Most people have been taught that personal debt is a bad thing.
And when it comes to buying depreciable assets this is almost always a good rule to follow; if you want a new car, new furniture, anything that rapidly loses value, then save your money and spend cash to buy these consumer items.
But, when it comes to buying a house, which is the most valuable asset most of us will ever own, and which is likely to appreciate over time, then borrowing money is almost a necessity.
Unless you are independently wealthy, have inherited a large sum of money or win the lottery, if you decide to purchase your own home, you’re going to need to borrow at least some portion of the purchase price!
So, once you decide to make that leap and become a homeowner, what is the best home mortgage for you?
Basic Questions to Answer When Looking for Home Loan
Fixed rate or adjustable rate, fifteen year or thirty year term, balloon mortgage or no interest mortgage? There are hundreds of home mortgage products available in today’s lending market!
So, with all these choices, how do you determine the mortgage that is right for your comfort level and ability to repay your home loan?
First, you need to ask yourself a few basic questions and consider the answers as carefully as possible:
- How much financial risk am I willing to take?
- Am I buying real estate as a place to live or primarily as an investment?
- If I am buying a residence, how long do I plan to be in this house?
- Am I prepared to make home improvements myself?
- Where do I see myself five or ten years down the road?
- Do I need cash available for other investments?
Answering each of these questions will help determine the right mortgage for your situation.
Financial Risk Taking
There are two basic philosophies when it comes to using real estate to secure a loan; conservative and speculative.
The conservative philosophy is to borrow as little as possible and repay your home mortgage as quickly as possible in order to become debt free. This is a sound, conservative financial strategy for many people.
The second philosophy is that real estate is the most readily leveraged investment option available. People who are not afraid of taking financial risk can use this concept to create a long term financial growth strategy and many have speculated and invested in real estate to become very wealthy, basically borrowing against the equity in one property to purchase other properties.
Only you can decide upon your own comfort level with financial risk. Most real estate investors start by purchasing their own home first. When they have built enough equity and have enough income to comfortably afford their monthly homeownership costs, including payments on principle and interest, property taxes, insurance , repairs, utility bills, etc. they decide to invest in a vacation home or income property and make the step to becoming a real estate investor as opposed to just being a homeowner.
For the serious real estate investor willing to accept risk, creative financing options like balloon mortgages and interest only mortgages can make sense, enabling them to leverage their real estate investments as fully as possible.
But for the average homeowner, these types of mortgages may cause stress or anxiety and may not be worth consideration.
For the most conservative people, a standard 15 or 30 year fixed rate mortgage is the simplest answer.
Planning Ahead to Determine the Right Mortgage Product
Nobody can answer with certainty how long they plan to live in a home, but the average American moves approximately every seven years. And even those who plan to live in the same house for more than ten years is likely to refinance their homes within that period of time.
For these reasons, adjustable rate mortgages (ARM) and hybrid mortgage products have become increasingly popular, since they allow people to qualify for a larger loan amount. An ARM can be a good way to go if you plan to stay in the house for less than 10 year, but you really have to compare side-by-side the ARM and fixed rate programs to know where the break-even point is.
Most mortgage experts agree than an ARM should never be used simply to buy a home you really can’t afford … assuming you will make more money in the future if the rate and monthly payments increase! Nobody can predict the future well enough to avoid the possibility of mortgage disaster because they bought a house they really couldn’t afford with the hope that either interest rates will go down or they will somehow make substantially more money in time to meet those higher payments.
Should I get a Fifteen or Thirty Year Mortgage?
It is only obvious that the longer you pay interest, the more money you will pay. So, unless you are purposely trying to leverage your real estate investments, it makes sense to choose the shortest mortgage period that provides the necessary funds to purchase your home with monthly payments you can comfortably afford.
In addition to repaying your loan more quickly, you will also get a lower interest rate on a 15 year mortgage than you will on a thirty year home loan.
On the other hand, if you are buying your first home, you may not be able to afford the higher monthly payments of a 15 year mortgage. By deciding on a 30 year mortgage with lower monthly principle and interest payments, you can sleep comfortably knowing you can make the payments each month!
You always have the option of paying additional principle when you can afford it to reduce your mortgage debt, or refinance later if you decide that you can afford a 15 year mortgage and the loan closing costs are low enough to justify refinancing.
What Are the Main Factors in Choosing the Right Mortgage?
When you are shopping for a home mortgage there are three primary things to consider:
- What’s the lowest possible interest rate I can get?
- What mortgage repayment terms minimize my total cost without making my monthly payments too high to comfortably afford?
- How long do I plan to stay in the home or wait before refinancing?
The best home mortgage is typically the one you can afford to make payments on as long as you will live in the home or own the real estate if it’s an investment property.
Remember that with a fixed-rate mortgage, the interest rate and payments are constant for the duration of the loan, usually either 10, 15, 20 or 30 years. The shorter the term, the lower both your interest rate and total cost will be, but the higher your monthly payment will be for a given loan amount.
An ARM will have a lower initial interest rate lower than a fixed rate mortgage but will periodically increase or decrease, depending on economic factors and the interest rate index to which your loan is tied. The lower payment can help your short term cash flow but be sure you can afford the payments even if the interest rate reaches the cap, or highest rate specified in the terms of your ARM loan.
If you are conservative and simply want to finance the purchase of your own home, follow these tips:
- Use online mortgage calculators to compare your monthly costs and total costs for as many possible mortgage products as possible to determine what type of loan is best for you.
- Be sure to shop around for the best loan terms and rates available through local banks and national lenders. Consider working with a mortgage broker, but shop online for the best rates available since lenders who can keep their acquisition costs as low as possible can generally offer the best terms!
- Determine whether you are willing to pay “points” up front to get a lower interest rate or would rather accept a higher interest rate in order to reduce your closing costs.
- Always remember to factor all your monthly costs, including property taxes, insurance and homeowner’s association fees.
- Also, your lender may require an “impound” account for these types of expenses in order to ensure you don’t fall behind, especially if your down payment is less than 20 percent and you are required to have PMI.
- Also consider alternative mortgage terms, such as 20 years, which many lenders offer but are not widely promoted.
If you are comfortable taking a bit more financial risk and your credit score, income and net worth are all good, you stand the best chance of getting the lowest possible interest rates and best mortgage terms!
If you can qualify, consider these options to save money on your home mortgage:
- To optimize cash flow and keep the monthly payments as low as possible, choose a longer loan repayment term, although your total long term cost will be higher. For example, if you borrowed $100,000 at 8 percent interest for 30 years, your total interest cost would be $164,000. Your monthly payment would be $733, whereas with a 15 year mortgage your monthly payment would be $955.
- Leverage your real estate investment with an “80-20” loan package, which entails a first mortgage for 80 percent of the purchase price and the other 20% being at least partly funded by a second mortgage. In most cases, this will require private mortgage insurance (PMI) which protects the lender in case of default, so your costs will be higher but your out of pocket investment can be as little as 5 percent of the purchase price!
- Select hybrid adjustable rate mortgage (ARM) to minimize cash outlay or get a lower interest rate. With a hybrid loan, your interest rate and payment will be fixed for some period of time (typically 1 to 7 years) and then converts to an adjustable rate. If interest rates rise but you have built up equity in the mean while, you can sell the property for a profit or may have raised the rents enough to cover the higher interest cost.
- If you own a home already and are considering a second home or income property, you could refinance your existing home in order to make the down payment on the second property. Again, this means more risk, but you will be one step closer to financial freedom by leveraging your real estate investments more fully!
To leverage your real estate investments even further, if you are willing to accept the financial risks, consider these options:
- An interest only mortgage can further optimize cash flow by keeping your monthly payment as low as possible. With this type of loan, you will typically pay interest only for an initial period of 3 to 10 years, with the principle repayment being amortized over the remaining duration of the loan term. In most cases, real estate investors will later sell or refinance a property that has an interest only payment type of mortgage.
- A balloon payment mortgage is typically a short term, fixed rate loan with small monthly payments for a specified period of time, after which the entire amount of the loan must be repaid. As with an interest only mortgage, this can be risky if you are unable to either sell the property, refinance or otherwise have cash needed to repay the loan at that time, however many successful real estate investors and speculators have used this financing option to leverage their investments while keep their cash outlay lower than possible with other mortgage products.
- In some cases, if a property want appraises higher than the sale price, you may have the ability to borrow up to the appraised value in order to cover your closing costs.