What You Need to Know to Avoid Financial Disaster - Page 3
by Rob Favero
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The Crash
These loans worked pretty well for many people as long as two things took place:
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Their income increased enough each year to afford the increasing monthly payments.
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The value of their house increased faster than their loan amount.
Unfortunately, there came a time in the mid-1980's in some places -- like Denver -- where these two things quit taking place. For some people the increasing monthly payments became unaffordable. What typically happened is that either their income did not grow as expected or they lost their jobs.
For other people it seemed pointless to keep paying on a loan that had grown so large. It just so happened that in that same time period, the rising value of houses stalled -- and in many cases they actually fell. This resulted in people owing far more on their loan than what their house was worth. Many people, seeing a remaining loan balance that was higher than value of their home, just walked away.
A Miscalculation of Risk
To the chagrin of many mortgage companies, they were left with an unusually high rate of homes going into foreclosure. The risk they had so carefully tried to control had taken a hard left turn, and they ended up losing a lot of money.
There's No Stopping Profitable Enterprises
After the experience of the mid-1980's, many mortgage companies took a much more guarded approach to managing their risk. Over time, though, as competition increased and as companies looked to make greater profits, they continued to come up with new, innovative offers of home loans. And while this particular loan from the 1980's is no longer readily (if at all) available, mortgage companies are still looking for ways to make loans as profitable as possible for themselves while still being affordable for you.
What Does This Mean for You?
So far we've been looking at mortgages from the point of view of the mortgage companies. It is important to understand their point of view, because they are the ones who create the various types of loans that are available. But this information is useful to you only if you can see how to apply it to your situation. So now we need to shift our focus to see this same information from your point of view.
Mortgage company profits, seen from your point of view, are costs. The money that the company makes on every loan comes directly from the money you pay. So mortgage company profits and your costs are the same, just seen from different sides of the loan.
On the other hand, what we've called risk for the mortgage company translates into risk for you. However, the relationship between the risk you take on and the risk the mortage company takes on can be pictured as a seesaw. Most of the time if your risk rises, the mortgage company's risk falls. The opposite is also true. And as we discussed before, a mortgage company wants higher (potential) profits if it takes on higher risk.
So, for example, if your credit is poor, a loan will cost you more (in terms of a higher interest rate) than it will cost someone with better credit. Your low credit rating creates more risk for the mortgage company. Therefore, they charge you more; the increased amount they charge lowers their risk of not making the profit they want. For you, however, the higher amount you have to pay increases your risk of not being able to make your payments.
Applying This Knowledge to Your Loan
When you are trying to decide on what kind of loan you want to get, it's helpful to keep in mind the tradeoffs that are embodied in the Profit/Risk formulas. Let's say your loan representative offers you a loan with an unusually low monthly payment. This loan, then, will almost certainly have provisions that will eventually cost you a much more significant amount of money later on. Or it may be that the low monthly payment is part of a loan type that creates low risk for the mortgage company. In this case, it's almost certain that you are taking on a large amount of risk. It may even be the case that you are signing up for both delayed high costs and high risk.
Applying the Profit/Risk Formulas to Common Loans
To see how these formulas apply in the real world of your mortgage, let's take a look at three popular types of loans. We'll evaluate each one in terms of what the Profit/Risk formulas reveal about each one.
Fixed-rate Loans
The fixed-rate loan has been the standard loan in the mortgage industry for many years. It's the bread-and-butter loan of the industry. This is a loan where you borrow money for a certain number of years -- 30 years has long been a popular term length for a fixed rate loan -- and you (usually) make monthly payments over the 30 years. With this type of loan, the amount of your first monthly payment stays at the same level as it starts. Therefore, the monthly payment you qualify under is the monthly payment you will have to keep being able to afford.
If we think about the Pay Me Now or Pay Me Later formula, we could imagine loans where your monthly payment starts out high and drops over time. We could also imagine loans where your monthly payment starts low and increases over time, much like the example from the 1980's we discussed above. Since a fixed-rate loan keeps a steady monthly payment, this type of loan falls in the middle range of Pay Me Now or Pay Me Later possibilities. So your costs are at a moderate level.
Further, because the monthly payment stays steady, the amount of risk to you is moderate. There is risk that you may not be able to continue making your payment if your income drops or if you outspend your income. However, since most people's income rises over time, the risk is moderate that you will fail to make your loan payment.
So a fixed-rate loan is pretty much a middle-of-the-road kind of loan.
But even within a fixed-rate loan, we can see ways to vary profit and risk. A popular length of loan for many people is a 15-year, fixed-rate loan. Your risk increases, as compared to a 30-year loan, because the monthly payment is higher. However, your total costs are lower for two reasons. First, the interest rate for a 15-year loan is lower than it is for a 30-year loan. Second, the total amount of interest paid over 15 years is less than the amount paid over 30 years.
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