A quick guide to mortgages

Q: –– We just got transferred and are in the market for a new house, but are getting confused by all the mortgage options. Can you help us sort it all out? – J.P., California 

A:  Getting the right mortgage “for you” is a vary important financial decision. By choosing poorly, you could end up overspending by tens of thousands of dollars over the life of the loan. Before shopping for your mortgage, get to know the fundamental mortgage types and some of the terms. 

WHAT’S A MORTGAGE?

A mortgage is a loan, using your house as collateral to secure the loan. Through the monthly payment, you repay a portion of the loan principal and interest on the outstanding loan balance. The interest paid is tax-deductible for most people.

Mortgages can be obtained from banks, savings and loan associations, mortgage companies, federal credit unions, and a variety of other financial institutions as well as private individuals.

The key components of a mortgage are

• Interest rate
• Length of the loan
• Amortization (monthly payments)
• Other mortgage fees associated with the loan (acquisition mortgage fees and pre-payment penalties.)

Mortgage agreements can be based on a fixed interest rate or a variable rate.

Standard fixed-rate mortgages typically have a term length of 15, 20, or 30 years. Variable-rate mortgages, also called adjustable-rate mortgages or ARMs, most commonly have initial terms of one, three, five or seven years.

Mortgage interest rates and terms are reported widely; you can find them in the newspaper or online. Making a larger down payment, or in the case of a refinance, having a larger equity position, often results in a lower interest rate. 

POINTS

There is a trade-off between the interest rate you will pay on your loan and the amount of money the lender will charge up front for the loan. The up-front charge is called “discount points” or more simply, “points.” A point is equal to 1 percent of the loan amount.

If you are going to keep the house for many years, generally you’ll save money over the life of the loan by paying higher points at the start. This way you can get a lower interest rate and lower monthly payments.

You can figure out how long it will take to break even for the extra cost of paying points by dividing the amount you pay in points by the amount you save each month in a lower mortgage.

For example, if you pay an extra $2,100 in points to lower your monthly payment by $70, it will take 30 months to break even (not counting any interest the $2,100 might have earned during that 30 months by investing it.) 

FIXED-RATE MORTGAGES

With a fixed-rate mortgage, the loan interest rate  never changes during the life of the loan. The most common length terms for fully amortized loans are 15, 20 and 30 years, though some lenders now offer 40 and 50 year loans. Shorter term loans will require a higher monthly payment, however you will pay less interest over the life of the loan and you’ll build up equity in your home quicker.

You will usually pay the highest interest rate on a long term fixed-rate mortgage. That’s because the lender is taking a risk that market interest rates will rise during the duration of the loan and that will cost them money.

Most people who take out 30-year mortgages end up paying off the loan in less than 30 years either because they sell their house, or because they refinance the mortgage when rates come down or they need additional money for any number of reasons.

Before you decide to accept a 30-year mortgage, ask yourself about the possibility that your needs will change within 30 years in one of these ways:

• You will move to a new location.
• You will need a different house with more room for more children, or less room when they move out.
• You will be able to afford a better house.

If any of these are true, you might look into taking an adjustable-rate mortgage that might give you a lower initial and overall rate for your length of stay. 

ADJUSTABLE-RATE MORTGAGES (ARMS)

ARMs are loans that allow for changes in the interest rate over time. The most popular ARMS adjust the mortgage rate once a year. Some ARMs will offer an initial fixed rate for a certain term (usually three, five, seven or 10 years) and then make annual adjustments.

The interest rate is based on a published financial index, to which the lender adds a margin, typically between 1 percent and 3 percent. The financial index used may be based on government bonds, certificates of deposit or another widely recognized index.

ARMs usually have two rate caps that limit how much the interest rate can move up or down.

• A periodic cap limits how much the interest rate can go up or down each adjustment period.
• A lifetime cap sets the largest amount the loan rate can increase or decrease during the entire term.

As a general rule, ARMs will have a lower initial interest rate than a fixed-rate mortgage. Because the rate is lower, the monthly payment is lower for the same loan amount.

This means it’s easier to qualify for the loan since your mortgage will amount to a lower percentage of your income. It also means that you can get a larger mortgage with an ARM than with a fixed-rate loan.

If you are going to keep your house only for a few years, you may benefit financially by accepting the risk of a higher interest rate at some time in the future. This can get you in at a lower interest rate at the start of your mortgage.

BALLOON MORTGAGES

This type of loan offers a relatively low interest rate, usually for five, seven or 10 years. At the end of this term, the loan has to be paid off or refinanced. A balloon mortgage may be appropriate if you are confident that you will qualify for a new mortgage at the end of the term, or if you plan on selling your home before the term is over.

However, if you are not 100 percent certain about this, you could get stuck owing your entire remaining mortgage amount at the end of the term, so be cautious in accepting this type mortgage. 

GOVERNMENT-SPONSORED LOANS

Government-insured loans are offered by the U.S. Department of Veterans Affairs (VA), the Federal Housing Administration (FHA) and the Rural Housing Service (RHS). Certain mortgage lenders are approved to handle these loans, and you have to check to see if you are eligible.

• FHA loans allow you to buy a home with a very low down payment of 3 to 5 percent.
• VA loans allow purchase with no down payment for qualified veterans.
• RHS loans, which feature low interest rates and no down payment, are for people in rural areas or small towns.

In addition to the federal government, several states and local housing agencies have programs to help first-time home buyers. 

MORTGAGE FEES

Most lenders require that you pay an application fee, an appraisal fee and a credit report fee at the time you apply for a loan. There may be other fees due when the loan agreement is finalized and the home sale is “settled.” These costs may include transfer taxes, title insurance, title search fee, lender’s attorney fees, document preparation fees and others. Typical settlement costs can total between 1 percent to 4 percent of your mortgage amount. Also be aware of prepayment penalty fees. These are fees some lenders charge for paying of the loan too early!

This information is brought to you by The NAEPC Foundation and Noverus, your financial and estate planning partners. © Copyright NAEPC, The NAEPC Foundation, Noverus and Valentino Sabuco, CFP^®, AEP®.