Landlords and real estate investors need to be intimately familiar with how mortgages work, because mortgages are in many ways a tool of the trade. Like all powerful tools, they can also be extremely dangerous, as 18 million homeowners and landlords who were foreclosed on between 2008-2013 can attest.
A shocking number of homeowners and real estate investors alike make appalling mistakes when considering a mortgage, so here’s a review of the most common – and most costly – mistakes made by real estate investors.
1. Failing to Know Your Credit and Options
Before you even start shopping mortgages, you need to know what’s on your credit report. Fortunately, you can pull it once each year for free from AnnualCreditReport.com, as a “soft” pull that does not hurt your credit by appearing as a credit request.
With your credit report in hand, you can then shop around different mortgage brokers, without having each of them pull your credit report separately. Once you choose the best lending option, that lender (or broker) will need to pull your credit report on their own to verify it, but before committing you can shop around for the best rates and options with your “informal” credit report.
2. Failing to Understand Mortgage Fees
Mortgages cost an absurdly large amount of money, both in up-front fees and in amortized interest (more on that later).
If you go through a mortgage broker, rather than a direct lender, you may incur two sets of fees, one for the broker who sold you the loan, and one for the lender who’s actually ponying up the money. Further, keep in mind the word “sets” of fees, because brokers and lenders often charge a whole range of fees.
The fee most people are familiar with is the “loan origination fee”, which is calculated in “points”, with one point equaling one percent of the mortgage loan. But fees don’t stop at points, they start; “administration fee”, “document preparation fee”, “underwriting fee”, “processing fee”… it’s telling that in the industry, lenders call them “junk fees”. When shopping mortgages, get a copy of the Good Faith Estimate (GFE) form for the proposed loan, for a full accounting of these junk fees up front. While one broker or lender might exclaim “We charge no points!” and hit you with $1,500 in junk fees, their more honest competitor might have quoted you a fee of one point, but not slap you with all the junk fees.
Lastly, beware of PMI (private mortgage insurance), which is simply lost money to the borrower and should be avoided by making a larger down payment, if possible.
3. Failing to Understand How “Simple Interest” Amortization Works
“Simple interest” is a misnomer if there ever was one. As a brief summary with minimal math, it works like this: in the beginning of your loan, almost all of each monthly payment goes towards paying interest. But over the life of the loan, more and more of each monthly payment goes towards paying down the principal balance of your loan. For example, imagine a 30-year mortgage for $100,000, at 8% interest – the borrower will pay nearly $8,000 in interest in the first year alone, while only paying $835 toward their principal balance. In fact, it would take 22.5 years just to pay off the first half of the loan ($50,000).
It’s the perfect system for banks: they lend money, knowing that for most of your loan term, you’ll mostly be paying them interest, and only really paying down your loan in the last few years. Before they let you get to that point, they’ll tempt you with a series of “too-good-to-be-true” refinance offers, or will force you to refinance through a balloon note (more on this below). This way, they can continue to keep a huge asset on their balance sheets, and just keep collecting interest without letting you actually pay off the loan.
Understanding how simple interest amortization works, you should now see that refinancing should be avoided if it all possible. Sure, it can occasionally make sense in some uncommon situations to refinance, but generally speaking you want to keep your old loan, so you can eventually reach a point where more of your payment is actually paying down your principal balance.
But even beyond the problem of amortization, refinancing costs a massive amount of money in closing costs, which is all downside for the borrower.
5. Being Sold on Balloons or ARMs
Lenders love to tempt you with balloons and ARMs (adjustable rate mortgages), because the math works so well in their favor. A balloon note is a mortgage that forces you to refinance after a certain length of time (usually three to five years). As discussed above, this is prime interest-earning time for banks, at the very beginning of the loan term, so your balance will be only slightly lower at the end of five years than the day you borrowed it. Then they get to charge those junk fees all over again when you’re forced to refinance.
An adjustable rate mortgage usually starts with a temptingly low interest rate… for a brief period. Then the interest rate jumps up, and becomes tied to the US Treasury rate (even when the Treasury rate is low, the balloon interest rate will be substantially higher). The strategy is similar to a balloon note, just subtler: the lender makes it so expensive to keep your current loan that you will jump at their offer to refinance it, at which time they can charge more junk fees and reset the amortization back to being mostly interest on each payment.
Take it from someone who used to be a mortgage account executive: shop until you find a low-interest, low-fee mortgage at a fixed rate for a 15-30 year term, and never refinance.