Before understanding the different mortgage types, there are three concepts that need to be understood: Points, annual percentage rate (APR), and mortgage insurance. One thing to keep in mind as we explore these concepts is that lenders count these loans as investments and will do all they can to maximize their return while balancing the risk.
Points and APR
Another word for a point is a fee, typically called a “loan processing fee.” The calculation for a point is pretty straight forward, one point being equal to one percent of the loan amount. If the unit is to be discussed smaller, it is called a basis point where 100 basis points is equal to one point. There are several ways these fees are made by the borrower: they can be paid in cash, deducted from the loan amount, or increase the interest rate to accommodate the fee over time (called a yield spread premium).
The APR is a calculation of all fees and interest rates to provide a “real” rate of interest. Disclosure of the APR is required by the Real Estate Settlement Procedures Act (RESPA) so borrowers can compare rates.
Mortgage Insurance
Mortgage insurance protects the lender from a borrower default, foreclosure, and recovery of funds that is less than the outstanding debt. Typically, this insurance is required by the lender if the loan exceeds 80 percent of the appraised property value.
There are two types of mortgage insurance: publicly funded and private.
Public funded insurance is provided either by the FHA (Federal Housing Administration) or VA (Department of Veterans Affairs). This insurance is only provided for property where the purchase price is smaller, and other guidelines must be satisfied. This insurance will fully recover the lender if the borrower defaults.
Private mortgage insurance (PMI) is typically obtained by the borrower paying a premium to the lender. This insurance is often required if borrower cannot pay up to a 20 percent down-payment. However, if the borrower obtains the insurance then pays off the debt until the outstanding balance is less than the 80 percent property value, the borrower can discontinue the insurance. This insurance may only partially cover the lender if the borrower defaults, most covering only 20–25 percent of the appraised value.
Mortgage Types
Fixed Rate Mortgage (FRM)
The FRM is where the mortgage interest rate is fixed throughout the life of the loan. During the life of the loan, the borrowers monthly payment goes towards two things: (1) paying interest, and (2) paying the principal. This process is called amortization. Unfortunately for buyers, amortization schedules are designed to front load the interest. That is, most of the early payments cover interest rather than principal. So, borrowers who wish to pay off their debt sooner are mainly paying off their interest. In other words, do not view your loan only in the principal amount because lenders plan to recover both interest and the principal amount.
Typically, FRMs take the form of 30-year or 15-year loans. There are pros and cons to both options. For instance, the 30-year loan has a lower monthly payment than the 15-year loan, but will result in over double the amount of interest to be paid before the loan is fully amortized.
Adjustable Rate Mortgage (ARM)
As the name assumes, mortgages based on ARM are adjustable throughout the life of the loan. This loan may be desirable when the current interest rates are high and the borrower anticipates the interest rates to drop throughout the life of the loan. Thus, the borrower is banking on receiving, on average, a lower interest rate than they would have if they obtained a FRM. Because of the fluctuation in interest rates, lenders tend to be more careful who they giver ARM loans to, for they want to make sure a borrower can make higher payments if the interest rate increases rather than decreases.
The ARM rate is determined by three factors: index, adjustment periods, and caps.
The index takes several factors into account who create a table of interest rates. When certain factors align, that determines what the interest rate is for that period. Rather than starting with the index amount, loans often provide a “teaser” interest rate, to encourage and market individuals to take the loan.
Adjustment periods refer to how often adjustments may be made. For example, the promissory note may say that adjustments occur every 12 months. At the end of the adjustment period, the lender and borrower will refer to the index to determine the interest rate for the next period.
Caps limit how drastic the adjustment may be made at the end of the adjustment period. For instance, the promissory note may limit the adjustment to a maximum of two percent, even if the index would indicate the adjustment should be four percent.
No-Point and Buy-Down Mortgage
Both these options are designed to rearrange the when the lender gets its profit.
A no-point mortgage agrees that there are no point fees in exchange for a higher interest rate. The purpose of this option is to appeal to borrowers who do not have the cash on hand to pay the points at the time of closing. This method, however, only benefits borrowers who anticipate selling the property within about 4–5 years. After that period, the higher interest rate would exceed the value of the cash saved at the time of closing.
A buy-down mortgage is where the borrower pays extra at closing to obtain a lower interest rate. Again this is a trade off of when cash is going to be paid. This method will obviously benefit a borrower who anticipates staying in a property long-term.
Balloon Mortgage
This is a short-term loan where the payments are for the interest only and then the balance of the loan is due in a large sum some time afterwards. Picture an expanding balloon as the date of payment in full is due approaches (called the balloon payment). Three main purposes for these loans exist: (1) The loan acts as a bridge loan, typically when a borrower is trying to sell their home and thus would not afford a double mortgage during the transfer; (2) To obtain low payments when the interest rate is high, hoping the market rates fall before the balloon payment is due; (3) Sellers use it when they are having a hard time selling their homes as an incentive to make a purchase, again hoping the market rates will fall.
Other
Above lists the most popular mortgage options; however, more options are available. Below lists the different types without going into detail of how they function:
- Level payment rate mortgage (LPRM) – Like ARM but length of loan shifts instead of payment amounts shifting.
- Shared appreciation mortgage (SAM) – Lender gets paid for increase of property value.
- Reverse annuity mortgage (RAM) – Lender pays elderly borrower (like a retirement) until the credit line is filled and the lender reclaims the property.
- Growing equity mortgage (GEM) – Lower monthly payments gradually increasing as time goes on.
- Graduated payment mortgage (GPM) – Same.
- Price level adjusted mortgage (PLAM) – Adjust the debt to account for inflation.
- Interest-only mortgage – Pay only the interest until the sell of the property.
- Piggyback mortgage
Mortgage Obligations
Paying the Debt: Usury
Usury laws restrict the lender’s ability to set interest rates. Quite simply, lenders cannot set the interest rates too high. Most states have a cap (varying depending on the transaction) that does not allow interest rates to exceed 12 percent. Additionally, usury laws limit how often interest is allowed to compound (yearly compounding seems to be the standard). Additionally, points and other fees are calculated into the interest considered by usury laws.
Penalties for violating usury laws can be quite intense. Depending on the state, a lender in violation of usury can lose all rights to collect interest, collect any more principal, or pay damages double the amount of interest.
Ron King Corp. v. R. & R. Mohring Enterprises, Inc.
2011 N.Y. Misc. Lexis 4642.
Facts
The plaintiff Ron King Corp. issued a promissory note to R. & R. Mohring Enterprises at a rate of 18 percent which would increase to 24 percent if Mohring defaulted. The note was to be paid back on a monthly basis over the course of a year with two points. Presently, the usury law set the criminal penalty at 25 percent. Mohring defaulted on the note and Ron King sought to foreclose on the property.
The defendant is arguing this note violated usury law (24 + 2 = 26) and would thus be declared void and the collection be cancelled.
On the other hand, the plaintiff is arguing the note did not violate usury law (18 + 2 = 20) and would therefore be able to foreclose on the property in the case of a default.
Analysis
Usury law is only violated if there was no intent to evade the usury law. Here, had the defendant made the payments, usury law would not have been violated. Because the violation came due to the defendant’s default, no violation actually occurred. Thus, summary judgment in favor of the plaintiffs is warranted.
Paying the Debt: Late Payment
Subject to state and federal regulations, lenders often have late fees for installments that are made late. Usually there is a 10–15 day grace period before the fee goes into effect. Of course, enough late payments and the lender will assume the borrower is in default and could then require all the payment due (acceleration). Most late fees are assessed as either (1) a fixed charge for all borrowers, (2) a higher interest rate for the missed payment, or (3) a higher interest rate on the entire principal balance.
The whole purpose is discourage people making late payments.
Paying the Debt: Prepayment
Most of the time, a borrower will want to pay back the loan earlier. This can occur in either full or partial prepayment and may be either voluntary or involuntary. Involuntary prepayment comes in the form of acceleration (the whole balance is due before anticipated). Voluntary prepayment typically is partial where the borrower pays additional as the funds come in. Because prepayment reduces the amount of interest to be paid off sooner, often lenders will put restrictions on the ability to make prepayments. These come in the form of a “prepayment premium or penalty”, a charge based on a percentage of the amount of principal being prepaid.
Lopresti v. Wells Fargo Bank, N.A.
88 A.3d 944 (N.J. Sup. 2014)
Question
Whether the prepayment fees were statutorily invalid or, in the alternative, excessive.
Rule
In N.J. prepayment fees cannot be accessed against a residential mortgage, but can against a business mortgage. Excessive fees will consider the normal industry standard, purpose of the fee, whether the parties are represented and sophisticated, and whether there was any fraud or duress.
Holding
The mortgage was commercial and the fee was not excessive. Thus, the fees were fine and the case should be dismissed.
Facts
Lopresti owned a business called Body Max. This business took out a mortgage for over 500,000 and secured the mortgage on Lopresti’s mortgage. This agreement had a prepayment fee of 1%. Later, Body Max amended the agreement for a higher interest rate but a reduced principal. This new agreement also provided a calculation designed to protect the interest of the lender. If interest rates fell and the borrower attempted to refinance, then a prepayment fee could be assessed against them. If interest rates increased and the borrower refinanced, then no fee would be assessed. Eventually, Body Max refinanced with another bank and Wells Fargo assessed nearly 50,000 of prepayment fees, about 13% of the principal.
This transaction was completely fine statutorily because this was a commercial mortgage. Additionally, the parties were sophisticated, there was no fraud or duress, and the purpose of the fee was not arbitrary (designed to protect the lenders bargained for interest). Thus, the transaction was valid and the plaintiff’s claim ought to be dismissed.
Disclaimer
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.
