What is the Best Type of Mortgage? (It Might Not Be a 30-Year Fixed Rate!)

 

The 30-year fixed rate mortgage has been the standard for American home financing for a long time.  It is so standard that many homebuyers don’t even consider other alternatives. 

 

To quote many a parent, “Just because it’s right for someone else doesn’t mean it’s necessarily good for you.”   Financing your home with a 30-year fixed rate mortgage has its advantages.  You know what your interest rate will be and eliminate the anxiety of potential future increases that could affect your payment.  You also will have 30 years to pay off your loan with a lower payment than plans with shorter terms.

Depending on your situation, the 30-year mortgage may not be the best option for you.

Benefits of an adjustable rate mortgage

The adjustable rate mortgage (or “ARM”) has its index rate that can fluctuate throughout your term, which can be as long as 30 years.  Movements in an index rate (usually the prime rate) determine what your rate will be, often adjusting annually.  The rate can go up, or it can go down, usually within limits defined in the mortgage.  Often, an ARM locks in your rate for a certain number of years before it becomes adjustable.

Historically, a homeowner could have been better off with an adjustable rate mortgage.  Since 1992, 30-year mortgage rates have peaked at about 9.25%.  A one-year ARM could be had for just shy of 7.00%.  Since then, the average rate on the ARM maxed out at about 7.50%, never coming close to the rate on that fixed loan.

Since rates have fallen, the savings between a fixed rate mortgage and an ARM have narrowed.  With rates at historic lows, the odds of an ARM rate adjusting upward are greater than a rate reduction.

Still, there is a case to be made for the ARM in some situations.

 

An ARM may be the best mortgage for first time buyers.

Many first-time buyers are looking for a starter home that they plan to stay in for a few years and then move.  If this is your plan, the ARM may be the smart choice.

As mentioned, many ARMs lock in your rate for a certain number of years before rate changes can begin.  Suppose you think you will stay in your home about five years, you might opt for an ARM that fixes your rate for seven years (just to give you a little wiggle room) and then begins to adjust yearly after that.  It's called a 7/1 ARM.

Here’s the math based on some recent rate offerings.

 

If you put the savings in the payment amount in a savings account each month for five years, you will have $1,675 and an additional amount for whatever interest you earn.  Also, since less of your payment was going toward interest, your balance is $771 less after five years than it is with the 30-year option.  That’s over $2,000 to put toward your next home purchase without considering any tax deductions you may have gained from the higher 30-year rate.

 

How to pay off your mortgage faster.

Another option to consider is a shorter-term mortgage.  While it has been the standard, the 30-year mortgage is not your only choice.  If the financial benefits of home ownership are as valuable to you as the lifestyle factors, it can pay to set your mind to a 15 or 20-year mortgage.

 

Again, some math based on recent rate offerings.

 

As you can see, there can be a substantial increase in the monthly payment when going with a 15 or 20 year fixed rate loan.  However, the savings on the back end can be huge, increasing the equity in your home $40,000 after ten years of payments.

 

The payment amount may scare you off if you are trying to buy the most house you can.  If your interests lie in managing your debt and building up your home’s equity, consider this scenario:

Suppose you are shopping for a home and you find one you like that will require a mortgage of $200,000.  Not wanting to settle on the first home you find, you keep shopping.  You shop a little longer and find another that will require an additional $25,000 in financing but has some amenities you did not find in the first home.

After more shopping, you find your dream home with everything you ever wanted and more that will require a $275,000 loan.

 

Let’s tie each of these choices to a different mortgage option with some more (oh no!) MATH.

In some ways, this is comparing apples to oranges.  However, it puts into perspective the financial impact of your three choices.  What other needs could you fund in ten years with the savings from the lower priced home and shorter-term mortgage?

 

A final word of advice

Evaluate all your options and make the decision that is best for you.  The 30-year fixed rate mortgage may certainly be the best choice for you.  Don’t settle for it just because someone tells you it’s the only option.  First, get the facts so you can answer the question “What’s the best mortgage for me?”

 

Sources: http://mortgage-x.com/trends.htm

 

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