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Demanding More Down

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Posted On: 07/23/2008

Q: We were all set to close on a home when the lender demanded that we increase the down payment from 5 percent to 10 percent. Since our credit was unchanged, why did they demand a steeper down payment?

A: In the first half of the year many lenders and loan buyers determined that certain areas represented “declining” markets, markets where larger down payments would be required because of worries that home values could continue to fall. The good news is that such definitions have largely been abandoned.

A “declining” market could include all homes within a given ZIP code. Unfortunately, a ZIP code area can easily be large enough to include neighborhoods with strong sales, thus creating an unfair situation for many buyers and sellers.

If buying in some communities suddenly requires more down, then many buyers will look elsewhere. The result is that by classifying an area as “declining,” lenders effectively encouraged the very market conditions they hoped to avoid.

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The “declining” markets concept also impacted lender finances. If all the homes in a given ZIP code were now more risky, what about related mortgages in lender portfolios? Should they be written down to reflect their increased risk? Rather than answer, the “declining” markets concept has gone away.

Q: I have a mortgage in which a large portion of the initial payments go toward the interest, and I am about three years into the 30-year term. If I sell my home now, some people have suggested that because I only borrowed the money for three years, and not the entire 30 years, than some of the interest payments would actually go toward the principle. Is this true?

A: There used to be a simple answer to this question, but with the creation of toxic loans during the past few years the answer is not so simple for millions of borrowers.

In the usual case, if you have a traditional, self-amortizing 30-year, fixed-rate loan or a traditional adjustable-rate mortgage, then each monthly payment is divided with some money being used to pay off interest and the remainder used to pay down the principal balance. Each month during the loan term the amount of the payment used to pay interest declines, and each month the principal pay-off increases a touch. At the end of 30 years the loan is completely paid off.

If you sell the house after three years or 10 years or whatever, it doesn’t matter. Money from the sale is used to pay off the remaining loan balance. The less that’s owed, then the more you get to keep from the sale price.

If you make mortgage prepayments, then whenever you sell there is less debt to pay off and thus a bigger check for the homeowner at closing.

The traditional situation does not work with many toxic loans. For example, suppose someone has an “option” ARM and every month during the five-year start period they make the smallest allowable payment. In this situation, the smallest allowable payment is so tiny that it does not even cover the interest cost. The result? Instead of falling, the principal balance grows, a process called “negative amortization.” This means that if the option-ARM borrower sells in four years, the outstanding loan balance is actually larger than the original mortgage amount. Unless the value of the home has increased, the homeowner will have to bring cash to closing to pay off the debt -- lots of cash.

When looking at real estate loans, stick to dull, understandable, predictable mortgage choices. Reasonable picks include 30- and 15-year self-amortizing loans, loans insured by the FHA and VA and traditional mortgages backed by private mortgage insurance. Always ask lenders whether a loan has a prepayment penalty (and if so, how much), the maximum annual and lifetime payment caps and the maximum payment increase that is possible when the teaser period ends and the loan first re-sets. Get your answers in writing.

Some traditional ARMs remain attractive, especially those with indexes based on Treasury securities and the 11th District Cost of Funds. However, all adjustable-rate mortgages can result in higher monthly costs in the future if indexes rise. When considering ARMs, have lenders carefully show you the maximum monthly payment when the loan first re-sets -- and then ask if such a payment makes sense within your financial situation and personal comfort zone.

And always, of course, speak with several lenders for quotes and information. Local brokers and those who have recently financed or refinanced can be good referral sources.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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