Duane Duggan

Duane Duggan, Realtor and Author RE/MAX of Boulder

The 30-year mortgage has been the mainstay of American homebuying for decades. The 30-year mortgage came about as a result of the housing crisis of the 1920s. Back then, a typical mortgage was three to five years with a variable rate, and payments only covered the interest.

Often, large down payments were required. The most popular mortgage loan evolved into what is the 30-year amortized loan, which has become one of the primary reasons for increasing the level of homeownership in the United States. Amortizing means some of the principal of the loan amount is paid off each month, allowing homeowners to build equity and avoid a large single payoff of the loan. Interestingly, 30 years has become the most “reasonable” time frame to pay for a home, rather than 15, 20, or 40 years. This is because, in general, shorter-term payments are unaffordable, while jumping from a 30-year amortization to a 40-year amortization doesn’t really lower the payment that much.

Even with our 30-year mortgages, homebuyers are feeling the pressure that rising interest rates have on their purchasing power. Along with interest rates rising, home prices are still going up, making for a double hit on purchasing power. The main benefit of a fixed-rate mortgage while rates are rising is that your mortgage rate does not increase. If rates drop significantly, you usually have the option to refinance at a lower rate. Back in the 1980s, when mortgage interest rates rose to the 16% mark, homebuyers looked to alternative financing options in order to purchase a home. Today, we don’t have quite as many financing options as we did back then, but rates rising to 6% is hardly a reason to panic compared with 16%! When rates hit historically high levels, financing options included assumable loans, owner financing, wraparound mortgages, and selling second mortgages as tools to make housing affordable. As time went on, tools such as buying down the interest rate and variable rate mortgages with lower levels of risk, emerged into the marketplace. Today, most mortgage loans are not assumable, meaning that they are not loans for which the buyer can take over a seller’s mortgage loan. Some loans, however, are assumable, such as FHA and VA programs, for buyers who qualify. Sellers can check with their current lender to see if a loan is assumable, but almost all conventional ones are not. 

Variable-rate mortgages or adjustable-rate mortgages (ARM)
Variable-rate mortgages are a tool to keep housing costs lower as rates increase. They are also referred to as Adjustable-Rate Mortgages or ARM. An ARM will have an interest rate set for a fixed period. The initial period might range from six months to 10 years. The rate then fluctuates up and down in sync with an agreed upon, publicly available index, along with an agreed upon margin. The index added to the margin creates a new interest rate. Most ARMs will have an interest rate ceiling and floor agreed upon in the paperwork. Make sure you know and understand all the details of the adjustments. The main advantage is that the start rate is usually lower than the current available fixed mortgage rate. Or, if you plan to sell your home before the adjustments get too high, it may make sense to take advantage of lower payments in the early years of the mortgage. The risk is that once the fixed rate ends, you could wind up with a higher interest rate and, therefore, higher monthly payments. Make sure you’ll be able to afford those payments when the time comes, even if you think mortgage rates will eventually go down and give you the opportunity to refinance. In fact, lenders usually will need to qualify the buyer at an interest rate that is higher than the start rate. That makes qualifying for an ARM a little more difficult. In general, the longer you are planning on staying in your home, the more likely a fixed-rate mortgage will serve your needs best, especially if you and your mortgage professional think the interest rate trend will continue upward. 

Mortgage interest rate buydowns
When interest rates rise, the market slows down, and buyers are looking for ways to keep the monthly payment within their budget. One of the techniques used is an interest rate buydown. Money can be paid to a mortgage lender to lower the interest rate in a variety of formats. It could be a permanent buydown for the 30-year life of the loan, or a 3-2-1 or a 2-1 buydown. The 3-2-1 buys the rate down 3% the first year, 2% the second year and 1% the third year, then the rate remains at the face rate for the remaining 27 years. These buydowns are accomplished via a one-time payment to the lender. The payment can be made by the buyer, the seller, or the builder. 

Interest-only loans
Another tool to help buyers in an accelerating market – or rising interest rate environment – is the interest-only mortgage. During the pre-2007 real estate market, prices were rising rapidly, and this was a tool to help keep the payment lower. During the 2007 to 2012 recession, interest-only mortgages got a bit of a bad rap because consumers were missing out on paying down their loans. As values declined and the loans weren’t being paid down, homeowners were more likely to be foreclosed upon. When a market accelerates, interest-only mortgages become more commonplace. This is because prices are accelerating faster than salaries and the consumer looks for ways to afford a home. There is definitely a time and place to use the interest-only loan as a worthwhile tool. One example is when I had a client who had been laid off from his job. This client had other income streams, but the fully amortized payment was making things pretty tight. By leveraging an interest-only mortgage my client was able to reduce his mortgage payment and stay in his home. A feature that interest-only loans have is that if you prepay any principal, the following month, the interest-only payment is based on the remaining principal balance. That means the payment decreases immediately. That is a big difference from a 30-year amortized loan. On a 30-year amortized loan, if you prepay the principal, it reduces the term of the loan, but the payment remains the same. With the interest-only loan, if you are disciplined enough to make extra principal payments, the monthly loan payment will go down each time you do. Interest-only loan availability varies with the marketplace. Typically, when these loans are introduced to the marketplace, they are first available for primary residences and second homes. The typical product structure is 3,5,7, or 10 years fixed, then it becomes an ARM (Adjustable-Rate Mortgage). In general, qualifying is more stringent than for a typical mortgage and down payments are larger. When available, an interest-only loan on investment property is an amazing tool. Each time you make an extra principal payment, the next month’s payment is lower, and the cash flow gets better. As the cash flow improves, you can keep applying the increased cash flow to the principal and before you know it the loan is paid off!

Reverse mortgages
As interest rates rise, there is a way for seniors (62 or older), to purchase a home with no payments. The interest rate on reverse mortgages still fluctuates with the market. However, a homeowner who qualifies based on their age and the amount of equity in their home can create a structure of zero payments on their current home. If the equity in a senior’s home and the purchase price of a replacement home match the reverse mortgage formula, it is possible to purchase and have no payments. A reverse mortgage professional and help you review the details.

Owner financing
As interest rates rise, there might be more owners/sellers willing to carry the financing for a buyer. If mortgage rates are at 7, a seller might be very happy to get a return of 5 or 6%, making it a win/win for both buyer and seller. Generally, the drawback of owner financing is that few owners are willing to finance for 30 years the way an institutional lender is willing to. Bottom line, consult your professional REALTOR® and mortgage professional to review any of the above options to see if they work for you.

By Duane Duggan. Duane graduated with a business degree and a major in real estate from the University of Colorado in 1978. He has been a Realtor® in Boulder since that time. He joined RE/MAX of Boulder in 1982 and has facilitated over 2,500 transactions over his career, the vast majority from repeat and referred clients. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail [email protected], call 303.441.5611 or visit boulderco.com.