Read an Excerpt
Selecting a Mortgage
In This Chapter
- The difference between fixed-rate and adjustable-rate mortgages
- Hybrid loans, balloon loans, and negative amortization (Oh, my!)
- Choosing the loan that's perfect for you
- A look at points, caps, and other mortgage mumbo-jumbo
- Finding a lender (or finding someone to find a lender for you)
"A bank is a place that will lend you money if you can prove that you don't need it." -Bob Hope
If you were Oprah Winfrey or Bill Gates, you could skip Chapters 5 and 6, which explain everything that you need to know about mortgages. If you have enough money to pay cash for your home, you can happily thumb your nose at bankers and other mortgage lenders. If you can afford to pay cash for your home, who needs them?!
As for the rest us, we need to take out a mortgage to buy a home for the simple reason that doing so is the only way we can afford a home that meets our needs. This chapter helps all non-wealthy folk to comprehend mortgages and then choose one. (If you are wealthy and have a great deal of money to put into a property, this part of the book can also help you to decide how much of your loot to put into your home purchase.)
Start with the basics. What is a mortgage? A mortgage is nothing more than a loan that you obtain to close the gap between the cash you have for a down payment and the purchase price of the home that you're buying. Homes in your area may cost $70,000, $170,000, or $370,000. No matter -- most people don't have that kind of spare cash in their piggy banks.
Mortgages typically require monthly payments to repay your debt. The mortgage payments are comprised of interest, which is what the lender charges for use of the money you borrowed, and principal, which is repayment of the original amount borrowed.
Learning how to select a mortgage to meet your needs ensures that you'll be a happy homeowner for years to come. You also need to understand how to get a good deal when shopping around for a mortgage because your mortgage is typically the biggest monthly expense of homeownership (and perhaps of your entire household budget). Paying more for interest on your mortgage than you pay for your humble abode itself is not unusual.
Suppose that you borrow $144,000 (and contribute $36,000 from your savings as the down payment) for the purchase of your $180,000 dream palace. If you borrow that $144,000 with a 30-year, fixed-rate mortgage at 7 percent, you end up paying a whopping $200,892 in interest charges alone over the life of your loan. That $200,892 is not only a great deal of interest -- it's also more than the purchase price of the home or the loan amount you originally borrowed!
So that you don't spend any more than you need to on your mortgage, and so that you get the mortgage that best meets your needs, the time has come to get on with the task of understanding the mortgage options out there.
Fixed or Adjustable? That Is the Interest(ing) Question
You may remember the skit from Saturday Night Live where Dan Aykroyd and John Belushi worked in a restaurant that served only cheeseburgers, chips, and Pepsi. Customers who tried to order a hamburger, fries, and Coke were out of luck. No hamburgers, just cheeseburgers; no fries, just chips; and no Coke, just Pepsi. At that restaurant, your choices were already made. If only you were so lucky with mortgages.
Like some other financial and investment products, tons of different mortgage options are available for your choosing. The variations can be significant or trivial, expensive or less-costly.
You will note throughout this chapter that two fundamentally different types of mortgages exist. Mortgages differ in terms of how their interest rate is determined. The two types of mortgages are fixed-rate mortgages and adjustable-rate mortgages.
Distinguishing fixed from adjustable mortgages
Before adjustable-rate mortgages came into being, only fixed-rate mortgages existed. Usually issued for 15- or 30-year periods, fixed-rate mortgages (as the name suggests) have interest rates that are fixed (unchanging) during the entire life of the loan.
With a fixed-rate mortgage, the interest rate stays the same and your monthly mortgage payment amount does not change. No surprises, no uncertainty, and no anxiety for you over interest-rate changes and changes in your monthly payment. Your mortgage interest rate and monthly payment remain locked for the life of the loan. If you like the predictability of your favorite television show airing at the same time daily, you'll probably like fixed-rate mortgages.
On the other hand, adjustable-rate mortgages (ARMs for short) have an interest rate that varies (or adjusts). The interest rate on an ARM typically adjusts every six to twelve months, but it may change as frequently as every month.
As we discuss later in this chapter, the interest rate on an ARM is primarily determined by what's happening overall to interest rates. If interest rates are generally on the rise, odds are that your ARM will experience increasing rates, thus increasing the size of your mortgage payment. Conversely, when interest rates fall, ARM interest rates and payments generally fall.
If you like change -- you enjoy trying different foods and getting up at a different time each day -- you may think that adjustable-rate mortgages sound good. Change is what makes life interesting, you say. Please read on, because, even if you believe that variety is the spice of life, you may not like the financial variety and spice of adjustables!
Looking at hybrid loans
If only the world were so simple that only pure fixed-rate and pure adjustable-rate loans were available. But one of the rewards of living in a capitalistic society is that you often have no shortage of choices. Enter hybrid loans (or what lenders sometimes call intermediate ARMs). Such loans start out like a fixed-rate loan -- the initial rate may be fixed for 3, 5, 7, or even 10 years -- and then the loan converts into an ARM, usually adjusting every 6 to 12 months thereafter.
In case you care (and you may not), loans called 7/23s (which are fixed for the first seven years and then have a one-time adjustment and remain at a fixed rate for the remaining length of the loan term) are also available. We discuss the pros and cons of these loans in the next section.
Making the fixed-rate/adjustable-rate decision
So how do you choose whether to take a fixed-rate or an adjustable-rate loan? Is it as simple as a personality test?
As with many things in life that give you choices, tradeoffs and pro and cons apply to each option. In this section, we talk you through the pros-and-cons of your mortgage options; but as we do, please keep one very important fact in mind: In the final analysis, which mortgage is best for you very much hinges upon your personal and financial situation. You are the one who is best- positioned to make the call as to whether a fixed or an adjustable loan better matches your situation and desires.
One type of mortgage, known as a balloon loan, appears at first blush to be somewhat like a hybrid loan. The interest rate is fixed, for example, to five, seven, or ten years. However, and this is a big however, at the end of this time period, the entire loan balance becomes due. In other words, you must pay off the entire loan.
Borrowers are attracted to balloon loans for the same reason that they are attracted to hybrid or ARM loans -- because balloon loans start at a lower interest rate than do fixed-rate mortgages. Buyers are sometimes seduced into such loans during high-interest-rate periods or when they can't qualify for or afford the payments of a traditional mortgage.
We don't like balloon loans because they can blow up in your face. You may become trapped without a mortgage if you are unable to refinance (obtain a new mortgage to replace the old loan) when the balloon comes due. You may have problems refinancing if, for example, you lose your job, your income drops, the value of your property declines and the appraisal comes in too low to qualify you for a new loan, or interest rates increase and you can't qualify for a new loan at those higher rates.
In the real estate trade, balloon loans are also called bullet loans. Why? If the loan comes due during a period of high mortgage rates, industry people say that it's like getting a bullet in the heart.
Remember that refinancing a mortgage is never a sure thing. Taking a balloon loan may be a financially hazardous short-term solution to your long-term financing needs.
The one circumstance under which we say that it's okay to consider a balloon loan is if you absolutely must have a particular property and the balloon loan is your one and only mortgage option. If that's the case, you should also be as certain as you can be that you'll be able to refinance when the balloon comes due. If you have family members that could step in to help with the refinancing, either by cosigning or by loaning you the money themselves, that's a big back-up plus. Oh, and if you must take out a balloon loan, get as long a term as possible, ideally for no less than seven years (and preferably for ten years).
It stands to reason that, because the interest rate does not vary with a fixed-rate mortgage, the advantage of a fixed-rate mortgage is that you always know what your monthly payment is going to be. Thus, budgeting and planning the rest of your personal finances is easier.
That's the good news. The bad news is that you will pay a premium, in the form of a higher interest rate, to get a lender to commit to lending you money over many years at a fixed rate. The longer the mortgage lender agrees to accept a fixed interest rate, the more risk that lender is taking. A lender who agrees to loan you money, for example, over 30 years at 8 percent will be hurtin' if interest rates skyrocket (as they did in the early 1980s) to the 15+ percent level. (With the rise of interest rates and inflation at that time, mortgage lenders were paying depositors interest rates that were almost double the levels of the interest that they were charging for mortgages that had commenced a decade before. Not a very profitable way to run a bank!)
In addition to paying a premium interest rate when you take the loan out, another potential drawback to fixed-rate loans is that, if interest rates fall significantly after you have your mortgage, you face the risk of being stranded with your costly mortgage. That could happen if (due to a deterioration in your financial situation or a decline in the value of your property) you don't qualify to refinance (get a new loan to replace the old). Even if you do qualify to refinance, doing so takes time and usually costs money for a new appraisal, loan fees, and title insurance.
Here are a couple of other possible minor drawbacks to be aware of with some fixed-rate mortgages:
- If you sell your house before paying off your fixed-rate mortgage, your buyers probably won't be able to assume that mortgage.
- Fixed-rate mortgages sometimes have prepayment penalties (explained in the nearby sidebar). The ability to pass your loan on to the next buyer (in real estate talk, the next buyer assumes your loan) can be useful if you're forced to sell during a rare period of ultra-high interest rates, such as occurred in the early 1980s. Selling during such a time could reduce the pool of potential buyers for your home if, in order to avoid a prepayment penalty, you don't allow an otherwise-qualified buyer who is having trouble obtaining an affordable loan to assume your mortgage.
Fixed-rate mortgages aren't your only option. Mortgage lenders were intelligent enough to realize that they couldn't foresee interest rates, and thus were born adjustable-rate mortgages (adjustables for short).
Although some adjustables are more volatile than others, all are similar in that they fluctuate (or float) with the market level of interest rates. If the interest rate fluctuates, then so does your monthly payment. And therein lies the risk: Because a mortgage payment is likely to be a big monthly expense for you, an adjustable-rate mortgage that is adjusting upwards may wreak havoc with your budget.
Given all the trials, tribulations, and challenges of life as we know it, you may rightfully ask, "Why would anyone choose to accept an adjustable-rate mortgage?" Well, people who are stretching themselves -- such as some first-time buyers or those trading up to a more expensive home -- may financially force themselves into accepting adjustable-rate mortgages. Because an ARM starts out at a lower interest rate, such a mortgage enables you to qualify to borrow more. As we discuss in Chapter 2, just because you can qualify to borrow more doesn't mean that you can afford to borrow that much, given your other financial goals and needs.
Avoid loans with prepayment penalties
Some mortgages come with a provision that penalizes you for paying off the loan balance faster. Such penalties can amount to as much as several percentage points of the amount of the mortgage balance that is paid off early.
Some lenders won't enforce their loan's prepayment penalties when you pay off a mortgage early because you sold the property or because you want to refinance the loan to take advantage of lower interest rates as long as they get to make the new mortgage. Even so, your hands are tied financially unless you go through the same lender.
Many states place limits on the duration and amount of prepayment penalty lenders may charge for mortgages made on owner-occupied residential property. The only way to know whether a loan has a prepayment penalty is to ask and to carefully review the federal truth-in-lending disclosure and the promissory note the mortgage lender provides you with. We think that you should avoid such loans. (Many so-called no points loans have prepayment penalties.)
Other homebuyers who can qualify for both an adjustable-rate and fixed-rate mortgage of the same size have a choice, and some choose the fluctuating adjustable. Why? Because they may very well save themselves money, in the form of smaller total interest charges, with an adjustable-rate loan instead of a fixed-rate loan.
Because you accept the risk of a possible increase in interest rates, mortgage lenders cut you a little slack. The initial interest rate (also sometimes referred to as the teaser rate) on an adjustable should be less than the initial interest rate on a comparable fixed-rate loan. In fact, an ARM's interest rate for the first year or two of the loan is generally lower than a fixed-rate mortgage.
Another advantage of an ARM is that, if you purchase your home during a time of high interest rates, you can start paying your mortgage with the artificially depressed initial interest rate. If interest rates then decline, you can capture the benefits of lower rates without refinancing.
Another situation when adjustable-rate loans have an advantage over their fixed-rate brethren is when interest rates decline and you don't qualify to refinance your mortgage to reap the advantage of lower rates. The good news for homeowners who are unable to refinance and who have an ARM is that they probably already capture many of the benefits of the lower rates. With a fixed-rate loan, you must refinance in order to realize the benefits of a decline in interest rates.
When to consider hybrid loans
If you want more stability in your monthly payments than comes with a regular adjustable, and you expect to keep your loan for no more than from five to ten years, a hybrid (or intermediate ARM) loan, which is explained earlier in this chapter, may be the best loan for you.
The longer the initial rate stays locked in, the higher it will be, but the initial rate of a hybrid ARM is almost always lower than the interest rate on a 30-year, fixed-rate mortgage. However, because the initial rate of hybrid loans is locked in for a longer period of time than the six-month or one-year term of regular ARMs, hybrid ARMs have higher initial interest rates than regular ARM loans.
During periods, such as in 1995 and 1996, when little difference existed between short-term and long-term interest rates, the interest-rate savings in the early years with a hybrid or regular adjustable (versus a fixed-rate loan) were minimal (less than 1 percent). In fact, during certain times, the initial interest rate on a seven- or ten-year hybrid was exactly the same as on a 30-year, fixed-rate loan. During such periods, fixed-rate loans offer the best overall value.
To evaluate hybrids, weigh the likelihood that you'll move before the initial loan interest rate expires. For example, with a seven-year hybrid, if you're saving, say, 0.5 percent per year versus the 30-year, fixed-rate mortgage, but you're quite sure that you will move within seven years, the hybrid will probably save you money. On the other hand, if you think that there's a reasonable chance that you'll stay put for more than seven years, and you don't want to face the risk of rising payments after seven years, you should opt for a 30-year, fixed-rate mortgage instead.
The downside to an adjustable-rate loan is that, if interest rates in general rise, your loan's interest and monthly payment will likely rise, too. During most time periods, if rates rise more than 1 or 2 percent and stay elevated, the adjustable-rate loan is likely to cost you more than a fixed-rate loan.
Before you make the final decision between a fixed-rate mortgage versus an adjustable-rate mortgage, read the following two sections.
What would rising interest rates do to your finances?
Far too many homebuyers, especially first-timers, take out an adjustable-rate mortgage because doing so allows them to stretch and borrow more and buy a more expensive home. Although some of this overborrowing is caused by the modern-day American spendthrift "I gotta have it today" attitude, overborrowing is also encouraged by some real estate and mortgage salespeople. After all, these salespeople's income, in the form of a commission, is a function of the cost of the home that you buy and the size of the mortgage that you take on.
Short-term versus long-term interest rates
When choosing between an adjustable-rate mortgage and a fixed-rate mortgage, many people don't realize that they are making a choice between a mortgage on which the interest rate is determined by either short-term or long-term interest rates.
"What's a short-term versus a long-term interest rate?" you say. Glad you asked. When a mortgage lender quotes an interest rate for a particular type of loan, he should specify (in terms of how many years until the loan is completely paid off) the length of the loan.
Most of the time, borrowers must pay a higher interest rate to borrow money for a longer period of time. Conversely, borrowers generally pay a lower rate of interest for shorter-term loans. So?
Well, the interest rates that are used to determine most adjustable-rate mortgages are short-term interest rates; whereas fixed-rate mortgage interest rates are dictated by long-term interest rates. During most time periods, longer-term interest rates are higher than shorter-term rates because of the greater risk the lender accepts in committing to a longer-term rate.
It stands to reason, then, when little difference exists in the market level of short-term and long-term interest rates (such as occurred during 1995), that the rates of fixed-rate mortgages shouldn't be all that different from the rates of adjustable-rate mortgages. Thus, adjustables appear less attractive, and fixed-rate mortgages appear more alluring.
On the other hand, when short-term interest rates are significantly lower than long-term interest rates (such as during the early 1990s), adjustable-rate mortgages should be available at rates a good deal lower than the rates for fixed-rate loans. All things being equal, adjustables appear more attractive during such time periods and save you more money during the early years of your loan.
If you haven't already done so, let your fingers do the walking back to Chapters 2 and 3. Read and digest these chapters in order to understand how much you can really afford to spend on a home, given your other financial needs, commitments, and goals.
If you're at all considering an ARM, you absolutely, positively must understand what rising interest rates (and, therefore, a rising monthly mortgage payment) would do to your personal finances. Only consider taking an ARM if you can answer all of the following questions in the affirmative:
- Is your monthly budget such that you can afford higher mortgage payments and still accomplish other financial goals that are important to you, such as saving for retirement?
- Do you have an emergency reserve (equal to at least six-months' living expenses) that you can tap in order to make the potentially higher monthly mortgage payments?
- Can you afford the highest payment allowed on the adjustable-rate mortgage?
The mortgage lender can tell you the highest possible monthly payment, which is the payment that you would owe if the interest rate on your ARM went to the lifetime interest-rate cap allowed on the loan.
- If you are stretching to borrow near the maximum the lender allows or an amount that will test the limits of your budget, are your job and income stable?
If you expect to be having children in the future, consider now the fact that your household expenses will rise and your income may fall with the arrival of those little bundles of joy.
- Can you handle the psychological stress of changing interest rates and mortgage payments?
If you are fiscally positioned to take on the financial risks inherent to an adjustable-rate mortgage, by all means consider taking one -- we're not trying to talk you into a fixed-rate loan. The odds are with you to save money, in the form of lower interest charges and payments, with an ARM. Your interest rate starts lower (and stays lower, if the overall level of interest rates doesn't change). Even if rates do go up, as they are sometimes prone to do, they will surely come back down. So, if you can stick with your ARM through times of high and low interest rates, you should still come out ahead.
Also recognize that, although ARMs do carry the risk of a fluctuating interest rate, almost all adjustable-rate loans limit, or cap, the rise in the interest rate allowed on your loan. We certainly wouldn't allow you take an ARM without caps. Typical caps are 2 percent per year and 6 percent over the life of the loan. (We cover ARM interest rate caps in detail later in this chapter.)
Consider an adjustable-rate mortgage only if you're financially and emotionally secure enough to handle the maximum possible payments over an extended period of time. ARMs work best for borrowers who take out smaller loans than they are qualified for or who are consistently saving more than 10 percent of their monthly income. If you do choose an ARM, make sure that you have a significant cash cushion that is accessible in the event that rates go up. Don't take an adjustable just because the initially lower interest rate allows you to afford a more expensive home. Better to buy a home that you can afford with a fixed-rate mortgage. (And don't forget hybrid loans if you want a loan with more payment stability but aren't willing to pay the premium of a long-term, fixed-rate loan.)
You can't (nor can the experts) predict where interest rates are headed
All the logicians out there are probably commenting that the choice between an adjustable-rate mortgage and a fixed-rate mortgage is simple. All you need to know in order to make a decision is the direction of interest rates. It's only logical. If interest rates look set to rise, a fixed-rate mortgage would be favorable. Lock in a low rate and smile smugly when interest rates skyrocket.
Conversely, if you thought that rates were going to stay the same or drop, you would want an ARM. Some real estate books that we've read even go so far as to say that your own personal interest-rate forecast should determine whether to take an ARM or fixed-rate mortgage! "Interest-rate forecasts should be the major factor in deciding whether or not to get an ARM," argues one such book.
Now we don't think that you're stupid, but you are not going to figure out which way rates are headed. The movement of interest rates is not logical, and you certainly can't predict it. If you could, you would make a fortune investing in bonds, interest-rate futures, and options.
Even the money-management pros who work with interest rates and bonds as a full-time job can't consistently predict interest rates. Witness the fact that bond-fund managers at mutual fund companies have a tough time beating the buy-and-hold bond-market indexes. If bond-fund managers could foresee where rates were headed, they could easily beat the averages by trading into and out of bonds when they foresaw interest-rate changes on the horizon.
How long do you expect to stay in the home/mortgage?
If you don't plan or expect to stay in your home for a long time, you should consider an ARM. Saving money on interest charges for most adjustables is usually guaranteed in the first two to three years, because an ARM starts at a lower interest rate than a fixed-rate loan does.
Should interest rates rise, however, you can end up paying more interest in subsequent years with the adjustable-rate loan. If you're reasonably certain that you'll hold onto your home for fewer than five years, you should come out ahead with an adjustable.
As we explain earlier in this chapter, a mortgage lender takes more risk when lending money at a fixed rate of interest for many (15 to 30) years. Lenders charge you a premium, in the form of a higher interest rate than what the ARM starts at, for the interest-rate risk that they assume with a fixed-rate loan.
If you expect to hold onto your home and mortgage for a long time -- more than five to seven years -- a fixed-rate loan may make more sense, especially if you're not in a position to withstand the fluctuating monthly payments that come with an ARM. If you don't plan on keeping your home and mortgage for more than five years, an ARM likely will save you money. However, you should also ask yourself why you're going to all the trouble and great expense of buying a home that you expect to sell so soon. If you're in the intermediate area (expecting to stay seven to ten years, for example), consider the hybrid loans we discuss earlier in this chapter.
If you're still stuck on the fence, go with the fixed-rate loan. A fixed-rate loan is financially safer and easier to shop for than an ARM.
Choosing between a 15-year and a 30-year mortgage
After you've decided which type of mortgage -- fixed or adjustable -- you want, you may think that your mortgage quandaries are behind you. Unfortunately, they're not. You also need to make another important choice -- typically between a 15-year and a 30-year mortgage. (Not all mortgages come in just 15- and 30-year varieties. You may run across some 20- and 40-year versions, but that won't change the issues we're about to tackle.)
If you're stretching to buy the home that you want, the choice of how long-term your mortgage will be may very well not be yours to make. You may be forced (we should say forcing yourself, because you choose what home to buy) to take the longer-term, 30-year mortgage. Doing so isn't necessarily bad and, in fact, has advantages.
The main advantage that a 30-year mortgage has over its 15-year peer is that it has lower monthly payments that free up more of your monthly income for other purposes, such as saving for other important financial goals (such as retirement). You may want to have more money so that you aren't a financial prisoner to your home and can just have a life! A 30-year mortgage has lower monthly payments because you have a longer time period to repay it (which translates into more payments). A fixed-rate 30-year mortgage with an interest rate of 7 percent, for example, has payments that are approximately 25 percent lower than those on a comparable 15-year mortgage.
What if you can afford the higher payments that a 15-year mortgage requires? Should you take it? Not necessarily. What if, instead of making large payments on the 15-year mortgage, you make smaller payments on a 30-year mortgage and put that extra money to productive use?
If you do, indeed, make productive use of that extra money, then the 30-year mortgage may be for you. A terrific potential use for that extra dough is to contribute it to a tax-deductible retirement account that you have access to. Contributions that you add to employer-based 401(k) and 403(b) plans (and self-employed SEP-IRAs or Keoghs) not only give you an immediate reduction in taxes but also enable your money to compound, tax-deferred, over the years ahead. Everyone with employment income may also contribute to an Individual Retirement Account (IRA). Your IRA contributions may not be immediately tax-deductible if your (or your spouse's) employer offers a retirement account or pension plan.
If you have exhausted your options for contributing to all the retirement accounts that you can, and if you find it challenging to save money anyway, the 15-year mortgage may offer you a good forced-savings program.
If you elect to take a 30-year mortgage, you retain the flexibility to pay it off faster if you so choose. (Just be sure to avoid those mortgages that have a prepayment penalty.) Constraining yourself with the 15-year mortgage's higher monthly payments does carry a risk. If you fall on tough financial times, you may not be able to meet the required mortgage payments.
Selecting a Fine Fixed-Rate Mortgage
If you decide, based upon our advice and selection criteria, to go with a fixed-rate loan, great! You shouldn't be disappointed. You'll have the peace of mind that comes with stable mortgage payments. And because fixed-rate loans have fewer options, they are a good deal easier to compare than adjustable-rate loans.
However, we don't want to give you the false impression that fixed-rate loans are as simple to shop for as carbonated beverages. Unfortunately, because of the hundreds of lenders in your local area who likely offer such loans and the seemingly never-ending, nit-picky, extra fees and expenses that lenders tack onto loans, you will need to put on your smart-consumer hat and sharpen your No. 2 pencil.
Be sure that you understand the following sections before you attempt to choose the best fixed-rate loan to meet your needs.
(this chapter has been abridged)