affordability planning: mortgages explained
A mortgage is a loan from a bank used to finance your home purchase. Mortgages come in all shapes and sizes, but are generally broken down by interest rate type (fixed vs floating), length, and guarantor (Lending Institutions, Government Bodies).
Historical & Current 30 Year Fixed Rate Mortgage & 15 Year Fixed Rate Mortgage Rates
Fixed vs Floating
Fixed rate mortgages benefit from a rate that is unchanged, meaning your monthly payment is the same (sans changes in insurance and property taxes). For most, this stability provides comfort in budgeting and simplifies the buying process. Floating rate, or adjustable rate (ARMs), generally have a fixed period of time where the rate is constant, then begins to change at fixed intervals based on changes in market rates. In some forms, these mortgages start at rates lower than fixed rates, but then can reset much higher and adjust in the same manner. Note: some of these loans only require the borrower to pay interest during the initial period, so when they reset, the lack of paying principal kicks in and the payments become much higher. These are attractive for many borrowers with low incomes who envision earning more in the future. While the downsides are obvious to adjustable rate mortgages, for many, they can make a lot of sense. Here’s why:
Floating rate loans often come with low initial rates than can last for 5–7 years before they adjust. If you plan on living in your home for less time than the initial low-rate period, you can sell your home and pay off the mortgage (as you do with any typical home sale). The risk of course is that at the time you sell, rates are higher and your new mortgage rate is higher. Adjustable rate mortgages that reset in 2007 and 2008, which in turn created 100–300%+ increases in monthly payments, were a very contributing factor to the recent financial crises.
The standard and most widely quoted mortgage is a conventional, 30-year fixed rate mortgage. This means the mortgage term is for 30 years (or 12*30, 360 months) and fixed rate. Similarly, every lending institution will offer 15 year, fixed-rate mortgages. There are also 10 year mortgages and potentially longer term mortgages. Your lender will be able to provide you with all the available options.
The three most widely used mortgage types are those considered ‘conventional’ that are guaranteed by government sponsored entities Fannie Mae and Freddie Mac and require as little down as 3%.
Federal Housing Administration Loans (FHA) require as little as 3.5% down and are available to borrowers with credit scores as low as 580, making them easier to qualify for, but also carry insurance that is paid throughout the life of the loan if you put down less than 10% (conventional mortgages stop when the borrower has amassed 20% equity in the home). FHA loans also permit higher debt to income ratios (up to 50% for total monthly debt, from 40% conventional).
Veterans Affairs Loans (VA) are just as they sound — available to veterans and require no down payment, are available to those with lower credit scores and do not require mortgage insurance. Veterans who do take advantage of these products do pay a funding fee (generally 1.25% to 3.3% of the mortgage amount), however, but do benefit from lower rates than conventional loans.
Alternative no-down options include USDA loans that offer low rates from low-to-moderate income borrowers with good credit who are seeking homes in designated rural areas.
There are two things to note here. The first is that for those who consider the funding fee equivalent to a down payment, a down payment is simply the transfer of your cash from a savings account into the value of your home whereas the funding fee is a true fee that you release. Secondly, if you are making no down payment, an immediate decrease in the value of your home puts you at serious risk of being ‘under-water’ — meaning you owe on your mortgage more than what your home is worth. If you need to sell your home in this scenario you will need to cough up the cash to pay off the mortgage or at worse, declare bankruptcy and lose the home. So while down payments are not required, it’s still a good idea to make one.
Mortgage points are fees paid when the loan is distributed to you. Every 1% of your mortgage loan amount is equivalent to one point. Often, lenders will allow borrowers to “pay points” ahead of receiving the mortgage loan in exchange for a lower rate (the borrow is basically pre-paying some portion of the mortgage). Ask your lender how this would play out under different point payments. Points are also tax-deductible, as they are amortized, so there is an additional benefit to paying points.
How Different Rates Affect Your Payment
How much difference do changes in rates make in your monthly payment? From the time you engage with a mortgage lender to closing, it’s unlikely rates will change substantially. Here’s how the mortgage payments differ for a loan amount of $300k and incremental rises in rates of 0.25%.
Mortgage Payment Scenarios ($300,000 Mortgage over 30 Years)
A common struggle for home buyers is the choice to “lock in” rates. This occurs when the lender has sufficiently determined you are likely to purchase and close on your home in the near future. The lender will offer to “lock in” the rate as it stands today. The downside of course is that if rates drop during the lock period (30–90 days), you miss out (although many will offer a concession). Depending on the loan size, the tradeoff may be worth gambling, but in most scenarios it’s not. If you’d like to hedge your bets, you could comparison shop across two lenders and have one request a rate lock and the other not, and if rates fall, go with the one where you did not lock. Worth the effort, however? Likely not.