By Verónica Cool @verocool
Borrowing THOUSANDS OF DOLLARS?? FOR 15 OR 30 YEARS?? WHY?
The fundamental reasoning is simple: While you could save your money and buy clothes, cars and maybe even college tuition outright with cash, very few people could ever hope to save enough to buy a home for cash, especially during their child-rearing years when they have the greatest need. A mortgage allows you to buy a home after having saved only a relatively small amount of its value, and to reap the financial gains as its value grows over the years.
How much can you afford?
Choosing the right mortgage, however, can be a make-or-break decision for your overall financial picture. Just as the home is the greatest asset for most people, their mortgage payment is usually their biggest monthly bill, so you need to shop carefully for the right one.
Ensure you have completed your budget and know how much you can afford to spend. Have you considered whether you are retiring in the near-future? Do you have a student going to college? All of these factors impact how much you can comfortably afford to pay monthly. Very often, this amount can be cheaper than paying a rent monthly.
Judith Shine, a Certified Financial Planner in Lone Tree, Colo., advises borrowers to look at all types of loans and to choose the one with specific provisions that are most closely tailored to their financial situation.
“A mortgage is an expensive purchase and people don’t see it that way. They see it as a commodity, and it’s as far away from a commodity as it can be.”
For example, she likes to look for adjustable-rate mortgages that give the borrower the opportunity to pay a little bit extra to the have the option of locking in his or her rate at some point. “Not everyone has a lock, but we look for it.”
What she does not like to see in a mortgage is a lot of built-in risk. “I do not like to see low down payments. That’s where you get in trouble. I don’t like to see loans that are bumping up against what people are able to afford.”
However, as long as the payments are well within the range that a borrower can afford, she’s open to all types of loans, even those that have garnered bad reputations in recent years, such as mortgages that allow interest-only payments or adjustable-rate loans that change frequently. The problem was the wrong people got the wrong products, she says.
“It’s not risky if you buy the house correctly. When people get ‘upside down’ (owing more on their mortgage than the house is worth), it’s because they paid too much for the house. That’s what a lot of people are confusing. Lending money on a house that is not worth the price is risky.”
GET THE RIGHT LOAN TO FIT YOUR LIFESTYLE
The key to finding a good mortgage is first to understand your own financial picture thoroughly. Know what you can really afford to pay, and have a realistic estimate of how long you expect to live in that home. If you’re certain that a job relocation will cause you to move in five years, for example, there’s no need to pay extra for the security of a mortgage with an interest rate that’s fixed for 30 years.
Conversely, if you can barely afford the payment during the first year of an adjustable-rate loan, it would be foolish to commit to a payment that is all but certain to grow.
“It’s like so many things nowadays,” says Shine. “People are busy and they don’t pay enough attention to contracts, and this is a contract. Or they’ll read it and not understand it.”
If you don’t understand the terms of any loan, you owe it to yourself to find a lender or a financial adviser who will take the time to explain them all to you.
Types of Mortgages
Variety in mortgage offerings may ultimately be a boon to borrowers, but, at least at the start of the mortgage-shopping process, variety holds the potential for plenty of confusion. Here’s a guide to some of the basics.
Always be aware that some lenders, in their desire to offer something the competition doesn’t have, may offer loans that mix features in new — and potentially confusing — ways.
- 30-year fixed rate.
- One-year adjustable-rate, or ARM.
- Payment-option loans.
30-year fixed rate mortgage
The traditional mortgage remains a favorite of borrowers. Although the interest rate is generally higher than the starting rates on other loan types, your interest rate and payment will remain fixed for 30 years with this type of loan, and that’s a boon to planning your long-term finances.
A variety on this is a fixed-rate loan with a term of 15 or 20 years. Required monthly payments on these loans will be significantly higher than on a 30-year fixed, but you will build equity faster and, in the long term, pay much less in interest. Most lenders allow you to prepay principal on a 30-year loan, so you can retire the debt earlier.
One-year adjustable-rate mortgage, or ARM
This is the original variety of an adjustable rate mortgage, commonly referred to as an ARM.
|•||Index||•||Frequency of rate adjustment|
|•||Margin||•||Annual and life-of-loan caps|
A one-year ARM has a 30-year term, but your interest rate will adjust every year. The interest rate will be determined by the index that your loan is pegged to, typically one-year Treasury rates or the LIBOR index (an acronym for the London Interbank Offered Rate) or the COFI index (Federal Reserve Cost of Funds Index). LIBOR and COFI indexes also are used frequently for mortgages that adjust their interest rates more frequently than once a year.
Sometimes called a “three-year fixed” or a “five-year fixed,” these loans incorporate some of the features of fixed- and adjustable-rate loans. For example, a basic “3/27 hybrid” loan will offer you a rate that is fixed for the first three years and then converts to a one-year ARM for the remaining 27 years of the full 30-year term.
Similarly, a “5/25 hybrid” offers a fixed rate for the first five years and then converts to a one-year ARM for the remaining 25 years. These loans can be a money-saver for borrowers who are all but certain that they will move within three or five years and thus don’t need to pay extra for an interest rate that is fixed for a longer period.
As the name implies, these loans, usually an ARM or a hybrid, allow a borrower to make interest-only payments during the first five years or so. After that, borrowers are expected to repay principal and interest in order to pay off the loan within the remaining 25 years of its term.
Borrowers can be in for a big payment shock once the interest-only period ends because they have to pay off the entire amount borrowed in only 25 years, compared to the typical 30. Rising interest rates will exaggerate that shock. Typically this type of loan works best for a borrower who is certain he or she will be selling the home or refinancing within the interest-only period and is simply seeking to keep his or her house payment temporarily at its rock-bottom low. If combined with a low down payment, these can be very risky loans for borrowers because they may not find it as easy to refinance out of this loan as they had anticipated, especially if the value of their home has not grown enough to give them a good equity stake.
They come by different names, usually incorporating the words option or choice. These loans offer borrowers a choice of two or three payments each month, but their complexity grows right along with those choices.
- Make full payment of principal and interest.
- Pay more than a full payment.
- Pay only the interest due for the month.
- Pay only a portion of the interest.
The first two choices are fairly straightforward: You can pay the full amount of principal and interest owed that month, just as you would with a traditional mortgage, or you can choose to pay even more and pay off a 30-year-loan on a 15-year schedule. However the other two choices can get borrowers in over their heads if they aren’t careful. In any given month, a borrower can opt to pay only the interest that is due that month, or the borrower can choose an even smaller minimum payment, an amount that covers none of the principal and only part of the interest that is owed. To make things even more complicated, these loans often have interest rates that adjust as frequently as every month. And payment caps could allow your minimum payment to rise by as much as 7.5 percent in a given year.
If borrowers choose to make the minimum payment frequently, these loans can set the borrower up for a huge payment shock after just a few years. At the end of five years, or whenever the borrower’s outstanding loan balance has grown to 10 percent or 15 percent above their original loan amount, the loan will be recast. That means the lender will draw up a new payment schedule designed to get the loan paid off on time, and the minimum payments can grow dramatically. There are no caps on how high the payment can go at these recast periods. Only the most financially sophisticated borrowers (perhaps those few who already understand from personal experience how hedge funds and arbitrage work) should consider these very complicated mortgages.
Sticking points on any type of mortgage
Prepayment penalties, which can amount to six months of interest, restrict borrowers from refinancing out of a mortgage within the first few years. Some even apply if you were to sell the home. Avoid them unless the lender is giving you a very deep discount on the interest rate as compensation.
Also check for balloon payments. These can be called for in some ARMs that have easy terms in the early years. If your loan calls for a balloon payment, that is payment of all the money outstanding, at year 10, you’d better have good plans lined up for refinancing that loan — or a lot of cash on hand
Almost every lender requires you to split the risk of purchasing this large asset by investing anywhere from 5 to 20% as a down payment. If you purchase a home for $150,000, expect to put down $7500 to $30,000 and to borrow $142,500 to $120,000. Since this is probably the largest purchase most people make, begin to build your savings several years in advance.
Impact of Credit History
The ability to repay this large debt is measured by your prior credit history, including how long you’ve had credit, what type of accounts you’ve held and have you been tardy? Protect your credit history by handling your credit cards, car and other debts responsibly.
Poor credit indicates higher risk, which impairs your ability to get approved for a mortgage and if you are approved, your interest rate will be higher than an individual with stronger credit.
Acquiring a home is a tremendous investment with a lot of risk, for the lender that provides the mortgage, to you and your family that builds a home in this house. Be prepared: have your financial records in order, ensuring taxes are filed in a timely fashion, sufficient down payment, and clean credit history.
Predatory & fraudulently lending practices
Be wary of predatory lenders and practices. If a loan or mortgage sounds too good to be true, it’s probably fraud. Always compare 2 or 3 lenders and their loan prices (including interest rate and points, terms and prepayment terms). Be wary of excessive fees or upfront payments and ask for a recommendation (use Facebook or Twitter and ask your friends for recommendations). Be sure to research and understand the terms and details that are being presented.
This entire process is complex, but you can successfully navigate this journey with the partnership of an expert and honest lender with experience.