Understanding Mortgages

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.

Fees

There are a number of fees associated with a mortgage. Some of these petty fees can add up so pay attention. You will have to pay for a title fee, courier fee and credit report. There will be a closing fee, paid either to a title company or an attorney, which compensates that party for completing and filing all of the appropriate paperwork. You will also have to buy title insurance. This insures the bank in case there is a problem with the title, such as a mechanic's lien, that means the bank cannot take the house back in case you stop paying your mortgage. Keep in mind, the policy is only for the bank; if you want title insurance also (protecting your investment) you need to buy an additional policy.

You will also have to pay some sort of "origination fee." Sometimes, these are called by other names, but they all amount to the same thing: profit for the lender. The origination can be based on "points" or a fixed amount. Points for origination are a percentage of the mortgage's value. For example, a half-point origination on a $150,000 mortgage is $750 in fees. Don't confuse these origination fees as the points normally shown on mortgage ads in the paper. Paying points on the mortgage reduces your interest rate, as you are essentially prepaying part of the interest. Paying points lowers your monthly payment, which can be helpful if you have saved properly to pay for the fees and down-payment.

If at all possible, you want to put 20% down on your house. This exempts you from PMI, or private mortgage insurance. PMI is a fee you pay that again insures the bank in case you stop paying, or default. It helps ensure that the bank will not lose money if they repossess the house and sell it at auction.

Many of these fees are fixed and non-negotiable. However, you can save some money by trying to negotiate certain bank charges, such as the credit report, courier fee, etc. You can also find your own title insurance and title company (or closing attorney); the mortgage company is not particularly inclined to find the best price since you are paying the fees anyway. It's a little extra work, and may save you a few hundred dollars, so you’ll have to decide if the effort is worth the time.

One last note on fees: your mortgage company would love to roll your fees into your mortgage. This sounds great to you, as it lowers the amount of cash you have to pay when you sign for the mortgage. Avoid this like the plague. If you put all of these costs into the mortgage, you will be paying interest on this amount for 15 or 30 years. The mortgage company will emphasize that it only raises your monthly payment by a few dollars, but they don't point out that you will pay thousands more in interest over the course of the loan.

Conclusion

While there are a number of mortgage options, for most of you the best option is a 15-year or 30-year fixed mortgage. Rates won't get much lower than they are today, so you are getting a good deal. While some markets may make it too difficult to get a decent house on a 15-year mortgage, if you can survive with the payments and house, you are better off with the 15-year mortgage. As you save for your house, remember to have a 20% down payment to avoid PMI and remember to save extra for all the associated fees.

Happy house hunting!



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