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There are a lot of decisions to be made when buying a house. Details like realtor, location, size, floorplan and offer are all important choices. But, for many, the most challenging decision relates to financing. When you’re in the market to buy a house, your Realtor will suggest that you arrange your financing ahead of time, and a preapproval letter from your lender is often required when submitting an offer. Having a general understanding of financing options ahead of time can give you a leg up, making one of your biggest financial decisions a prudent one.
- Fixed-Rate Mortgage (FRM): By far the most commonly used form of financing, the interest rate on a fixed-rate mortgage, and monthly payments, are fixed for the term of the loan—most often ten, fifteen, or thirty years. Payments are lower on thirty-year mortgages, because the repayment period is longer. However, interest rates are lower for shorter-term, ten- or fifteen-year loans. If cash flow is high, and you would like to pay off your mortgage faster or before a certain date, like retirement, a shorter term might make sense. If you prefer lower payments, consider a thirty-year mortgage instead. Fixed-rate mortgages are fiscally responsible, because set monthly payments are applied to interest and principal, steadily reducing your liability, and, therefore, increasing your net worth over time.
- Adjustable-Rate Mortgage (ARM): Also commonly used for financing, interest rates on adjustable-rate mortgages are fixed only for a portion of the term (most often five or seven years), then the rate adjusts each year thereafter. The new rate is tied to an index rate, such as the LIBOR rate, plus additional percentage points, which will vary by lender. Once loan rates become variable and subject to annual adjustments, your payment will adjust to the amount required to amortize the balance of the loan at the current rate over the remaining loan term. The adjustable nature of rates and payments make ARMs riskier than fixed-rate options. ARM borrowers take a chance that they will move before the fixed-rate period ends, that income will increase in the future to support higher payments, or that interest rates will go down. Given the uncertainty of these variables, it is hard to make the case for an ARM for most borrowers looking to buy a house. ARMs might be better suited for real estate investors looking for non-residence purchases that they anticipate selling within the fixed term.
- Interest-Only Mortgage: As the name implies, interest-only mortgages only require payments of interest and do not pay down principal. During the interest-only term, the balance of the liability does not decrease, and your net worth does not improve. Typically, interest-only loans are fixed interest for a period of seven or ten years, and then adjust to fully amortized, variable-rate loans requiring payments that include principal and interest for the balance of the loan term. Tackling principal on a now-shorter loan term (still continuing to pay interest) can dramatically increase payments. Similar to ARMs, interest-only borrowers make some predictions about the future, anticipating that they can pay off the loan balance or that they will sell the property before the interest-only term ends. The use of interest-only loans should be limited to speculators and experienced real estate investors.
In addition to financing options, your lender might also have a discussion with you about points. Mortgage points are fees paid up front, in exchange for a lower interest rate. One point will cost 1% of the planned loan balance. So, on a $500,000 mortgage, one point will cost $5,000. In exchange for paying points, your interest rate might drop by one-eighth (0.125%) to one-quarter (0.250%), on average. A lower interest rate for a long period of time can save a lot of money, but there are other factors to consider and break-even is important. Before deciding to pay points up front, divide your monthly savings (with the lower rate) by the cost of the point(s). If you do not plan to carry your mortgage for at least this long, an upfront cost might not be worth it. For this reason, many borrowers choose to add the cost of points to the loan balance to be paid down over time.