Mortgages... Which One to Get?
Pacific Beach Real Estate, Mission Beach Real Estate, San Diego County Real Estate
OK, class is in session. What are the three most asked questions that I receive from my friends and clients? If you answered with the following you would be correct.
- What is the market doing?
- What do you expect that the market will do?
- What type of mortgage should I get?
If you read each edition of this newsletter then you know all too well that I attempt to answer questions 1 and 2 on a regular basis. This month, I am going to step into an arena most Realtors try to avoid and answer question # 3.
Shopping For A Mortgage
Shopping for a mortgage is like buying a suit or a dress. One size definitely does not fit all. I recall years ago that when my spouse and I went shopping for our first mortgage, the choices were few - very few, in fact. "Yes, Mr. Mattix, we can offer you a 30 year fixed, a 15 year fixed and we even have a brand new product which is an adjustable rate mortgage (ARM). That´s it, pick from one of the three", the loan officer asked. WOW! Have things ever changed since then! Today, when it comes to choosing a mortgage, consumers have an amazing array of choices... so many so that no one lender or even mortgage broker has access to all of them.
Yes, the most popular loans are still the 15 and 30 year fixed mortgages. However, few buyers realize that they can also shop fixed-rate loans in other five-year increments that span 10, 20 or 25 years. Or they can adjust the length of their mortgage by paying additional principal as they go along. And some elect a 40-year mortgage to capture the house of their dreams. Then, about 35 percent of home buyers are going for hybrid loans which offer a few years of a fixed rate before switching over to an adjustable rate.
With so many options, how do you select the right one for you?
OK, here are three basic things to consider:
- What's the best rate you can get?
- How much is the monthly payment?
- And, most important, how does the payment and payoff date fit with your financial plans?
For most people, the basic issue comes down to affordability
. The shorter the term of the loan, the lower the interest rate and lower monthly payments. In contrast, 30 year fixed loans lock in the lender for an extended period of time, increasing the risk that the interest rate charged today will not provide a satisfactory dollar yield in the future. Thus, lenders hedge their bets by charging a higher interest rate for 10, 15, and 30 year fixed loans which result in higher payments. Which one is right for you is often answered by asking yourself: how long will I occupy this home and what payment can I comfortably afford when allowing for savings, retirement and other obligations. One caution that I bring to all my client´s attention is by asking "how good a job do you do in saving money?" The point I try to make is that your home is first and foremost a place to live and the payments should not burden you to the point where it becomes your sole investment vehicle. Like most things in life, balance is the key and while we are all paying an increasing amount of our take-home income on housing here in San Diego, I still advocate investing some amount of savings into a retirement account. You also need to consider whether you have an emergency fund? The top reasons families lose their homes are unexpected financial disasters: A spouse becomes ill or dies or there is a job loss, divorce or other calamity. For that reason, you want to make sure that you've put up some financial safeguards to protect your family. While now you might be able to stretch to meet that 15 year mortgage payment, what happens if you go from two incomes to one? You might be better off taking the longer mortgage and putting the difference into a life insurance policy or emergency fund and realizing that the "extra" money is not disposable income.
That all said, which mortgage fits? Well, here are some of your options:
Fixed Rate Mortgages
- 15-year fixed-rate: You'll get a lower rate than with a 30-year mortgage, but a stiffer monthly payment to go with it because of the shorter term. Is it something you can handle comfortably and still meet all your other financial obligations? It can be a great strategy, but it's not for everyone. It's riskier so if you do it, you want to be prepared and have the emergency reserves and financial wherewithal to handle a job loss or any other curve balls that come your way.
- 30-year fixed-rate: The old reliable. It offers a higher interest rate than the 15-year mortgage, but is sweetened with a lower payment. If you're really risk averse, you may want a 30-year fixed loan because you lock in today's low rates forever.
- 40-year fixed-rate: You have to shop it to see if it makes any sense for you. Is the monthly debt that much lower to make it worth paying an extra 10 years of interest and the impact on the payment is very small. Here´s an example: At a 6% rate, going from 10 years to 20 years on your mortgage will reduce the monthly payment by 35.5%. Extending the loan to 30 years and you slice an additional 16.3%. But going from a 30 year to a 40 year mortgage only cuts the payment by 8.2%. And then, the savings could easily be offset by an extra quarter-point increase in the rate.
- Nontraditional fixed-rate mortgages such as 10, 20 and 25 years: While you can log onto a computer and shop 15 and 30 year fixed mortgages, you might not be able to do that with a non-standard length mortgage. You may well have to approach your lenders individually to ask what they would charge for a loan term with the length of time you need and often they're not priced very well. The reason is that mortgage holders often will resell your loan and there is a ready market for the traditional 15 and 30 year mortgages. But, that's not the case with non-traditional length loans. Since they can't make money reselling them, lenders may not offer attractive rates for such loans.
Hybrid Adjustable Rate Mortgages
The most popular types of hybrids give the borrower a fixed rate for one, three, five, seven or ten years and then convert to an adjustable rate mortgage. The upside: The rate is often cheaper than a 30 year fixed rate plus, most people stay in a home for only about five years.
Five and seven year ARMs are particularly good for first-time home buyers and others who are planning on being in their homes for a short period. The idea is to sell while you still have the fixed rate. Shop the rate caps too. When the loans move into the adjustable phase, the rates usually can change annually. The first year hike can be capped at anywhere between 2 and 5% with successive years usually capping at 2% per year. You also want to understand what the rate is based on. What index does the lender use to decide whether the rate will go up or down?
One important question for consideration is what happens if you don't move? If interest rates have gone up, you may not be able to find a rate that's as attractive. So before you sign for that adjustable rate loan, ask yourself "what's the maximum payment of this mortgage and can I afford that?"
One other important caution about adjustable rate mortgages. Determine if the loan includes negative amortization. Here´s how this little "jewel" works: Negative amortization loans are a way to get the initial payment down but, when the interest rate goes up, your payment is capped. When the payment isn't enough to cover the interest expense and principal, the shortage is added to your loan balance. Bad news! My recommendation is to stay clear of anything that has a "neg am" feature because even when your loan term is up, you could still be paying. Like most things in life, there are no free lunches in mortgage design!
Make Your Own Mortgage
- One Extra Payment. One other option allows homeowners to easily adjust the length of their mortgage by making additional principal payments. Assuming you have no prepayment penalties, every extra dollar of principal you pay shortens your payoff period. For example, you could take out a 30 year mortgage and pay it off several years ahead of time by making one extra payment at the end of each year by just telling the lender to apply it to the principal. You also get the additional tax deduction on the interest paid.
- Bi-Weekly Mortgage. Here´s another clever way to set up monthly mortgage payments so that you can reduce principal faster and end up paying-off a mortgage in 211/2 years which will save you thousands of interest dollars. Essentially, a bi-weekly involves 26 bi-weekly payments every 12 months which is the equivalent of making 13 regular monthly payments within a 12 month period. Most folks believe that you need to have your mortgage company set this up for you which is not correct. In fact, there is no reason to pay a set-up fee that can run approximately $395 and continuing monthly charges of $6 just to have them set it up for you. Here´s how you can do this yourself without any extra costs. Look at your monthly principal and interest payment statement. Disregard any escrow/impound charges for property taxes or insurance premiums. Then, divide your monthly principal and interest payment by 12 and add that amount to each regular monthly mortgage payment you make. Be sure that you designate on your payment slip that the extra amount paid is for "principal reduction".
P.S. Occasionally I do "walk my own talk". I do this myself for my own home.
Where are you on the road of life? When choosing the length of a loan, give some thought to whether you want the mortgage to be paid off in advance of some anticipated financial event, like sending kids to college or retiring. There is some logic to matching the mortgage's payoff to approximately when you're going to have to ante up for college room and board or when you retire. Also, if you are now living or will be living on a relatively fixed income after retirement, it might be wise to choose a mortgage that will give you fixed payments during that same time. That way, you will know what your payment will be each month.