How to Pick the Right Mortgage Product for You
With her career and family close by, Katherine knew she would be in the same Evanston, Ill. home for the foreseeable future. "Unless something catastrophic happens," says Katherine, she doesn't anticipate moving "for quite some time."
While not all buyers are in Katherine's situation, brokers in today's market are increasingly using the term "lifestyle" to help borrowers figure out what type of mortgage product is right for them. However, unlike the pre-housing-bust days, this doesn't mean the lifestyle you want to live, but rather addresses the fundamental question: How long do you anticipate living in your new home. Naturally, for many this is difficult to predict, but as you'll see, it's essential to figuring out what the right mortgage product is for your lifestyle.
The first thing a potential homebuyer needs to understand is the basic types of mortgage products available: fixed-rate and variable or adjustable-rate mortgages. A fixed-rate mortgage charges a constant amount, generally over a longer period of time. Adjustable-rate mortgages, commonly known as ARMs, typically begin with a low, constant interest rate, then after a set number of years it re-adjusts to a higher rate.
However, just because a fixed-rate or adjustable-rate mortgage is the flavor of the moment doesn't mean that it's the right mortgage product for you. This is where lifestyle comes in, and how it can affect your ability to pay off a home loan.
Here's a breakdown of the major types of mortgages on the market and why they may or may not be best for you:
Fixed Rate Mortgage Products
In the U.S., the 30-year-fixed mortgage is the most common mortgage product with roughly 75 percent of all borrowers opting for it. Borrowers pay steady, predictable payments -- at an unchanging interest rate -- over the course of 30 years, even if the market rate jumps. It is a conservative way to pay off your home over the long term. The burden of this loan can ease in time as inflation -- and your potential wage growth -- make payments seem smaller. Because mortgage interest and principal payments are known, it is easy to budget for this investment.
The downside is that, at the start, your home payments are higher than an ARM's initial, low, "teaser" rate, so you might be limited in how much house you can buy. Because lenders see the risk as greater, fixed-rate mortgages have a higher interest rate than ARMs.
The 30-year fixed is also a less flexible mortgage product. Real estate experts say that this type of mortgage works for individuals and families who know that they are going to be in a home for the next 30 years of their life. This means that a borrower--regardless of the economy, occupational and budgetary changes--foresees that they will still be able to make the payments on their home.
Like the 30-year fixed plan, the 15-Year mortgage is paid off at a constant interest rate, but repayment is made faster and in bigger chunk because the term is shorter. The primary advantage is that the interest rate is usually lower for the 15-year that the 30-year. For example, current interest rates on the 30-year Fixed are around 4.3 percent. For the 15-year Fixed, rates are significantly lower at about 3.8 percent.
There are also other fixed rate mortgage products. The 40-year-loan was used often during the subprime years because it spread payments out over a longer period of time, lowering your monthly payments.
For example, at 6 percent interest, extending the term 10 to 20 years would reduce your monthly payment by 35.5 percent; lengthening it to 30 years lowers monthly costs by 16.3 percent; and in 40 years, they go down another 8.2 percent. While it makes your loan more affordable, the advantages aren't as significant past the 30-year marker. Plus, interest rates may be even higher since lenders are assuming the risk for an even longer amount of time.
On top of that, while your monthly payments would be lower with a 40- or 50-year mortgage, the long-term costs may be higher because of what you are spending on interest. For instance, someone with a 30-year, $300,000 mortgage would pay $1,837 a month, for a total interest cost of $361,466. And by stretching the loan out for 50 years, they only would save $213 a month and end up paying about $300,000 more in interest.
To calculate the differences between 15, 30 and even 40-year mortgage products, try plugging your numbers into Bankrate's mortgage calculator.
Adjustable-Rate Mortgage Products:
An adjustable-rate loan starts with low interest and after five years adjusts to the fully indexed interest rate, which is usually capped at a 2 percent increase annually. What's appealing is that a low interest rate at the outset allows homebuyers to buy a pricier property. And when home values were higher and rising, homeowners were able to sell or refinance before their mortgage rate jumped. Variable rate mortgage products are great if you believe you will be in your home for less than 10 years.
For example, real estate experts say that a 5/1 ARM is ideal for someone who knows that they are only going to live in the home no more than five years. Tom Vanderwell, a mortgage lender and writer for the blog, www.straighttalkaboutmortgages.com, says he asks his clients who are interested in a 5/1 ARM the hypothetical question: If in five years interest rates are 12 percent, would you still move? If the answer is yes, Vanderwell says, then the individual is a good candidate for this type of mortgage product.
The risks are that many people are not certain if they can move within five years--one reason there are also 7/1 and 10/1 ARMs. And if they chose to stay, they are in jeopardy of having to pay the costs of high, fluctuating interest rates. The other pitfall is that when home prices are falling, homeowners aren't always guaranteed that they'll be able to sell or refinance their home at precisely when they need to move.
Interest Only Mortgage Products
An interest-only mortgage allows buyers to pay just the interest on a mortgage, in monthly payments for a fixed term. When that term is over, you can refinance or ante up the balance of the loan in a lump sum -- or your payments will spike to pay off the principal. A mortgage that resets in one year bets that interest rates have plateaued or are headed down, which doesn't make sense in the current climate, with interest rates so low.
Even when interest rates are sky-high, interest-only mortgage products usually are recommended only for an individual with erratic income, such as large but infrequent commissions or bonuses. A savvy money manager might also use this type of mortgage to bet that investing the savings on the difference between an interest-only mortgage and an amortizing mortgage will make more money.
Interest Only mortgage products are notable for one other reason: unlike most other mortgages, they bear simple, not compound interest: over the course of your loan, the amount of interest you pay keeps declining to zero--at which point you finally begin to pay off the balance of your loan. That makes Interest Only loans interesting mortgage products for those who might have eyes for bigger properties than they could reasonably afford if they were to attempt to purchase other variable or fixed rate mortgage products.
Still trying to decide which is right for you? Here are some AOL Real Estate guides to help you no matter whether you choose to buy or rent:
Find out how to calculate mortgage payments.
Find homes for sale in your area.
Find foreclosures in your area.
Get property tax help from our experts.