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It makes sense to select the right mortgage loan for your home. The question is, how?
First, you need to have knowledge of the different types of mortgage products
available. We hope the information have here would provide you with the basic
knowledge of the loan options, and which may fit your situation the best.
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Fixed Rate Mortgages
Fixed rate mortgages allow a borrower to know upfront what all future payments
will be. The rate on a fixed rate mortgage should be competitive, and depends on
what general interest rates are at the time. You would know the monthly principal
and interest payments from your first till the last. They are the most
popular home financing options.
Fixed rate loans are available for a variety of terms, from 10 to 30 years.
Typically, shorter term fixed rate mortgage loans also have lower rates than
comparable 30 year fixed rate loans. At the same time, the monthly payment is
higher with a shorter term loan, so the total interest over the life of the loan
will be reduced substantially, and the home equity will increase faster since the
loan is paid off sooner. On the other hand, many borrowers choose the traditional
30-year term because the lower payment on it is attractive.
For example, the mortgage payment on a $100,000 30-year loan at 7% is $665 while on
a 15-year loan at 6.75% is $885. After 5 years the borrower who took out the 15-year
loan has repaid $22,933 while the borrower who took out the 30 has repaid only
$5,868. That amounts to a difference in wealth accumulation of $17,065.
Depending on what your financial goal is, shorter term and longer term both can be
used to your advantage.
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Adjustable Rate Mortgages
With an adjustable rate mortgage loan, your interest rate is subject to change on a regular basis, based on market conditions and the kind of ARM you have. Some ARMs have rates that adjust annually, others adjust every few years. There are a variety of terms available for ARMs to suit your needs.
ARMs offer many benefits, including an initial interest rate that is usually lower than a fixed rate loan, and limits on how much the interest rate can be adjusted at one time. Some ARMs even offer the option to convert to a fixed rate loan in the future.
Some home buyers choose ARM loans because with a lower initial rate, they can qualify for a larger loan amount than would be possible with a fixed rate option. Or, they may be planning to be in their home for only a few years. In this case, a lower initial rate can save money.
Finally, some home buyers choose an ARM because they anticipate that their income will grow over time. An ARM will give people in this situation the security of lower monthly payments during the early years of the mortgage, making their home purchase more affordable.
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Compare Mortgage Terms
The term of a mortgage is the period used to calculate the mortgage payment. It should
be distinguished from the maturity, which is the period until the final payment is
due. On most mortgages they are the same, but on some the maturity is shorter. This is
true of balloon mortgages, for example, where the term is usually 30 years but the
borrower must make a final "balloon" payment in 5 or 7 years.
The longer the term, the lower the mortgage payment but the slower the borrower
builds equity. Borrowers who want to make their payments as small as possible select
the longest term available. The reduction in payment from lengthening the term,
however, becomes less and less effective as the term gets longer. This is illustrated
in the table below, which shows the mortgage payment on a $100,000 loan at various
interest rates and terms.
Mortgage Payment Per $100,000 of Loan Amount
|
| Term |
6.00% |
6.25% |
6.50% |
6.75% |
7.00% |
7.25% |
7.50% |
| 5 Years |
$1933 |
$1945 |
$1957 |
$1968 |
$1980 |
$1992 |
$2004 |
| 10 Years |
1110 |
1121 |
1135 |
1148 |
1161 |
1174 |
1187 |
| 15 Years |
844 |
857 |
871 |
885 |
899 |
913 |
927 |
| 20 Years |
716 |
731 |
746 |
760 |
775 |
790 |
806 |
| 25 Years |
644 |
660 |
675 |
691 |
707 |
723 |
739 |
| 30 Years |
600 |
616 |
632 |
649 |
665 |
682 |
699 |
| 40 Years |
550 |
568 |
585 |
603 |
621 |
640 |
658 |
| Interest Only |
500 |
521 |
542 |
563 |
583 |
604 |
625 |
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For example, at 6% extending the term from 10 years to 20 years reduces the payment by $394 but extending it to 30 years and 40 years reduces the payment by only $116 and $50, respectively. The furthest you can possibly go in extending the term is to infinity, which is an interest-only loan -- you never repay any part of the loan. On a 6% loan, the monthly interest is $500, just $50 less than the payment at 40 years.
Extending the term to reduce the payment also becomes less effective at higher interest rates. For example, at 6% extending the term from 20 to 30 years reduces the payment by $116 but at 12% the reduction is only $72. Where the interest payment at 6% is $50 less than the payment at 40 years, at 12% the interest payment is only $8 less than the payment at 40 years.
Borrowers who want to build equity in their home as quickly as possible select the shortest term they can afford. As illustrated in the table below, the shorter the term, the more rapid the increase in equity. For example, after 10 years the borrower with a 15-year term at 7% has repaid 54.6% of the original balance whereas the borrower with a 30-year term at the same rate has repaid only 14.2% of the balance. Since 15-year loans usually carry a lower rate than 30-year loans, this understates the difference in the rate of equity buildup.
| Percent of Loan Balance Repaid After Specified Periods at 7%
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| Term |
After 5 Years |
After 10 Years |
After 15 Years |
After 20 Years |
After 25 Years |
After 30 Years |
After 40 Years |
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5 Years |
100.0% |
100% |
100% |
100% |
100% |
100% |
100% |
|
10 Years |
41.4% |
100% |
100% |
100% |
100% |
100% |
100% |
|
15 Years |
22.6% |
54.6% |
100% |
100% |
100% |
100% |
100% |
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20 Years |
13.7% |
33.2% |
60.8% |
100% |
100% |
100% |
100% |
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25 Years |
8.8% |
21.4% |
39.1% |
64.3% |
100% |
100% |
100% |
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30 Years |
5.9% |
14.2% |
26.0% |
42.7% |
66.4% |
100% |
100% |
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40 Years |
2.7% |
6.6% |
12.1% |
19.8% |
30.9% |
46.5% |
100.0 |
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There is one situation where an equity-building borrower who can afford the payment on a shorter term might select a longer term. A borrower with attractive investment opportunities, such as a family business or the stock market, might select a longer term and invest the mortgage payment savings in high-yield investments. Since the rate on longer term loans is usually higher than the rate on shorter- term loans, however, the borrower must stay with the longer term loan long enough for the high earnings on the savings in the payment to offset the loss from the higher mortgage rate.
The tables below show how long you must stay with a 7% 30-year mortgage to come out ahead of a shorter-term mortgage carrying a lower rate when the difference in payment is invested to earn a return higher than 7%. For example, if you can invest current cash flow to earn 12%, and your alternative to a 7% 30-year loan is a 15-year loan at 6.75%, you will come out ahead if you stay more than 41 months.
Number of Months to Break Even in Selecting a 30-Year 7% Mortgage Over Shorter-Term Mortgages Carrying Lower Rates
| Rate on Short-term Mortgage 6.75% |
|
Shorter Term Loan |
8% Return on Savings |
10% Return on Savings |
12% Return on Savings |
14% Return on Savings |
16% Return on Savings |
| 10 Years |
75 months |
31 Months |
20 Months |
15 Months |
12 Months |
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15 Years |
144 |
63 |
41 |
30 |
24 |
|
20 Years |
274 |
124 |
81 |
61 |
49 |
|
25 Years |
None |
296 |
204 |
156 |
126 |
| Rate on Short-term Mortgage 6.875% |
|
Shorter Term Loan |
8% Return on Savings |
10% Return on Savings |
12% Return on Savings |
14% Return on Savings |
16% Return on Savings |
| 10 Years |
44 Months |
17 Months |
11 Months |
9 Months |
7 Months |
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15 Years |
87 |
34 |
22 |
16 |
13 |
|
20 Years |
166 |
69 |
44 |
32 |
26 |
|
25 Years |
None |
165 |
109 |
81 |
65 |
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