Buying your first home can be a challenge, especially for first-timers. There is so much to learn, and you don't have much time to know everything. So the goal of this post is to simply explain what a mortgage is, and the options you have when it comes to choosing one. In a later post, we will dive much deeper into mortgages and home buying techniques, but for now, let's start with the basics.
What is a Mortgage?
A mortgage is a loan from a bank or lender, in which the bank gives you the amount needed to purchase your home, and in exchange, you agree to pay the loan back over a specified amount of time plus an agreed interest rate.
For example, let’s say you have a $500,000 mortgage and you agree to pay the bank back over 30-Years bearing a 5% annual interest rate. Using a mortgage calculator, I found you will pay the bank $32,209 a year or $2,684 a month for 30-Years. The $2,684 payment is broken into principal and interest. As you pay off your mortgage the principal payments will increase, and the interest payments will decrease, but your monthly payment will remain the same $2,684 throughout the 30 years. This is called a 30-Year Fixed-Rate Mortgage and is one of the most common mortgages on the market. Now that you understand the basics let’s get into the details.
Fixed-Rate Mortgage vs. Adjustable-Rate Mortgage (ARM)
A Fixed-Rate Mortgage will have the same interest rate and monthly payment over the life of the mortgage. An Adjustable Rate Mortgage also called an ARM will have a low initial interest rate for a set number of years, usually five but does vary and then after five years, will reset every year (again varies on the ARM), generally to a higher rate. The low initial rate is called a "teaser-rate" since consumers are drawn to the low-interest rate and sometimes do not understand the rate will adjust at a later date. Don't fall victim to "payment shock," which is when you lose track of time, and your mortgage rate adjusts to a much higher rate, and you're literally shocked by the increased payment.
30-Year Fixed Rate. Mentioned earlier, a 30-Year Fixed-Rate Mortgage is one of the most common and is for someone who wants predictable monthly payments. Once the interest rate is set, which is agreed upon beforehand, the rate will never change throughout the life of the loan, unless you refinance your home.
15-Year Fixed Rate. This mortgage will have higher monthly payments than a 30-Year mortgage because you are paying off the loan in half the time. The benefit is you will save a fortune in interest but will have higher monthly payments versus a 30-Year mortgage.
Napkin Note: For example, we will assume two individuals have mortgages of $500,000 bearing a 5% interest rate. Person A chooses a 30-Year mortgage, which results in a monthly payment of $2,684 and a total interest cost of $466,279 over the life of the mortgage. Person B, chooses a 15-Year mortgage, resulting in a monthly payment of $3,954, but the total interest cost is $211,714 over the life of the loan. Person B saves over $250,000 in interest costs. As you can see, the interest component of your mortgage is more substantial than you may realize even when interest rates are low like they have been over the last several years.
5/1 ARM. Adjustable-Rate Mortgages work like this: The interest rate is fixed for a specified amount of time, and then resets usually annually, usually at a higher rate. Reading an ARM lingo: The number left of the slash, in this case five, represents the amount of time the interest rate is fixed. The number right of the slash, in this case one, is how often the interest rate will reset.
In the 5/1 ARM example, the interest rate is the same for the first five years and then resets every year starting in year six through 25. Adjustable-Rate Mortgages come in all shapes and sizes, like 10/1, 5/5, and 3/3 to name a few and follow the same logic described above. Since it is challenging and complicated to predict where interest rates will be in the future, you will need to understand once your mortgage rate begins to reset, your monthly payments will likely increase. A 5/1 ARM and most ARM’s are best suited for buyers who plan to sell or refinance their home before the interest rate adjusts.
A Fixed-Rate Mortgage is a conservative mortgage due to the stability it brings to consumers. Adjustable-Rate Mortgages while riskier can be an excellent option for first time home buyers, who do not plan on being in their home for more than five or ten years. But what if there was a way to afford a more expensive house and pay significantly less than if you went the fixed or adjustable route. There is a product called an Interest-Only Mortgage.
As you can probably tell by the title, this type of mortgage only pays interest. Here’s the kicker; after a specified number of years, you will have to begin paying principal. For example, let’s assume you have a 30-Year Interest-Only Mortgage for $500,000 bearing a 5% interest rate. This means you will pay no principal for the first ten years and will begin paying principal in years eleven through thirty. Your monthly payments will be $2,083 for the first 10 years, which is comprised of interest only. At the start of year eleven, your monthly payment will increase to $3,299; $1,216 in principal and $2,078 in interest. That is a considerable increase, but there is a way to avoid paying it. The key is to sell your home before the principal portion kicks in. The two immediate pros from this type of mortgage are 1) your payments are approximately $600 lower than a 30-Year Fixed Mortgage assuming both mortgages are for $500,000. And 2) if your home appreciates in value, you will be able to realize that gain once you sell your home.
Some drawbacks of an Interest-Only Mortgage are 1) you are not building equity since you are only paying interest. Should you need a home equity loan, which will be described in detail in a later post, you will be unable to acquire one. And 2) your home may be worth less than what you purchased it for when you have to begin paying off principal, due to a recession or other unpredictable economic event. Many homeowners who used this strategy got burned during the Great Recession of 2008, so please be careful should you wish to use it.
Mortgages can be tricky, but if you understand them, you can learn to use specific strategies to your advantage to save money, which can be applied towards your retirement, student loans, or anything else that isn't a mortgage. Now that you understand the basics, you are ready to move on to the next step which is to speak with an experienced loan officer or mortgage broker who can assist your individual needs.