When you're taking out a mortgage on a home, you have many factors to consider. The term of the loan is definitely one of your most important considerations. Mortgages are available with 15-, 30-, 40- and even 50-year terms. How can you determine which is best for you?
How Long will you Stay in the Home?
Start by deciding how long you plan to keep the home. Many people buy a home and sell within a seven-year period. If you know you're simply purchasing the home to live in before moving to another location, the longer term mortgage may be a wise choice for you. After all, if you can pay a lower payment for three years and then sell, you may actually end up saving money on your home. If on the other hand, you plan to retire in your home and live there the rest of your life, you should take out a shorter term mortgage, such as a 20- or even 30-year mortgage.
The difference between a 20-year mortgage and 50-year mortgage is tremendous. The following is an example of what the total payoff will be on mortgages with different terms.
|Amount Borrowed: $200,000
Interest Rate: 7.00%
As shown above, the difference between the payment of a 15-year mortgage and a 50-year mortgage is approximately $600. However, in choosing a 50-year term, you will find yourself paying almost $400,000 more on interest. If you choose to take out a 50- year mortgage on a home you plan to live in the rest of your life, you will be paying over $700,000 in total for a $200,000 home.
Smart Planning Now Can Pay Big Dividends Over Time
You don't need to overpay on your home. If you plan to live in the home for a short period before moving, take out the longer loan and save some money on the interest. However, if this will be your home indefinitely, it is much wiser to take out a shorter term loan and save yourself the money on interest, unless you are of an age where you will not be around for the life of the loan. For example, if you're a 50-year-old who takes out a 50-year mortgage on a retirement home, it may be a wise decision. After all, most people do not live long enough to pay off their mortgage.
Take some time now to determine which path makes the most sense for you. A wise choice now can pay major dividends down the road.
Getting a mortgage isn't always a case of simply heading down to your bank and applying. There are several different types of institutions that arrange mortgages, and you may want to consider your options carefully before choosing which type to go for.
An interest-only loan is a fixed-term loan for which you pay only the interest, leaving the balance of the principal unchanged over the term of the loan. In America an interest-only period is typically between one and five years, sometimes extending as long as ten years. After this time, the borrower has the option to pay the principal, convert to an amortized (principal and interest payment) loan, or take out an interest-only mortgage.
Advantages of an Interest-only Loan
The practical result of taking out an interest-only loan is that your repayments are substantially lower than they would be with a conventional loan. This leaves you with increased cash-flow for the period of the loan, and gives you the option of using the extra money to create investments in other areas. It also means that you can afford a larger mortgage than you could by more traditional means.
Because loan interest is tax-deductible, your entire monthly payment qualifies for deductions during the period of the interest-only loan.
You have the Option to Pay
If you take out an interest-only loan, you're not confined to paying only interest for the length of the loan. You're not required to pay principal under the terms of the loan, but you can make principal payments at any time, which will build equity in your property and reduce your interest payments.
Disadvantages of an Interest-only Loan
No Principal Payment Equals No
One of the most significant risks of an interest-only loan is that when you're not paying off principal, you're usually not building equity. If you're forced to sell up and move much sooner than you expected, you may end up losing a significant amount of money in agent fees and closing costs - and you've got no equity in the house to help offset those unforeseen expenses.
With an Interest-only Loan, You're at the
Mercy of the Market
An interest-only loan can quickly turn into a financial trap if the property market stagnates, or if mortgage interest rates rise sharply (most interest-only loans have an adjustable interest rate). And if the worst happens and the value of your property decreases, you stand a good chance of owing much more than the home is actually worth.
The Interest-only Period Will
And when it does, your mortgage payments will rise sharply. You may think you have it covered, but what if your plans end up falling short? If you take out an interest-only loan because you can't afford a conventional one, and then you don't get that salary-increase you were counting on, you'll find yourself unable to meet the amortized payments that you couldn't afford in the beginning.
Take Out an Interest-only Loan for the Right Reasons
An escrow account is a means of safeguarding the interests of both the buyer and the seller of a property. The contents of the account are held by a neutral third party (an escrow agent), and are released only when all of the conditions of the contract between the seller and the buyer of a property are met.
Mortgage interest rates are dependant on federal interest rates, which are influenced by the Federal Reserve. The aim of the Federal Reserve is to stimulate the economy while avoiding inflation, by setting terms for the federal funds rate (the interest rate which banks charge each other for short-term loans), and the discount rate, (the interest rate lenders pay to borrow from the Federal Reserve). The interest rates that banks pay directly influence the interest rates they charge consumers. If the Federal Bank sets a relatively low interest rate, lenders respond by lowering interest rates for consumers, which reduces the cost of getting a mortgage, enables more people to purchase property, and stimulates the economy.
Case histories of subprime loans that have gone to foreclosure often generate righteous indignation. With benefit of hindsight, many if not most of them look as if they never should have been made. Such indignation is one important motivator for recent demands that government should require that all home mortgages be "affordable."
While affordability is a difficult concept to define rigorously, one well-defined affordability rule has emerged with the approval of bank regulators, community groups and many legislators. It applies to adjustable-rate mortgages, or ARMs, which have more than their proportionate share of foreclosures.
In many cases, lenders assess the ability of ARM borrowers to make their payments at the initial interest rate, which is artificially low. When the rate increases, the payment also increases and may become unaffordable.
I will use the 2/28 ARM, the most widely used instrument in the subprime market, to illustrate. The rate is fixed for two years, after which it is adjusted every six months to equal the value of the rate index at the time of the adjustment, plus a margin, which is fixed for the life of the loan. Any rate increase may be limited by a rate-adjustment cap.
For example, assume the initial rate is 6 percent; the index is one-year LIBOR, which currently is about 5.4 percent; the margin is 6 percent; and the adjustment cap is 3 percent. If the index remains unchanged, the rate after two years will rise to 9 percent, the maximum permitted by the cap, and six months later to 11.4 percent. Assuming a 30-year mortgage, the payment will increase by 32.7 percent in month 25, and by another 21.3 percent in month 31. The borrower may not be able to manage such formidable increases.
The affordability proponents propose that lenders should be required to qualify borrowers at the fully indexed rate, or FIR, which is the current value of the index plus the margin, rather than the initial rate. In the example, the FIR is 5.4 percent + 6 percent = 11.4 percent. The logic is that borrowers who at the outset can meet the payment calculated at the FIR will find it affordable 24 or 30 months later when the rate increases.
The requirement, however, would have little impact because it can be so easily (and legally) evaded. This may be a good thing because the consequences of an effective rule might well be unacceptable.
Borrowers are qualified using maximum ratios of mortgage payment plus other housing expenses to income. Assume the maximum ratio is 36 percent and that the borrower taking out the 2/28 ARM described above barely qualifies -- his ratio is 36 percent -- when the payment is calculated at 6 percent. Calculating the payment at the FIR of 11.4 percent would push the ratio to 51 percent, making the borrower ineligible.
The maximum ratio, however, remains within the lender's discretion. This means that a lender who wants to make the loan has only to increase the maximum ratio to 51 percent and, presto, the borrower qualifies at the FIR. This would be a completely legal evasion. In the subprime market, ratios of 50-55 percent are not uncommon.
In principle, government could close this escape valve by freezing the qualification ratio, and 25 years ago this might have been possible. Ratios of 36 percent and 28 percent, measured with and without nonmortgage debt service, were then more or less the norm. As underwriting systems have evolved, however, maximum ratios have proliferated. They now vary from one loan program to another, and with other factors that affect risk, such as credit score, down payment, type of property, and loan purpose.
Government intrusion into this very complex process in order to make the FIR rule effective would be a disaster, and nobody has suggested it.
Proponents of the FIR rule either don't realize how easily the rule can be evaded, or are satisfied to go through the motions. If the rule was effective, they might be forced to confront a really thorny issue.
Any government underwriting rule that is more restrictive than those selected by lenders, and which cannot be evaded, will reduce the number of households who qualify for loans. Of this group that is cut from the market, some would lose their homes through default and foreclosure had they received loans. This is the intended benefit of the more restrictive rule. A larger number, however, would have become successful homeowners under the previous rules and are now denied this opportunity. This is the unintended but inescapable cost of the restrictive rule.
To prevent one foreclosure by tightening standards, we prevent a larger number of successful loans. I don't know what that number is, or what society should view as an acceptable number. These questions have been studiously avoided.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania.