Understanding how mortgage rates and loan terms affect your long term wealth is wise for any homeowner. Choose poorly and you’ll leave a lot of money on the table for bankers. Choose correctly and you’ll keep more cash in your pocket. Wealth accumulation is not just about your home’s price appreciation - that will be the same whether you choose a fixed rate or an adjustable rate mortgage loan. The question is, overall, how much did you spend on the mortgage loan while you held it?
So which loan type should you choose? Let’s have a look at how both loans function, and then we’ll discuss how to make the right decision...
Fixed Rates
A fixed rate mortgage is exactly what it says. The interest rate and monthly payment you’re required to make will never change. They’re “fixed” - month after month, year after year.
For many homeowners this provides a comfortable level of certainty knowing exactly how much they’ll have to budget for each and every month without regard to what happens in the macro economy.
A fixed rate loan will contribute a portion of your payment to interest and a portion to your principal in order to have the loan completely paid off at the end of the term. Typically, lenders will offer a 30 or 15 year amortization periods in which to pay off your loan.
For those interested in paying off a 30 year loan in 15-20 years, a well known strategy for that is to make a 13th payment in December each year. Not only will this slash your payoff period nearly in half, it might also be possible to write-off the extra interest in your current tax year. Ask your loan officer and tax advisor about the current laws affecting this strategy.
Adjustable Rates
Adjustable Rate loans are called by different names, such as “Variable” or 5/1 “ARM” (Adjustable Rate Mortgage). The essence of an adjustable is they have a built-in mechanism to, well, adjust. They are fixed for a specific period of months and then become subject to periodic adjustments. Your payment can either be reduced or increased depending on the specific terms of the loan and prevailing interest rate conditions.
The specific terms of adjustable rate loans can vary widely. The differences lie in Periodic Adjustment Caps, Lifetime Caps, Margins, and Benchmark Indexes. This is where a professional loan officer becomes invaluable in helping explain all the details.
The primary attraction for borrowers who take out an ARM is the lower initial rate that keep payments lower what the current fixed rate is offering - at least for the initial period before an adjustment takes place. The longer the initial period, the longer you’ll be saving money versus the fixed rate option.
Another benefit to an adjustable rate is having the ability to pay down the loan at adjustment periods. For example, let’s say you take the monthly savings difference vs the fixed rate option and put it in a savings account. Then, when the loan adjusts, put those savings toward the principal balance. By doing this your principal balance will be reduced by the amount of those savings. Because your monthly payment is based on outstanding principal amount, your payment will drop proportionally.
Now, let’s have a look at some things to consider before choosing a fixed rate or an adjustable rate.
How Long Will You Stay?
One of the first decisions a borrower should make is estimating how long they will be staying in the home before they move on. We can’t predict the future of course, but some reasonable assumptions can be made if the right questions are asked?
● How many years do your children have left to complete high school?
● Are you just starting out and plan to build a family?
● Do you have a historical pattern of moving - what is it?
● How certain are you to stay put for the next 15 plus years?
● Will your property eventually become a rental?
● Are you a good manager of money?
Next, ask what sort of risk tolerance you have? Fixed rates require no worrying, no risk to external upheavals in the interest rate market. Adjustable rates have the risk of going up to the maximum Cap Rates, eventually clawing back the initial years savings.
Understanding how mortgage rates and loan terms affect your long term wealth is wise for any homeowner. Be sure to find a professional to help you consider all the options before signing on the dotted line.
References
https://www.investopedia.com/terms/a/arm.asp https://www.debt.org/real-estate/mortgages/how-to-pay-30-year-mortgage-in-15-years/ https://www.bankrate.com/glossary/f/fixed-rate-mortgage/ https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-fixed-rate-and-adjustable-rate-mortgage-arm-loan-en-100/
