A mortgage is far and away the most common way to finance a home. By definition, a mortgage is a security instrument where the borrower pledges property to a lender as collateral for the debt. The way in which you secure that loan and subsequently pay it back is dictated by the type of mortgage you have. There are countless types of mortgages available and each has its own advantages and disadvantages. If your home loan comes from a lending institution, such as a bank, you will almost certainly have either a conventional or government-backed loan. Private loans, hard money lenders, and transactional lending are vehicles often reserved for real estate investors and probably best left to a different discussion. Unless you plan on paying cash for your new home, knowing the options you have for financing is just as important as finding the home in first place.
While this chart is by no means exhaustive, it provides an organized look at a majority of the loan options a pharmacist would encounter.
Fixed vs. Adjustable
Most pharmacists will be familiar with fixed and adjustable rate loans in the form of student debt. As the name suggests, adjustable rate mortgages (ARM) have interest rates that changes over the life of the loan. Conversely, fixed rate loans obviously have a set interest rate that does not change until the loan is paid off or refinanced. Fixed rates are simple to understand and easy to plan for. The rate doesn’t change so neither does your payment. Easy to plan for an no surprises. Most first time home buyers will benefit from a fixed rate mortgage. On the other hand, the main advantage of an adjustable rate is that the initial costs are often significantly lower compared to a fixed rate. Typically, an ARM will be described as 5/1, 7/1, or 10/1. The first number represents how long the initial interest rate will remain fixed. The second number is how often the rate will change after that time period. In this case (and in most cases), yearly. From that point on your rate could be higher or lower than your initial rate depending on the market. For the past decade or so, ARMs have gotten a bad reputation because the fixed rate has been so low. With the economy recovering and the Fed increasing interest rates, ARMs may once again become and attractive option for some buyers. Just remember that an adjustable rate can be fairly difficult to budget for once the rate changes start to take place. Both types of loans are generally available in 15 to 40-year loan terms and are further classified as either conventional or government-backed.
A conventional loan is really any loan that is not secured, insured, or guaranteed by the government. The lending institution that supplies the loan assesses the borrower and takes on the risk themselves. At present, most of these loans are long-term, fully amortized, fixed rate loans. A fully amortized loan is one where the total payments over the life of the loan will fully pay off the entire balance of principal and interest due at the end of the term. Prior to the housing crisis of 2008, some loans had only partial amortization or none at all. This created negative amortization—resulting in huge balloon payments of deferred interest at the end of the loan term that people simply couldn’t afford.
All these loans are being made by primary lenders but what happens to them? Are they held by the banks as portfolio loans? Some may be maintained by the local institution but most are often sold to the secondary market. Secondary mortgage markets are private and government agencies that buy and sell real estate mortgages. The biggest players being the government entities known as Fannie Mae and Freddie Mac. This becomes import to borrowers because in order for banks to sell those mortgages they must conform to these preset standards. This makes underwriting for a conforming loan much less flexible and ends up being fairly time consuming. Because of this, lenders try to make most of their loans conforming because they like the ability to liquidate these mortgages should the need arise.
Post housing crisis, the only real non-conforming conventional loans left are Jumbo loans – those that exceed the maximum allowable loan amount. At the time of this writing that amount was $424,000 for most counties in the United States. Places like New York, San Francisco and Chicago have higher limits (upwards of $636,000). Again the reason this matters to the borrower is that if you need a less-flexible jumbo loan, the bank will likely charge you a higher interest rate in order to get it.
Another important stipulation of a conventional loan is that the borrower provide a 20% down payment. This shows the lender you are serious and are more likely to pay back the rest of the loan. There are actually several ways to get around this stipulation and still obtain a conventional mortgage. The most common is through private mortgage insurance (PMI). As the name suggests, PMI is provided by private companies to protect the lender in the event the borrower defaults on the loan. This extra protection allows borrowers to put only 10% or even 5% down on a mortgage. The downside is that the borrower has to pay monthly for that PMI until they have paid up to 20% of the principal. What the lender often neglects to tell you is that unless you submit a request at that 20% they can actually continue your PMI requirement up until your reach 78% loan-to-value. Although it might not seem like much, this 2% difference could equate to hundreds of dollars! If you do decide to put only 5% or 10% down, make sure you are paying attention for when you reach the 20% mark and are aware of the process your lender requires for waving PMI on time. In some cases, the lender will offer to “pay” the PMI for you and charge you a higher interest rate as a result. This usually results in lower monthly payments but a higher cost loan in the long run.
Other methods for avoiding a 20% down payment include secondary mortgages, specialty loans through Freddie Mac and Fannie Mae, and occupation-related or professional loans. Secondary mortgages effectively allow you to put 10% down and take out the other 10% as a second, more expensive loan, usually through the same institution. This option generally becomes more popular as interest rates rise. Government sponsored conventional loan products usually require a down payment of only 3% but have strict credit score or debt-to-income requirements. Most also contain income limits so borrowers that make “too much” may not qualify. Special occupation-based loans are also growing in popularity. Physicians have the best options available at the moment and can generally get a 0% down, 40-year loan with no PMI and special underwriting, sometimes even while still in residency! Pharmacists are starting to be included in more of these programs each year and may be worth looking into depending on your situation.
Mortgage Financing Part 2: Government-Backed Loans will be coming soon!