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'Alternative mortgages' gain a foothold

There's a lot more out there than plain-vanilla 30-year fixed-rate mortgages.

There are mortgages for people who have little or no down payment money. There are loans for people, such as doctors just out of medical school, who expect their incomes to skyrocket. Loans for people who plan to move within a few years. Loans for observant Muslims, who are prohibited by Islamic law from paying interest.

"A lot of people are just thinking 30-year fixed," says Bob Walters, senior vice president of Quicken Loans, "and if someone tries to sell them something else, they think, 'Hey, are you trying to scam me or something?'"

The answer is no. A good mortgage broker or loan officer will ask questions to find out what kind of loan best suits you. It might not be a 30-year fixed-rate loan. Walters says, with perhaps a bit of hyperbole, that 30-year fixed-rate home loans "are not the right mortgage for 90 percent of borrowers."

The case for hybrids
Walters feels passionately that most borrowers would be better off getting hybrid ARMs -- adjustable-rate mortgages that have an initial interest rate that lasts three to 10 years, then adjusts annually thereafter.

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The most common hybrid arms are known as 3/1, 5/1, 7/1 and 10/1. A 3/1 ARM starts out with a low rate that lasts three years, then is adjusted annually. A 5/1 ARM has an introductory rate that lasts five years, and 7/1 and 10/1 ARMs have intro rates that last seven and 10 years.

Right now, people with good credit can get 3/1 ARMs at less than 5 percent. Rates are so low today that it's almost certain that a 3/1 ARM's rate will rise after three years. Most ARMs can't rise more than 2 percentage points annually. So if you get a 3/1 ARM today at an introductory rate of 4.5 percent and stay in the house four years, you will pay 4.5 percent for three years, and 6.5 percent the fourth year.

Compare that to paying 5.5 percent for four years on a 30-year, fixed-rate loan of $150,000. Over four years, you save $3,100 interest by going with the 3/1 ARM, while building about $400 more equity.

Walters feels impatient with borrowers who ignore the advantages of hybrid ARMs. "People say, 'I'm going to be absolutely sure to pay a higher rate now, on the chance that they might rise in three or four years,'" he says. "It's a Depression-era mentality."

ARMs for the footloose
He could bolster his case by pointing out that few people live in their homes long enough to pay off a 30-year mortgage. Half of homeowners live in their houses for less than nine years. People who plan to relocate or move up to a bigger house in a few years should seriously consider hybrid ARMs.

There's always those buyers who are well-suited to 30-year fixed-rate loans: People who have little or no down payment money. Some 30-year loans allow them to get around the no-down payment squeeze.

Many lenders offer mortgages for 97 or 100 percent of the home's price. You might see these marketed as Alt 97 or Flex 97 or Flex 100 loans, after the Fannie Mae and Freddie Mac programs underlying them. You are expected to come up with cash of 3 percent of the home's value, either as a down payment or to pay closing costs.

You also are expected to come up with a down payment of at least 3 percent on loans insured by the Federal Housing Administration. These FHA-insured loans are permissive about the source of the 3 percent, which can come as gifts or as charitable donations. An industry of nonprofit down payment assistance programs has sprung up because of this rule.

Here's how these programs work: The seller gives a 3 percent donation, plus a handling fee, to the down payment assistance program, which then gives a 3 percent grant to the home buyer to use as the down payment.

Which is better? Run the numbers
Which is better: getting a 100 percent loan or getting an FHA loan using a down payment assistance program?

"A really good case can be made that FHA with down payment assistance can be a better alternative," says Richard Ferguson, president of Neighborhood Gold. The Provo, Utah,-based nonprofit has given grants to 30,000 home buyers.

To know for sure, you have to run the numbers. Ferguson says that FHA mortgage insurance generally costs less than mortgage insurance on conventional loans, and that rates on FHA-insured loans often are lower than rates on conventional loans for 97 percent of 100 percent of the home's value.

Rate and the cost of mortgage insurance aren't the only factors. When a buyer uses a down payment program, the seller is less likely to bargain on the home's price. That's another way of saying that buyers pay more for houses when they use down payment assistance.

Many buyers do the math and conclude that down payment assistance is a better deal. About one-third of FHA-insured loans go to buyers who use down payment assistance programs, Ferguson says.

More alternatives
There are other creative ways to finance homes.

Interest-only mortgages, in which the borrower is required to pay only interest for the first few years, are popular with people with unpredictable incomes (for example, self-employed people whose incomes are up one month and down the next). Interest-only borrowers have the flexibility of paying only the interest when money is tight, and interest plus principal when the money is rolling in.

Interest-only mortgages also are popular with people, such as new doctors and lawyers, who know that their incomes will rise much higher in a few years. Interest-only loans allow them to buy houses that they otherwise can't afford, but will be able to afford in a few years.

Then there is financing for observant Muslims, who are prohibited from paying interest. American Finance House - LARIBA puts together lease-purchase deals that fall within guidelines approved by Islamic scholars.

-- Posted: March 15, 2004
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