Since the reader was already looking at difference between fixed rate mortgages (FRM), he probably knew what they are, but that’s still a good place to start. There are basically two types of mortgages when it comes to rates – Fixed Rate (FRM) and Adjustable Rate (ARM). A fixed rate mortgage is exactly

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what it sounds like, a mortgage with a specific interest rate that is set at closing (or when the rate is “locked”) and never varies for the life of the loan.

An adjustable rate mortgage starts at a certain rate and is adjusted periodically as market interest rates change. When it is adjusted depends on the specific terms of the loan. The first adjustment may come after a year or it may come after some other time. 2, 3, 5 and 7 year time frames for the first adjustment are typical. Once the first adjustment happens, the rate can be adjusted again periodically. Annual adjustments are common. There is usually a limit on how much the rate can adjust at one time and often a maximum rate.

ARMS have gotten a lot of bad press recently as rates have started to adjust upward for many borrowers, especially those that took out zero percent “teaser rate” loans. A loan which adjusts annually starting after 1-year and which has a low teaser rate can be very dangerous for the borrower, as the payment can increase substantially in just a couple of years. The longer term adjustments, especially in the 5 to 7 year range for the first adjustment, may be a good deal for many borrowers as the typical US consumer moves roughly every 7 to 10 years and there is plenty of time for saving or increasing income before the first adjustment.

The number of years in a 15-year and 30-year Fixed Rate Mortgage actually refers to the number of years in the loan payoff schedule or “amortization.” If you get a 30-year FRM and make the payments as scheduled, in 30-years the mortgage will be paid off. Get a 15-year FRM and in 15-years it will be paid off.

Adjustable rate mortgages aren’t so simple. A commonly quoted ARM rate is for a “1-year ARM.” If you’re like many people, you may be thinking “How could I pay it off in 1-year?!?!” You don’t. The loan is still amortized over a “normal” loan period – usually 30-years, though 15 is also an option. The “1-year” refers to the time before the first rate adjustment. So, if you see a “7-year ARM with 30-year amortization” or a “7/30 ARM”, you’re seeing a loan that has a fixed rate for the first 7-years and is paid off over a 30-year period. 5/30 – The first adjustment will happen after 5 years and the loan is paid off over a 30-year period. The initial payment on a 1-year ARM with a 30-year amortization will be the same as a 30-year FRM with the same interest rate. In a year if the rate adjusts up, the payment will adjust up to be the same as a fixed rate mortgage with the new higher rate and the same initial payoff period/number of payments.

With so many loan products available, the key here is that if you venture outside the relatively simple world of 15-year and 30-year Fixed Rate Mortgages, you need to understand very specifically the terms of the loan you are taking and all possible scenarios for interest rate changes. The sooner the first adjustment happens and the bigger the annual adjustments that are allowed, the more important it is to examine the “worst case” scenarios that may catch you before you’ve saved or built equity.

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What’s the difference between a 15 and 30 year fixed mortage? An adjustable rate mortgage?

This reader question is especially timely given the turmoil in the mortgage markets the last three months:

Who are Ginnie Mae, Freddie Mac and Fannie Mae and what do they do?

Freddie Mac and Fannie Mae are the two biggest players in the US mortgage markets, dominating the market for loans under the conforming loan limit (currently $417,000) and ultimately purchasing about 2/3 of all single family mortgages between them. Ginnie Mae is a much smaller player, focused entirely on government guaranteed (FHA, VA, Agriculture Department) mortgages. I’ll get to their exact roles further on, but what’s really important to understand is that over 2/3 of the mortgage market would function much differently, if it functioned at all, without these three players. The second thing worth noting, and this is the timely part, is that these players have little involvement with the “subprime” or “jumbo” sections of the market and all three of them are functioning normally. (Freddie Mac and Fannie Mae do purchase some of the very top subprime mortgages, called “Alt-A” paper, that barely miss the requirements to be considered “conventional” loans.)

Freddie Mac has a portfolio of $1.5 trillion in loans, more than the Gross Domestic Product of Russia, Canada, India or Mexico. Fannie Mae’s portfolio is even larger. Freddie Mac’s revenue, which is a fraction of a percent of the loans it underwrites, is over $40 billion a year and Fannie Mae’s is over $50 billion.

Fannie Mae was initially Federal National Mortgage Corporation, Freddie Mac was the Federal Home Loan Mortgage Corporation and Ginnie Mae was the Government National Mortgage Association. Fannie Mae and Freddie Mac are privately owned corporations chartered by Congress and have lines of credit with the US Treasury for $2.5 billion. Though there is a common perception that they have an implicit federal guarantee against failure, there is no legal guarantee and in fact the law authorizing them specifically disclaims any government guarantee. Ginnie Mae is a government agency and as such is legally backed by the full faith and credit of the US government.

But what do they actually do? Fannie Mae and Freddie Mac perform similar roles, while Ginnie Mae performs a bit different role. The typical mortgage loan is for a 15 or 30-year term. Bank deposits are mostly in checking accounts, savings accounts and certificates of deposit with terms of a few years. So, when a bank makes a mortgage loan, the bank may not want to actually hold the loan for its full life. This is where Fannie Mae, Freddie Mac and Ginnie Mae step in. Freddie Mac and Fannie Mae buy mortgage loans from the banks, package large numbers of loans into securities and then sell the securities, Mortgage Backed Securities, to investors and the banks get cash for the loans. (Technically, in most cases, the banks actually receive Fannie Mae, Freddie Mac or Ginnie Mae securities in exchange for the loans and the banks can then sell those securities to investors for cash or can use them in lieu of cash for some purposes.) The function of the three agencies is to package loans for sale to investors so the banks can cash out. They make a market for the loans, called the secondary market. Because of their size and their relationship to the federal government, Fannie Mae and Freddie Mac are able to translate the demand for their securities into lower interest rates for mortgage borrowers and a more stable market for mortgage loans.

So, why three agencies instead of one? Each has a different purpose written into its charter.

Ginnie Mae has the narrowest charter of the three. Ginnie Mae doesn’t actually issue any securities or buy and sell any loans. Ginnie Mae does “guarantee investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans.” These are insured or guaranteed by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Department of Agriculture’s Rural Housing Service (RHS) and the Department of Housing and Urban Development’s Office of Public and Indian Housing (PIH). Ginnie Mae also provides a computer platform that allows Ginnie Mae approved lenders to package the mortgage backed securities that Ginnie Mae ultimately guarantees.

Fannie Mae was initially chartered to create and guarantee Mortgage Backed Securities for government loan programs and then for conventional mortgages. In 1968, Ginnie Mae was split off from Fannie Mae and Fannie Mae was privatized. From 1968, it’s purpose was to promote liquidity in mortgage markets by packaging conventional loans into securities for resale to investors.

In 1970, Congress chartered Freddie Mac. Part of the rationale was to provide competition for the newly private Fannie Mae, to avoid a mortgage market monopoly. Freddie Mac was also chartered specifically to promote “activities relating to mortgages
on housing for low- and moderate-income families” and “to promote access to mortgage credit throughout the Nation (including central cities, rural areas, and underserved
areas).”

Freddie Mac and Fannie Mae are both regulated by the Department of Housing and Urban Development (HUD) and the Office of Federal Housing Enterprise Oversight (OFHEO).

For the home buyer or seller, what’s most important to understand is that Freddie Mac and Fannie Mae may ultimately end up owning your mortgage loan. As such, they have the right to set certain requirements on the lender who makes the loan. What this means for you is that it won’t matter how nice a tie you wear when you apply, whether you lose to your lender on purpose at golf or who you buy lunch for – if you and the house you are buying don’t meet the loan requirements set by Fannie Mae or Freddie Mac, you’re out of luck. If you’re getting a government guaranteed loan, Ginnie Mae won’t end up owning the loan, but the role of it and the government agencies involved will give them similar power to set requirements for the borrower and the property.

Investors should note a couple of things about Fannie Mae, Freddie Mac and Ginnie Mae securities. First, Fannie Mae and Freddie Mac securities are high quality debt securities backed by high quality mortgages. As private securities go, they are quite low risk. But, the market probably prices them as if they carried less risk than they do, because of the mistaken perception of a federal guarantee. By law, there is no federal guarantee on Fannie Maes or Freddie Macs. It’s also important to note that the capital requirement on Fannie Mae and Freddie Mac is 1/2 the required capital for other mortgage backed securities.

Ginnie Mae securities on the other hand are backed by the full faith and credit of the US government and are also backed by high quality mortgages making Ginnie Maes a very low risk fixed income security. (Arguably the backing by real estate makes them slightly less risky than even Treasury securities, though the distinction is trivial and for capital purposes they have a risk-weighting of zero.)

Technorati Tags: Fannie Mae, Ginnie Mae, Freddie Mac

Further reading:
Fannie Mae
Freddie Mac
Ginnie Mae
OFHEO

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Who are Ginnie Mae, Freddie Mac and Fannie Mae and what do they do?

So, what’s the average loan amount? I don’t know of any good source for that statistic. But fortunately I have some more useful information, the answer to this question: “How much can a household with good credit and $50,000 income borrow?” That answer varies a little depending on the type of loan. It also varies literally day-by-day as interest rates change.

For conventional, conforming loans, there are two relevant “debt ratios” – 28% of gross income for housing and 36% of gross income for total debt. Gross income is your total pay before any taxes are withheld. This means that the allowed house payment, including taxes and insurance, for a $50,000 income, good credit borrower is $1166.67/month. But that’s not the full picture. Total debt payments, including the house payment plus credit cards, car payment and any other consumer debt that shows up on the credit report, are limited to 36% of gross income. For a borrower with $50,000 income this total is $1,500. So, if the borrower has a $350 car payment and $150 in credit card payments, that leaves $1,000 available for the house payment. In other words, the total debt ratio can leave the borrower with less than 28% for the house payment, but generally speaking it’s not possible to exceed that 28%.

Let’s assume that our $50,000 borrower has little other debt and can spend the full 28%. Let’s set aside a reasonable amount for taxes and insurance, $2,000/year or just under $167/month. This leaves $1,000 a month for the principal and interest payment – the actual loan payment. For a 30-year Fixed Rate Mortgage today’s rate (Oct. 19, 2007) according to the Freddie Mac Primary Mortgage Market Survey is 6.4%. This allows a loan amount of $159,870.59. For a 15-year mortgage, current rate is 6.08%. This allows a loan amount of $117,898.80. With a 1-year Adjustable Rate Mortgage with a 30-year amortization, you could borrow $163,793.83 – but that rate could adjust upward and the payment would also increase. (Thanks to Bret Whissel for the amortization calculator I used to figure these loan amounts. When rates change, you can use his calculator to find the answers for the new rates.)

With an FHA loan, the borrower can get a slightly larger housing debt ratio of 29% and a bigger total debt ratio of 41%. The 1% difference in the housing payment isn’t a big difference, but the extra 5% on total debt could mean an extra $200 for our $50,000 borrower each month for car payments, credit cards, etc.

The reader was interested in average amounts and I suspect was as interested in knowing what’s advisable as what’s average or allowed. Those are the allowable amounts. Does that mean they are advisable amounts? Not necessarily. A lot will depend on your current situation. If you’re paying high rent, those amounts could represent a drop in your monthly bills. If you’re in one of the, increasingly common, areas where house prices have run up faster than rents, buying may mean substantially raising your monthly payments. Of course, there is a savings component to paying off a mortgage, so if you currently have a good savings plan, you may still be in good shape saving a little less and paying a little higher mortgage than your current rent. The main point to consider is that all those decisions are yours to make in the context of a your own budget and your own financial goals. The banks and mortgage companies are not concerned with whether you have extra money to buy pizza on Friday nights. They are perfectly content with your eating a bowl of beans and rice as long as you can, in theory, meet the house payment.

Technorati Tags: mortgage, payment, ratio, income, debt

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What is the average loan amount for $50,000 income with good credit?