For most people, their mortgage represents more than just a monthly payment to a third-party for a place to live. Yes, in the short run this is what it is, a monthly payment, but over time it morphs into something much more. Understanding your mortgage from every angle is what this article is about.
Your mortgage represents both hope for the future when paid off, and a burden for today while it is being paid off. It is security and risk wrapped up in the same package. Its construct is designed beautifully, because during the years when you are working (or in the case of the recently unemployed, the years when you are more apt to find a new job), the highest debt burden and lowest home valuation (in theory) are in the early years when you have both personal career growth, and energy to back it. Later when you are more “mature” and reflecting back on life (and your mortgage is paid off or nearly so), your home will have become a massive store of value, which will give back to you financially. With the kids grown and the job winding down, you can live in your abode payment free, or can even sell it, take out cash and move into a snazzy condo that is a fraction of the price.
This is how many people look at their mortgage, and it makes sense to us as well.
What most people don’t spend nearly as much time on is the mortgage itself. Yes, they have a vague idea about the different types of mortgages, they sort of know that interest rates are low so it’s time to finance or refinance, but they do not know, in great detail what the options are and the interplay between them. That is what we’re focused on in this article.
It’s not just about the rate, in fact it’s more about the terms
There are conversations occurring all around the country about the magnificent rate that people are getting on their mortgages. A few years ago, people were bragging about 6%, then it was 5%, then 4%, now the rate is in the 3%s for some types of mortgages. Many people think that “now is the time to take out a mortgage.” The real estate market seems to have bottomed and rates are at levels never seen before.
Assuming you are educated and comfortable about the rate, then the next question is, what are the terms? Terms are not just important, they are vital; but many people just ignore them, big mistake. BIG MISTAKE. There are many terms to consider, but they generally fall into six categories.
2. Amortizing principal or interest only
3. Fixed Rate
4. Adjustable Rate
5. Fixed and then Adjustable
6. Reverse Mortgage
Mortgages come in a variety of maturities. 15, 20, 30, 40 and even 50 year in some cases. The longer the term, the lower the payment and the slower it is paid off.
This means that the interest rate that you pay does not change, it is fixed for the life of the notes
This means the rate is reset periodically, say every one, three, six, nine or 12 months, based a measurement rate in the market, such as the 1 year US Treasury rate, the prime rate, LIBOR or some other data point.
Fixed and then Adjustable
Some mortgages allow you to fix a rate for a certain period of time, typically 5 or 7 years, and then the rate will reset periodically. These are called annual renewable mortgages. They often called either 7/1 A.R.M. or 5/1 A.R.M., meaning the rate is fixed for 5 or 7 years and then resets annually thereafter.
Amortizing or interest only
People get paid differently. Some people earn a salary and no bonus, some people earn a commission check and no salary, and some people are somewhere in between. For those that earn a steady income without a big periodic payment the best option is a normally a 15, 20 or 30 year mortgage whose principal pays down over time. For those that earn a significant amount of money based on periodic payout of commission or other performance related income, it might make sense to have an interest only mortgage (I/O) – an I/O mortgage allows a person to make minimum payments throughout the year and then, as big checks come in pay-down the principal. This is often called a banker’s mortgage because investment bankers often earn most of their income once a year, on bonus day.
A reverse mortgage is designed for people with significant equity in their home who want to monetize it. This usually comes about at the end of one’s career when the house is paid off or nearly so. During this time, a retiree monetizes the equity in the form of a loan against value of the house. I personally do not like this type of loan since it leaves the borrower with significant debt and no real means to pay it off, but others swear by it, stating that the borrower can always sell when the time comes, and in the interim can take out a loan that is lower in interest rate because it is secured by the value of a home. This is really a personal choice, but proceed with your eyes wide open – once the equity is gone it’s not coming back.
Buying a home is always very exciting, and today’s would be buyers have both an opportunity to buy low and an opportunity to finance low. Take advantage if your financial situation permits because this type of situation does not present itself more than once or twice in one’s lifetime.