|
|
Mortgage Types Available To You
In today's times, whether you are buying a house, or considering
refinancing an existing mortgage, deciding which type of a mortgage
is best for you can be confusing. That's because it involves more
than just numbers crunching. You must also make certain decisions
and assumptions about which way interest rates will go, how long you
will be in the house, and what your tax bracket will be over the
life of the mortgage, as well as the present and future tax
deductibility of the interest you will pay.
To make matters even more confusing, these quantitative aspects are
also linked with certain qualitative issues that need addressing.
How do you feel about having a debt on your head? Are you a good
saver? Are you a bit of a gambler or are you a serious conservative?
Basically, mortgages can be divided into two main types: Fixed, and
Adjustable Rate. Within these two categories further division occurs
as we shall see.
Fixed Mortgages
By definition, fixed mortgages refer to the fact that the interest
rate you will pay is fixed (locked in) over the entire life of the
loan. Thus, no matter how long of a mortgage you have selected, and
no matter what happens to interest rates over the years, your
mortgage rate will not change–nor will your contracted payment for
the mortgage itself. This is the most prevalent type of mortgage out
there. In 1998, it accounted for 76% of all residential-type
mortgages.
The main choice in this category centers around the length of the
mortgage you want. Do you select the 30 year? Or the growingly
prevalent 15 year? These represent the two most common fixed
mortgage choices, so we will focus on them.
Obviously, a 15 year mortgage is shorter. Also, interest rates you
will pay on a 15 year are usually a bit lower(1/4 to ½ point lower).
This is because the bank's risk period is halved compared to a 30
year, so some of this risk-saving is passed on to you, the borrower.
However, your monthly payment will be higher since you are paying it
off over a much shorter time period. Thus, a 15 year mortgage is
more of a "forced savings" vehicle than a 30 year, and you build up
house equity faster by paying more each month.
Add to this the fact that all mortgages are "front-loaded"(meaning
more of your early payments go toward interest instead of
principal), and you can conclude that a 15 year mortgage will save a
considerable amount of total interest over the life of the loan. In
fact, you have probably seen the bank advertisements comparing the
difference in total interest saved, and it appears staggering. So
this is definitely the way to go by a large margin, right?
Not necessarily. This is where two of the variables we suggested
earlier come into play. The first variable is your income tax
bracket. Since the current 2000 federal tax codes allow you to
deduct mortgage interest paid on a residence (up to a $1 million
acquisition mortgage), the rate of your tax bracket can narrow the
gap between the total payments of a 15 and 30 year mortgage.
Why? This is because the higher your projected tax bracket, the more
interest you may be able to deduct. That means the 30 year mortgage
creates larger tax deductions, which is a form of savings to you.
Thus, while you are paying a larger absolute amount of interest on a
30 year mortgage, you may not always be paying a great deal more in
after tax dollars.
Second, what will you do with the difference in monthly mortgage
payment amounts between a 15 and a 30 year mortgage? Will you invest
it? And if you do, will you do it successfully? If you can answer
Yes to both of these questions, you can narrow the gap even further
between the two choices. In fact, if you were successful enough as
an investor, you may even make enough on the invested differential
to offset ALL the savings on a 15 year fixed mortgage. So while the
15 year mortgage creates a quicker equity build-up than a 30 year,
the two issues of your tax bracket, and what you will do with the
monthly mortgage payment differential are the critical factors.
Note: We will not address the other two important issues of
liquidity value, and portfolio diversification in comparing the two
types of mortgages, although these factors have real value to many
people, both in quantitative terms, and psychological comfort as
well. However, entire books can be written on these two issues
alone.
As a point of interest, most 30 year mortgages allow you to make
extra payments periodically. This can create almost the same result
as having a 15 year fixed without legally committing you to the
higher monthly payment. This may be a good compromise when deciding
which type to get. The "Reverse Laws Of Compounding" show that, by
making an extra monthly payment each year on your new 30 year
mortgage, you can shave 7-9 years off its payout period, with the
current 2000 mortgage rate averages. So, if you are considering this
with a 30 year mortgage, make sure there are no extra charges if you
make any pre-payments on principal.
As you can surmise, there is no simple answer in deciding between a
15 year and a 30 year mortgage. You must know a bit about yourself
as a saver, and an income earner projected over the life of the
loan. On the other hand, there is one general rule of thumb to
consider following, which goes like this: The lower your tax
bracket, and the less disciplined/less successful you are as a
saver, the more you may wish to lean towards a 15 year mortgage if
you can handle the extra current amount you would be paying on the
monthly mortgage. Everything else being equal, forced savings is
better than none at all!
Adjustable Rate Mortgages
These are exactly what they say. They are mortgages in which the
interest rate you will pay is variable, not fixed; it adjusts
according to a certain index the lending institution is using.
Issues such as when the rate changes, by how much it will change,
and the maximum amount it can rise are all variables that can differ
from one lending authority to another. These mortgages are nicknamed
"ARMS."
However, most have similar features you should check out. First, the
bulk of the adjustables will change their rates according to one of
two main indexes or variations thereof: A formula based on the
change in US Treasuries is a very common index; and, the use of the
so-called 11th District cost of funds which is coordinated by the
Federal Home Loan Bank Board is the other main index.
Second, many ARMS have a maximum lifetime "CAP" which means they
limit the total amount the interest rate can change. A commonly used
figure here is 6 points over the contracted rate, meaning that if
you contracted at 5%, it couldn't go higher than 11%.
However, be careful here because the contract rate for this is
usually higher than the initial "Come-on" rate that is frequently
advertised. Again, a common technique lending institutions use to
promote these adjustable rate mortgages is to give you a first
year's discount on the actual contracted rate. So, you may be paying
only 3% in year-one when in fact you have actually contracted for a
5% ARM. After the first year, your mortgage automatically adjusts
upward to the 5% rate, and all loan CAPS may be based on the 5%
contract not the 3% starting point. This is important to know when
deciding on fixed vs adjustable, or which ARM to choose from
another.
Finally, many ARMS limit the amount they can raise the interest rate
to no more than 2 points a year. So, if you contract at an initial
4% rate with a lifetime CAP of 6 points, and a 2 point maximum
yearly rise limit, you know that your maximum exposure over the life
of the loan is a 10% interest rate. You also know that it will take
until the fourth year to hit the 10% no matter how much, or how
fast, interest rates rise.
A variance on this type of adjustable mortgage is called a Hybrid.
The rate is fixed for a certain number of years, then it changes
according to what has happened in the open market after that period
of time. A "5/25" for instance means your rate will stay fixed for
the first 5 years, then change to a new rate for the remaining 25
years.
So, is an Adjustable Rate Mortgage better for you than a Fixed? And
which type: a basic ARM, or a Hybrid? Obviously, for most people it
is easier to qualify for an ARM than a Fixed, since one of the
qualifying issues most lending institutions use keys off the monthly
mortgage amount, and a monthly ARM payment is lower in the beginning
than fixed mortgages.
However, here is where you must get out your crystal ball to really
decide. Do you think interest rates(hence your mortgage rate) will
stay down, go lower, or rise over the life of your proposed ARM? Or,
if they do change, when will they change? Will you still own the
house by then, or will you have sold it? So, the issue of how long
you plan to keep the house enters into the equation as well.
Are there any guidelines here? Yes! First, if you definitely know
you will be selling the house in a short time, you can do some
numbers crunching to calculate your maximum exposure on an ARM
mortgage vs a Fixed. Conversely, you can figure out where the
breakeven year is between a lower rate, maximum Capped ARM vs a
Fixed if you make some basic assumptions. Naturally, if you believe
interest rates will go down over your expected liability period, an
ARM makes sense.
But, if you are planning to stay in the house indefinitely, and you
couldn't handle the ARM if it hit its maximum rate, be careful.
There are many people taking out ARMS because they can't qualify for
a regular Fixed based on their income levels. That may be fine in
the current interest rate environment, but what happens if interest
rates continue on an upward tear? It could create a serious cash
flow problem.
Sources To Apply For Mortgages
BANKS: The most commonly known places to apply for mortgages are
commercial banks and Savings & Loan Associations. The majority of
these institutions serve as initiators and collectors of these
mortgages. They do not keep the mortgage they establish for you.
Rather, they "sell" it off along with others they have made into
blocks(or pools) of mortgages.
Because of this type of selling of mortgage blocks, they need common
denominators for the pool, so they tend to follow so-called
"Fannie-Mae" requirements as to loan qualifying formulas. They
evaluate you in terms of your income level, any other long-term and
short-term debt, the proposed new monthly mortgage payment, house
taxes, and house insurance, coupled with your credit worthiness, and
the amount of your downpayment to determine if you will get the
loan. These are the strictest of loans for which to qualify.
MORTGAGE BROKERS: Mortgage brokers can be another source, and
may be better for those who can't meet the stricter Fannie-Mae
rules. Basically a loan source "middleperson," a mortgage broker may
represent numerous sources of funds, including individuals, pension
plan money, or other exotic sources.
In the cases where the loan sources as represented by this broker do
not sell off their loans, it may prove easier to get a loan. There
is more discretion in the qualifying factors. There may or may not
be extra fees associated with getting loans through mortgage
brokers, depending on their size and the competitiveness of the
market in which you are located. Also, these mortgage contracts are
not as standardized as many large banks, so they should be read with
care – every line of fine print.
CREDIT UNIONS: Some of the larger credit unions offer very
good deals on mortgages. So, those who have a credit union at their
job should always check there first. Special allowances may also be
made to members of the credit union as to qualifying formulas.
HOUSING FINANCE AUTHORITIES: Most of the states have a
program along these lines. Basically these are quasi-independent
agencies set up to provide mortgage rate subsidies and/or reduced
downpayment requirements for the purchase of a residence. Most of
these loans are given to first time home buyers or people who have
not owned a home for at least 3 years.
Not everyone can use this program because funds are limited, and
there are usually maximum caps on how much income you have, and the
price of the home you can buy. The programs are geared toward
low-income, and moderate-income applicants.
Conclusion
It's nice to have choices. A choice of places in which to apply
helps you to get the least expensive mortgage within your selection
category. But, oh that selection category! What type of mortgage do
you choose? Fixed 30, Fixed 15, Adjustable Rate, or Hybrid?
While the answers require some careful thought, and some serious
number crunching to maximize your efficiency of choice, it can be
done with the right facts, figures, and assumptions.
|