Even at a time of record low mortgage rates, home ownership remains out of reach for millions of Americans. But there may be solutions.
The cost of the average home in states across the country may seem overwhelming to many people, but new mortgage options — combined with record-low interest rates — are making it easier for many aspiring home owners to pursue their dream.
Meanwhile, with so many options, it can be hard to figure out which mortgage is right for you. First, you need to find out how much you can afford to spend. Then you have to educate yourself about all of the options that are currently available to you. Keep in mind, some of the new mortgage options come with more risk than traditional mortgage options.
Can I Really Afford that Home?
Mortgage rates are once again hovering at near record lows with the current 30-year fixed rate mortgage at 5.37 percent, according to the Mortgage Bankers Association.
At this time last year, the average rate for a 30-year-fixed mortgage was 5.61 percent, off from the lowest ever recorded rate of 5.26 in June.
Although low mortgage rates equate to lower mortgage payments, they can often lead to greater debt. In fact, according to the Federal Reserve, U.S. consumers had $6.8 trillion in mortgage debt, accounting for almost three-quarters of their total debt at the end of 2003-up 64 percent from five years ago.
Additionally, the Federal Reserve's financial obligations ratio, a measure of consumers' abilities to repay their debts based on their current income, is at the lowest level it has been for the last two years.
When it comes to mortgage delinquencies, borrowers with poor credit histories and those who take out loans which are riskier to lenders (referred to as subprime loans) are more likely to have their homes foreclosed than standard borrowers (prime loans).
In fact, during the fourth quarter of 2003, the percentage of prime loans in foreclosure was 0.55 percent compared to 5.63 percent on subprime loans. Keep with Tradition: A prospective buyer should assess the following when purchasing a home: How much home they can comfortably afford and how long they plan on living in the residence.
When it comes to getting a mortgage, the traditional loan options of a fixed-interest rate or an adjustable rate mortgage (ARM) offer consumers the best options with the least amount of risk.
A fixed rate means the interest rate on your loan remains consistent throughout the life of the loan, unless you refinance or secure another loan. Typically, a fixed rate mortgage has a life of 30 years, but you can also secure this type of loan for a shorter timeframe, such as 10 or 15 years.
With an ARM, the interest rate on your loan adjusts over time. ARMs generally have a fixed interest rate for a short period of time, such as one, three, five or seven years — generally, the shorter the period, the lower the interest rate.
After this period elapses, the rate adjusts either up or down annually depending on interest rates at that time. There are overarching limits as to how much the interest rate can adjust which provides some protection for the borrower.
Unconventional mortgage madness: Median home prices rose 7.5 percent last year, the biggest increase since 1980 according to the National Association of Realtors. The current home buying environment — low interest rates and high prices — has spurred a new era of creative and "extreme" mortgages.
Additionally, according to the National Association of Realtors, the median price of a home is now $172,000. While these innovative approaches may enable more people to become homeowners, they also can pose a number of risks which may outweigh the benefit of ownership.
When You're Stretched, You Can Skip: Countrywide Home Loans now offers a loan option-known as "PaymentPower," which allows a borrower to skip a mortgage payment every so often. PaymentPower permits qualified borrowers to skip up to two mortgage payments per year for a maximum of ten skipped payments over the life of the loan. It is available on loans up to $333,700 with 30-year fixed interest rates in Arizona, California, Colorado, Florida, Georgia, Illinois, Indiana, Massachusetts and Washington. If a borrower elects PaymentPower, there are two options to choose from: 1.) One-time upfront fee with no additional charges for skipped payments. The fee ranges from $1,000 to $1,250, based on a loan amount of $200,000.
2.)"Pay per skip" option which necessitates a smaller upfront fee plus a per skip fee based on the original loan amount (typically, $100 to $230 for each missed payment).
According to Countrywide, the math is as follows: On a 30-year fixed rate loan amount of $150,000 at 7 percent, with monthly taxes and insurance totaling $300, one skipped payment would be $1297.99. After one payment is skipped, the loan is re-amortized and results in a new payment of $1306.65, an increase of $8.66. Mellody's Tip: Keep in mind that in essence, you are paying extra fees for the option to skip payments twice a year and those skipped payments are simply added back on to your original balance, meaning you will pay more in interest overall. If your income is seasonal this may be an option for you. In addition, if you miss a payment you do not have to worry about the adverse impact on your credit rating.
Fix-Up Your Mortgage: Another creative mortgage available these days is a "fixer-upper" mortgage which means your loan will not only cover the cost to purchase a house, but will also include the funds to make home improvements. Typically, the loan amount is based on the lesser of either the project cost or the "as completed" value of the property. The benefit of such a mortgage is that the interest on the cost of your improvements may be tax-deductible, and you have the ability to begin renovations immediately.
Several national and regional banks, including HSBC, North American Mortgage (a division of Washington Mutual) and Wells Fargo offer fixer-upper loans.
Keep in mind that given the added risk for the lender, interest rates on this type of loan may be slightly higher than a traditional loan-usually one-eighth to one-quarter of a percentage point higher. In addition, you may need to have plans in place when you meet with the lender and the lender generally remains involved throughout the renovation project, with appraisers having to sign-off on all final projects.
Mellody's Tip: When considering this option, beware of the additional costs associated with this type of loan, such as multiple appraisals. Also, over the life of the loan, the interest paid on the cost of your renovations may be significant, meaning it might be more economical to take out a home equity loan or line of credit which may have lower interest rates.
Also, with rates as low as they are, time is of the essence when locking in a mortgage. The additional steps required to secure the project/renovation work may result in you missing out on today's attractive rates and may keep you "locked out" from a desired rate. Lastly, unless the value of your home immediately increases with the renovations, this mortgage option is not a good idea.
Mellody's Math: If you choose a fix-up mortgage, the $25,000 in home improvements, could cost you a lot more than the price of the repairs. Here is the math:
Traditional 30-year Mortgage Purchase price: $150,000 Down payment: 10 percent ($15,000) Mortgage: $135,000 Interest Rate: 5.37 percent
Your monthly payment would be $755.54 and you would pay a total of $136,994.55 in interest over the life of the loan.
Fixer-Upper Mortgage Purchase price: $150,000 "As completed" value of the property after repairs: $175,000 Down payment: 10% ($17,500) Mortgage: $157,500 Interest Rate: 5.62 percent (.25 percent higher due to fixer-upper mortgage) Your monthly payment would be $906.16 and you would pay a total of $168,718.21 in interest over the life of the loan, meaning the extra $25,000 for repairs would cost you an additional $31,723.66 in interest.
Piggyback Loans With Lines of Credit: If a buyer is unable to make a down payment of at least 20 percent, they are required to get private mortgage insurance which protects the lender if the borrower defaults on the loan. The downside for the borrower is not only an additional monthly fee, but unlike mortgage interest, no portion of the mortgage insurance payment is tax deductible. As a result, in order to avoid mortgage insurance, some consumers are turning to second or "piggyback" loans with home equity loans or lines of credit-to cover their costs. The first loan is for 80 percent of the purchase price, and the second loan covers the amount the borrower needs in order to fund the 20 percent down payment on their home. The danger with this scenario is it allows borrowers to push the limits by putting next to nothing down while taking on a higher burden of debt.
Mellody's Tip: The problem with this strategy is that as interest rates increase on the line of credit, the amount of your payments could increase beyond your means. The interest rate you pay on your loan is tied to the Prime rate and often has an additional margin added on by the lender (as high as 6 percent). Although the Prime rate is currently at 4 percent, unlike an ARM, there is no safety net which will protect you if it climbs to 12 percent.
Interest-Only: An interest-only mortgage allows a borrower to pay interest only for a set period of time at the beginning of a 30-year loan, lowering the monthly payment during this period. At the end of period (usually 3, 5, 7 or 10 years), the payments are adjusted to include principle and interest over the remaining life of the loan.
In addition to an initial lower monthly payment, the greatest advantage of this type of mortgage is that during the interest-only payment period, the entire monthly payment can be deducted on your tax bill as interest payments are tax-deductible (principle is not). Although there are benefits to this type of financing, especially if the money saved is invested wisely, the downsides can be far greater than the potential upsides.
First, most interest-only mortgages do not have a fixed rate conversion option, meaning when the interest-only period expires, the interest on your loan becomes adjustable (it adjusts on an annual basis for the remaining life of your loan) — potentially at much higher rates than today. Second, if the value of your home declines, you will need to make up the difference when you sell your home. Third, paying only the interest on a mortgage does not allow you to build any equity in your home-meaning home "ownership" is more like home "leasing."
Mellody's Tip: Interest-only loans are most suitable for people who only plan to stay in their home for a few years. However, while an interest-only loan allows a buyer to qualify for a larger mortgage and a more expensive home, biting off more than you can chew is rarely a wise financial decision.
Again, keep in mind the interest-only portion fluctuates with the Prime rate and is very sensitive to rate increases. It is important, if you choose this route of financing, to pay down the principle along the way as well. Also, many interest-only mortgages come with a pre-payment penalty. So, if you decide to chip away at the principal with this type of loan, beware that you may face additional charges, often up to 2 percent of the principle.
E-mail Mellody with your personal finance questions.
Mellody Hobson, president of Ariel Capital Management (arielmutualfunds.com) in Chicago, is Good Morning America's personal finance expert. Ariel associates Matthew Yale and Aimee Daley contributed to this report.