Mortgage Shopping In a Stressed Market
December 22, 2008
Current stresses in the home loan market have changed the ground rules for borrowers in many ways. A companion article focuses on the confused state of affairs in the market for jumbos – loans larger than $417,000. Jumbos are priced higher than smaller loans even when they can be purchased by Fannie Mae and Freddie Mac, and much higher when they can’t. See Shopping For a Jumbo Mortgage.
This article reports on the results of an on-line shopping exploration I did on Friday, December 12, 2008. I priced conforming loans of $400,000 that can be purchased by Fannie and Freddie, and $800,000 (jumbo) loans that cannot. Within each size class, I looked at 15 and 30-year fixed-rate mortgages, and 5/1 adjustable rate mortgages (ARMs). Prices were obtained from 7 Upfront Mortgage Lenders (UMLs), who are internet-based lenders that meet my standards for pricing transparency, and from the four largest depository institutions in the market: Bank of America, Citicorp, Chase and Wells Fargo.
To assure comparability, I posed as a prime borrower purchasing a single-family house in California with a large down payment, while fully-documenting my income and assets. What I learned probably holds for non-prime transactions, but one can never be entirely sure of that.
The differences in prices quoted by different lenders was extremely large. It is plausible that some of this diversity can be attributed to the crisis, but I don’t have the earlier data needed to verify this. On the popular 30-year conforming FRM, on which spreads usually are the smallest, the highest quote was more than 1% above the lowest quote. On ARMs, the spreads were even larger. On a 5/1 jumbo ARM, one lender quoted 8.125% plus $9800 in points while another quoted 5.75% with zero points.
Bottom Line: Borrowers can save a ton of money by shopping loan providers.
One striking fact about the current market is that conforming ARMs cost more than 30-year FRMs, something I cannot remember ever having seen before. The rate difference between the 30-year FRM and the 5/1 ARM, holding points constant, was almost 1%. Furthermore, 3/1 and 7/1 ARMs were both priced higher than the 5/1s. On the other hand, all the lenders offering jumbo loans except one priced ARMs below the 30-year FRM, which is the usual pattern.
Bottom Line: There is no reason for a borrower to select a conforming ARM, but on jumbos, ARMs continue to enjoy a significant rate advantage.
The 15-year FRM has always been my preferred instrument for borrowers who could afford the payment, because it carried a significantly lower rate than the comparable 30, and it amortized much more rapidly. On jumbo loans, the spread remains very attractive at about 5/8%, but on conforming loans, it has dwindled to about half of that.
Bottom Line: No reason to avoid 15-year FRMs, but on conforming loans the advantage is not what it was.
Until recently, the 30-year FRM that allows interest-only (IO) payments for the first 10 years was very popular. Borrowers could avoid making payments to principal for 10 years. To get the IO option, borrowers typically paid a rate premium of about 1/8%.
No more, in an environment of declining home prices, investors don’t like loans that build no equity for 10 years, and they have raised the premium to 1.4-2%.
To illustrate, one lender priced a standard 30-year FRM for $400,000 at 5.75% and the IO version of the same mortgage at 7.25%. This means that the borrower was offered a choice between paying a) $2354 a month, of which $1917 is interest and $437 is principal, and b) $2416 a month, all of which is interest. This pricing eliminates the only benefit borrowers receive from an IO, which is the lower payment.
Bottom Line: Borrowers should avoid the IO option on the 30-year FRM. On ARMs, however, the rate premium to get an IO option is still reasonable.
Stressed markets do offer one significant bargain: buying down the interest rate by paying points. In 2005, it cost about 1.5 points to buy down the rate by .25% on a 30-year FRM. In early 2007, it cost about 1.125 points. Today, the price is down to about half a point.
In part, the lowered price is due to the shorter average life of loans, which increases the value to investors of collecting points upfront. In addition, lower rates carry lower payments, which reduce the likelihood of default. In a stressed market, this carries a lot of weight.
Borrowers viewing a rate buy-down as an investment can earn a very high return. For example, one lender on December 12 offered a rate reduction of .5% for 1.119 additional points. Using calculator 11c, Mortgage Points Calculator: Rate of Return on FRMs, I determined that this investment in points would yield 28% over 5 years and 32% over 30 years.
Bottom Line: Buying down the interest rate is a very good investment.
Current stresses in the home loan market have changed the ground rules for borrowers in many ways. A companion article focuses on the confused state of affairs in the market for jumbos – loans larger than $417,000. Jumbos are priced higher than smaller loans even when they can be purchased by Fannie Mae and Freddie Mac, and much higher when they can’t. See Shopping For a Jumbo Mortgage.
This article reports on the results of an on-line shopping exploration I did on Friday, December 12, 2008. I priced conforming loans of $400,000 that can be purchased by Fannie and Freddie, and $800,000 (jumbo) loans that cannot. Within each size class, I looked at 15 and 30-year fixed-rate mortgages, and 5/1 adjustable rate mortgages (ARMs). Prices were obtained from 7 Upfront Mortgage Lenders (UMLs), who are internet-based lenders that meet my standards for pricing transparency, and from the four largest depository institutions in the market: Bank of America, Citicorp, Chase and Wells Fargo.
To assure comparability, I posed as a prime borrower purchasing a single-family house in California with a large down payment, while fully-documenting my income and assets. What I learned probably holds for non-prime transactions, but one can never be entirely sure of that.
Differences in Price Quotes by Different Lenders
The differences in prices quoted by different lenders was extremely large. It is plausible that some of this diversity can be attributed to the crisis, but I don’t have the earlier data needed to verify this. On the popular 30-year conforming FRM, on which spreads usually are the smallest, the highest quote was more than 1% above the lowest quote. On ARMs, the spreads were even larger. On a 5/1 jumbo ARM, one lender quoted 8.125% plus $9800 in points while another quoted 5.75% with zero points.
Bottom Line: Borrowers can save a ton of money by shopping loan providers.
Conforming ARMs
One striking fact about the current market is that conforming ARMs cost more than 30-year FRMs, something I cannot remember ever having seen before. The rate difference between the 30-year FRM and the 5/1 ARM, holding points constant, was almost 1%. Furthermore, 3/1 and 7/1 ARMs were both priced higher than the 5/1s. On the other hand, all the lenders offering jumbo loans except one priced ARMs below the 30-year FRM, which is the usual pattern.
Bottom Line: There is no reason for a borrower to select a conforming ARM, but on jumbos, ARMs continue to enjoy a significant rate advantage.
15-Year Conforming FRMs
The 15-year FRM has always been my preferred instrument for borrowers who could afford the payment, because it carried a significantly lower rate than the comparable 30, and it amortized much more rapidly. On jumbo loans, the spread remains very attractive at about 5/8%, but on conforming loans, it has dwindled to about half of that.
Bottom Line: No reason to avoid 15-year FRMs, but on conforming loans the advantage is not what it was.
Interest Only Version of the 30-Year FRM
Until recently, the 30-year FRM that allows interest-only (IO) payments for the first 10 years was very popular. Borrowers could avoid making payments to principal for 10 years. To get the IO option, borrowers typically paid a rate premium of about 1/8%.
No more, in an environment of declining home prices, investors don’t like loans that build no equity for 10 years, and they have raised the premium to 1.4-2%.
To illustrate, one lender priced a standard 30-year FRM for $400,000 at 5.75% and the IO version of the same mortgage at 7.25%. This means that the borrower was offered a choice between paying a) $2354 a month, of which $1917 is interest and $437 is principal, and b) $2416 a month, all of which is interest. This pricing eliminates the only benefit borrowers receive from an IO, which is the lower payment.
Bottom Line: Borrowers should avoid the IO option on the 30-year FRM. On ARMs, however, the rate premium to get an IO option is still reasonable.
Paying Points to Reduce the Interest Rate:
Stressed markets do offer one significant bargain: buying down the interest rate by paying points. In 2005, it cost about 1.5 points to buy down the rate by .25% on a 30-year FRM. In early 2007, it cost about 1.125 points. Today, the price is down to about half a point.
In part, the lowered price is due to the shorter average life of loans, which increases the value to investors of collecting points upfront. In addition, lower rates carry lower payments, which reduce the likelihood of default. In a stressed market, this carries a lot of weight.
Borrowers viewing a rate buy-down as an investment can earn a very high return. For example, one lender on December 12 offered a rate reduction of .5% for 1.119 additional points. Using calculator 11c, Mortgage Points Calculator: Rate of Return on FRMs, I determined that this investment in points would yield 28% over 5 years and 32% over 30 years.
Bottom Line: Buying down the interest rate is a very good investment.