What Kind of Mortgage Should I Get?
This decision used to be a heck of a lot easier; before the 1980s, mortgages came in one basic flavor. The rates were fixed, you paid them back over 30 years, and then you held a mortgage-burning party where you triumphantly set fire to your loan paperwork.
Spiking interest rates in the 1980s brought adjustable-rate loans, where borrowers got low “teaser” rates in exchange for the possibility that their payments would change with interest rate swings.
Today, the variety of mortgages available is staggering. One of the more popular options is the hybrid loan, which combines features of both fixed and variable rates. Typically, the loan is fixed for the first three to seven years before becoming adjustable.
Also gaining popularity, particularly in expensive real estate markets, is the interest-only mortgage. As the name implies, these loans don't pay anything toward the principal for the first few years. You pay just the interest and hope that rising markets build your equity for you.
Then there's the option or “flexible payment” mortgage, which lets you pick and choose how much you pay each month. You can make a full payment or pay only the interest. You can skip a payment or make an extra payment toward the principal.
Each of these loans initially offers borrowers lower payments than they'd get with a 30-year loan—sometimes much lower. But all expose borrowers to the risk that their payments will raise, perhaps sharply, in the future.
At the other end of the scale are short-term, fixed-rate loans that help you pay down your principal faster. When interest rates plummeted at the beginning of this century, many borrowers refinanced into 15-year fixed-rate loans so that they could own their homes free and clear in half the time of a traditional mortgage.
So, how in the world do you decide what's right for you?
There's no one right answer. It all depends on your plans, the prevailing interest rates, and your tolerance for risk.
There's a lot to be said for the traditional 30-year mortgage. Your interest rate is fixed for the life of the loan, so you don't have to worry about rising payments. If rates drop, you can always refinance. Meanwhile, you're paying off a little principal with each payment, that “forced savings” that helps you build wealth over time. Payments are lower than for a loan with a 15-year term, which can give you more financial flexibility. If you want to pay more toward your principal, you can, but you're not locked into higher monthly payments.
All that flexibility and stability comes at a price, however. Interest rates and monthly payments on 30-year fixed-rate mortgages will be higher than with many of your other options.
That's why many mortgage experts say you should match your mortgage to the length of time you expect to be in your home. Someone who plans to move in five years, for example, would be advised to choose a five-year hybrid loan or even an interest-only loan where the rate is fixed for the first five years.
The thinking is that even if you stay a year or two longer than you expected, you'll still save money compared to what you would have spent with a fixed-rate loan.
Short-term adjustable-rate loans are a bigger gamble. You know the payment will go up because you're paying a low “teaser” rate for the first few months that will eventually adjust upward to the “regular” rate. What happens after that depends entirely on what's going on in the economy and with the Federal Reserve, which controls short-term interest rates. If the Fed decides it needs to battle inflation, it will raise rates rather abruptly. If the Fed is worried about an economic slowdown, it could lower rates just as fast.
Most adjustables come with built-in safeguards. Typically, the rate isn't allowed to rise more than 2 percentage points a year, or 6 percentage points over the life of the loan.
But that's still a pretty big potential rise. An increase from 5% to 11%, for example, would about double the monthly payment on your mortgage.
The risk on interest-only loans is even greater. While many interest-only loans offer fixed rates initially, they usually change to variable loans after a number of years. At some point, the loan also will require you to start making principal as well as interest payments.
This can lead to huge payment shock. Instead of paying principal over 30 years, you're typically paying principal over 20 years or less. Table 4.3 shows what you might see with an interest-only $500,000 loan where the principal payments are required starting with year 11.
| Years | Rate | Monthly Payment |
|---|---|---|
| 1 to 10 | 3.875% | $1,615[*] |
| 10 to 30 | 3.875% | $2,997[**] |
[*] Interest only
[**] Includes amortization of the principal over 20 years
This example assumes the absolute best-case scenario: Interest rates stay exactly the same—and near record lows. Neither is likely.
Table 4.4 shows a more frightening example in which interest rates increase to the loan's caps over the years. The first five years have a fixed rate, the second five have a variable rate that starts at 6.875%, and the final decades have the highest rate allowed, plus principal payments starting in year 11.
| Years | Rate | Monthly Payment |
|---|---|---|
| 1 to 5 | 3.875% | $1,615[*] |
| 6 to 8 | 6.875% | $2,864[*] |
| 8 to 10 | 9.875% | $4,114[*] |
| 10 to 30 | 9.875% | $4,783[**] |
[*] Interest only
[**] Includes amortization of the principal over 20 years
Most likely, your experience with an interest-only loan, or any kind of hybrid or adjustable, would be somewhere between the extremes. But you should at least know how bad things might get before you make the choice.
You also should do your homework before taking out an option or flexible payment mortgage. These are so complicated that I won't even attempt to discuss their pros and cons here. Just know that the interest rate can change as often as monthly, and if you choose to make less than a full payment, these mortgages can actually get bigger over time. Also despite the lender's assurances about your payments being capped, these loans can “reset” after a certain number of years, and your payments can jump significantly.
When people get into trouble is when they choose an alternative mortgage because it's the only way they can purchase the home they want to buy. At some point, their payments will rise, and they may be forced to sell prematurely if they can't afford the increased cost.
When you're evaluating loans, take the following steps:
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Do the math.
Make sure you calculate exactly how high your monthly payment can go if you opt for anything other than a fixed-rate loan. If you don't know how to do the math, look online for a mortgage amortization calculator or ask your mortgage broker or lender to help. Don't accept the loan officer's blandishments that a variable-rate loan will “never” reach its caps. Nobody can predict the future of interest rates, and people have been surprised before. Make sure you'll be able to swing the higher payments or be willing to sell your house if worse comes to worst.
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Consider your need for financial flexibility.
If your income is quite variable or you expect heavy expenses like college tuition payments in a few years, be careful about taking on a loan with payments that could spike. Many people choose an adjustable or hybrid loan for the low initial payments, only to find themselves trapped when payments rise.
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Evaluate your tolerance for risk.
You may be willing to literally “bet the house” that interest rates will stay stable or that your income will rise sufficiently to manage higher payments. But if that's not the case, there's nothing wrong with opting for the safety of a fixed-rate loan.
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Don't expect to refinance your way out of trouble.
When interest rates were near their historic lows in 2004, I interviewed several homeowners about why they'd chosen variable rates when they had no plans to move. Many of them shrugged and said they would just refinance to a fixed-rate loan if rates went higher.
A look at historic interest rates would have given them pause. Rates on variable and fixed-rate loans tend to rise and fall at about the same time. If their variable-rate loan payments shoot up, chances are good that the payment on a fixed-rate loan would be even higher.
Should You Gamble on an Interest-Only Loan?You may think interest-only loans are a relatively new innovation. You'd be right—and wrong. Interest-only loans actually were quite popular in the 1920s, when investors wanted to minimize their mortgage payments and throw their extra money into the roaring stock market. The 1929 stock market crash and a steep rise in foreclosures took the shine off interest-only loans for most homeowners. A few brokerage firms continued to make the loans, however, to their wealthy clients who already had plenty of real estate exposure in their portfolios and who didn't feel the need to build equity in their homes. As housing prices started to soar in recent years, interest-only loans started gaining wider appeal. The trend was goosed along by mortgage professionals who were trying to keep the refinancing boom going after most people had already traded in their loans for new versions. As the name implies, interest-only loans don't require you to repay any principal—at least not in the early years. The interest rate may be adjusted annually or be fixed for a period (usually five, seven, or 10 years) before becoming variable. The interest-only portion may end after the fixed period, or it may continue for a few more years before principal payments are required. As with other adjustable-rate mortgages, there are typically caps that determine how much your interest rate can rise each year and during the life of the loan. What catches most borrowers' attention is how low the initial payments are compared to those of other loans (see Table 4.5).
Lower payments mean you can qualify to buy a lot more house, which is why interest-only loans have become so popular in pricey markets where it's difficult to afford a home. Ironically, though, people who are using them to stretch to buy a home are among the worst candidates for these kinds of loans. Payments can jump as soon as the rates become variable, and they can jump again—sharply—when principal payments become mandatory. If you could barely afford the home when the payments were low, you might be in foreclosure soon after the first adjustment. Another group of buyers don't want to tie up their money in a mortgage; they'd rather invest it somewhere else for a better return. They're content to let rising real estate markets build their equity for them, and they see no need to pay down their equity. This strategy can work well when home prices are rising, but it can leave the homeowner stranded—owing more on the home than it's worth—if the real estate market tanks. It's also a dangerous strategy for the financially undisciplined. If you use your smaller payments as an excuse to spend more, you won't be building wealth over time. Many people need the forced-savings aspect of a regular mortgage; otherwise, they just wind up poorer in the long run. |