Tuesday, June 27th, 2017

Choose the Right Mortgage

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Choosing the Right Mortgage

  • Fixed Rate vs. Adjustable Rate
  • 30-Year vs. 15-Year Terms
  • Rates and Points
  • Should You Pay More Or Less “Up-Front”?
  • Buydowns vs. Graduated Payment Mortgages (GPMs)

Fixed-Rate vs. Adjustable Rate

Fixed-Rate Mortgage

A Fixed-Rate Mortgage applies the same interest rate toward monthly loan payments for the life of the loan. Fixed-rate mortgages are more straightforward and easier to understand than Adjustable Rate Mortgages (ARMs), are more secure for the buyer, and are popular with first-time homebuyers. Since the risk to the lender is higher, fixed-rate mortgages generally have higher interest rates than ARMs.

For example, a lender can offer a 30-year fixed loan to a homebuyer at a 7.0% interest rate. The loan is locked in to the 7.0% interest rate, even if the market interest rate rises to 9.0%. Conversely, if the market interest rate decreases to 5.5%, the borrower will continue to pay the 7% interest rate.

Fixed-Rate benefits include:

  • No change in monthly principal and interest payments regardless of fluctuations in interest rates
  • More stability may give you “peace-of-mind”

Fixed-Rate considerations include:

  • Higher initial monthly payments compared to those of adjustable rate mortgages
  • Less flexibility

Adjustable Rate Mortgage

An Adjustable Rate Mortgage (ARM) does not apply the same interest rate toward monthly payments for the life of the loan. Throughout the life of that loan, the homebuyer’s principal and interest payment will adjust periodically based on fluctuations in the interest rate.

For example, a lender could offer a 30-year ARM loan to a homebuyer at an initial 6.5% interest rate. During an adjustment period for the ARM loan, the market interest rate could rise to 8.0%, resulting in a significantly larger interest payment. Similarly, the market interest rate could decrease to 6.0%, resulting in lower interest payments.

ARM benefits include:

  • Initial payments lower due to lower beginning interest rate, usually about 2 percentage points below the fixed rate
  • Ability to qualify for a higher loan amount due to lower initial interest rates
  • Lower interest payments if the interest rate drops over time
  • Interest rate caps limit the maximum interest payment allowed for the loan

ARM considerations include:

  • Initial lower interest rate and monthly payments are temporary and apply to the first adjustment period. Typically, the interest rate will rise after the initial adjustment period.
  • Higher interest payments if the interest rate rises over time

30-Year vs. 15-Year Mortgage Terms

Typically, a 30-year mortgage term will have lower monthly payments than a 15-year mortgage term. If you decide on a 15-year loan, you will pay significantly less in total interest over the life of the loan, but your monthly mortgage payments will be higher. As a homebuyer, you will need to consider the implications of supporting higher monthly payments when accepting a 15-year term. Can you consistently meet those monthly payments over time? Look at the table below.

Advantages Considerations
15-Year Lower Overall Mortgage Cost Higher Monthly Payment
Builds Equity Faster Must Qualify for Higher Monthly Payment
You have Debt for Only 15 Years You have Less Cash for Other Expenses
Lower Interest Rate Less Money goes toward Tax Deductions
30-Year Lower Monthly Payment Higher Overall Mortgage Cost
Qualifying is Easier You Pay More in Overall Interest
You have More Cash for Other Expenses You have Debt for 30 Years
More Money goes toward Tax Deductions Higher Interest Rate

Rates and Points

The interest rate determines the monthly interest payments over the lifetime of the loan. A “point” or “discount point” is equivalent to 1% of the loan amount and usually reduces or “discounts” the loan rate by an eighth of a percentage point.

For example: You want to get a loan for $100,000 to buy a home. Each “point” would cost you 1% of $100,000 or $1,000 but would reduce your loan’s interest rate by .125%. The lender might offer you an 8.0% loan with zero points, a 7.875% loan with one point, or a 7.75% loan with 2 points.

Points, like the down payment, are paid at closing. In some cases, lenders will allow borrowers to finance the points over the term of the loan. Lenders sometimes use points to make their interest rates appear lower. Be aware that lower interest rate offered by a lender may translate into higher points requirements.

Should You Pay More or Less “Up-Front”?

The size of the down payment, money paid at closing, can affect your mortgage in a number of ways.

Higher up-front payments result in:

  • lower monthly payments
  • lower private mortgage insurance (PMI) costs (if applicable)
  • lower interest payments

In fact, making a down payment of 20% or more can save the homebuyer money by avoiding the monthly mortgage insurance payments.

On the other hand, lower up-front costs mean that your cash requirements at closing are much less, although monthly payments may be somewhat higher.

These lower up-front costs may be a significant benefit for first-time homebuyers and people who simply don’t have a lot of cash on hand. The Department of Housing and Urban Development (HUD) has some tips that may be helpful to you as you shop for mortgages.

Buydown vs. GPM

While these two mortgage types start the homebuyer off at one rate and increase the rate over time, one of these types of mortgages may be right for you:

Buydown

Type of mortgage loan where the loan rate is reduced by paying more up-front at closing and is increased by one percent each year for the period set for the loan product.

For example: For a 2-1 buydown at an 8% rate, Year 1 the rate is 6%, Year 2 the rate is 7%. For Year 3 through the life of the loan, the rate is 8%.

Qualification rules for the loan programs remain the same. Depending on the lender, the buyer may qualify using the reduced rate. (Example: For a 3-2-1 Buydown at a rate of 8%, the buyer could qualify using the 5% rate.)

The difference between the actual payment schedule and the rate schedule is usually paid “up-front” at closing. This can be paid by the seller, the buyer, the homebuilder, or in some cases, the lender. If the cost is borne by the lender, it is usually offset with increased rates or in points. Generally the funds used to buy down the loan are held in a separate account and are applied with the borrower’s payment to equal the true interest rate.

Graduated Payment Mortgage (GPM)

Type of mortgage loan where the mortgage payments increase gradually for a period established in the loan product, typically five years. This is a negatively amortizing loan, which means that the difference between the interest paid and the interest due is deferred and added to the loan balances. Because of this, your loan amount will increase once you start paying off the loan; it will amortize normally at the end of the loan period. These loan products are more popular when the interest rates are higher, providing a financial incentive for potential buyers.

Since many lenders will qualify a buyer at a lower rate, a buyer can secure a larger mortgage. These loan types are good for those buyers who expect their incomes to increase to cover the increase in loan amount.

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