June 19, 2008
Originally published by The St. Louis Beacon on Thursday, June 19, 2008:
By Mary Delach Leonard, St. Louis Beacon staff
If you — or someone you know — are worried about making house payments, it’s time to take action. Trouble is, mortgage talk is a language many homeowners do not understand. ARMs, resets, balloons … and the dreaded F word: Foreclosure.
A sub-prime mortgage, for example, is not a reference to the interest rate of the loan but to the credit history of the borrowers.
Here are some simple definitions for complex terms you should know:
Adjustable-rate mortgage (ARM): A mortgage that starts out with one interest rate for a period of time and then “resets” to a new interest rate.
What you should know: The starting interest rate is often enticingly low. The new interest rate will be higher — and your monthly loan payments will get bigger. That’s called payment shock.
2-28 ARM: An adjustable-rate mortgage that has a fixed interest rate for two years. Then, the interest rate begins to float, based on an index, plus a margin. Typically, these adjustments increase interest rates every six months, which is why they are often referred to as “Exploding ARMs.”
What you should know: 2-28 ARMs fall into the category of “creative financing” mortgages that were typically aimed at people with poor credit ratings. The idea was that in two years, these borrowers could fix their poor credit ratings and then refinance to fixed-rate loans. Often, the new variable interest rates drive monthly payments higher than borrowers can afford.
Balloon or reset mortgage: The total of monthly payments does not cover the entire loan balance. At the end of a balloon loan — usually three to seven years — the homeowner must either pay off the balance in a lump sum or refinance the loan.
What you should know: Think of these as temporary loans. After three or seven years, you need to come up with the balance. Balloon loans have higher foreclosure rates than traditional mortgages because borrowers often can’t afford to pay off balances when they come due – and may be unable to find refinancing.
Conventional mortgage: The interest rate is locked in — and your monthly payments remain the same — for the term of the loan. Also called a fixed-rate mortgage.
Deed in lieu of foreclosure: If you can’t afford the mortgage payments and are unable to sell your home, a lender may accept ownership of your property in place of the money you owe. This is referred to as “walking away.”
Default: When a borrower has missed payments, the loan is in “default.”
What you should know: The sooner a borrower takes steps to find a remedy, the more options there are.
Equity: The value of your home, minus what you owe on it. If you owe $80,000 on a house you mortgaged for $100,000, your equity is $20,000.
What you should know: If property values decline, your equity will also decline. For example, if that $100,000 home drops in value to $90,000, you still owe the $80,000 you borrowed, but your equity is now only $10,000. When your house falls in value below what you owe on it, it’s called negative equity. On the bright side, if your home rises in value, so does your equity.
Fixed-rate mortgage: The interest rate is locked in — and your monthly payments remain the same — for the term of the loan. Also called a conventional mortgage.
Forbearance: A lender agrees to let a borrower postpone payments for a temporary period to give the borrower time to catch up on late or missed payments.
What you should know: This remedy is more likely to be available to borrowers who seek help early, before they fall several payments behind.
Foreclosure: When a homeowner is unable to make the payments on a mortgage, the lender can legally seize and sell the property as stipulated in the mortgage contract.
What you should know: Foreclosure is a worst-case scenario that will trash your credit rating for years and prolong your battle to get back on your feet.
Interest-only loans: Loan payments, due at intervals, go only toward the interest on a loan. When the loan is up, usually five to seven years, the full principal is due.
What you should know: This is a “creative financing” mortgage. Interest-only loans might work for people who are paid big bonuses once or twice a year — or, borrowers who expect a big inheritance. For most people, they are risky business.
Loan modification: A lender agrees to change the terms of a loan when a borrower has the means to make monthly payments but is not able to meet the current terms of the loan, often due to “resetting” interest rates. Modifications typically lower the interest rate of a loan, extend the length of the loan or switch the borrower to a different type of loan.
What you should know: Act quickly; good lenders may be willing to work something out because foreclosures are costly to them, as well.
Loss-mitigation department: When contacting your lender, ask for this department. This is where you’ll find the people who can help you find a temporary remedy to your problem or work out a loan modification.
What you should know: The collections department and the loss-mitigation department have different missions, so be sure you know to whom you are talking. Also, when working out a temporary solution or modification, get it in writing.
Mortgage broker: Brokers are not lenders; they find mortgage loans for borrowers. Brokers are compensated directly by borrowers — usually a percentage of the total loan, plus other fees. They have no legal obligation to work in the best interests of borrowers. Sometimes, brokers are paid a commission by lenders based on the profitability of the loan, which again works against the interests of the borrower.
What you should know: The majority of sub-prime loans were originated by mortgage brokers.
Predatory lending: Loans that victimize borrowers with excessive or hidden fees, high-interest rates, steep prepayment penalties and other terms that trap borrowers in debt.
What you should know: If it sounds too good to be true, it probably is. Get a second opinion — or consult an attorney — before signing on the bottom line.
Prepayment penalty: A fee a lender charges if the borrower pays off the loan before the agreed upon end of the loan.
In other words: If you pay off a 20-year loan in 10 years, you must pay whatever you still owe on the loan (the principal), plus a fee that is specified in the loan contract. Steep prepayment penalties are common in sub-prime mortgages with high interest rates because borrowers try to pay these loans off as early as possible.
Reset: See balloon mortgages and adjustable rate mortgages.
Short sale: When the sale of your home brings less than the outstanding loan, lenders may agree to forgive the difference.
What you should know: This may be a way to avoid foreclosure and protect your credit rating. Unfortunately, you still lose your home.
Sub-prime mortgages: The word “sub-prime” is applied to a wide range of mortgages that have a common characteristic: risk. In general, sub-prime mortgages are aimed at borrowers with less-than-perfect credit histories and may offer “creative” financing approaches: adjustable rates, balloons, interest-only, no down payments, little documentation.
Here’s the confusion: The word sub-prime does not refer to the interest rate of the loan, but to the borrower’s credit quality. In fact, the interest rates on these loans are almost always higher than the overall market rates.
Sources: Federal Housing Administration; the Pew Charitable Trusts; Federal Reserve Bank of St. Louis; www.Investopedia.com.