How can I get the best deal on a home? Where do I start? Part 3
As you zero in on a loan for your home you are going to have a number of choices. This post will discuss the good, bad and ugly aspects of the most common loan offerings.
Fully Amortized Fixed Rate Loans
The most conservative loans in the market are fully amortized, fixed interest rate option; you are going to know what your monthly payment is going to be for the entire term of the loan. There will be no surprises or hidden changes. You will also be paying down the principal each month, along with the interest. However, the monthly payments on these loans are usually higher and many people can not qualify for them. (This is one reason that so many borrowers opt for another type of loan.)
The standard loan terms in the industry are 15 years, 30 years, 40 years and 50 years. The shorter the term of the loan the higher the payment. Conversely, the longer the term of the loan the higher the amount of interest you are going to pay—MUCH HIGHER.
Let us take a loan amount of $ 250,000 at 6% interest as an example.
The principal and interest payment would be:
For a 15 year loan…………………………$ 2109.64
For a 30 year loan…………………………$ 1498.88
For a 40 year loan…………………………$ 1375.53
For a 50 year loan…………………………$ 1316.01
As you can see, there is little incentive to extend your loan term to fifty years.
The way the process works is that the early payments are applied mostly to interest, with very little going to the principal. As the loan term progresses the portion applied to interest declines and the portion applied to the principal increases. This has an impact on your annual tax deduction, since the interest portion is tax deductable. However, the lenders get their money early in the transaction in the form of that interest.
Fixed Rate Interest Only Loans
A loan option that many borrowers select is a fixed rate Interest Only product. In this provides a fixed rate for the term of the loan, usually thirty years with an initial period of interest only payments. At the end of the interest only period the loan recasts and you end up with a fully amortized loan for the remaining term of the loan.
The most common interest only periods are five or ten years. The interest only loan rates are higher than the fully amortized loans. So if we go back to our $ 250,000 loan again, at a 6.5% interest rate the payment will look something like this:
The initial interest only payment would be $ 1354.17, slightly lower than that of a fully amortized loan for the thirty year period. However, that $ 144.71 per month can be the difference between qualifying to buy the home or not.
If the interest only period is five years, when the loan recasts the payment increases to $ 1688.02. You have to repay the principal over the remaining 25 years of the loan period.
If the interest only period is ten years, when the loan recasts the payment increases to $ 1863.93. You have to repay the principal over the remaining 20 years of the loan period.
Interest only loans enable borrowers to qualify for loans when they can not afford the fully amortized loan option. The fixed rate eliminates any surprises. The borrower knows what is coming. Since the average buyer only stays in a home for five to six years, many plan to sell before the big adjustment. However, unless the market value of the home increases, they will have no equity in the property when they sell because their interest only payment has done nothing to reduce their loan principal.
This option works for many buyer/borrowers, especially if the value of the property appreciates during the interest only period. Some borrowers also consider an option of refinancing if interest rates decline or their financial picture improves during the interest only period.
Beware of the possibility that the property may not appreciate and the borrower’s financial picture can get worse. There is a potential for trouble down the road. Caveat Emptor–(Let the buyer beware.)
Adjustable Rate Mortgages
A third category of mortgage products is the ARM, or adjustable rate mortgage. This option enables a borrower to qualify for a loan at a fixed, reduced rate for the introductory period, one, two, three, five, seven or ten years, depending on the specific loan.
However, at the end of the fixed rate period, the mortgage becomes a fluctuating interest rate. The adjustments are tied to financial indices such as the Federal Cost of Funds Index or the LIBOR. Most adjust once a year after the initial fixed period, with caps on the amount that they can adjust each year and a maximum adjustment over the term of the loan.
Usually, the shorter the fixed period is, the lower the introductory interest rate. Depending on market condition these rates can be far below the fully amortized, fixed interest rate loans or they can be similar.
Adjustments can be increases in rate and payment or decreases. It is not prudent to expect decreases. The borrower knows what to expect when an increase is due unless they monitor the specific index very closely. Few have the interest or training to do so.
If we look at an example of a three year ARM with a fully amortized, introductory rate the payment would be 5.375%. Our $ 250,000 loan amount will result in a monthly payment of $ 1399.93, $ 98.95 less than the fully amortized, fixed rate, loan payment. However, at the end of the three year fixed term the interest rate can go up 2%, making the payment $ 1657.62 or less, depending on what happens to the governing index.
The more seductive three year interest only ARM with the same 5.375% interest rate would yield monthly payment of $ 1119.79. However, three years down the road the payment could be $ 1726.69, or lower, depending on the index.
As you can see, navigating this process is similar to sailing through a mine field. Find a loan consultant that you trust and ask a LOT of questions.
My next Blog with discuss some other, more risky, loan options. Stay tuned.
