How To Choose The Right Mortgage
Purchasing a home is one of the biggest and most important decisions you will make in your financial life. I have personally witnessed many families who purchased homes in the years leading up to the 2008 financial crises and ended up making all the wrong decisions and losing their homes and their financial well-being. Despite their experiences, though, purchasing a home can be one of the best financial decisions you can make compared to a lifetime of paying rent. Making the right choices in the type of mortgage you take on can go a long way to ensuring your financial future.
The main components of a mortgage
A mortgage has three main components that you need to consider, all of which add up to your making the right or wrong decision.
The size of the loan is, of course, based on the size of home you are purchasing and is based on how much you can afford in monthly payments. But, the size of the loan is also a function of how much down payment you make, and as we will see later in this article, affects other decisions that need to be made.
Mortgages today mainly come in two varieties, or terms – 15-year and 30-year. As a rule, I recommend getting a 30-year, but a 15-year term can give you a lower interested rate and is great for buyers who are sure they can afford the higher payment associated with a shorter payment period and really want to pay off the loan more quickly.
The rates is what most people focus on and are shopping around for. A lower interest rate means a lower monthly payment and the ability to purchase a larger home compared to higher rates.
Fixed or adjustable rates
The interest rate portion of the mortgage can either be an adjustable rate or a fixed rate, and the difference is straight forward. A fixed rate mortgage offers a single interest rate that will never change, therefore, your monthly payments will never change.
An adjustable rate mortgage typically offers a fixed initial rate for a preset period, anywhere from 1 month to 5 years. After the initial period, the rate, and your monthly payment, will change based on a preset measure. Banks typically base future changes in interest rate on rate indexes such as LIBOR (London Interbank Offered Rate). If LIBOR changes, your rate will change.
Other expenses associated with a mortgage
Once you decide on a mortgage size, term and negotiate a rate, understand that, as a buyer, there are other expenses that you will need to cover. Some of these expenses you will need to pay up front, others can be added to your monthly payment
The down payment
Typically, the largest up-front expense, most mortgages will not allow you to finance 100% of the purchase price of the property. Therefore, you will need to come up with a significant amount of money to make a down payment. Many mortgages allow as little as a 5% down payment; on a $500,000 purchase price, that is $25,000 up front. I recommend a 20% down payment which will be $100,000 up front on that same $500,000 home.
Private mortgage insurance (PMI)
Purchasing a home with only 5% or 10% down may sound like a good idea, but you will need to pay an extra monthly expense called PMI or Private Mortgage Insurance. If you make a 20% or more down payment, there is no PMI. The amount of your PMI is based on the total mortgage amount, the term and interest rate, as well as your credit score. On a recent quote I received on a $500,000 purchase with 10% down payment ($450,000 mortgage) at 4%, the principal and interest payment was $2,100 a month and the PMI was $220. That is over 10% increase in your monthly payment. You may be able to request that your PMI be terminated once your loan to value ratio drops below 80% – so be sure to check before you sign paperwork.
Most buyers are surprised by the fact that they need to cover tons of small closing costs or fees before completion of their purchase. The first fee is typically loan points which can be added to the loan balance and is used to cover compensation for loan offers and other loan origination personnel. Points are generally a percentage of the loan value. For a $450,000 mortgage, 1 point would equal $4,500 in extra fees. Most mortgage companies will also require an additional appraisal fee of between $500 to $,1000 to appraise the value of the home. Application fees, title insurance fees, recording and transfer fees may also be added to the up-front costs. Keep in mind, these fees are generally negotiable, so if a bank really wants your business, they may be willing to lower or completely drop some or all fees.
So which mortgage is right for me?
Like so many things in finance, the right decision is based on your specific situation.
The Right Mortgage Term - 30-Year Makes More Sense
A 15-year mortgage will be paid off in half the time of a 30-year mortgage. Additionally, the interest rate on a 15 is typically lower. I recommend, though, a 30-year mortgage because the monthly payments are lower. A 15-year forces you into making higher monthly payments since the mortgage is amortized of half the time. A higher monthly payment makes it more difficult for you to weather tough financial times. If you really want to pay off your mortgage faster than 30 years, take the 30 years mortgage anyway, and simply over pay each monthly payment.
Here’s an example. At the time of this writing, 30-year mortgage rates are at 4.25% and 15 years mortgages are at 3.75%. A $250,000 mortgage yields a monthly principal and interest payment of $1,230 per month over 30 years, or $1,818 per month for 15 years, a difference of $588 a month. If you choose the 15-year mortgage, you will be committing yourself to higher monthly payments, making it more difficult to overcome temporary financial hardships. Take the 30-year option and you can choose to overpay each month by the $588 per month difference, you will end up paying off the mortgage in 15 years and 9 months. So, for 9 months of extra payments, you are given the flexibility of making lower monthly payments.
The most important aspect to deciding between the fixed or the variable is in looking at the total payments to the bank over the course of the mortgage. The 30-year mortgage will end up paying the bank $442,746. The 15-year mortgage will end up paying the bank $327,250. So, it seems the 15-year is a better deal. But the present value of those payments, discounted by the mortgage rate itself, is $247,628 for the 30-year and $246,862 for the 15-year – virtually no difference. I would give the advantage to the 30-year mortgage. For a more detailed analysis of present value calculations in mortgages, click here to read my article comparing 15-year and 30-year options.
The Right Loan Amount - Put A 20% Down Payment
Always put a larger down payment rather than a smaller down payment. I have recommended to many clients over the years to not even think about purchasing a home unless they have a 20% down payment. In addition to the extra monthly payment imposed by PMI, it’s an issue of risk. If values come down and you need to sell, a larger down payment will give you a wide margin keeping you from going under water on your loan to value ratio. Think about it, if you purchase a $500,000 home with only 10% down payment, let’s say in Las Vegas, with a $450,000 loan balance, and real estate values decline by 20%, which they have in Las Vegas in the recent past, you are stuck with a $450,000 loan on a home worth only $400,000. I would only recommend smaller down payments for those sure they will not be selling the home for decades.
The Right Interest Rate - Fixed, Not Adjustable
At the time of this writing, 2018, mortgage interest rates are still at historic lows. In a low interest rate environment, you almost always want to lock in a fixed interest rate over a long period of time – interest rates are likely to rise during the term of your mortgage. Adjustable rate mortgages in the current environment only make sense for homes you intend to hold for a short period of time, say less than 5 years or less.