Suze Orman's take on Mortgages

Suze Orman is one of my favorite authors and financial adviser. About 4 years ago we started watching her show on CNBC and me and wife were hooked onto it. Taking her advise, we quickly got rid of our credit card debts, created an 8 month emergency fund and started saving almost 50% of our income.

Now we have started looking for a home. So with all thats going on about subprime mortgages, here's Suze's take on it.

Look out for more such posts while we make our way through this home buying experience.

Protecting Yourself from the Wrong Mortgage
by Suze Orman

Talk about being late to the game.

After the past few months of mortgage delinquency rates and home foreclosures creeping ominously upward, a lot of government attention is suddenly being focused on the "shocking" fact that many borrowers ended up with nontraditional mortgages they had little chance of affording once the alluring introductory periods expired.

From recent congressional hearings to the passage of new federal guidelines on mortgage qualification rules, Washington is playing catch-up in addressing aggressive lending practices that have led consumers into an unaffordable debt spiral.

Do-It-Yourself Protection

I suppose we should chalk it all up to "better late than never," but I'm not so sure that government intervention is the real solution. Besides, who knows if and when any meaningful legislation will be put into place to help borrowers avoid mortgage deals they can't really afford.

Instead, the real solution is for borrowers to step up to the plate and assume full responsibility for understanding what they're agreeing to when they sign their mortgage documents.

Given that we're now heading into the home-buying season, here's what I recommend that every homebuyer -- and anyone contemplating a mortgage refinance -- should consider before signing on the dotted line:

1. Focus on the "what if" factor.

If you're considering any type of mortgage that has a special-payment deal for a few years before the loan adjusts, study what your payment could rise to after the initial teaser period expires. In fact, that's exactly what the new federal guidelines are designed to help out with.

When you opt for any type of "nontraditional" mortgage that allows you to defer the repayment of principal (and even part of the interest) in the early years of the loan, the new federal guidelines -- which, alas, are just guidelines -- stipulate that the lender consider your ability to repay the loan once the loan "adjusts" and you have to start repaying the principal.

If you can't handle that fully adjusted rate, in theory the lender should be reluctant to give you the loan in the first place. Even if a lender still offers you the deal, you need to really crunch the numbers and make sure you can afford it once the adjustment kicks in. One of the big reasons for the recent rise in delinquencies and foreclosures is that borrowers who took out the interest-only or negative-amortization loans are now stuck with much higher payments because their assumptions were flawed.

Those assumptions -- pushed by the same aggressive lenders -- were that the borrower's income would increase enough in the intervening years so that they would be able to handle the higher payments. Or that the real estate boom would continue, so that there would be ample increase in equity to allow the borrower to refinance out of the loan before the adjustment hit.

Well, that's not so easy right now, as home price appreciation has stalled in many of the once hottest markets, and not too many people have seen a 20 percent or 30 percent jump in income, which is often what's needed to keep up with rising mortgage payments.

I'm not going to issue a blanket statement that you should never ever use a non-traditional loan. But you need to take full responsibility for understanding the "what if" factor: What if your assumptions don't play out and you have to make higher payments? What's your plan for handling that? That brings me to my next point.

2. Know your limits.

It's up to you to set your housing budget, and it's absolutely irrelevant what amount a lender says you can qualify for.

Lenders make more money if you borrow more money; in other words, they aren't necessarily motivated to tell you to borrow less rather than more. And the rules of their business have changed over the past decade or so. It used to be standard practice to offer loans with monthly mortgage payments that, along with borrowers' other recurring debts, wouldn't eat up more than 36 percent of gross household income. Now that percentage can be as high as 50 percent.

If you stretch yourself that far, you're leaving yourself less wiggle room if any unexpected expenses come your way, such as unforeseen medical bills, a layoff, and so on. If you're even considering a debt load that eats up half your household income, you'd better make sure you have an emergency cash fund that covers you for six to eight months. Otherwise, the slightest financial glitch could send you down the path to foreclosure.

3. Lower your price target.

I know this sounds un-American, but the best way to keep your mortgage costs in check is to start out with a smaller mortgage. Ideally, this is where I suggest you save up for a nice down payment of 20 percent or so. That's still my best advice, but I know patience isn't exactly in vogue these days.

Here's my second-best advice: buy a less expensive home. That is, a home you can easily handle the payments on, rather than a home that keeps you up at night worrying about the mortgage. That can mean rethinking where in the country you live, or what neighborhood you can afford.

Or reconsider exactly how much space you need. I find it fascinating that the typical square footage of a U.S. home has increased more than 40 percent since the mid-1970s, yet our family size has actually decreased slightly during the same period. A big reason housing is more expensive is because it's so much larger. Set your sites on a comfortable but not king-size home and you'll have a more affordable mortgage.

4. Read the ARM fine print.

The interest-only and negative-amortization loans I mentioned earlier are the riskiest deals, but you can still get in plenty of trouble with a straightforward adjustable rate mortgage (ARM) if you don't plan ahead for when the rate adjusts.

Don't plan on just refinancing before the adjustment, either. That may be your intention, but, as I said, the recent uptick in delinquencies and foreclosures is due in part to folks who had just the same intention a few years ago.

Consider that a $250,000 mortgage financed with a 3/1 ARM in 2004 will see its payment jump about $300 a month when it adjusts this year. The best way to handle an ARM is to calculate what the payment could be at the first adjustment, and start saving now so you could handle that potential increase. Check your loan document to find out the maximum annual rate increase. Typically it's 2 percentage points, but be careful -- if you have a longer-term hybrid such as a 5/1 ARM, your initial rate increase could be much higher.

While you're studying up, check for the inclusion of a prepayment penalty. This little nugget has tripped up many homeowners in the past few years. A typical penalty can be up to six months' interest if you refinance within the first three years of a loan. On a $250,000 mortgage, that's potentially more than $25,000.

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