Fixed-Rate Loans Mean No Surprises

What's the best course for the cautious borrower in today's mortgage market, where almost anything goes?

Some would say the best possible strategy is to adhere to the time-tested mortgage rules that have kept people's parents and grandparents out of financial trouble. Some of their great-grandparents, alas, fell victim to interest-only loans that went bad during the Great Depression. That scared people away from high-flying lending gymnastics for generations.

But now lenders are aggressively marketing such loans. For the traditionalist, taking out a mortgage today requires self-discipline. Borrowers need to be able to turn away from seductive offers of low payments now because they almost invariably mean higher payments later.

Traditionally, borrowers have been asked to pay interest on the loan, plus payments toward the principal, on the original amount borrowed. They also must pay property taxes and hazard insurance, to protect the lender's investment if the house burns down.

The old rules dictate that borrowers shouldn't pay more than 28 percent of their gross income for housing, and less than 8 percent more for all debt, including car and credit payments and student loans. Ten percent was viewed as a solid down payment. In other words, a buyer purchasing a $600,000 home would need to have an income of $16,285 a month, or $195,420 annually, and no more than $1,303 a month in debt, according to http://www.mtgprofessor.com , the Web site of Jack Guttentag, professor of finance emeritus at the University of Pennsylvania's Wharton School of Business.

The monthly payment would be $4,560, based on a 6.5 percent, 30-year mortgage, (fixed-rate, naturally). That would include the payment of mortgage insurance, which lenders require to protect their investment. Mortgage insurance is required with some loans if the buyer has less than a 20 percent down payment.

A 20 percent down payment, however, may seem impossible for many first-time buyers, especially in markets such as Washington, where a townhouse in a distant suburb is likely to cost $350,000, and a buyer would need to save $70,000.

That makes it easy to understand why many borrowers opt for what are known as "piggyback" loans, a second or even third loan that allows buyers to borrow the down payment, or part of the down payment. (Those loans are sometimes called 80-10-10 loans or similar names that describe what percentage of the purchase is covered by each loan. They don't require mortgage insurance.)

Piggyback loans make sense because down payments are so high, but they also carry some risk because they are frequently adjustable-rate loans. That means it is important to understand the exact circumstances under which the rate will rise. (Or possibly, and happily, fall.)

Most consumer advocates would also urge borrowers to avoid prepayment penalties, a lump sum charge by the lender, which can be $10,000 or more, for people who refinance or sell their homes within a specified period of time.

In addition to the down payment, buyers who approach the purchase the traditional way should expect to pay 3 percent to 5 percent of the purchase price in additional closing costs.

In other words, the traditional buyer purchasing a $600,000 single-family house would need nearly $200,000 in income and about $90,000 upfront. It's not surprising that many people are finding their incomes just don't stretch that far, creating a fertile market for nontraditional loans.