So, you want to buy a home. If you’re a first-time home buyer, obtaining a mortgage can be a very intimidating process. There are many different types of loans, and understanding the mortgage rate as well as the mortgage closing options practically requires a degree… or at least a class at the learning annex.
Choosing the right mortgage can be different for each person. Weâ€™ll like to offer some tips that will help make more sense out of the available mortgages.
First it might help to see just a sampling of the options available with most mortgages.
- Fixed vs Adjustable Mortgage
- 30 yr vs 20 yr vs 15 yr 10 yr Mortgage
- Interest only Mortgage
- Convertible Mortgage
- Reverse Mortgage
- Balloon Mortgage
Adjustable Rate Mortgage or ARM
Adjustable rate mortgages are can be attractive, because the adjustable rate mortgage may be half a point (.5%) lower than the fixed rate mortgage. Many feel that you can buy more house for your money. It also may seem easier to buy your first home with a slightly lower rate.
The general rule of thumb here is, when interest rates are already high, an adjustable rate mortgage may be good, since rates will hopefully go down in the near future. You can get into a house now with the hopes of refinancing in a couple of years. Now be careful. In order to refinance, you actually pay off the loan. Some banks have a significant early payment penalty fee for Adjustable Rate Mortgages. Read the fine print carefully to find the one that meets your needs. We think it’s possible to find a bank or credit union that offers a mortgage with little or no pre-payment or early payment penalties.
Jumping on a adjustable rate mortgage when rates are already really low, can be very attractive due to the low rate, but rememberâ€¦ the rates are likely to go one way.. up. Now, that being said, ARMs tend to have a maximum payment or cap, although don’t expect it to be comfortable. Some people’s monthly payments can easily double with high interest rates.
When rates are dropping and expected to drop even further, then an adjustable rate mortgage may be a good option, but only if you have the option to convert the loan easily to a fixed rate loan. Such loan conversion plans usually have a fee associated with the conversion, and you can usually only convert the loan once. After that, you would have to refinance your loan in order to get a different rate. Keep in mind that refinancing your home can be costly. It usually costs thousands of dollars in origination fees and closing costs.
If you donâ€™t plan on being in a house for very long, then an adjustable rate mortgage can also work for you, but the fixed rate may be just as good an option for you.
Fixed Rate Mortgage
When rates are low, go for a fixed rate mortgage loan. If you can lock in a low rate on your mortgage, you donâ€™t have to sweat it each time there is an upward shift in the interest rate. The nicest thing about a fixed rate mortgage is that there are really no surprises. Your payment will be the same every month for the life of the mortgage loan.
Itâ€™s much easier to set a budget and stick to it, when you know your mortgage rate will not go up and upâ€¦ and up.
So, how long of a mortgage loan should you get? Well, that depends on what you want to do with it. General rule of thumb. The longer the loan, the higher the interest payment, but your monthly payments will be lower, because they’re spread out across more years. You will, also pay a lot more for the loan in interest if you spread it across more years. A whole lot more.
A good strategy is to get the longer term mortgage, say 30 years. Then make double payments, one for the payment and one to pay down the principle. You’ll pay off the mortgage in half the time, therefore paying less interest, and you have the flexibility to make just the regular payment any given month in case money is a little tight. If you go for the shorter term mortgage loan, you don’t have that option. Just shop around and make sure you don’t have prepayment penalties with you mortgage.
The Interest Only Mortgage is a loan where you never pay down the principle of the loan. It allows for lower monthly mortgage payments.
In our opinion, this mortgage is very taboo and can be extremely dangerous if you are not the right person for the mortgage. This is NOT a mortgage for people who have limited funds and are just trying to get into a house quickly. Don’t fall for the trap of saying, “I’ll earn more soon.” If you can’t afford the house today, don’t do it. The only people who should consider this Interest Only loan are ones that will have the house for only a very short period of time. A good example might be someone who is planning to flip the house after a short period of time. Again, this mortgage is not for the inexperienced. Many people who have tried this loan as an easy way to get into a home, ended up in serious financial trouble and foreclosure.
A convertible mortgage or hybrid mortgage is a mortgage that starts off as a variable rate mortgage with the option to change it to a fixed rate mortgage a few years down the line. It can also convert the other way around. Many of these mortgage automatically convert after a set period of time, while other allow the buyer to choose when to convert it to a fixed rate loan, usually with a fee. The convertible mortgage is a very common option for many people and can allow flexibility. Once you convert from an ARM to a Fixed Rate mortgage, or from a Fixed Rate mortgage to an Adjustable Rate mortgage, however, you usually cannot go back.
A balloon mortgage is calculated in interest much like an adjustable rate mortgage. The big difference is that after a set number of years into the loan, say 7 or 10, you have to pay the remainder of the loan. So, basically you have either have to sell the house before the balloon payment is due, refinance the balloon amount or come up with the remainder of the cost of the home and pay it off. These loans can be very dangerous. They are attractive, because they can allow you to get in at a lower monthly payment, but very few people ever have the money on hand at the end of the period to pay off the loan. If you can’t come up with the money, sell the house, or get a new refinance the balloon amount, then you’re looking at foreclosure.
A reverse mortgage lets you basically sell off your equity in the home you either own entirely or at least have some equity. The reverse mortgage is marketed as a way to provide income for the cash strapped retiree who just can’t make ends meet. Retirement money just is providing the life the retiree wants. Here’s a mortgage that has a really bad reputation, and with just cause. It’s seen as preying on the elderly. While it can be beneficial to someone who has no other choice, banks and other companies play it off like it will make their lives so much better. If you have no family or dislike your family that much, then a reverse mortgage might work for you. If you want your family to keep the house, etc, then steer clear.
Origination Fees and Closing Costs
No matter the mortgage, they are going to be some fees involved with the mortgage origination process and some closing costs. This is where each bank, credit union, or mortgage lending institution differs dramatically. Some banks will offer no closing costs, although sometimes that is just rolled into the overall amount of your mortgage loan. See if you can get the seller to cover the closing costs, as part of the bargaining process. Only do this after you have agreed on a price, otherwise they won’t go down as far. If they’re eager to sell, you may get just what you want. Typical closing costs can run anywhere from $1200 to $10,000 or more, depending an many factors, including the cost of the home. Some banks and mortgage institutions tack on fees with terribly high mark up. Just shop around, and you can find a pretty good deal. Let’s say the home you’re purchasing is $200.000. $3500 is not an unreasonable amount to pay for a closing, but you might be able to find lower. Whereas $10,000 is just too high.
Points or Discount Points
Perhaps one of the more confusing aspects of any mortgage rate calculation are the points. What exactly are points? How do they work? Essentially, you pay money up front to get a lower interest rate. Buying points will add to your closing cost but keep your rate lower. Let’s say the rate is 7%, but you want the loan at 6%, you would have to buy discount points to lower the rate, so your monthly payments would be lower. How much do discount points cost? That depends on the value of the mortgage loan. Each point costs 1% of the total loan amount. Normally, each point you buy lowers your rate by 1/8%. So if you wanted to lower your rate from 7% to 6%, you would have to buy 8 points. If your loan is $200,000, buying 8 points would cost you $16,000. You need to calculate how long it would take you to pay off the 1% savings you bought. If buying the points drops your monthly mortgage payment by $200, then it would take over 6.5 years to break even. Pretty expensive proposition just to keep the rate down 1%. Is it worth it? Probably not in this case. Although most people would never buy down a whole percentage point, this example helps you see how points work.
Word of Caution
Prepayment penalties, exit fees, administration fees. These are all things you can face in a mortgage loan if you do not read the fine print. Banks offer mortgage loans, and they love to make money from these loans. Hey, you can’t blame them; it’s their business model. That doesn’t mean you can’t shop around. Banks are also competing to get your business. You will always benefit from their competition. So, when you are shopping for a new mortgage or looking to refinance your mortgage, look out for the prepayment penalties, exit fees, or the administration fees.
- Prepayment penalties
Fees that you are charged if you choose to pay extra on your mortgage before it due. Many people want to make extra payments to pay down the principle faster and therefore pay less interest over the life of the loan.
- Exit fees
These fees are charged if you refinance or sell your home earlier than the bank wants. In other words, they’ve calculated the amount of time they need to hold your mortgage in order to make money off it. If you leave early, they’re out that money. That’s why they may charge exit fees.
- Administration fees
What the bank is telling you it costs to manage your mortgage each month or year. We think these fees are rather superfluous. It really doesn’t cost them much of anything to manage that mortgage each year, and what it does cost is easily made up by the interest they collect. Shop around, and you’ll find a bank or credit union that does not charge these fees.
What is sub-prime, and why did it cause so many problems?
Ok, you know how we’ve seen so many homes foreclosed in 2007 and 2008? This is a result of sub-prime lending. Many banks, mortgage companies and some credit unions got the idea that they could sell many more mortgages if they just lowered the standards for approving mortgage loans. In other words, a lower credit score or lower income could now get you into a mortgage loan, when you couldn’t get one just months earlier. Banks, mortgage companies and some credit unions saw big dollar signs by that amount of new mortgages they could sell, and they felt the cost of the higher risk was worth the new earnings they would make…. They were wrong.
So why was this a problem? Well, there were 2 main issues. 1) A low credit score means you have trouble managing your finances or don’t have the money to cover your expenses. 2) You were allowed to buy more home than you could afford. Now we see banks, mortgage companies and credit unions becoming overly strict to make up for the loses.
Now we’re seeing a record number of foreclosures. Banks and mortgage companies are selling off bad debt or closing up shop. Now it’s harder to get a mortgage than ever before… at least with the companies that have been burned by their mistakes.