Discussions of mortgages often focus on interest rates, but there is a much more basic decision to make. Should you go with a 30 year mortgage term or a 15 year mortgage term?
30 Year vs. 15 Year Mortgages
Any discussion of mortgages tends to turn on two points. How can you qualify for the most money with the lowest payment? How can you get the lowest interest rate for the mortgage? While these are two important issues, there is an addition one that people fail to consider, resulting in significant wasted money.
The term of a mortgage is extremely critical for a couple of reason. First, it sets the length of the obligation you are undertaking. Second, it defines the amount of interest you are going to pay over the life of the loan. These are huge issues when it comes to building equity.
The Longer the Loan, the More Total Interest You Are Going to Pay.
The trade off, of course, is you are going to have smaller monthly payments the farther you stretch out the obligation. While this may sound like a good goal when you first get the mortgage, it can backfire on you in the long run.
Most People Focus on Interest Rates as a Way to Save Money on Mortgages.
This is a valid approach, but playing with the length of the loan is a better way to save money. If you can cut the payments in half by going with a shorter loan, you can save huge amounts on the total interest repaid to a lender.
The decision on the term of the loan is relatively simple, but entirely dependent upon your personal situation. There is no absolutely correct choice. First, you need to determine if you can comfortably afford the higher payments that come with a shorter term loan. In general, a 15 year mortgage will have payments 20 to 25 percent higher than a 30 year loan. Of course, you will pay the loan off faster, to wit, be building equity in the home quicker.
The modern mortgage industry has a variety of different term length products. When applying for a loan, take the time to evaluate the different terms to see if you can find a loan that is perfect for your situation.
Discussions of mortgages often focus on interest rates, but there is a much more basic decision to make. Should you go with a 30 year mortgage term or a 15 year mortgage term?
There are thousands of loan programs available in the market. Every lender tries to be as different as they can to create a special niche, which they hope will increase business. It would be impossible to provide a review of every type of loan, so in this article, we’ll just stick to the main ones. Most loan programs are variations of the loans we will cover here. First of all, we will go over some terminology you should understand and then we will delve into the different mortgage programs available today.
Amortization is the paying back of the money borrowed plus interest. The actual term, or length of the mortgage along with the amortization is what determines what the payments will be and when the loan will be paid off. It is a means of paying out a predetermined sum (the principal) plus interest over a fixed period so that the principal is eliminated by the end of the term. This would be easy if interest weren’t involved since one could simply divide the principal amount into a certain number of payments and be done with it. The trick is to find the right payment amount, which includes some principal and some interest. The formula of amortization uses only 12 days a year to compute the interest. The interest payment on a mortgage is calculated by multiplying 1/12th (one-twelfth) of the interest rate times the loan balance of the previous month.
On a 30-year, $150,000 mortgage with a fixed interest rate of 7.5 percent, a homeowner who keeps the loan for the full term will pay $227,575.83 in interest. The lender does not expect that person to pay all that interest in just a couple of years so the interest is spread over the full 30-year term. That keeps the monthly payment at $1,048.82.
The only way to keep the payments stable is to have the majority of each month’s payment go toward interest during the early years of the loan. Of the first month’s payment, for instance, only $111.32 goes toward the principal. The other $937.50 goes toward interest. That ratio gradually improves over time, and by the second-to-last payment, $1,035.83 of the borrower’s payment will apply to the principal while just $12.99 will go toward interest.
There are four types of loans when dealing with amortization and term. They are:
1. Fixed: with conventional fixed-rate mortgages, the interest rate will stay the same for the life of the loan. Consequently, the mortgage payment (Principal and Interest) also stays the same. Changes in the economy or the borrower’s personal life do not affect the rate of this loan.
2. Adjustable: (ARM) also called variable-rate mortgages. With this loan, the interest rates can fluctuate based on the changes in the rate index the loan is tied to. Common indexes are 30 year US Treasury Bills and Libor (London Interbank Offering Rate). Interest rates on ARMs vary depending on how often the rate can change. The rate itself is determined by adding a specific percentage, called margin, to the rate index. This margin allows the lender to recover their cost and make some profit.
3. Balloon: A loan that is due and payable before it is fully amortized. Say for example that a loan of $50,000 is a 30-year loan at 10% with a five-year balloon. The payments would be calculated at 10% over 30 years, but at the end of the five years, the remaining balance will be due and payable. Balloon mortgages may have a feature that would allow the balloon to convert to a fixed-rate at maturity. This is a conditional offer and should not be confused with an ARM. In some cases, payments of interest only have to be made, and sometimes the entire balance is due and the loan is over. Unpaid balloon payments can lead to foreclosure and such financing is not advisable to home buyers. Balloons are used mainly in commercial financing.
4. Interest-only: This type of loan is not amortized. Just like the name implies the payments are of interest only. The principal is not part of the payment and so does not decline. Interest-only loans are calculated using simple interest and are available in both adjustable-rate loans and fixed-rate loans.
Fixed-rate: The fixed-rate loan is the benchmark loan against which all other loans are compared to. The most common types of fixed-rate loans are the 30 year and the 15-year loans. The 30-year loan is amortized over 30 years or 360 payments while the 15 year is amortized over 180 payments. For the borrower, the 15-year loan has higher payments, since the money needs to be repaid in half the time. But because of that same feature, the interest paid to the bank is much lower as well.
Even though these two are the most common terms, others are gaining in popularity, such as the 10, 20, 25, and even 40-year term loans Depending on the lender, the shorter the term, the less risk, and thus the lower the rate.
Other types of fixed-rate loans:
The bi-weekly mortgage shortens the loan term of a 30-year loan to 18 or 19 years by requiring a payment for half the monthly amount every two weeks. The biweekly payments increase the annual amount paid by about 8 percent and in effect pay 13 monthly payments (26 biweekly payments) per year. The shortened loan term decreases the total interest costs substantially.
The interest costs for the biweekly mortgage are decreased even farther, however, by the application of each payment to the principal upon which the interest is calculated every 14 days. By nibbling away at the principal faster, the homeowner saves additional interest. The ability to qualify for this type of loan is based on a 30-year term, and most lenders who offer this mortgage will allow the home buyer to convert to a more traditional 30-year loan without penalty.
GRADUATED PAYMENT MORTGAGE (GPM)
This loan is a good idea for buyers who expect their income to rise in the future. A GPM will start these borrowers off at a much lower than market interest rate. This allows them to qualify for a larger loan than they would otherwise. The risk is that they assume they will have enough income to pay increased payments in the future. This is similar to an ARM but the rate increases at a set rate, not like the ARM where the rate is based on the market. For example, a GPM for 30 years might start with an interest rate of 5% for the first 6 months, adjust to 7% for the next year, and adjust upwards .5% every 6 months thereafter.
GROWING EQUITY MORTGAGE (GEMS)
For as long as mortgages have been around conventional fixed loans have been the standard against which creative financing has been measured. In the early 1980s, the GEM was developed as a new alternative to creative financing. The GEM loan, while amortized like a conventional loan, uses a unique repayment method to save interest expense by 50% or more. Instead of paying a set amount each month, GEM loans have a graduated payment increase that can be calculated by increasing the monthly payment 2, 3, 4, or 5 percent annually during the loan. Or the monthly payments can be set to increase based on the performance of a specific market index.
So far it sounds like a graduated-payment mortgage but there is a difference. As monthly payments rise, all additional money paid by borrowers is used to reduce the principal balance. This results in a loan paid off in less than 15 years.
While a reverse mortgage is not exactly a fixed-rate mortgage (it is more of an annuity), I have included it here because the payments made to the home buyers are fixed. Reverse mortgages are designed especially for elderly people with equity in their homes but limited cash. They allow individuals to retain homeownership while providing needed cash flow. In a traditional mortgage, the homeowners repay the amount borrowed over a specified period. With a reverse mortgage, the homeowner receives a specified amount every month.
To illustrate, say Mr. and Mrs. Smith are 70 and 65 years old respectively and retired. Their home is free from all encumbrances and worth $135,000. They would like to get the money out of their house to enjoy it, but instead of receiving it in one lump sum by refinancing it, they want to receive a little bit every month. Their lender arranges for a $100,000 reverse mortgage. They will get $500 a month from their equity and the lender will earn 9% interest.
Unlike other mortgages where the same $100,000 represents only the principal amount, with a reverse mortgage $100,000 is equal to the combined total of all principal and interest. On this particular loan, at the end of 10 years and 3 months, the Smiths will owe $100,000. The breakdown being $61,500 principle and $38,500 in interest. At this time the loan will end. So the Smiths will only receive $61,500, and they now owe the bank $100,000.
An ARM is a type of loan amortization where the most prevalent feature is that the interest rate adjusts during the loan. Thanks to the adjustable-rate feature, banks, and lenders are better protected in case interest rates fluctuate wildly like in the 1970s when banks were lending at 8% fixed and then rates went as high as 18%. This left the banks holding loans that were losing money every month since the banks had to pay money to depositors at higher rates then they were making on their investments.
Important Tip: ARM interest rates are usually lower than fixed rates. There are multiple types of ARM loans in the market today. This makes it easier for borrowers to qualify for a larger loan amount with an ARM. differ from each other in minor but important ways. There are four main criteria to look at when dealing with an ARM loan: the Index used, the Margin, the Cap, and the Adjustment Frequency.
The interest rates of an ARM loan are based on an Index, which is a published rate. The most commonly used indexes are:
COFI – The Cost of Funds Index. This index is related to the 11th District Federal Home Loan Bank Board in California. This index is also the most stable of all the common indexes.
The Treasury Series – This is a series of maturity lengths for Treasury Bills. These bills are used as investments by millions and are actively traded every day and so the rate varies daily.
LIBOR – The London Inter-Bank Offered Rate is the rate the central bank in England uses to lend money to its banks.
Prime – This rate is the rate that banks in the US use to lend money to their best clients. This number is published daily in US newspapers, but it is important to know that each bank can set its Prime rate.
CDs – This index is from the rate paid to purchase of 6-month Certificates of Deposits.
Margin is defined as the amount added to the index rate to determine the current rate charged on the ARM. Once you add the margin to the index rate you arrive at what is called the Fully Indexed Rate (FIR). This rate is the true rate which the borrower will pay. The interest rate quoted to a borrower at closing might be lower than the FIR.
The Cap is a very important number because it is the maximum that a rate can change. So even if the index rises 10% in one period, the FIR will not do so if there the rate cap is reached. There are two types of caps to worry about when discussing an ARM. The Rate Adjustment Cap which is the maximum the rate can change from one period to another. And the Life of the Loan Cap which is the maximum rate that can be charged during the loan. To figure out how the rate will change, you have to know the index, the margin, the rate, and the cap. Add the index and the margin to determine the FIR. Then take the rate and add it to the cap. Whichever is the smaller change is what the new interest rate will be.
This is how often the rate changes. Initially when the loan is closed the rate will be fixed for a certain amount of time, then it will start changing. How often it changes is the Adjustment Frequency. So you can have a 7/1 Arm which means the rate will be fixed for 7 years and then adjust every year after. Or you can have a 3/1 ARM. Fixed for 3 years. The more frequent the adjustment and the sooner it starts, the lower the initial interest rate. So a 3/1 ARM will have a lower rate than a 10/5 will. And that is because the 10/5 has more risk for the lender. The 10/5rate will be much closer to a fixed-rate loan.
When a borrower considers an ARM, it is usually because the rate is lower than the fixed-rate loan. And thus it is easier to qualify for. But the borrower is then betting against the bank. The ARM loan might turn out to be more expensive then the fixed-rate loan, in the long run, if rate rises during the term of the loan.
You must have an idea of how long you are going to live in the house you are borrowing to buy. If you are going to stay there long-term, a fixed-rate may make more sense. ARM’s are better for the military and other people who buy and sell within shorter periods.
A conventional mortgage is a non-government loan financed with a value less than or equal to a specific amount established each year by major secondary lenders. As of 2008, financing for less than $417,000 was regarded as conventional financing. A conventional loan is the most popular loan today, as so it has become the benchmark against all the other mortgages. It has 4 special features:
1. Set monthly payments
2. Set interest rates
3. Fixed loan term
4. Self amortization
A conventional loan is one that is secured by government-sponsored entities such as Fannie Mae and Freddie Mac. Since they are secured, the lender is assured that they can easily sell the loan on the secondary market.
And because of that assurance, these loans have the lowest rates.
To qualify as a conventional loan, the home and borrowers must fall into the guidelines set by the secondary lenders.
HOME EQUITY LOANS
Real estate has traditionally been considered a non-liquid asset. Property can be converted to cash only by either selling or refinancing. Both are very expensive and time-consuming ways to raise money. Today’s borrowers can convert their house to cash immediately by using the equity in their homes.
These loans take much less time to approve and fund then regular home loans. And the fees are generally less than a normal loan as well. But home equity loans are usually placed in a second lien position after the original mortgage, at a higher interest rate. If the borrower does not pay, the house could be foreclosed upon.
The Equity Loan is an open-ended mortgage similar to a credit card. Borrowers can take the money out, use it, and pay back the money when they choose. Recently, home equity loans have brought about new government regulations in some states since people were getting these loans without really understanding the consequences and thus being taken advantage of by less than honest lenders.
A second mortgage is a loan against a property in a second or “junior” position. In case of foreclosure, the creditor in the first position gets first dibs on any monies. In many cases, there is not enough equity in a house to pay off both the first and second mortgage. So the second mortgage holder can get nothing. Therefore, being in the second position can be a very risky place to be.
That is why second mortgages come with higher rates than first mortgages. Second mortgages come in two main forms – a fixed mortgage and a home equity mortgage. The fixed mortgage follows the same format as a regular fixed loan. The equity mortgage is based on the equity in the home.
Second mortgages are used by loan officers to either help the borrower avoid paying PMI or to avoid a jumbo loan. A jumbo loan would be a non-conforming loan and thus would have a higher rate for the entire loan. If a borrower wanted to avoid this, he could get a first mortgage at the max conventional loans allow, and a second for the balance. The rate on the second would be high but blended, the rate would be less than on the jumbo.
Two governmental agencies guarantee loans: The Department of Veterans Affairs (VA), and the Federal Housing Administration (FHA).
VA loans are one of two types of government loans and are guaranteed by the Department of Veterans Affairs under the Serviceman’s Readjustment Act. Lenders rely on this guarantee to reduce their risk. The best thing about VA loans is that for veterans is allows them to get into a house with zero or very little down. The amount of down payment required depends on the entitlement and the amount of the loan. Military service requirements vary. These loans are available to active-duty as well as separated military veterans and their spouses.
These loans are self-amortizing if held for the complete term of the loan, yet it may be paid off without penalty. These loans are only available through approved lenders. The amount of entitlement a veteran has is reported in a Certificate of Eligibility which must be obtained from the VA office in your area.
Veterans who had a VA loan before may still have “remaining entitlement” to use for another VA loan. The current amount of entitlement was much lower previously and has been increased by changes in the law. For example, a veteran who obtained a $25,000 loan in 1974 would have used$12,500 guaranty entitlement, the maximum then available. Even if that loan is not paid off, the veteran could use the difference between the $12,500 entitlement originally used and the current maximum to buy another home with VA financing.
Most lenders require that a combination of the guaranty entitlement and any cash down payment must equal at least 25 percent of the reasonable value or sales price of the property- whichever is less. Thus, in the example, the veteran’s $23,500 remaining entitlement would meet a lender’s minimum guaranty requirement for a no down payment loan to buy a property valued at and selling for $94,000. The veteran could also combine a down payment with the remaining entitlement for a larger loan amount.
The Federal Housing Administration is one of the oldest and largest sources of mortgage assistance available to the general public. The Department of Housing and Urban Development (HUD) run this program.
FHA backed mortgages are the other type of government loans and are an outgrowth of policy in the interest of the public, with the view that the government should stimulate the economy in general and the housing industry in particular. FHA loans like VA loans can only be obtained through approved lenders.
Why are FHA loans so popular? Because they have liberal qualifying standards, low or even no down payments and even closing costs can be financed and added to the loan. There is no prepayment penalty. FHA loans made before February 4, 1988, are freely assumable by a new buyer when the house is sold. Loans made after December 15, 1989, may only be assumed by qualified owner-occupants and cannot be assumed by investors.
FHA loans have limits too. Recent housing appreciation has pushed up the limits on this year’s loan program by nearly 16 percent in the continental U.S.
If you want to find out what the loan limit is where you live you can call the consumer hotline for the Housing and Urban Development Department. Their toll-free number is available on their site. The FHA is a division of HUD.
As always, consult a mortgage professional. A Certified Mortgage Planner will work with your financial planner, Realtor, CPA, and other advisers to find a mortgage loan product that is right for you.
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