By Jack Guttentag
Saturday, January 10, 2009
Current stresses in the home loan market have changed the ground rules for borrowers in many ways.
To see how those changes are affecting mortgage pricing, I did some online loan shopping. I compared prices for conforming loans of $400,000 that can be purchased by Fannie Mae and Freddie Mac, and $800,000 (jumbo) loans that cannot. Within each size class, I looked at 15- and 30-year, fixed-rate mortgages and 5/1 adjustable-rate mortgages (ARMs).
I obtained prices from 11 lenders on Dec. 12. To assure comparability, I posed as a prime borrower purchasing a single-family house in California with a large down payment, while fully documenting my income and assets. What I learned probably holds for nonprime transactions, but you can never be entirely sure.
· Price differences: The range of prices quoted by different lenders was extremely wide. On the popular 30-year, conforming, fixed-rate loan, on which spreads usually are the smallest, the highest quote was more than 1 percentage point above the lowest quote. On ARMs, the spreads were even larger. On a 5/1 jumbo ARM, one lender quoted 8.125 percent plus $9,800 in points, while another quoted 5.75 percent with zero points.
Bottom line: Borrowers can save a ton of money by shopping around among loan providers.
· Conforming ARMs: One striking thing about the current market is that conforming ARMs cost more than 30-year, fixed-rate loans, something I cannot remember ever having seen before. The rate difference between the 30-year fixed and the 5/1 ARM, holding points constant, was almost 1 percentage point. Furthermore, 3/1 and 7/1 ARMs were priced higher than the 5/1s. However, all the lenders, except one, offering jumbo loans priced ARMs below the 30-year, fixed-rate loans, which is the usual pattern.
Bottom line: There is no reason for a borrower to select a conforming ARM; but on jumbos, ARMs continue to enjoy a significant rate advantage.
· 15-year, conforming, fixed-rate mortgages: The 15-year, fixed-rate loan has always been my preferred instrument for borrowers who could afford the payment, because it carried a significantly lower rate than the comparable 30, and it amortized much more rapidly. On jumbo loans, the spread remains very attractive at about 5/8 percentage points; but on conforming loans, it has dwindled to about half of that.
Bottom line: There's no reason to avoid 15-year, fixed-rate loans, but on conforming loans the advantage is not what it was.
· Interest-only, 30-year, fixed-rate loans: Until recently, the 30-year, fixed-rate mortgage that allows interest-only payments for the first 10 years was very popular. Borrowers could avoid making payments to principal for 10 years. To get the interest-only option, borrowers typically paid a rate premium of about 1/8 percentage points.
No more. In an environment of declining home prices, investors don't like loans that build no equity for 10 years, and they have raised the premium to about 1.4 to 2 percentage points.
To illustrate, one lender priced a standard 30-year, fixed-rate loan for $400,000 at 5.75 percent and the interest-only version of the same mortgage at 7.25 percent. This means that the borrower was offered a choice between paying $2,354 a month, of which $1,917 is interest and $437 is principal, or paying $2,416 a month, all of which is interest. This pricing eliminates the only benefit borrowers receive from an interest-only loan, which is the lower payment.
Bottom line: Borrowers should avoid the interest-only option on the 30-year, fixed-rate mortgage. On ARMs, however, the rate premium to get an interest-only option is still reasonable.
· Paying points to reduce the interest rate: Stressed markets do offer one significant bargain: buying down the interest rate by paying points. In 2005, it cost about 1.5 points to buy down the rate by 0.25 percentage points on a 30-year, fixed-rate loan. (A point is 1 percent of the mortgage.) In early 2007, it cost about 1.125 points. Today, the price is down to about half a point.
In part, the lowered price is due to the shorter average life of loans, which increases the value to investors of collecting points upfront. In addition, lower rates carry lower payments, which reduce the likelihood of default. In a stressed market, this carries a lot of weight.
Borrowers viewing a rate buy-down as an investment can earn a very high return. For example, one lender on Dec. 12 offered a rate reduction of 0.5 percentage points for 1.119 additional points. This investment in points would yield 28 percent over five years and 32 percent over 30 years.
Bottom line: Buying down the interest rate is a very good investment.
Next Saturday: Some tips on shopping for the best deal in a stressed market.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.
© 2009, Jack Guttentag
Distributed by Inman News Features
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