Because of the relatively high price of most real properties, real estate purchases are typically financed through loans or mortgages. Seldom is a real property purchased all cash/outright. As such, there are various financing mechanisms available to purchase real property.
Definitions:
Equity: The difference between the value of your property (asset) and your loan balance (liability). Therefore, if your home is worth $500,000, but you only owe $400,000, your equity is $100,000.
Loan-to-Value (LTV): The amount of a loan divided by the value of the property securing the loan. Therefore, if you borrow $400,000 on a $500,000 house, your LTV is 80%. Most lenders will not give out loans with an LTV greater than 80%. Overtime, your lower loan balance and higher home value should result in a lower LTV.
Amortization: Spreading out the payments on a loan (principal and interest) over a period of time in fixed installments. Most real estate loans are amortized over 30-years.
Conventional Loans: Loans that meet the guidelines set forth by Government Sponsored Enterprises (GSE’s) such as Fannie Mae and Freddie Mac.
Non-Conforming Loans: Loans that do not meet the guidelines set forth by GSE’s.
Basis Point: One-hundredth of one percent (0.01%). Therefore, 100 basis points equal 1%.
Loan Types
1) Fixed Rate Loans: These are the most popular loans, especially for buyers of residential real estate. As the name suggests, fixed rate loans have a fixed interest rate and fixed monthly payments over the life of the loan. Borrowers like these loans, because they provide stability and predictability, which enables the borrower to budget their finances accordingly. There are different options for fixed rate loans, including 10-year fixed, 15-year fixed and 30-year fixed. Most borrowers opt for the 30-year fixed rate loan, because the monthly payments are the lowest. However, some borrowers like the shorter-period loans because they build equity (i.e. payoff the loan) much faster. With regards to loans in general, the longer the duration, the higher the interest rate. Basically, you pay a higher rate because you are able to lock-in the price of money for a longer period of time.
2) Adjustable Rate Mortgages (ARM’s): ARM’s have fixed rates only for a certain period of time, after which interest rates become variable. This type of loan maybe a bit risky for many borrowers, because your interest rate may spike after the fixed period is over. However, some buyers/borrowers like these loans because rates are lower and they don’t intend to hold onto their property for a long period of time. For instance, a person who relocates to a new area as part of their job, might want to buy a property to live-in for the next 5-8 years. Therefore, instead of getting a fixed rate loan, which has a higher interest rate, they may opt for 10-year ARM, which carries a lower interest rate. This person probably doesn’t care about long-term interest rates, because they plan on selling the property after only a few years.
3) Interest Only Loans: The minimum payments on these loans only cover the interest charged by the lender. Unless you pay more than the minimum amount, you will not be making a dent in the amount you owe/principal amount. Therefore, if you keep making only the minimum payments, you will be required to make a lump sum payment (balloon payment) at the end of the life of the loan. As such, these types of loans can be very risky and should only be used for short term periods, unless you plan on making additional payments towards your principal every month. Interest-only loans are usually made in cases where the borrower needs a second loan, or a Home Equity Line of Credit (HELOC) to buy a property. It is usually only the second loan that is interest only.
4) Negative Amortization Loans: These types of loans have fallen out of favor since the real estate-driven financial crisis of 2008. In their zeal to get more buyers qualified for a loan, lenders offered extremely low interest rates. However, in order to protect their profit margins, the size of the loan increased over time. Therefore, instead of your loan balance going down over time, it actually went up. Unless you paid more than the minimum payment each month, you were becoming more in debt. Basically, under this type of loan, you were borrowing more money against your home every month. To make matters worse, there were clauses that required additional payments if the value of the property went down (i.e. a drop in the Loan-to-Value ratio). Many borrowers never fully understood how these loans worked, and when the value of real estate dropped in 2008, they weren’t able to make the additional monthly payments and simply walked away from their properties, further exacerbating the real estate meltdown.
5) Subprime Loans: Loans made to borrowers who wouldn’t otherwise qualify for a typical fixed rate mortgage. These borrowers either had poor credit histories, insufficient income or were simply buying homes that were too expensive. The banks liked these loans because they charged very high interest rates. However, when these borrowers started defaulting on their loans, banks were stuck with real estate assets that were going down in value and were insufficient to cover the amounts of the loans they made. Subprime loans are one of the major reasons why lenders such as Countrywide Mortgage and Washington Mutual are no longer in business.
6) Home Equity Line of Credit (HELOC): This type of loan usually occurs after you buy a property. Basically, if you own a property that has gone up in value, you can approach a bank and ask them for another loan secured by the same property. The reasoning is that you have built additional equity over time either by paying off part of your first loan balance, or because your property increased in value (or both). The more equity you have in your property, the greater the amount of HELOC you might get. HELOC’s are subordinate loans, meaning that in the event of default, your primary/first lender gets paid first. HELOC’s are often interest only loans.