Buying a house is a big step in life (although arguably not for everyone). Most likely, when you decide to buy a home, you’ll need to finance your purchase. You’ll be confronted with several types of mortgages to choose from. The most common type of mortgage is the 30-year fixed rate mortgage. However, don’t just assume that this one is the best kind for you.
The Big Bad Balloon
Hopefully your banker or mortgage officer won’t even offer you a balloon mortgage. If they do, run out the door. The only balloons you want on your home are the colorful ones hanging from your door. A balloon mortgage lets you make small monthly payments for a period of time, but then requires you to make one or a few large payments at the end of the loan term to pay off the balance.
The balloon mortgage might sound attractive because the initial low payments help you get in a bigger house than you could otherwise afford. The banker might try to convince you that you’ll be able to afford the larger payments down the road because income will go up. That’s a big if. The reality is that balloon payments are an easy way to have your house foreclosed on. The payments at the end of the loan are so big that the balloon just pops.
ARM stands for Adjustable Rate Mortgage. The name is pretty self descriptive. As market rates go up or down, so does your mortgage interest rate. As your rate changes, so does your monthly payment. Typically ARM is accompanied by two numbers- 5/1, 5/5, 3/3, etc. The first of these two numbers tells you how many years your initial rate is locked in. The second is how often after the intro period the rate is subject to change. So on a 5/1 ARM, your initial rate would be locked in for 5 years, but then could change every year.
In theory, ARM rates are slightly lower than fixed mortgage rates. Lately, however, it seems that the two are pretty close. If the ARM rate is significantly lower than fixed mortgage rates, then the ARM is worth considering. The other benefit ARMs offer is the potential of a lower interest rate down the road.
The biggest downside of an ARM is the potential for your payment to go up, although nothing like the balloon mortgage payment spike. If you do decide to go with an ARM, be aware of this possibility and budget accordingly.
Although you can make an ARM work, I strongly recommend getting a fixed mortgage. The payment on a fixed mortgage stays the same for the life of the loan, taking a lot of uncertainty out of your budget. Especially with current rates, locking in a low rate for 15 or 30 years is especially wise.
Fixed rate mortgages typically come in 15 or 30 year terms, although 10 year terms are also available. The 15 year variety typically has a slightly lower interest rate. Simply having the mortgage for a shorter time also means you’ll pay much less in interest. However, as long as rates stay as low as they are, having a 30 year mortgage can work well in your financial plan, since it might allow you to put more towards retirement or other goals. You can use this calculator to get an idea of how the payments compare in each mortgage type.
Smaller down payments are becoming increasingly popular on mortgages, partly with the help of government sponsored programs. The obvious benefit of a low down payment is being able to buy a house sooner. However, putting less than 20% down does come with added costs.
The most significant cost is PMI- and insurance that the bank takes out to cover any loss in a foreclosure. The PMI varies, but typically adds up to a percentage point to the interest rate, easily costing you an extra $100 per month. The good news is that the PMI comes off as soon as the principle on your loan drops below 80% of the home’s value.
Having a lower down payment also increases the likelihood that you will be denied by the loan. This can happen even after you’ve been pre-approved and have made an offer on a house. Low down payments make the loan look riskier to underwriters and increases the chance that the loan amount exceeds the house appraisal- often an automatic denial.
In addition to avoiding the hassle of a low down payment, the process of saving the 20% down payment can be a good buffer period. Committing a certain amount each month towards your down payment can test your budget to see how you handle the extra monthly costs of home ownership. It also gives prevents you from rushing into home ownership, allowing you extra time to make a wise decision.
Running the Numbers
Whichever kind of mortgage you choose, make sure you really understand your monthly payment. Understand how it fits in your budget now, and how it aligns with financial goals or changing life circumstances down the road. Keep in mind all the other costs of home ownership, and know whether any are incorporated into your monthly payment. Figure out which mortgage works best for you. Or maybe you can indeed buy with 100% cash and skip the mortgage process entirely.
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- While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.