is fixed for two years and adjustable for twenty eight years (the frequency with which it is adjusted is not indicated in its name as it is for the other ARMs.) By the way, a 2/28 is typically a sub-prime loan that allows a credit-challenged individual to clean up their credit over two years in hopes that they can get a better conventional loan in the future.

The factor most overlooked is how the adjustment is determined. ARMs typically take an interest rate and tack it onto an index like the LIBOR (London Interbank Offered Rate) or Prime, or some other index. Your initial interest rate is calculated by taking the Index and adding the adjustment. The index will go up or down over the years during the fixed interest period of your loan. When you get to the adjustable period, they recalculate what the interest should be by adding the same adjustment onto the most current index reading. If the index has gone up 1%, your interest rate will go up 1%. If it goes up 2.5% but you are capped to a maximum of 2%, it will go up 2%. When selecting an ARM, it is very important to understand which index the adjustable rate will be based, how frequently they can adjust it, and the maximum adjustment per period and for the life of the loan.

The lenders came up with Adjustable Rate Mortgages as a way to offer a slightly lower interest rate. They can offer a lower initial interest rate because they are betting you will hold the loan past the fixed period and that they will make up the difference in the adjustable rate period. Remember, the adjustable period could be 23 years or longer.

Personally, for me, if I'm not getting 0.75% or lower on a 5/1 when compared to a 30 year fixed, I'll stick with the fixed. That said, I'm typically finding ARMs 0.75% to 1% lower than a similar 30 year fixed product.

AMORTIZATION
Generations before us only had access to fully amortized loans. This means that a portion of your payment goes toward principal reduction and the remainder (the vast majority at the beginning) pays the interest. By the end of the loan, you have fully paid it off.

These days, you can get loans where you only pay a portion of the principal off, and whatever remains at the maturity of the loan is due in what they called a balloon payment. Today, we see this most often in the form of an Interest Only loan. This is where you pay only the interest, and you pay none of the principal down at all. At the end of the loan, you owe exactly what you did at the very beginning.

At first glance this might sound bizarre, that you'll never own your home, but that assumption follows very poor logic. If you borrow $200,000 on a $200,000 home, in thirty years, you'll still owe $200,000. But if the property appreciates at 7.2% a year, in thirty years your home would be worth EIGHT times more, or $1,600,000. Even if it only appreciates at 5%, it would be worth $800,000.

Another benefit of an interest only loan is that it is based on a simple interest formula, not compound. If you were to borrow $200,000 at 6% annual compound interest, your monthly principal and interest payment would be $1,200. If you had a 6% simple interest loan, however, your monthly payment would be $1,000, a $200 a month savings.

There has been quite a negative buzz about interest only loans, but this negativity is spread by those that don't understand the loan products and those that are much more financially conservative. "Interest only is for those that can't afford to get in to a house otherwise." "If you don't pay down the principal, you'll have to bring money to the table when you sell the house." Nationwide, it costs about 8.5% to sell a house, and this includes taxes, escrow fees, and commissions. If the property appreciates at least 8.5% over the entire time you own it, you shouldn't have to come out of pocket at all. Therefore, if you live in a market where housing is only going up 1% a year, you might not want to do this kind of product. If you're in a market where things are rapidly appreciating, paying down the principal is probably not as important. Realize this: most investors that buy properties in a rapidly appreciating market are buying in that market because they've done their due diligence and they believe the market will appreciate better than other markets in the country.

Consider this example. If you buy a $200,000 condo, you could either pay the $1,200 principal and interest, or you could pay $1,000 in just interest. (In this example, while it doesn't always work out this way, the principal reduction on the $1,200 happens to be $200). If you hold this investment property for 3 years, or 36 months, you will have reduced the principal by $7,200. If the property did not appreciate at all over three years and you had to sell the property for some reason or other, you'd have to come up with about $17,000 to sell the place. Certainly you could say that with the $7,200 you paid down in principal would help offset that $17,000, but didn't YOU have to put that $7,200 in over the three years? So aren't you still coming up with the $17,000? And if you did reduce the principal by $200 per month, that was $200 three years ago. Your $7,200 was worth more to you (in today's dollars) over the last three years. The point is that picking a bad market is not dependent upon whether you reduce your principal or not. The house will appreciate or not independent of what kind of loan you get on the property. If it does not appreciate, you will have to come up with the $17,000 one way or the other, but it will come from you. If it appreciates only 8.5% (which is roughly a paltry 2.5% a year, compounded), then you'll be covered and would not have to worry about whether you paid the principal down or not.

Basically, I look at principal reduction as forced savings, an involuntary way to increase my investment (which lowers my end-of-investment Return On Investment (ROI)), and a degradation of my ability to leverage. I look at interest only as a way to sustain my leverage, keeping the amount I invest in the property to a minimum. Taking this to the logical conclusion, however, there is another loan product that works very well for investors. This is a Negatively Amortizing loan.

I look at Negatively Amortizing loans, or Neg Am loans as they're called in the industry, as Interest Only loans where I'm not paying all of the interest. The lender is certainly going to expect that interest, but what they do is allow you to defer a portion of your interest payment to the end of the loan. So I might have a $1,000 monthly interest payment, but my Neg Am loan might only require that I pay $800 of it a month. The remaining $200 is tacked onto the principal amount, and in the end, I will owe MORE than I borrowed. Not only that, but my interest is calculated on principal balance, so each period (annually, monthly, depending on how the note was written), my interest payment will increase slightly because I actually owe more money than the last period.

Now this might sound like voodoo lending, but let's look at a real estate investor who is debating on how much to put down. Very frequently, these clients tell me they don't really care how much they put down, typically the less, the better. If they put 5% down on a $200,000 house, they'll borrow $190,000. If they went with a negatively amortizing loan product and we assume that $200 a month of the interest was deferred and added to the principal, they would have added about $7,200 to the principal amount over three years. They would then owe $197,200, and would have to pay that off when they sold. If they had gone with 0% down, however, they would owe $200,000, so our first scenario results in less principal to pay off than the 0% down scenario. Many investors have less than perfect credit or work history and have trouble finding 0% products. A Neg Am loan with 5% will allow them to further leverage themselves, month by month.

Negatively Amortizing loans certainly aren't for everyone, and I typically don't bring them up in detail unless the client has some experience with Interest Only loans. Interest Only loans have become extremely popular in the last two years. There are a lot more loan products out there these days, and Fully Amortized loans are no longer the only game in town.

DOCUMENTATION
Most of us think of the loan process in the sense of a Fully Documented, or Full Doc, product. This is where you bring in your W-2s and your bank statements, the loan officer verifies your employment, and you jump through many bureaucratic hoops. The up side of all this is that the lender has more confidence in your ability and history to pay, so they can provide you a lower interest rate.

But what if you don't get a W-2? What if you have changed careers several times in the last two years? How are limo drivers and table dancers supposed to get a loan when they are paid a very low hourly wage but earn significant tips? This is where the Stated and No Doc loans come in.

A Stated loan, which is more accurately referred to as a Stated Income, Stated Asset loan, allows you to tell the loan officer what you make and what you own, and if they seem reasonable for your line of work, they accept it as if it were the truth. You can easily see the downside here, and that is the human propensity to exaggerate and lie. Because accepting stated income makes for a weaker case, you will pay a higher interest rate. You can have a Stated Income, Verified Assets, or even a Verified Income, Stated Assets loan. Or you can go No Doc, which means all they do is run your social security number to get your FICO (credit) score. If your credit is good, you get the loan. Obviously, the interest rates on these types of loans is even higher than a Stated loan.

While there are a few good reasons to go with a lower grade of documentation (privacy, time being of the essence, no desire to jump through all the full doc hoops flipping a property where interest isn't that much of a factor), the more documentation you provide, the better your interest rate should be.

OCCUPANCY
This one isn't too hard to figure out. Either you're going to live in the house as a primary residence, or you're going to use it as a second home or vacation home, or you're going to rent it out. The interest rates are best on primary residences and worst on non-owner occupied properties. The logic behind this is that if a person gets behind in their bills, they will allow one of their investments to be foreclosed upon instead of their own home.

Typically, you cannot do a second home within 200 miles of your primary residence. Vacation homes can be an exception if you live near a large vacation area like a beach. While there isn't a occupancy police that will come and check up on each and every primary residence to see if you're living there, if you don't intend to live in a property and rent it out the day you take possession, you run the risk of the builder or lender ratting you out and having your note called. I understand what goes on out there, I'm just letting you know the down side to a very popular practice.

SUMMARY
There are a lot of other factors out there, but these are the basics. Here's what I'd like to see you take away from this article:

1. There are many, many loan products out there, and it is important for real estate investors to know as much as they can about them.

2. A 30 Year Fixed is not always Fully Amortized, and it is not always a Full Doc. The names of the loans are very literal, so a "30 Year Fixed" is just that, FIXED FOR THIRTY YEARS. A "5/1 ARM" is a loan where the interest rate will begin to adjust in 5 years and is not necessarily Interest Only or Fully Amortized.

3. Think of loans in terms of the five basic factors: Duration, Interest Rate, Amortization, Documentation, and Occupancy. Like Garanimals, each component can be mixed and matched with the others.

Click here for Tax Advice ...