Nolo's Essential Guide to Buying Your First Home (28 page)
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Authors: Ilona Bray,Alayna Schroeder,Marcia Stewart
Tags: #Law, #Business & Economics, #House buying, #Property, #Real Estate
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The Saver’s Special: 15-Year Fixed
The Endless Loan: 40-Year Fixed
The Poser: Balloon Loans
If you’re extremely disciplined and can afford it, you might consider a shorter-term fixed loan, most typically a 15-year mortgage. Like any fixed rate mortgage, these have stable interest rates and predictable terms. By paying more each month, you ultimately pay less interest overall. As an added plus, you probably get a relatively low interest rate.
You can see why they’re not as popular, however: Paying money back faster means committing yourself to relatively high monthly payments.
EXAMPLE:
Adina wants to take out a loan for $150,000 to buy a new condo. She can choose between a 30-year, fixed rate mortgage with a 6.25% interest rate, and a 15-year fixed rate mortgage with a 6% interest rate.
Adina wants to take out a loan for $150,000 to buy a new condo. She can choose between a 30-year, fixed rate mortgage with a 6.25% interest rate, and a 15-year fixed rate mortgage with a 6% interest rate.
With the first loan, Adina will have a monthly principal and interest payment of around $924. After 30 years, she’ll have paid about $183,000 in interest. If Adina takes the second loan, she’ll have a significantly higher principal and interest payment, approximately $1,266 each month. However, at the end of 15 years, she’ll have paid off her mortgage and spent about $78,000 on interest ($105,000 less than with the 30-year mortgage).
Shorter-term fixed rate loans free your income for other purposes earlier than longer-term mortgages do. If you know you’re going to want money for something else—for example, to pay college tuition, purchase a second home, or retire—such a loan can act as a serious forced savings plan.
That doesn’t necessarily make it the most financially savvy option, however—especially not if you can make money by investing elsewhere or reducing your higher-interest debt (like on credit cards). For example, if you commit to a 15-year mortgage instead of contributing your money to a retirement plan, you could end up house-rich but cash-poor—with a place to retire in, but not enough money to do so. A better way to accomplish your savings goals might be to take out a longer-term loan and contribute the cash you’ve freed up to a 401(k) or IRA.
As a compromise, some people take out a 30-year fixed rate loan but then make higher-than-required monthly payments to the loan principal. The more principal you pay, the less interest accrues, so if you make early payments, you also end up paying less interest overall. While this strategy won’t save you quite as much money as a shorter-term fixed rate loan would (since your interest rate will probably be a little higher), you face less future risk. If someday you can’t afford to make more than the minimum payment, you’re not locked in.
TIPPut it to principal.
If you decide to make a prepayment, write on the check that the payment is to be applied toward principal. Otherwise, the lender might apply it toward the next payment that’s due, which will defeat your purpose.
If you’re interested in the stability of a fixed rate loan but won’t qualify for a 30-year term, you may be drawn to another option: the 40-year loan. These loans have become less available in recent years, but if you’re able to find one, it can offer a tempting combination of relatively low monthly payments and a stable interest rate.
However, the 40-year fixed is expensive over the long term. Since you’re borrowing the money for a longer period of time, you’re going to pay a lot more total interest, so you won’t see a huge reduction in your monthly payment.
EXAMPLE:
Sarah and Jorge plan to borrow $300,000 to buy a home. They’re considering two options: a 30-year, fixed rate mortgage at 6.5% and a 40-year fixed rate mortgage, also at 6.5%.
Sarah and Jorge plan to borrow $300,000 to buy a home. They’re considering two options: a 30-year, fixed rate mortgage at 6.5% and a 40-year fixed rate mortgage, also at 6.5%.
If Sarah and Jorge get the 30-year loan, their monthly principal and interest payments will be about $1,896 and they’ll pay $382,637 in interest over the life of the loan. If they get the 40-year loan, they’ll pay $1,756 per month ($140 less) in principal and interest—but their total interest payments after 40 years will be $543,058—a whopping $160,421 more in total interest.
Another drawback of 40-year fixed rate loans is that most have a higher interest rate than would be offered on a 30-year loan, so the difference in monthly payments is even less. Finally, remember that taking out a 40-year loan means that you’ll have debt hanging over your head for 40 years (assuming you stay put and don’t refinance or prepay). Depending on your age, that could take you well into retirement.
CHECK IT OUTTally up how your 401(k) contributions will grow between now and retirement:
Go to
www.bankrate.com
, click “Calculators,” then under “Investment Calculators,” click “401(k) planning.”
At first glance, balloon loans look pretty attractive. Their interest rate usually starts below the market rate on a 30-year fixed rate mortgage. You make payments for a fixed period of time—usually somewhere between three and ten years. However, your monthly payments are calculated as if you were paying the same amount each month for 30 years, which keeps them low. (The technical way to say this is that the loan is amortized over a 30-year period.)
However, at the end of the fixed period, you owe the entire loan balance, then and there. This isn’t necessarily a problem, since you may be able to refinance with another lender, assuming interest rates are favorable at the time and that you have sufficient equity.
But it’s difficult to bank on that happening, which is one reason these loans aren’t as readily available as they were a few years ago. The balloon payment could become a problem if you find yourself unable to qualify for another loan because the value of your house has dropped (hopefully temporarily), your financial circumstances change, or you have some credit snafus in the meantime. Unlike an ARM, you won’t even have the option of continuing to make payments at a higher rate. A better alternative is to get a hybrid loan, discussed below.
Adjustable Rate MortgagesAs the name implies, the interest rate on an adjustable rate mortgage (“ARM”) can fluctuate during the loan term—and no one can predict with certainty where interest rates will go. For buyers who aren’t put off by this risk, or see buying their first home as a short-term stepping stone, the ARM may be an attractive option.
The relatively low initial interest rates are certainly eye-catching and have made ARMs a favorite among new buyers.
But what about those fluctuating interest rates? They’re definitely the main risk factor in an ARM. After the starter rate runs out, the rate adjusts periodically at an agreed-upon term. This term (called the
adjustment period
) may vary from one month to several years. Buyers in the last several years were lured by lenders offering ridiculously low initial interest rates, only to find their payments completely unaffordable once the rate adjusted (sometimes, as quickly as a month later). This contributed to the very problems in the mortgage market that make lenders more careful about offering ARMs today.
adjustment period
) may vary from one month to several years. Buyers in the last several years were lured by lenders offering ridiculously low initial interest rates, only to find their payments completely unaffordable once the rate adjusted (sometimes, as quickly as a month later). This contributed to the very problems in the mortgage market that make lenders more careful about offering ARMs today.
When you’re looking at the loan description for an ARM, check out a number called an
index
: The lender will adjust your rate to equal the index plus an extra amount, so that it makes a profit. That bit of profit, calculated as either a set amount or percentage, is called a
margin
.
index
: The lender will adjust your rate to equal the index plus an extra amount, so that it makes a profit. That bit of profit, calculated as either a set amount or percentage, is called a
margin
.
Luckily, your lender doesn’t get to invent the index. It will draw on a particular published, market-driven number. Common indexes include the London Interbank Offered Rate (LIBOR), the 11th Federal Home Loan Bank District Cost of Funds (COFI), U.S. Treasury Bills, or Certificates of Deposit (CDs). The LIBOR is usually the most volatile, meaning it jumps up or down quickly and dramatically, while the COFI is less volatile. Also, an index that averages rates over the long term (a year or every six months) is preferable to one that moves up and down based on the weekly “spot” rate.
Another number to seek out when comparing ARMs is the
life-of-the-loan cap
. This is a maximum on the ARM’s total interest rate, no matter how high the index rises. The lender usually allows a well-padded 5%-6% above the starting interest rate, which can affect your monthly payment by hundreds or even thousands of dollars. Still, it’s far better than getting an ARM without a life-of-the-loan cap—that’s downright dangerous.
life-of-the-loan cap
. This is a maximum on the ARM’s total interest rate, no matter how high the index rises. The lender usually allows a well-padded 5%-6% above the starting interest rate, which can affect your monthly payment by hundreds or even thousands of dollars. Still, it’s far better than getting an ARM without a life-of-the-loan cap—that’s downright dangerous.
In addition to a life-of-the-loan cap, most ARMs limit how much your interest rate can increase at any adjustment period. This number is called the
periodic cap
. It’s also a floor, limiting the amount the rate can decrease at one time. Look for an ARM that doesn’t change by more than 2%-3% at each adjustment period. Otherwise, your monthly payment could shoot up very rapidly.
periodic cap
. It’s also a floor, limiting the amount the rate can decrease at one time. Look for an ARM that doesn’t change by more than 2%-3% at each adjustment period. Otherwise, your monthly payment could shoot up very rapidly.
EXAMPLE:
On a $200,000 loan, you’re choosing between a 30-year, fixed rate mortgage with a 5.85% interest rate and an ARM with an initial 5.5% rate. The life-of-the-loan cap on the ARM is 11.5%. Your monthly principal and interest payment on the fixed rate loan would be approximately $1,180 and never increase above that. Your monthly payment on the ARM would start at approximately $1,136. However, if your interest rate adjusts to the maximum 11.5%, your payment could go as high as $1,980—about $700 more.
Traditional ARMsOn a $200,000 loan, you’re choosing between a 30-year, fixed rate mortgage with a 5.85% interest rate and an ARM with an initial 5.5% rate. The life-of-the-loan cap on the ARM is 11.5%. Your monthly principal and interest payment on the fixed rate loan would be approximately $1,180 and never increase above that. Your monthly payment on the ARM would start at approximately $1,136. However, if your interest rate adjusts to the maximum 11.5%, your payment could go as high as $1,980—about $700 more.
The traditional ARM works like this: The loan starts out at a below-market interest rate, called a
teaser rate
. This rate adjusts frequently, as frequently as every month in some cases. As we’ve seen, that adjustment can make a big difference in your monthly payment.
teaser rate
. This rate adjusts frequently, as frequently as every month in some cases. As we’ve seen, that adjustment can make a big difference in your monthly payment.
A traditional ARM is rarely a good financing strategy. Many people who choose it can’t really afford the home that they’re hoping to buy. If you can only afford the monthly payment in the first few months when the interest rate is artificially low, what are you going to do when it goes up?
The exception is if you expect a significant increase in your income very soon, or you’re in line for some other form of income, such as an inheritance or gift. If so, a traditional ARM might be a bridge until you can qualify for a loan with better terms or pay off your property entirely.
CHECK IT OUTInterested in a traditional ARM?
You’ll need to know what maximum amounts you could owe each month. Your mortgage broker should be able to calculate this for you, or you can use an online ARM payment calculator, like the ones at
www.nolo.com/calculators
,
www.interest.com
, or
www.dinkytown.net
.
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