Thinking about Buying a First Home or Moving Up to a Larger Home?

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Lessons You Can Learn From Today's Housing Market

June 2007

The housing market has been much in the news recently. After years of steadily rising home values, the market has cooled. In many areas, home values have leveled off; and in some areas, home values are actually going down. At the same time, a record number of home foreclosures have been reported to date in 2007. The press is full of news about rising default rates, particularly for “subprime” mortgages.

As some of the heavily marketed “creative” financing products such as Option Adjustable Rate Mortgages (ARMs) “reset,” many homeowners suddenly face higher monthly payments they can no longer afford. The impact appears to be unsettling to the whole market.

If you are thinking about buying a first home or perhaps a larger home to fit your growing family, what can you learn from what’s been happening in the housing and mortgage markets? For savvy consumers, recent events offer many sound lessons that lead to smarter decision-making.

What’s been happening? Some background.

Owning a home is part of the American Dream. As home values continued to rise in recent years, “creative” financing options were marketed to a broad range of consumers (including families whose income or credit rating did not qualify for traditional mortgages). Mortgage products like Option ARMs attracted consumers with promises of larger loans for smaller monthly payments.

Originally intended for consumers who had high but irregular incomes, Option ARMs were heavily marketed to middle- and lower-income consumers as a way to buy more house for less money or as a “creative” way to qualify for a mortgage.

Option ARMs. An Option ARM is an adjustable rate mortgage that offers “flexible” payment options: borrowers may choose a minimum payment, an interest only payment, or a payment that pays interest and principal. Minimum payments pay only part of the monthly interest accrued, and the balance of the interest is added to the loan principal. And an estimated 80% of Option ARM borrowers make only minimum payments.

This practice results in a “negative amortization” loan—the amount borrowed (the principal) increases rather than decreases each month. After a fixed initial period or when certain criteria are met, the loan “resets” the interest rate and payment, usually to higher amounts. Thereafter, the rate typically resets frequently. The sales rationale offered to consumers was that they could “get into” a home using an Option ARM with its lower “affordable” payment options, then as the home’s value increased, refinance to a traditional ARM or 15- or 30-year fixed mortgage.

The problem with Option ARMs. Several things turned out to be wrong about that scenario for many consumers. Here are some of the facts and risks about Option ARMs many borrowers did not understand.

• Making only minimum payments increases the loan principal rather than paying it down.
• When the loan principal increases beyond an amount stated by the loan terms, the ARM interest rate and monthly payment reset immediately, without regard to the initial “fixed” period.
• Because many borrowers make no down payment or a very small down payment, they have little or no equity in their home. The increased loan principal they owe may be more than the value of the house. This is particularly true in areas where home values have dropped.
• In the cooling climate of home values and because they owe more than the home’s value, these borrowers cannot refinance their homes, nor can they usually sell it for more than they owe.
• Many begin to fail to make the much higher payments. Mortgage lenders begin to foreclose.
• Many mortgage companies who made these loans are now in financial distress or are shutting down. You’ve been seeing a lot about that in the news.

Because thousands of option ARMs and other similar products were sold in 2005 and 2006 and are due to reset in 2007 just as many home values are falling, many financial experts forecast increasing defaults and foreclosures, a surplus of homes on the market, and a tightening of mortgage availability. Just what will happen, of course, we don’t know yet.

What can smart consumers learn from these events?

Smart consumers can literally take home several important lessons.

1. Make a down payment on a home whenever possible. You will usually owe less than your home is worth. In addition, if you are able to put at least 20% down (typically from the proceeds of a home you are selling), you will save the cost of PMI (private mortgage insurance).
2. Choose less risky mortgage options. Mortgages that change payments frequently, such as Option ARMS, are risky for many consumers. CCU’s Fixed/Adjustable Mortgages are a safer choice. For people who move or refinance every five to seven years, a 5/1 Fixed/Adjustable can make sense. Even if you plan to refinance, your payments have been paying interest and principal, so you are typically building equity in your home, making it easier to refinance.
3. If down payments and payment affordability are concerns, ask CCU about what special programs are available for you. CCU (and many other reputable mortgage lenders) offer or can connect you to mortgage programs that offer special terms tied to income. CCU offers no down or low down payment loans.
4. Be honest with yourself about what you can afford. Look for homes in the most affordable communities. Smaller or existing homes are typically more affordable than new homes. The mortgage payment may be the biggest cost of owning a home, but it isn’t the only one. You have to add the cost of heating, water and sewerage, telephone, maintenance, property taxes, and other expenses. It is always a good idea to do a family budget before you decide to buy your first home. CCU’s Mortgage Calculators can help you consider many variables.
5. Read and understand the terms of your mortgage before you sign. If you are getting your mortgage at CCU, ask us questions. CCU Mortgage Specialists are very happy to give you all the answers you need to make the best choice for you.

Owning a home truly is a big part of the American Dream. The right decisions can keep it from becoming a nightmare.

For More Information

StraightTalk Mortgage Guide

CCU’s Mortgage Center

CCU's Mortgage Loan Options

Prepared for Corning Credit Union by Remar Sutton & Associates, June 2007. All rights reserved.