Choosing your mortgage

Because this book is about selling a house rather than buying one, we won’t cover in detail how to choose a mortgage when you’re buying a home. However, if you’re thinking about trading up, you’ll ultimately buy as well as sell, so we highlight the important considerations in selecting a mortgage. Keep these issues in mind as you begin thinking about selling your house, particularly if you’re stretching your finances for the trade up.

Because you already own a home, this section may just be a refresher course. But the following are some brief definitions for the major types of mortgage options:

• Fixed-rate loan: As the name implies, this loan is one with a permanent interest rate that never changes. You take out the loan at a certain interest rate, and that rate is locked in for the life of the loan, which, in most cases, is a term of 15 or 30 years. Obviously, with an interest rate that is constant, your monthly mortgage payment is also constant.
• Adjustable-rate mortgage (ARM): The interest rate of an ARM varies over time, typically adjusting every 6 to 12 months, but sometimes as frequently as every month. These adjustments reflect the fluctuations in the interest rates in the overall economy. The monthly mortgage payment usually changes as often as the loan’s interest rate does.

• Hybrid loans: Mortgage lenders weren’t content to leave you with only two options, so they did some grafting and came up with another one, sometimes called intermediate ARMs. A hybrid loan starts out like a fixed-rate loan and then, after a certain number of years — three, five, seven, or even ten years — converts into an ARM, usually adjusting every 6 to 12 months thereafter.

  A twist on this type of mortgage, which we generally don’t recommend, is interest-only loans that have lowered payments in their early years because you’re only paying interest. When you begin paying back principal, the mortgage payment jumps significantly.

When choosing among the three mortgage options, ask yourself two questions:

• How able and willing are you to take on financial risk? Getting an ARM is a bit of a gamble. Although its initial interest rate usually is lower than that of a fixed-rate loan, if market interest rates go up, so does your monthly mortgage payment. If your cash flow doesn’t have much breathing room, you may get into trouble. Before you take out an ARM, check out its periodic adjustment cap (the amount that the loan’s interest rate can change at each adjustment) and life of loan adjustment cap (the highest interest rate allowed on the loan), so you know how fast your monthly payments can increase and how high the allowable interest rate and your payment can go. If the ARM’s maximum monthly payment would break your budget, don’t get the loan.
• How long do you plan to keep the mortgage? If you don’t intend to stick around in your new home for longer than five to seven years, then a hybrid loan makes more sense. Because the initial interest rates are lower than the rates on fixed loans, a hybrid loan definitely saves you money on interest charges in the early years of your mortgage. If, however, you intend to keep your mortgage more than seven years, you may be better off with a fixed loan.

If, after analyzing your financial situation as we discuss in Chapter 2, you see that you’re stretching yourself financially, but you nevertheless want to trade up, be extra careful in going with an ARM. Although a fixed-rate loan starts off at a higher interest rate than an adjustable-rate loan, at least you know your payment on a fixed-rate loan can’t increase. If an ARM’s potentially higher future payments would destroy your budget, stick with a fixed-rate loan.

Financing improvements

After reading our discussion in the earlier chapters of this book, you may decide to stay in your current home because you can improve it and make it more to your liking. Instead of having to go through all the time, trouble, and expense of selling your home and buying another, you can “trade up” by upgrading your current property.

Although improving your current home may enable you to get the home you want at less total cost than selling and buying another, you still need to make sure you can afford the costs of the improvements. The more you spend on housing, the less you have for other important future expenditures, such as retirement, college educations for your little gremlins, and vacations.

Just be careful not to overimprove your home. For example, suppose you want to add a second story and put in a pool. If those additions give you the most expensive house on the block, you may have a problem recouping the renovation costs when you attempt to sell your house. If that situation is okay with you or you can rationalize by saying, “Heck, it’ll cost me big bucks to sell this house and buy another,” then improve to your heart’s content.

For an estimate of which improvements add to your home’s value and which do not, pick up a copy of Remodeling Magazine or go online to www.remodeling.hw.net. Its “Cost vs. Value" data (see tab at top of homepage) is used by many real estate professionals when consulting with sellers about which improvements they might make before placing their home on the market.

You have several options for financing the work to be done on your home. If you can afford it, the simplest route is to pay cash for the improvements. Unless you have some investment in mind that you think can provide a high enough rate of return to justify borrowing to finance the project, you’re better off using your available cash.

Here’s why. Suppose you have the choice of using available cash or borrowing money at 6 percent interest to finance your home improvements. If you borrow to pay for the project and keep your cash to invest, you’re going to lose out financially if you don’t earn at least 6 percent, before state and federal income taxes, on your investments. (Note that, although your mortgage interest may be tax-deductible, your investment profits are generally taxable.)

For example, if you invest your cash in a boring old bank savings account that pays just 2 or 3 percent interest, you’d have been better off using your cash to pay for your home improvements instead of borrowing. Unless you invest in growth investments, such as stocks or rental real estate, you’re unlikely to earn an average of more than 6 percent annually over the long term. “Safer” investments, such as Treasury bonds or certificates of deposit (CDs), simply won’t provide returns that high.

What if you don’t have tens of thousands of dollars burning a hole in your wallet, crying out for you to spend them on remodeling your kitchen? If you have equity in your home — that is, the market value of your home exceeds the mortgage balance you owe on it — you may be able to borrow against that equity.

Generally, you can most cost effectively borrow on your home’s equity up to the point where the total mortgage(s) outstanding on the property is equal to or less than 80 percent of the market value of your home. For example, suppose your home is currently worth $250,000 (as determined by a lender’s appraisal), and you have an outstanding mortgage of $150,000. As long as your financial situation enables you to qualify, you can borrow up to a total of $200,000 (that is, 80 percent of $250,000) — $50,000 more than you currently owe — under reasonably favorable terms. If you borrow more than 80 percent of the current market value of your home, you generally must pay a higher interest rate and more upfront loan fees. You may also get stuck paying private mortgage insurance, which protects the lender financially in the event you default.

You can tap the equity in your home in two ways. You can pay off your current mortgage and get a new first mortgage for enough additional money to cover the remodeling job, or you can take out a separate home-equity loan. The best option for you depends mainly on how good the deal is on your current mortgage compared to the current level of mortgage interest rates.

For example, suppose your existing fixed-rate mortgage was taken out at an interest rate of 5 percent and fixed-rate mortgages currently are going for 6 percent. You probably don’t want to give up your existing loan because the interest rate is lower than current loan rates. Under this scenario, taking out a home-equity loan (second mortgage) probably makes more sense. (Note: Because home-equity loans are riskier from a lender’s perspective — they make the lender a secondary creditor to the first mortgage lender — the interest rate on a home-equity loan generally is a little higher than the rate on a comparable first mortgage.)

Now reverse the scenario. Suppose you took your fixed-rate mortgage out years ago at a higher interest rate, say 7 percent. Now, you can obtain a loan at a lower rate, 6 percent. In this case, you may as well go ahead and refinance to benefit from the current, lower interest rates.

One final consideration in choosing between a home-equity loan and a refinanced mortgage: If you don’t need to borrow much money to pay for the improvements and you think that you can pay the money back within a few years, you may want to go with a home-equity loan. The reason: Refinancing a large first mortgage is probably going to run you much more in upfront fees than taking out a smaller home-equity loan.

Asking yourself why you’d ever want to be a lender

So, why all this talk about bankers, and why in the world would you want to be one? You may want to take on the role to lend money to the buyer of your house, that’s why. And what would possibly motivate you to do such a thing? Usually one of the following:

• Desperation: Some houses are difficult to sell because of major warts, and some won’t sell because they’re overpriced.
• A high interest rate on your money: We can see those dollar signs in your eyes. You can earn a higher rate of interest lending money to the buyer of your house than you can investing through bank accounts and most bonds.

If your local real estate market is slow or you’re having difficulty selling your property, you may sweeten the appeal of your house by offering to be the mortgage lender. Prospective buyers of your property may realize that they can save thousands of dollars in loan application fees and points (upfront interest). After all, you’re not a big bank with costly branches to operate and countless personnel to pay.

By offering seller financing, you broaden the pool of potential buyers for your house. Traditional mortgage lenders are subject to many rules and regulations that force them to deny quite a number of mortgage applications. But, as we discuss in upcoming sections, making loans to borrowers rejected by banks can be risky business.

So you absolutely, positively must thoroughly review a prospective borrower’s creditworthiness before you agree to lend him money as a condition of selling him your house. We explain how to make this evaluation later in this chapter in “Finding creditworthy buyers.”

In addition to helping sell a house, some sellers are motivated to play banker and lend money to the buyer of their property because the mortgage usually carries an attractive interest rate, at least when compared to the typical returns on conservative investments, such as bank savings accounts (currently 1 to 2 percent) or CDs and Treasury bonds (currently around 2 to 3 percent). If you have money to invest but investing in stocks terrifies you, lending money to the buyer of your house may interest you. You may be able to earn 7+ percent in interest by lending your money to a borrower.

Agreeing to offer a mortgage to the buyer of your house can clearly be advantageous; the loan may help sell your house faster and at a higher price and, at the same time, provide a better return on your investment dollars. However, nothing that sounds this good ever comes without some real risks. If you lend your money to someone who falls on difficult financial times or simply chooses to stop making mortgage payments, you can lose money, perhaps even a great deal of money. And you may have to take legal action and foreclose if the buyer defaults on the loan. And if all that isn’t bad enough, you’ll again be the owner of a house that you thought you’d sold, with all the associated expenses of home ownership, including higher loan payments for the buyer’s new first mortgage and, most likely, a higher property tax bill. Foreclosed homes also tend to deteriorate under the care of the prior owners, so you can also expect fix-up costs.

Deciding if seller financing is for you

Most house sellers aren’t in a position, financially or otherwise, to provide financing to the buyer of their home. So, before you waste too much of your time reviewing and reading the rest of this chapter, make sure you’re in a position to seriously consider providing financing.

To consider making a loan against the house that you’re selling, you should be able to answer yes to all the following questions:

• Will you be able to purchase the next home you desire without the cash you’re lending to the buyer of your current house? This issue keeps most sellers out of the financing business. If you need all the cash you have as a down payment to qualify for the mortgage on your next home, seller financing is out of the question. And, if you can lend some of your money to the buyer of your house, don’t make the loan if you then need to borrow more yourself for your next home purchase. Even if you can charge the buyer of your current house 2 percent or more in interest on the money you lend than you’ll pay for the money you’re borrowing to buy your next home, such an arrangement generally isn’t worth the hassle and financial pitfalls.
• Do you desire income-oriented investments? Understand that mortgages are a type of bond. When you invest in a bond, your return comes from interest if you hold the bond to maturity. Unlike investing in stocks, real estate, or a small business, you have no potential for making money from appreciation when investing in bonds held to maturity. So if you’re looking for growth as well as income, seller financing isn’t for you.
• Are you in a low enough tax bracket to benefit from the taxable interest income on the mortgage loan? If you’re in the federal 28 percent or higher tax bracket, consider investing in tax-free bonds, such as municipal bonds, and not mortgages, the interest on which is fully taxable. The reason: The interest income from municipal bonds is free of federal taxation and sometimes state income taxation. By contrast, the interest income from a mortgage is taxable as ordinary income at the federal and state levels.
• Are you willing to do the necessary and time-consuming homework to determine the creditworthiness of a borrower? As we discuss in the next section, unless you secure a large down payment (25 percent or more of the value of the property) from the buyer of your house, you need to be darn sure that the borrower can pay you back. So if you’re looking for a simple, non-time-consuming investment, look elsewhere. Try mutual funds and exchange-traded funds.
• Can you weather a default? Even if you do all the homework we suggest in this chapter before agreeing to lend money, the buyer/borrower still can default on you just as he can on a banker. Bad and unforeseen events can happen to borrowers. Accept this reality. Ask yourself if you can financially tolerate going without the borrower’s payments for many months during the costly and time-consuming process of foreclosure.

Finding creditworthy buyers

After you determine that you have spare cash to invest or lend, and you’re looking for taxable interest income, the hard work comes: putting on your detective hat and assessing the merits of lending your money to a prospective buyer who’s more than likely a complete stranger.

So how do you, someone who isn’t a mortgage lender by profession, become a savvy credit analyst? Perhaps you’ve heard the expression, “Imitation is the sincerest form of flattery.” Well, do what bankers do when deciding whether to lend someone money.

The first thing a lender does in her evaluation of the creditworthiness of a prospective borrower is to bury him in paperwork. As a lender, you absolutely, positively must gather financial facts from the borrower. You can’t accurately assess the risk of lending money to a buyer, even one whom you’ve known personally for a number of years, without going through the information-gathering exercise in this section.

Only agree to make a loan to the buyer of the property when he’s able to make at least a 20 percent down payment. Bankers normally require a down payment of that size for good reason: If the borrower defaults and the banker is forced to hold a foreclosure sale, the down payment provides a cushion against the expenses of sale and possible losses in property value if real estate prices have declined since the loan was made. If the buyer falls on hard times at the same time real estate prices go into the tank, you may find yourself in the unfortunate position of repossessing a house that’s worth less than the amount the borrower owes on it.

So, what documents should you request and what information should you look for? We’re glad you asked; we tackle that topic in the following sections.

The loan application

The best way we know to get data from a prospective borrower is to have him complete the Uniform Residential Loan Application (see Figure 4-1), also known as Form 1003, which mortgage lenders almost always use. You can obtain one of these forms through mortgage lenders or mortgage brokers. If, because no profit is in it for them, they’re unwilling to send you a form for your personal use, you can pose as a prospective borrower and have them mail you their standard application package. You can also find the forms online for free at www.fanniemae.com/content/guide_form/urla-borrower-information.pdf. (Please note that the sample form in Figure 4-1 is the version set for release in July 2019.)

Be sure to review the sample real estate purchase contract (for California) in Appendix A. Pay particular attention to Paragraph 2, which covers financing terms and conditions. Even if you don’t live in California, the provisions and precautions in this excellent contract are useful.

After you receive the completed application from the borrower, be sure it’s completely filled out. Ask for explanations for unanswered questions. The following list explains how to evaluate the information in various parts of the form:

• Borrower information: In this section, the borrowers tell you about themselves. If the borrower hasn’t lived in his most recent housing situation for at least two years, be sure he also lists his prior residence. If the borrower was renting in his recent housing situation(s), request a letter from the buyer’s landlord to verify that rent was paid on time. Alternatively, ask for both sides of canceled checks or checking account statements covering the most recent 12-month period evidencing timely rental payments. If the person moved frequently in recent years, check with more than the most recent landlord. Borrowers who’ve had trouble paying rent on time may well have trouble making regular mortgage payments. Ask for explanations of any red flags you find.
• Employment information: Even more important than a borrower’s recent housing record is the employment record. Here, you’re again looking for stability as well as an adequate income to make housing payments. If the borrower hasn’t been in the most recent position for at least two years, ask the person to list prior employment to cover the past two years. The borrower also lists his/her monthly income from the current job in this section of the application.

• Monthly income and income from other sources: In this important section, the borrower details monthly employment income as well as income from bank, brokerage, and mutual fund investments. In addition to income from bank accounts, stocks, bonds, or mutual funds, a borrower may have income from real estate rental properties. For most people, obviously, employment provides the lion’s share of their income.

  The buyer’s expected monthly housing expenses (which include the mortgage payment, property taxes, and insurance) should be compared against (divided by) the borrower’s gross (before-tax) monthly income. Most mortgage lenders require that a homebuyer’s monthly expenses do not exceed about 33 percent of the homebuyer’s monthly income; we think that’s a good ratio for you to work with as well.

  However, like a good banker, you don’t want to be rigid. If someone’s proposed monthly housing expenses come in at 34 percent or 35 percent of her monthly income and the borrower has a good job, large down payment, solid references, and so on, then you may decide to go ahead and make the loan, especially if the deal gets your house sold.

• Assets and liabilities: The borrower should also tell you about her personal assets and liabilities. (The next section lets the borrower do the same for other real estate if he owns any.) The mortgage application form divides the buyer’s assets between those that are liquid, and therefore available for a down payment or closing costs (for example, savings and money market account balances outside retirement accounts), and those that aren’t so liquid (retirement account investments or real estate).

  In the liabilities section, the borrower should detail any and all outstanding loans or debts. Be wary of lending to someone who carries a great deal of high-interest consumer debt (such as credit cards or auto loans). If the borrower has the cash available to pay off consumer debts before closing, have her pay those balances.

• Type of mortgage and terms of loan: Asking the borrower to fill in these sections isn’t vital; the legal loan document that you both sign later contains information on the terms of the loan — the loan amount, interest rate, length of the loan, and the loan type (fixed-rate or adjustable-rate). Later in this chapter, we walk you through the steps for setting the terms of your loan and having a loan agreement prepared.

• Loan and property information: Although you know that the borrower is obviously buying, you may not know whether he’s going to use the property as a primary or secondary residence or as an investment property. If the buyer intends to rent the property for investment purposes, your loan is riskier, and you should charge a higher interest rate than you’d charge an “owner-occupied” buyer (see “Deciding what to charge” later in this chapter).

  Verify the source of the buyer’s down payment and closing costs to ensure this money isn’t yet another loan that may handicap the buyer’s ability to repay the money you’re lending him. The down payment and closing costs should come from the buyer’s personal savings. Ask to see the last several months of the buyer’s bank and investment account statements to verify that the funds have been in the accounts during that time and didn’t arrive there recently as a loan, for example, from a relative.

• Declarations: In this section, the borrower should disclose any past financial or legal problems: foreclosures, bankruptcies, and so on. If the borrower answers any of these questions in the affirmative, ask for a detailed written explanation.

Deciding what to charge

After determining that a buyer is creditworthy, you can get down to the brass tacks of setting the terms — interest rate and fees — on the mortgage. As with collecting the financial data on a borrower, you don’t need to reinvent the wheel.

Because agreeing to terms and administering an adjustable-rate loan are complicated, you’re far more likely to make a fixed-rate mortgage. Call several local lenders to find out the rates they’re charging for the size and type of loan that you’re contemplating (for example, 15- or 30-year fixed-rate mortgage, first or second mortgage, owner-occupied or rental property). Be sure to ask about all the fees — application, appraisal, credit report, points, and so on. Although you may not charge all these same fees, you nevertheless need to understand what the competition is charging.

Some states have usury laws that forbid unregulated lenders (that is, private individuals like you) to charge loan origination fees, prepayment penalties, and so on. These laws also put a ceiling on mortgage interest rates that unregulated lenders can charge. You should consult a local, competent real estate lawyer about local usury laws.

All else being equal, you should charge a higher interest rate for jumbo loans (loans in excess of $424,100 for a single-family dwelling as of 2017; $636,150 for the highest-cost housing counties), longer-term loans, loans with less than 20 percent as a down payment, rental property loans, and second mortgages. (See the limit by county at http://www.loanlimits.org/conforming/.)

If the borrower is in good financial health and can easily qualify to borrow from a traditional lender, offer better terms than the commercial competition. You may decide to charge the same interest rate but not upfront fees. Most buyers are short on cash, so a reduction in closing costs usually is well received. Besides, unless the buyer sells or refinances within a few years, a mortgage’s ongoing interest rate is the greatest determinant of how much you make anyway.

Charge a premium to borrowers to whom you’re willing to lend but who are unable to get a good loan — or any loan — from traditional lenders. Remember, you need to be compensated for the extra risk you’re taking. You may add as much as 1 percent or 2 percent to the ongoing interest rate on the loan and charge fees comparable to a lender. Be absolutely sure about the reasons why the borrower got turned down for a loan from a traditional lender, and make certain you’re comfortable with taking on a risk that an experienced mortgage lender wouldn’t.

Protecting yourself legally

Unless you’ve made mortgage loans before, you may not have a clue as to how to go about drawing up a loan agreement, so hire a real estate attorney to draw one up for you. Expect the cost to be several hundred dollars — that amount is money well spent. See Chapter 7 for how to find a good real estate attorney.

You also want to make certain that the buyer of your home is paying the property taxes. In most states, the taxing authority can foreclose upon the home if property taxes become delinquent. The timing and procedures vary, so check with an attorney or your local taxing authority. In some areas, you can hire a tax service to monitor whether the taxes are paid each year.

One final piece of advice: If you sell the house and make an owner-occupied loan to the buyer, you may afterward want to ask for proof that the borrower is living in the property rather than renting it out. You can ask for utility and other household bills to see if the bills are in the buyer’s name. Or you may just stop by and knock on the front door of your old house to see who’s living there.

Rental property loans are riskier to make and should carry a higher interest rate.