What You Need to Know to Avoid Financial Disaster - Page 2
by Rob Favero
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What a Mortgage Company Will Do
Obviously, a mortgage company is trying to make as much money from you as it can. But to do so, it has to loan you as much money as possible in a way that you can afford.
And a mortgage company does this by doing three things that may surprise you:
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It varies how much risk it is willing to take.
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It varies how much profit it is willing to accept.
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It will take a lower profit early in a loan if it can get a higher profit later in the loan.
I know. I know. This doesn't make sense. Just a bit ago I pretty much said that the mortgage company jealously guards its risk and its profit. Now I'm claiming that the mortgage company plays loose with those same things. Seems like playing with fire -- right?
However, the company doesn't really doesn't have much choice; it's operating in a competitive environment where its customers -- real people with real choices -- are looking for affordable ways to borrow money. And the two things that affect affordability are risk and profit. So a mortgage company can only succeed if it can beat its competitors, at least some of the time, in attracting customers.
The Profit/Risk Formulas
There are two formulas that govern how mortgage companies use risk and profit to create their loan products. Whether or not the mortgage companies think of their loans this way, the two formulas, which I call the Profit/Risk Formulas, still apply. The formulas go this way:
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More Risk = More Profit
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Pay Me Now or Pay Me (More) Later
The first formula means that a mortgage company is willing to take on more risk if it has a greater potential for higher profits. The more risk the company assumes, the more profit it hopes to make; the less risk, the less profit it seeks to make. It's a lot like those daring kids who participate in extreme sports. The more risk there is in the sport, the more fun the sport needs to be. (Of course, I'm assuming these kids have thought processes that still work this well. Given some of the spills I've seen them take, I'm not sure my assumption is correct).
The second formula means that a mortgage company is willing to adjust how much profit it collects at different points during the term of your loan. For example, the company may be willing to accept a low monthly payment during the early part of your loan if it can get a large payment later.
These two simple formulas get combined in a variety of creative ways to make loans affordable (sometimes only early in the term of the loan) while ensuring a healthy profit for the company (sometimes only later in the loan). A surprisingly large number of different types of loans is the result. Let's look at an example.
The Loan That Will Blow Your Mind
Back in the 1980s, interest rates were quite high. As a result, home buyers were struggling to find loans with affordable monthly payments. So some loan companies came up with an unusual beast of a loan (and I purposely call it a "beast," because it eventually turned into a monster of a loan for many people).
The loan consisted of a set of tiered interest rates -- rates that started low and increased at a preset amount over time. So let's say the standard 30-year, fixed-rate loan was 10% (rates were much, much higher back then). You might have a 5% loan for the first two years, a 7% loan for the next two, a 9% loan for one year, and a 10% loan for the remaining 25 years. Each time your rate went up, so did your monthly payment.
What Was the Point?
But how did this kind of loan help? It helped was because it made the loan affordable at the most critical time in the loan -- at the beginning. And beginning affordability was very important, because the mortgage company qualified you based only on your starting monthly payment. It did not matter what your payment would eventually grow to. The key was the amount of that starting payment and your ability to pay it. Since your payment started out quite low, you could qualify for a pretty hefty loan. The assumption was that your income would increase each year, and the increase was expected to rise faster than your monthly payment.
But There Was a Catch
But as cute and loveable as the young loan was, it eventually grew up and revealed its true beastly nature. To those who did not understand the details of the loan, it seemed that the low, initial rate was a free gift from the mortgage company. But the mortgage companies were not playing Santa. Instead they were quietly increasing the principal (or total amount) of the loan to make up for the profits they gave up in the early years. They did this for as long as the loan rate was discounted.
And surprisingly there was nothing wrong with the mortgage companies doing this. It was all legal and above board -- the fact that the loan amount would increase was clearly spelled out in the loan agreement. However, people who did not understand the tradeoffs and risks with this type of loan were surprised to find, after several years of payments, that they now owed more -- not less -- than when they started.
This was an example of the loan companies using the "Pay Me Now or Pay Me Later" formula. They were willing to take a lower payment early on, in exchange for more money later.
This was also an example of the "More Risk = More Money" formula. In the early part of the loan, since the mortgage payment was low, risk was low because chances were good that you would be able make your payment. As your payment amount increased over the years, so did their risk; a higher payment made it harder for you to pay. But with rising risk came rising profit. Also, the amount they added to the principal during the first several years gave the promise of higher future profits. The promise of higher profits made them willing to take on the risk associated with your rising mortgage payment.
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