Mortgage Fundamentals

Here is what you will learn in this tutorial:

1. What is an interest-only mortgage?

2. For what types of borrowers is it suitable?
3. What are the hazards you should watch out for?
4. How much more does an IO cost?
5. What information do you need to assess an IO mortgage?
6. How do you get this information?
7. How do you keep track of pay-off progress on an IO?

 What Is An Interest-Only Mortgage?

A mortgage is “interest only” if the scheduled monthly mortgage payment – the payment the borrower is required to make
--consists of interest only. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Borrowers
have the right to pay more than interest if they want to.

If the borrower exercises the interest-only option every month during the interest-only period, the payment will not
include any repayment of principal. The result is that the loan balance will remain unchanged.

For example, if a 30-year loan of $100,000 at 6.25% is interest only, the required payment is $520.83. In contrast,
borrowers who have the same mortgage but without an IO option, would have to pay $615.72. This is the "fully
amortizing payment" – the payment that would pay off the loan over the term if the rate stayed the same. The difference in
payment of $94.88 is “principal”, which go to reduce the balance.

For a more complete illustration of the difference between an interest-only and a fully-amortizing mortgage, see Interest-
Only Versus Fully Amortizing.

For What Types Of Borrowers Are Interest-Only Mortgages Suitable?

Interest-only mortgages are for borrowers who have a valid use for a lower initial required payment, and are prepared to
deal with the consequences.

Pay Principal When Convenient: Borrowers with fluctuating incomes may value the flexibility the IO mortgage gives
them. When their finances are tight, they can make the IO payment, and when they are flush they can make a substantial
payment to principal.

Ask yourself whether you are disciplined enough to make the payment to principal when you aren’t obliged to.

Buy More House: It is common for families to begin with a "starter house", then move into a more expensive house as
their incomes rise. This process of "trading up" carries high transaction and moving costs.

You can avoid these costs by skipping to the second house now. In the short term, this will cause a cash flow strain, but
the IO mortgage may make it manageable.

Ask yourself whether you are comfortable with the risk that the expected higher income won’t materialize.
Invest the Cash Flow: For most homeowners, paying down mortgage debt is the most effective way to build wealth.
Nonetheless, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage.
For this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn
when they repay their mortgage.

A valid example is the young borrower with a long time horizon who invests  in a diversified portfolio of common stock.
This should generate a yield of 9% or more over a long period. Another are business owners who might earn a high return
investing in their own businesses. 

Ask yourself whether you really will invest the excess cash flow, as opposed to spending it; and whether you have a firm
basis for believing that your investments will yield a return higher than the mortgage rate. I don't recommend it as a
wealth-building strategy for most borrowers. See Is Unused Home Equity a Missed Fortune?

Quick Capital Gain: An interest-only (IO) is the instrument of choice in a quick turnover situation if you are trying to
maximize the amount of house you can buy, and are limited by your income. The IO option lowers the required initial
payment, which allows you to qualify for a larger loan amount.

This is why buyers in markets undergoing strong price appreciation, who are looking for quick capital gains, gravitate to
IOs – or to their big brother, the flexible payment (option ARM), which has even lower payments in the first year than an
IO. See Questions About Option (Flexible Payment) ARMs.

The more expensive the house they can buy, the larger the expected capital gain. However, if you don’t need an IO to
qualify for the house you want to buy, it is not the best choice in a quick turnover situation. See Is Interest-Only Best For
a Quick Turnover?

Allocate Cash Flow to Second Mortgage: John Doe finances his home purchase with an 80% fixed-rate mortgage (FRM)
at 5.5%, and a 20% HELOC (home equity line of credit) at 7.75%. The FRM is IO, and Joe uses all his available
cash flow to pay down the balance on the HELOC. This makes sense because of the higher rate on the HELOC, and the
possibility of future rate increases.

Payment Responsive to Principal Reduction: On most IO loans, whether fixed or adjustable rate, the monthly mortgage
payment will decline in the month following an extra payment. This is the only type of mortgage that has this feature. On
a conventional FRM, the payment never changes while on ARMs, the payment doesn't change until the next rate
adjustment.

Some borrowers find this feature extremely convenient. For example, a home purchaser who must close before his
existing house is sold may want to use the proceeds of the sale, when it occurs, to reduce the payment on the new
mortgage. On many but not all IOs, a large extra payment reduces the payment in the following month

On some IOs, however, the payment doesn't change until the anniversary month, and on others it does not change until the
end of the IO period. If you are contemplating an interest-only loan and find immediate payment adjustments in response
to extra payments a highly desirable feature, ask about it. See When Will Extra Payments Reduce Monthly Payments?

What Hazards  Should YouWatch Out For?

The major hazard is being deceived into accepting an interest-only mortgage that does not meet any of the suitability tests
described above. The deceptions are about alleged desirable features of IOs that don’t in fact exist.

Borrowers can immunize themselves against most deceptions by remembering one critical fact. If two mortgages are
identical except that only one has an interest-only option, lenders view that one as riskier. The reason is that, after any
period has elapsed, the loan with the IO option will have a larger balance.
Deception 1: An interest-only loan carries a lower interest rate. Lenders usually charge a higher rate for an identical loan
with an interest-only option, for reasons indicated above. I have never seen a price sheet in which a lender quotes a lower
rate on an identical loan with an IO option, though I am told it happens; this is not a perfect market.

The deception arises from comparisons of apples and oranges. Most interest-only loans are adjustable rate mortgages
(ARMs), and ARMs have lower rates than fixed-rate mortgages (FRMs). ARMs with the IO option have lower rates than
FRMs because they are ARMs, not because they are IO.

Deception 2: An interest-only loan allows the borrower to avoid paying for mortgage insurance. Since loans with an IO
option are riskier to the lender, the option cannot cause the disappearance of mortgage insurance.

Any IO loans with down payments less than 20% that don’t carry mortgage insurance from a mortgage insurance
company are being insured by the lender. The borrower is paying the premium in the interest rate rather than as an
insurance premium. 

Deception 3.  On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. It may
or may not be. The interest-only period is the period during which you are allowed to pay interest only, usually 5 or 10
years. The period for which the initial rate holds can be as long as 10 years or as short as one month.

Where the initial rate period is 3, 5, 7 or 10 years, the interest-only period is likely to be the same. Where the initial rate
period is a month, 6 months or a year, the interest-only period will probably be longer. These are the cases where
deception is most likely to arise.

Deception 4. It is less costly to amortize an interest-only loan.  This is patently ridiculous, but some variant of it keeps
popping up in my mail. 

There is no magic connected to amortizing an interest-only loan. A borrower who takes an interest-only option but decides
to make the fully amortizing payment instead will amortize in exactly the same way as the borrower who takes the same
mortgage without the option. Read Does an an Interest-Only Amortize Faster?   

How Much More Does an IO Cost Than the Same Mortgage Without IO?

Among two loans that are identical except that one has an IO option, that one will be priced higher.

I recently compared the wholesale prices of 30-year FRMs with and without IO options in a variety of market niches. All
prices assume the borrower has good credit and puts 20% down.

On a home purchase mortgage of $300,000, I found a wholesale rate difference greater than .375%. On a purchase for
investment, the rate difference was almost .625%. On a cash-out refinance covering an owner-occupied home where
neither income not assets are documented (called "NINA"), the rate difference was almost .875%. And on the same loan
covering an investment property, the rate difference exceeded 1%. Similar differences arise on ARMs.

Read How Much More Does Interest-Only Cost?

What Information Do You Need To Assess An IO Mortgage?

 ARMs have the advantage of carrying a lower interest rate, and lower monthly payment, in the early years than fixed-rate
mortgages (FRMs). But because the ARM rate is adjustable, it may rise in later years, and the payment will rise with it.
Intelligent decisions about ARMs, therefore, require that account be taken of what might happen when the initial rate
period ends. 

While future interest rates are not known, we can make assumptions about what will happen to rates; these are called
interest rate scenarios. Usually, we focus on rising rate scenarios, because those are the ones we worry about.
For any given scenario, we can calculate exactly how high the rate and mortgage payment will go, and when it will get
there. This is scenario analysis. We can also calculate the total cost over any period specified by the borrower. In 
assessing ARMs with an IO option, borrowers will want to compare scenarios with and without the option.

When ARM rates are much lower than FRM rates, shrewd borrowers may take an ARM but make the payment that they
would have had to make had they taken an FRM. By paying the balance down faster, the cost imposed by rising rates in
the future is reduced. Hence, it is useful to perform scenario analysis based on the assumption that the borrower pays at
the FRM rate for as long as that payment is larger than the ARM payment. 

This is an alternative to an IO, and based on the opposite premise. Where an IO attempts to minimize the borrowers
payments in the early years, for any of the reasons noted earlier, the FRM payment option is designed to pay down the
balance as much as possible in the early years.

To see a sample of rates/payments and costs on an ARM, with and without both the interest-only and FRM payment
options, click on Sample Rates/Payments and Costs.

How Do You Get This Information?

You get it in two steps. In step 1, you have your loan officer or mortgage broker provide the essential data on the features
of each loan you are considering. To make it as easy as possible for them, print out and give them Worksheet of ARM
Features.

Step 2 involves transferring the data on ARM features into the ARM Tables calculator which will generate your tables.

 Have your data in hand before clicking on ARM Tables calculator above or selecting the ARM Tables calculator on the
Tutorials Menu.

1. What is a flexible payment or option ARM?

2. How will I know an  option ARM when I see it?
3. What are the advantages of an option ARM?
4. What are the risks of an option ARM?
5. How do I protect myself against the risks?
6. Who should select an option ARM?
7. Should I shop for an option ARM?
 

What Is an Option ARM?

It is an ARM on which the interest rate adjusts monthly and the payment adjusts annually, with borrowers offered options
on how large a payment they will make. The options include interest-only, and a "minimum" payment that may be less
than the interest-only payment. The minimum payment option results in a growing loan balance, termed "negative
amortization".

How Will I Know an Option ARM When I See One?

Ask the loan provider if the rate adjusts monthly, and if negative amortization is allowed. If the answer to both questions
is "yes", you almost certainly have an FPARM. Their names are all over the lot and include "1 Month Option Arm", "12
MTA Pay Option ARM," "Pick a Payment Loan", "1-Month MTA", "Cash Flow Option Loan", and "Pay Option ARM".

What Are the Advantages of an Option ARM?

Their main selling point is the low minimum payment in year 1. It is calculated at the interest rate in month 1, which can
be as low as 1%, and it rises by only 7.5 % a year for some years.
The low initial payment entices some borrowers into buying more costly houses than would have otherwise, or use the
monthly payment savings for other purposes. You don’t need a list from me of ways to use the cash flow savings because
your loan provider is sure to oblige. What they are less likely to give you is a sense of the risks you will face down the
road.

What’s Are the Risks of an Option ARM?

For those electing the minimum payment option, the major risk is "payment shock" – a sudden and sharp increase in the
payment for which they are not prepared.

The rule that the minimum payment can rise by no more than 7.5% a year has two exceptions. The first is that every 5 or
10 years the payment must be "recast" to become fully-amortizing. It is raised to the amount that will pay off the loan
within the remaining term at the then current interest rate – regardless of how large an increase in payment is required.

The second exception is that the loan balance cannot exceed a negative amortization maximum, which can range from
110% to 125% of the original loan balance. If the balance hits the negative amortization maximum, which can happen
before 5 years have elapsed if interest rtes have gone up, the payment is immediately raised to the fully amortizing level.

Either the recast provision or the negative amortization cap can result in serious payment shock.

How Do I Protect Myself Against The Risks?

Three ways:

1. Measure the Risk: You can do this yourself using calculator 7ci. It will show you what will happen to the payment on
your FPARM if interest rates follow any of a number of future scenarios selected by you. An important side benefit is that
the calculator lists the information you need, which you want for shopping purposes anyway.

2. Minimize the Risk by Shopping For the Lowest Margin. The margin on your loan is the amount added to the interest
rate index to get your rate. Since the margin affects the rate in months 2-360, it is the most critical price variable on an
FPARM. The lower the margin, the lower your cost and your vulnerability to payment shock. Note: The margin is not a
required disclosure, so don’t expect that it will necessarily be volunteered.

3. Minimize the Risk by Taking the Highest Initial Payment You Can Afford. The higher your initial payment, the smaller
the potential payment shock down the road. Since the initial payment is determined by the interest rate in month 1, you
should select the highest rate that results in a payment with which you are comfortable. Asking for a higher rate sounds a
little strange, but remember, the quoted rate holds only for one month.

Who Should Take an Option ARM?

 Choose one if your time horizon is short and you want to maximize your home-buying capacity. Because of their low
initial rates and payments, borrowers can usually qualify for a larger loan using an option ARM. Since payments will be
substantially higher in later years, you should confidently expect your income to rise in the future. The option ARM is
also a refinance option if your income has dropped and the alternative to lower payments is default. I do not advise using
this instrument to generate cash flow savings to invest, see Is Unused Home Equity a Missed Fortune?

Should I Shop For An Option ARM?

Yes, emphatically, but not for the rate. Your major focus should be on the margin, because that is what determines your
rate after the first month. Your second priority should be the maximum rate. Your third priority should be total lender
fees. 
The good news about monthly ARMs is that lenders don’t reprice them every day as they do other mortgages, which
makes comparison shopping much easier. You don’t need a rate lock, but ask the loan provider to specify the margin,
maximum rate and fees on paper.

1. What does "saving money" on a refinance mean?

2. Should you finance the origination costs?
3. What hazards must be avoided?
4. Determining whether or not you will save money: what is the "break-even" period?
5. How do you find the break-even period?

This tutorial is for those who want to save money on their one existing mortgage. If you have a mortgage but need to raise
cash, or if you now have two mortgages, you must wait for tutorials dealing with those topics.

What Does "Saving Money" on a Refinance Mean?

Saving money means that over the period you will hold the mortgage, the total costs net of offsets will be lower on the
new mortgage than on the existing one.

The costs include a) Origination costs - points and other settlement costs, on the new mortgage only; b) Monthly
payments of principal and interest, on both mortgages; and c) Lost interest on (a) and (b), also on both mortgages. Cost
offsets on both mortgages are tax savings, and reduction in the loan balance.

If the interest rate on the new mortgage is lower and there are no points or other settlement costs, the new mortgage will
save you money, even if you pay it off after one month. However, a "no-cost" mortgage carries a higher rate. If you expect
to have the new loan more than 3 or 4 years, you usually save more if you pay your own settlement costs rather than have
the lender pay them in exchange for a higher rate.

Most borrowers, therefore, incur refinance costs upfront that must be recovered over time through the savings generated
by the lower interest rate. The critical number is the "break-even period" -- the minimum length of time you must hold the
new mortgage to make the refinancing pay.

Should You Finance the Origination Costs?

Many borrowers who refinance today finance the upfront costs. They add the costs to the mortgage rather than pay them
in cash. Usually, this reduces the gains from refinancing because the borrower must pay interest on the upfront costs at the
mortgage rate. Pay the costs in cash if you can manage it.

What Hazards Must Be Avoided?

The refinancing market is something of a jungle, but you are safe if you observe one basic principle: You cannot save
money on a refinance unless the interest rate on the new mortgage is below the rate on the existing one. Those who argue
that you will profit by refinancing into their mortgage at a higher rate are either fooling themselves or are out to fool you.

Some con artists will show you that your total interest payments will decline if you refinance into their higher-rate loan.
However, they get that result by assuming that you will repay your new mortgage (but not your old one) on an accelerated
(biweekly) schedule. You don’t need to pay a higher rate to accelerate your repayments.

Some others will show you that your monthly payment will decline if you refinance into their higher-rate loan. However,
they get that result by extending the term. If your current mortgage does not have many more years to run, an extension of
the term can reduce the payment by more than the higher rate increases it. If you do it, you pay for it big time in the form
of a higher loan balance in future years.
Beware, some mortgage calculators calculate a break-even period by dividing the upfront costs by the reduction in
mortgage payment. This is a phony break-even because it ignores changes in the loan balance, tax savings and lost
interest.

Determining Whether or Not You Will Save Money: What Is the "Break-Even" Period?

The break-even period is the number of months before the savings from the lower rate completely offset the upfront
refinance costs. Even if you are not sure how long you will have the mortgage, if you are confident that you will have it
longer than the break-even period, you know the refinance will pay.

To see a sample set of break-even periods, click on Sample Break-Even Periods.

Sample Break-Even Periods

How Do You Find the Break-Even Period?

You find it in two steps. In step 1, you collect the followng information:

Your Income Tax Rate: This is the tax rate you pay on your last dollar of income. If you pay only Federal income taxes, it
is the highest of the Federal tax brackets you used. Currently, these brackets are 10%, 15%, 25%, 28%, 33%, and 35%. If
you also pay state and/or local income taxes, you should add the highest bracket you used in connection with these taxes.
For example, if your highest Federal tax bracket is 28% and the highest state bracket is 5%, you should enter 33%.

Remaining Term on Your Existing Loan: This is the number of months until the balance is paid off if you continue making
the mortgage payments you are making now. It is the original term less the number of months that have expired since
origination, provided a) you have a fixed-rate mortgage, and b) you have not made any extra payments. If one or both of
these conditions does not hold, or if you do not know how many months remain on your existing loan, use the Remaining
Term calculator below to find your remaining term.

Term on New Loan: For borrowers looking for a fixed-rate mortgage (FRM), a 15-year term is the best bet if you can
afford the payment. Most borrowers who take adjustable rate mortgages (ARMs) opt for 30-years, tho 40-year terms are
available.

Whether Points and Other Costs Are Paid in Cash or Financed: Finance the costs if you must, but doing so will extend
the BEP. In some cases, having to finance the costs could swing the refinance from profitable to unprofitable.

If you are selecting an ARM in order to make the payment affordable, try to avoid the riskiest ones with initial rate
periods of less than 5 years. If you are selecting an ARM because you expect to pay off the mortgage before the initial rate
period is over, leave yourself a margin for error. If you expect to be out in 6 years, for example, take a 7-year rather than a
5-year ARM.

If you are out of your house before the expiration of the initial rate period, the initial rate is the only rate feature that
matters. The index, margin and rate caps are not relevant if you avoid rate adjustments.

Some astute borrowers with long time horizons select ARMs indexed to Libor because they have low margins that are
likely to result in lower average cost than FRMs over long periods. Since Libor indexes are highly volatile, such
borrowers should be prepared for fluctuating payments. See my Libor Loan Tutorial.  

Borrowers who want to buy as much house as they can select an option ARM, on which the initial rate holds for a month.
It provides the lowest initial payment of any ARM, and also the greatest risk of  future payment increases. See my Option
ARM Tutorial.

While 15-year ARMs appear now and then, virtually all ARMs today are for 30 years.
FRMs vary by term, which is the period used to calculate the mortgage payment. It ranges from 10 years to 40 years. The
longer the term, the lower the mortgage payment but the slower you pay down the balance.

Selecting a term on an FRM should take account of the term structure of mortgage rates. Here is a typical structure in
April, 2006. It assumes that everything else – the borrower’s credit, documentation, down payment, etc – are the same.

Term Interest Rate Fully Amortizing Interest Only

Monthly Payment Per Payment First 5 Payment After 5
$100,000 Years Yrs
40 Years 6.500% $585.46 $541.67 $604.16
30 6.250 615.72 520.84 659.67
25 6.250 659.67 520.84 730.93
20 6.125 723.67 510.42 850.63
15 5.875 837.12 489.59 1103.94
10 5.750 1097.70 479.17 1921.68

The 30 and 15 are the most popular by far, and the rate on the 15 is always well below that on the 30. The rate on the 25 is
usually the same as that on the 30, while the 20 will be a little lower, but closer to the 30 than to the 15. The 40 is always
priced higher than the 30 while the 10 is usually priced a little lower than the 15.  

The selection process should start with the 15 because it is the best deal around for borrowers who can afford the
payment. Most of those who can’t afford it opt for the 30 because the payment is substantially lower. If you have trouble
even with the payment on the 30, an IO option on the 30 for the first 5 or 10 years would be less costly than the 40, and
more effective in reducing the payment. 

Typically there is no rate advantage in shortening the term from 30 to 25 years. If you want to pay off sooner, you can opt
for the shorter term, or you can take the longer term and make the payment of the shorter term. It all depends on whether
you prefer flexibility or discipline.  

The 20-year term is for borrowers who want to pay off as soon as possible but can’t quite make the payment on the 15.
IO’s are not available on 15s, so that is not an option. 

Points are fees the borrower pays the lender at the time the loan is closed, expressed as a percent of the loan. On a
$100,000 loan, 2 points means a  payment of $2,000. If points are negative, it is called a “rebate”, which the lender pays.

Points are traded off against the interest rate. For example, I took the following schedule for 30-year FRMs from
www.countrywide.com on September 7, 2005.

Interest Rate Points

5.125 3.75

5.25 3.25

5.375 2.75

5.5 2.375

5.625 1.875
 5.75 1.375

5.875 1.00

6 0.625

6.125 0.375

6.25 0.0

6.375 -0.375

6.5 -0.50

6.625 -0.875

6.75 -1.25

6.875 -1.5

Paying points is an investment. The return is the lower payment and faster balance reduction that results from the lower
rate. The return is higher the longer you have the mortgage.

Assuming you were choosing from the schedule above and elected to pay 1 point to reduce the rate from 6.25% to
5.875%. If you have the mortgage 3 years you earn 6.5% on your investment. The return rises to 17.6 % over 4 years, to
22.8% over 5 years, and to 29% over 12 years or longer. I calculated these returns, as you can, using calculator 11c. A
companion calculator, 11d, does the same for ARMs.

Negative points are payments made by the lender to you for paying a higher rate. For example, the lender shown above
will pay you 1.5 points for accepting a 6.875% rate rather than 6.25%. You can use the payments to defray settlement
costs.

Where points that you pay yield a higher return the longer you have the mortgage, points that you receive cost you more
the longer you have the mortgage. In the example above, you will be paying 2.9% for the 1.5 point rebate over 2.5 years,
12.7% over 3 years, and 23.0% over 4 years.

I have calculated returns from similar schedules covering a number of lenders and different types of mortgages. I found
that in most cases, paying points is a good investment if you hold the mortgage 3 years, but in a few cases you have to
hold it for 4 years. This holds for both FRMs and for ARMs with initial rate periods of 3 years or longer. Negative points
are very costly unless you are out within 3 years.

I also found that differences between lenders are large. One lender offered better deals buying down the rate on a 15-year
FRM than on a 30, while another lender offered a better deal on a 30. This is why it is a good idea to know exactly how
many points you want to pay (or receive) before you shop for a mortgage.

Since lenders quote rates in even increments of .125% and points to odd decimals, the way to shop is to find the rate
which most loan providers quote with about the number of points you want to pay, then select the lowest points offered at
that rate. For example, if you want to pay about 2 points and you find that A offers 6% with 2.13 points, B offers 6% with
1.97 points, you select B.
The down payment is the difference between the loan amount and the lower of sale price or appraised value. Many
borrowers have no down payment decision to make because they don’t have the money for one. Their challenge is
qualifying for a loan without a down payment, for which purpose excellent credit is critically important. 

Borrowers with enough money to make a down payment, who are not sure exactly how much to put down, do have a
decision to make. It is similar to the decision about whether or not to pay points, in that it is best viewed as an investment
decision. You pay money now and receive a return in the future. It is a good decision if the return is high relative to other
investment options. 

There are important differences, however, between investing in points and investing in a larger down payment. One
difference is in the amounts required. If you have surplus cash equal to 1% of the loan, you can earn a return of 20% or
more by buying down the rate, provided you hold the mortgage for 5 years or longer. The same amount used to increase
the down payment will only yield a return equal to the mortgage rate, or a little higher if you are also paying points, but
well below the return on points.  

To generate a higher yield from investment in a larger down payment, the investment must flip the loan into a lower
mortgage insurance or interest rate category. Mortgage insurance premium categories, expressed in down payments, are
generally 3-4.99%, 5-9.99%, 10-14.99%, and 15-19.99%. Where lenders pay for the mortgage insurance and price it in the
rate, they use the same categories.  

For example, if a borrower taking a 6% mortgage at zero points with mortgage insurance considers raising the down
payment from 5% to 7%, the loan will remain in the 5-9.99% mortgage insurance premium category. The premium will
remain the same, and the return on investment will be limited to the interest saved on the reduction in loan amount, which
is 6%.

If the borrower invests an additional 5% instead of 2%, however, the loan shifts into the 10-14.99% mortgage insurance
premium category. Since the premium is lower, the return on investment rises to 11.6%. (This and all other returns are
calculated over 5 years using calculator 12a.) 

Occasionally, a borrower’s desired down payment results in a loan amount slightly above the conforming loan limit—the
maximum size mortgage that can be purchased by Fannie Mae and Freddie Mac ($417,000 in 2006). In such case, an
increase in down payment that drops the loan amount below the maximum would also reduce the interest rate.

If the increase in down payment from 5% to 10% in the previous example not only reduced the mortgage insurance
premium but also brought the loan amount below the conforming loan limit, the rate would drop from 6% to about
5.625%. In such case, the return on the investment in a larger down payment would rise from 11.6% to 17.9%. 

When mortgage insurance is paid by the lender and incorporated in the interest rate, the return on an increment to the
down payment that flips the loan into a lower rate category is highest when the initial down payment is low. This is seen
most graphically in the sub-prime market where risk-based pricing is pervasive. The following schedule is taken from a
price sheet of a sub-prime lender on September 9, 2005, and applies to 30-year FRMs made to borrowers with credit
scores above 680. 

Down Payment Interest Rate Reduction Yield on Down Payment Increase

Increase
25% to 30% 6.60% to 6.55% 7.3%
20% to 25% 6.80% to 6.60% 9.8
15% to 20% 7.05% to 6.80% 11.1
10% to 15% 7.35% to 7.05% 12.3
5% to 10% 7.90% to 7.35% 17.4
0% to 5% 8.55% to 7.90% 20.3
Note that increasing the down payment from 25% to 30% reduced the interest rate only slightly, and the return on
investment was only 7.3%. But an increase from 0% to 5% dropped the rate substantially, with a return on investment of
20.3%. All rates of return are calculated from calculator 12a.

In sum, investment in a larger down payment earns a return on investment about equal to the mortgage rate unless it drops
the loan amount into a lower mortgage insurance premium or interest rate category, or below the conforming loan limit.
Usually, this requires a down payment increase of 5% of property value or more. In the sub-prime market, where
borrowers pay for smaller down payments in the rate rather than in mortgage insurance premiums, the return on
investment in a larger down payment is particularly high, especially when the down payment is low to start with.

Do I waive escrows?

Lenders generally require borrowers to include taxes and insurance premiums in their monthly mortgage payments, which
are placed in escrow until the payment date when the amount due is paid by the lender. Mortgages are priced on that
assumption.

When I had a mortgage I welcomed the escrow arrangement, because it simplified our budgeting and our life. It was a
small price to pay, I felt, for the interest on the escrow account, earned by the lender rather than by me.

Other borrowers feel differently, however, and want to control the payment of taxes and insurance themselves. This
avoids the risk that the lender will screw it up, which happens occasionally and which can be a nightmare for the
borrower. If you feel this way, the lender may let you waive the escrow requirement if you are making a down payment of
20% or more, or if you make a modest payment, usually ¼ of a point – that’s $250 for each $100,000 of loan amount.
Read How Can I Avoid Escrows?

Do I accept a prepayment penalty clause?

A prepayment penalty is a provision of your contract with the lender that states that in the event you pay off the loan
entirely, you will pay a penalty. Prepayment penalties usually decline or disappear with the passage of time, seldom
applying after the fifth year. For additional details, see Mortgage Prepayment Penalties.

Borrowers in the sub-prime market are required to accept penalties. Some lenders offer it to other borrowers as an option
on fixed-rate mortgages (FRMs) in exchange for a lower rate.

If you are taking an FRM, have a long time horizon, and would prefer not to be bothered refinancing if interest rates go
down, you are the perfect candidate to exchange a prepayment penalty for a lower rate. If it turns out, contrary to your
expectations, that you pay off the mortgage within the penalty period, the penalty is tax deductible. The option is not
widely available, however.

How long a lock period do I need, and when should I lock?

The lock period is the period during which the lender guarantees the rate and points. If an FRM is locked at 5.50% and 1
point for 30-days, for example, the lender is committed to make the loan at that price anytime within the following 30
days. Locks for longer periods are priced a little higher. Expect to pay another 1/8 point for each additional 15 days.

If the loan has not closed by the end of the lock period, it expires; the lender is no longer committed. If prices have not
increased during the period, the lender will usually be willing to extend the lock for a small additional fee. If prices have
increased, however, any lock extension will be at the new higher prices. This is a risk you want to avoid.
 On a home purchase, select a period long enough to include the expected closing date, plus a safety buffer of 15 days. On
a refinance, the required lock period depends on how long it takes the broker or lender to process your loan. You get that
period from them, then add 15 days just in case.

If you barely qualify at today’s rates, lock as soon as possible. You are in no position to risk an increase in rates.

If you are comfortable with the risk, you can delay the lock in order to take advantage of the decline in price as the lock
period shortens. For example, if market rates don’t change, a 45-day price of 5.5% at 1 point 15 days later should become
a 30-day price of 5.5% at 7/8 of a point.

This assumes, however, that you receive an honest reading of the market price on the day you lock. You will if you are
dealing with an internet lender who posts your price on the internet every day. You are also safe if you are dealing with an
Upfront Mortgage Broker (UMB) who gives you the best wholesale price on the lock day.

In other cases, you may or may not get an accurate reading. The loan provider who knows you are in too deep to back out
may up the price a bit, so the 1/8 point will go in his pocket rather than in yours. Indeed, he might discover that the market
price went up instead of down. With no independent check, the “market price” is what the loan provider says it is.

You can’t prevent an avaricious loan provider from pulling that stunt with you on a purchase transaction because you have
too much at stake and not enough time to start over. That’s why I recommend that you lock as soon as possible.

On a refinance with any lender other than your current lender, you can prevent it because you have a right to rescind the
deal within three business days after closing.  The threat to do this will be sufficient to protect you against any kind of
chicanery.

How do I apply for an HSBC mortgage?

There are a number of ways you can get started with your mortgage application:
 By phone: 866.731.4722
 By email – via secure online form
 In person - visit one of our locations

What type of refinancing programs does HSBC offer?

There are two types of full documentation refinancing that HSBC offers: Rate/Term Refinance and Cash Out Refinance.
A Rate/Term Refinance allows you to pay off your existing mortgage and include the new closing costs in the new mortgage amount. This type of refinance program can be used to reduce
your interest rate, loan term or both.
A Cash Out Refinance allows you to turn the equity you have built up in your home into cash which you can use for a variety of purposes. Many of HSBC's programs allow for cash out.
Does HSBC offer a "Streamline" refinance program?
If your existing loan has a higher than market interest rate, you may be eligible for a "streamline" refinance program at HSBC. Streamline Refinancing allows you to lower your interest rate
and monthly payment while providing a minimal amount of documentation. (Cash out at closing is not allowed for any of these programs.)

What are the main types of mortgages?

The most common mortgages are fixed and adjustable rate mortgages.
Fixed-rate mortgages offer the stability of regular monthly payments over a given length of time, or term. Many people feel these are ideal because they make it easy to budget family
finances and there is no rate risk.
Adjustable-rate mortgage (ARM) programs offer you the flexibility of an initial interest rate and payment lower than a standard fixed-rate mortgage. ARM mortgages may also be a great
option for homebuyers who do not plan to stay in their current home for a long period of time.

What is a VA mortgage?
The Veteran's Administration (VA) loan program is sponsored by the U.S. Government's Department of Veteran's Affairs. These loans are provided to credit-worthy individuals who have
given military service to the United States and have been honorably discharged, or to those who currently serve in one of the branches of the military.
You may be eligible for this loan if you are/were:
 an honorably discharged veteran
 an active duty service member
 an un-remarried surviving spouse of a military service member
 a Reservist, or
 a National Guardsperson
Quick Facts:
 0% down payment required
 Gift funds may be used to pay for closing costs
 Maximum loan amount: $417,000 or the geographic VA maximum mortgage limit
 What is an FHA mortgage?
FHA loans are government insured loans through the U.S. Department of Housing and Urban Development, also called HUD. These loans provide an excellent start for first time
homebuyers, offering options such as a low down payment or a low closing cost option.
Quick Facts:
 Low down payment is required
 Your own personal savings are not required to pay down payment or closing costs. Gift funds may be used instead
 You can buy an existing home, or build a new one
 Some geographic limitations apply

What is a SONYMA mortgage?

If you live in New York State and are a first-time homebuyer, SONYMA (State of New York Mortgage Agency) loans may be a great choice for you. Designed to provide affordable
mortgage financing, SONYMA loans offer you the chance to buy an existing home or build a brand new one.
Quick Facts:
 Only a 3% down payment is required for 1- and 2-unit properties
 Your income must meet SONYMA's Household Income Limit requirements
 A secured, down payment assistance loan is available from SONYMA
 The program is only available for New York State properties

What is the CommunityWorks Mortgage Program?

HSBC's CommunityWorks mortgage program has guidelines which allow you to use grant money to help pay for costs associated with closing your mortgage loan. It allows you to apply
the grant to both the minimum 3% down payment requirement as well as all of the closing costs. Any extra funds needed to close can then be paid through your own savings, a gift, or a
grant from another source.
Quick Facts:
 Only a 3% down payment requirement for 1-unit properties, including Co-Ops
 Homebuyer education is required
 Borrowers income must be at or below 80% of the median area income or the property must be located in a designated census tract
 Certain income level restrictions apply depending upon property location
 The program is only available in select states

How does my escrow account work?

An escrow account is one that is established to hold separate funds for the purpose of paying bills such as homeowner's insurance and property taxes. HSBC collects the funds to be
deposited into the account each month along with your monthly payment and then pays the bill for you when it comes due. This eliminates you having to come up with the additional cash
when they are due. By taking the annual amounts charged for homeowner's insurance, property taxes and other annually paid items and dividing them by 12, the escrow department
establishes a payment amount that is added to your monthly principal and interest payment. This spreads the cost of those items over 12 months, making it easier to budget those
expenses.

How is my homeowners insurance paid?

If you have an escrow account, HSBC will receive your insurance invoice and disburse the appropriate funds from your escrow account. Your monthly billing statement will display any
disbursements.
How are my real estate taxes paid?
If you have an escrow account, HSBC will receive your tax invoices and disburse the funds from your escrow account. Your monthly billing statement and year-end statement will display
any amounts disbursed.

What is Private Mortgage Insurance (PMI)?

Private Mortgage Insurance is provided by a private mortgage insurance company to protect lenders against loss if a borrower defaults. Private Mortgage Insurance is generally required
for a loan with an initial loan to value (LTV) percentage in excess of 80%. In most cases, this will mean that you will have to pay Private Mortgage Insurance if your down payment is less
than 20% of the value of the home you are purchasing or refinancing.
What is HSBC's First Home Club?
HSBC's First Home Club matched savings program is available for prospective home buyers in New Jersey and New York State. Financed by the Federal Home Loan Bank of New York,
this program allows qualified first-time home buyers to earn $4 in grant monies for every $1 saved over a 10 to 24 month period. As a result, potential home owners can obtain a maximum
grant of $7,500 by opening an account at HSBC Bank USA, N.A. and saving $1,875 through regular monthly installments. At the conclusion of the program, the applicant/depositor will
have funds totaling as much as $9,375 to go towards the down payment and closing costs for the purchase of a home.
When is my due date?
Your mortgage payment due date is listed on your monthly billing statement or coupon. A late charge is assessed if the payment has not been received and processed by the date noted. It
is very important that you establish and maintain good credit by making sure your payment reaches us by the due date each month. Late payments can affect your credit record.

How do I make payments?

Registered Personal Internet Banking ("PIB") customers can access and make payments to their mortgage or HELOC account(s) through the HSBC website. You will no longer be able to
utilize the transfer function for payments or advances; however, you may still submit online payments using the bill pay function. If you are not registered for PIB, you can access your
mortgage or HELOC by registering through the HSBC website.
Log on to Personal Internet Banking
Register for Personal Internet Banking
If you are not currently enrolled in an automatic debit program or equity accelerator program, and would like to enroll, please call 866.435.7085 for more information.
Pay by Mail:
Each month you will receive a Monthly Mortgage Statement with a detachable coupon and return envelope for payments. Simply mail your payment using the coupon and return envelope.
Upon receipt and processing of your monthly payment, we will produce and mail subsequent billing statements to you.
Send mortgage payments to:
 HSBC Bank USA, N.A.
P.O. Box 5443
Mt. Laurel, NJ 08054

What is the Equity Accelerator program?

Equity Accelerator is an electronic feature you can add to your standard mortgage account to reduce your overall mortgage debt. By breaking your regular mortgage payment into bi-weekly
transfers instead of a single monthly payment, you are paying down the balance more quickly, generally saving thousands of dollars over the cost of an average loan.
To learn more about this money-saving program, call Customer Service at 866.435.7085.

How do I pay off my loan?

Whether refinancing, selling your home or just paying off your mortgage, you can request information from Customer Service in two easy ways:
Via Internet:
If you're a registered Personal Internet Banking customer, log on and navigate to your mortgage account to view account details including pay-off details.
Request a Payoff Quote by Telephone:
Call 866.435.7085
Premier clients can call 866.435.7089
Monday through Friday 8:00 a.m. to 8:30 p.m.

What if I don't receive a statement?

If you misplace or do not receive your current billing statement, please mail your payment (with your mortgage account number written on the check) to:
HSBC Bank USA, N.A.,
P.O. Box 5443
Mt. Laurel, NJ 08054
How can I reach a live person who can answer questions about my account?
Contact our Customer Service Department. Our representatives are waiting to assist you.
I am having some payment difficulties. Can HSBC help me?
If you are an HSBC Mortgage Services (former Household Mortgage Services) customer, please visit www.hsbcmortgageservices.com.
We understand that losing a job, divorce, an illness or a death in the family are just some of the things that can cause a delay in paying your mortgage payments. If you are experiencing or
have recently experienced a hardship and are unable to keep up with your mortgage payments, contact us. We'll work with you to try to make the best of a difficult situation. Click here to
read about payment difficulty options.

How do I know how much I can afford?

Our complimentary mortgage calculator can help you with this question.