Understanding MortgagesThe parts of a mortgage and common mortgage loan options.
Most people can't afford to pay for a home with cash. Rather, they must qualify for a mortgage, which is a home loan, typically from a financial institution. A mortgage is made of three components:
- Down Payment - This is the amount of cash you bring to the purchase. Typical down payments range between 3% and 20% of the home's price - the higher the down payment, the lower the mortgage. Making a down payment of 20% or more allows you to avoid the purchase of private mortgage insurance, saving hundreds of dollars per year.
- Monthly Payment - Your monthly financial commitment. This payment includes both principal (the amount you owe), interest, and applicable fees.
- Closing Costs - The costs associated with taking out the mortgage. They include processing fees, title fees, local government fees, recording the deed, among others. These fees typically account for 1% to 3% of the price of the home. Some of these costs can be rolled into your mortgage, or you may be able to split them with the seller.
There are several types of mortgages, each of which offers some variation of a monthly payment versus total cost equation. Some mortgages are designed to be more affordable in early years, while getting more expensive later. Others offer a predictable monthly payment for the lifetime of the mortgage.
One of the most popular types of mortgages is the fixed-rate mortgage. These are the most predictable mortgages since the interest rate and payment remains the same over the term of the loan. Terms are typically either 15 or 30 years. Longer terms offer a lower monthly payment, but a higher cost over the entire term of the loan. Shorter terms offer a higher monthly payment, a somewhat lower interest rate on average, and a lower overall cost.
For example, the monthly payment on a $250,000 mortgage over 30 years at 6% interest would be approximately $1,500. The total in principal and interest over the 30 years comes to approximately $539,500.
A 15 year, $250,000 loan at 5.5% would result in a roughly $2,050 monthly payment - $550 more per month. But there are a lot of benefits for the extra money. Not only will the mortgage be paid in half the time, but the interest rate is a bit lower and the overall cost is much lower - just $367,500. That's $172,000 cheaper than the 30 year option.
Keep in mind that if you could afford the extra $550 per month, you may also be able to afford a $350,000 mortgage financed for 30 years. So while your finances may thank you for choosing a shorter-term mortgage, you may be required to buy a smaller home or a home in a less desirable location.
Mortgage Term Choices
Why would anyone choose a 30 year mortgage when a 15 year mortgage is so much cheaper? There are several reasons. As we mentioned before, a longer term lets you purchase a more expensive home. If you could afford to pay the $2,050 per month used in the previous example for a 15 year term, you could afford to buy a home worth nearly $350,000 - that's almost $100,000 more home, a significant difference. A more expensive home may be bigger, in better repair, or in a nicer neighborhood - factors to also consider when making a major investment.
Next, mortgage interest is tax deductible, so a shorter term means less interest to deduct, which narrows the difference by a significant amount. For example, in the 28% tax bracket, the federal tax benefit alone would be around $81,000 over the course of the loan for the 30 year option, while it would be just $33,000 for a 15 year loan. That's a discount of nearly $50,000 over the 15 year option, bringing the difference to $124,000 versus the $172,000 cited above.
Finally, keep in mind that the dollar amounts cited in the mortgage calculations are in current dollars. Because of inflation, the cost of your debt relative to your income is likely to get smaller and smaller. Using inflation figures from the last 30 years as a guide, if you earned $75,000 per year when you bought the house, in 30 years your salary would be nearly $225,000 per year. This fact further shrinks, but does not eliminate, the difference. Please see the "Saving vs. Investing" module for more on inflation.
To further complicate the 30 versus 15 year mortgage debate, imagine that rather than paying a mortgage payment for the final 15 years of a 30 year mortgage, you were able to save and invest the money. At just a 5% return, after 15 years you would have saved a nest egg of $546,000 and own your home outright.
Keep in mind that these calculations make a couple of important assumptions - that you would keep the house and not sell it before the mortgage was paid and that, in the 15 year option, the extra money would be invested for another 15 years. Life is rarely this simple, and just because you take out a longer mortgage does not mean that you will not save as much for the future. But having fewer financial commitments does mean that you will have more options for saving and investing.
Adjustable Rate Mortgage
The next type of mortgage is the adjustable rate mortgage (ARM). Unlike a fixed rate mortgage, the interest of an adjustable rate mortgage may change many times over the term of the loan. Interest rates are typically determined by a widely accepted standard, such as federal interest rates, and will vary depending on that rate. In the event of a large interest rate increase, the amount of a mortgage payment could go up significantly. For example, if mortgage interest rate was to increase from 5% to 10%, the monthly payment on a 30 year $250,000 mortgage would go from $1,350 per month to $2,200 per month - an increase of $850 per month or over $10,000 per year.
One of the reasons adjustable rate mortgages are popular is that they may enable people to buy a more expensive home than they would otherwise be able to afford. Interest rates are typically fixed at a very low rate (up to 40% below the prevailing rate for a 30 year fixed mortgage) and are guaranteed not to increase for a certain number of years. The interest rate will then adjust annually after that - almost invariably going up to make up for the artificially low fixed period.
Some people use adjustable rate mortgages because they think they will make more money in a few years or will sell the house quickly. Such assumptions may work out in the buyer's favor, but often they may not. Adjustable rate mortgages can be risky, and are best left to those with the resources to recover if something does not work out as planned.
Please note: There are many other types of mortgages that involve more risk than fixed and adjustable rate mortgages. For example, interest only loans allow buyers to only pay the interest on the loan - payments on the principal are optional. Negative amortization loans allow buyers to pay less than the interest due and none of the principal for a certain amount of time. These types of loans are best left to financially advanced home owners and investors.
Other Types of Loans
There are a couple of other loan programs that are available to some home buyers. In both of these programs, a government agency guarantees the loan, generally making the loans less expensive than the conventional options outlined above.
- Veterans Administration (VA) Loans - If you are a veteran, the Veterans Administration offers very favorable loan options. In some, a home can be purchased without requiring a down payment.
- Federal Housing Administration (FHA) Loans - These loans are backed by the US government and tend to be the cheapest non-veteran loans available. There is more red tape involved with these loans, and not all sellers will agree to a FHA loan. Homes purchased with these loans must also pass a rigorous FHA inspection, meaning the fixer-upper homes may not qualify.