Understanding Mortgages

With low mortgage rates, more people are looking at homes. Be educated to make the best financial decisions possible.

I know it's hard to believe, given all the negative news about the economy, but people are swarming to the house-buying market. You've heard plenty about the housing bubble bursting, but that means that home prices are both more affordable and more reasonable since the adjustment. There is also the current interest rate market, which is still at or near historical lows. This means people can get more house for the same payment. The last reason the market is picking up is that the US Government is giving an $8,000 tax credit to first time homebuyers.

So, with the house market becoming more attractive, it seems appropriate to offer a little review of mortgage terms and options. If you are considering buying a home, you need to ensure you understand what is reasonable versus unreasonable and required as opposed to desirable.

Types of Mortgages

The housing bubble was blamed partly on some of the exotic types of mortgages that are available. These allowed people to buy more house than they normally could afford, driving up demand and prices. But not all mortgages are a road to ruin. Below are the most common types of mortgages, as well as comments on their appropriateness and analysis of their costs (assuming a $150,000 mortgage):

  • 15 or 30 year fixed rate: this is the traditional mortgage. The interest rate is locked in for the life of the loan. This means the rate is not the lowest available on the market, but it cannot change on you... ever. Your monthly payment is fixed for 360 (or 180) months. With rates so low today, you should think long and hard before signing anything but one of these. A 15-year mortgage saves tens or hundreds of thousands of dollars in interest, but has higher monthly payments. Most financial gurus recommend a smaller house paid for in 15 years rather than a larger house bought in 30. For example, a 15-year fixed rate is about 4.75% interest rate now, or $1,167 a month; 30-year at 5.35% is about $838 a month. But the 30-year loan will cost you an extra $90,000 over time.
  • ARM, or adjustable rate mortgage: this mortgage will give you the lowest monthly payment... for now. An ARM uses a lower interest rate than the traditional mortgage, but that rate will change regularly. You can get a one-year, three-year or five-year ARM, which means that the interest rate will be fixed for that span of time, while the payments are calculated on a 30-year basis. After the fixed time span expires, the interest rate will adjust every year based on a market rate, called an index. Your interest rate is normally the index, plus a percentage. An ARM will frequently have a maximum that it can increase in any one year and over the life of the loan. These loans are great as long as interest rates stay low... but when they start to climb, your monthly payments go up with the rates. For example, you could start with a monthly payment as low as $674 at 3.5%. If the index rate climbs two points a year and can max out at six points over your starting point, your monthly payments could almost double to $1,261 at 9.5% just three years after your lock expires. These loans caught many Americans last year, as rates went up and payments skyrocketed. People failed to budget for the higher rates, and foreclosures followed.
  • Interest-only mortgage: this mortgage has the lowest payment of them all, because you are not repaying any of the loan. At 5.35%, your monthly payments would only be $669 on a 30-year basis. That means that every month, you are paying $669 to the bank to live in your house and not getting one penny richer in the process. You still owe the bank the entire $150,000 that you borrowed. That isn't too big a problem if house prices go up; but when they drop and you cannot sell the home for what you owe, that's a giant mess, as you are on the hook for the difference.
  • Five-year or seven-year balloon mortgage: this mortgage is a mix between an ARM and a traditional mortgage. You get a lower interest rate with a balloon mortgage, and it is priced as if you are paying for 30 years. However, at the end of the balloon period (five or seven years), you have to repay the entire amount remaining on the mortgage. For most people, that means taking a new mortgage at the interest rates prevailing then. Again, with rates at historic lows, this will probably result in higher payments when the balloon is refinanced. If you are confident that you will be moving in less than five (or seven) years, you can benefit from the lower rates since you will be financing a new house anyway.
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