Last weekend, my friends and I were packed into the car and headed on a summer road trip. Four girls, all of us homeowners. Naturally, you’d expect us to talk about fashion, work drama or the men in our lives. But surprisingly, we spent a chunk of time talking about the trials and tribulations of homeownership. One of the girls mentioned that she was going to refinance. “Your rate is already so low, why would you refi?,” I asked, recalling that her rate was somewhere around 3.75%. Apparently, her mortgage broker indicated he’d be able to help her refinance to sub-3%. “He knows best,” she said.
I started prying about the terms of the loan. But she wasn’t able to provide me with much detail. She just put her blind faith in him to get her a lower rate, not bothering to consider the hidden fees.
Here’s the thing: the likelihood of her getting a 30-year, fixed interest rate at sub-3% is about the same likelihood I’ll vacation on the moon in my lifetime. Yes, rates are low. But they aren’t that low—at least not for a conventional 30-year loan. Most likely, her mortgage broker was trying to convince her to get a 15-year fixed loan, or perhaps a 5-year adjustable rate mortgage (ARM)—which were the same loans that got people into a bind during the last housing bubble. It’s a bad idea for someone like my friend, who already lives paycheck to paycheck and who has very little equity in her condo.
Before you allow a mortgage broker to sweet talk you into a new mortgage, it’s important to understand the differences between these loan products. Here’s a quick overview:
Fixed Rate Mortgage
The interest rate is fixed for some period of time – from 5 years up to 50 years. The most common types are 15- and 30-year fixed rates (the “conventional” loan). If you go for a fixed rate mortgage, you have the security of knowing how much you’re going to pay every month, year in and year out. If rates go up, you won’t pay more. If rates drop significantly, you can refinance into another lower-cost, fixed rate loan. Most people will opt for the fixed-rate mortgage if they plan to stay in their property for more than five years.
Unlike a fixed rate mortgage, the interest rate on an ARM can fluctuate from year to year. Usually, interest rates for ARMs are lower because they come with higher risk over the long-term. Many lenders will offer a 5-year ARM in which the interest rate is fixed for the first five years of the loan, and then fluctuates thereafter. If you aren’t planning to stay in the same home for more than 5 years, this is a great option. You lock in a lower interest rate now, and if the rates fluctuate down the road (beyond the initial five years), it won’t matter to you because you will have sold the property.
This type of loan allows the borrower to pay interest only for a period of time before paying principal and interest. This loan isn’t common for the purchase of a new home, but is often used as a second loan—like a home equity line of credit—after a person has owned a home for a while. On the rare occasion a person is able to secure an interest-only ARM for the primary loan on the purchase of a new home, beware that the devil is in the details. If you are not able to pay interest and principal at the same time, it will be difficult to pay down the mortgage and build equity in your home.
One-year Treasury ARM
This type of ARM has a fixed interest rate for one year only before it become adjustable. The new rate is calculated by the U.S. Treasury average index plus the loan margin. When rates go down, you can benefit with 1-year Treasury mortgage because rates are lower than other fixed-price mortgages and ARMs.
This mortgage allows a person to convert their ARM into a fixed-rate mortgage after some period of time. Few people go this route; instead, most refinance into a conventional loan. The only real benefit is the convertible ARM allows people to save the up-front costs of refinancing.
A balloon mortgage is when a person pays a very low interest rate and small amount toward principle every month, but after a certain period of time (typically, 10 years), a “balloon” payment will become due equal to the principle balance of the loan that had not yet amortized. For instance, if you have a loan for $400,000 and through principle and interest payments over ten years you pay down the loan to $300,000, at the time the balloon payment is due you’d owe a lump sum of $300,000. Few people use these loans today, but they can make sense for someone who has a high salary/savings and/or if they own a home in a hot market and anticipate they’ll be able to sell the home for a significantly higher price—thereby putting the sales proceeds toward the balloon payment. The biggest risk if your life and/or the market changes and your balloon payment becomes due. In this scenario, you can refinance into a different type of loan but refinancing terms may be at a higher cost.
There are many types of hybrid mortgages, including: Option ARM mortgages, Combo Loans, and Mortgage Buy Downs. An Option ARM is a complicated mortgage type, and the interest rate fluctuates periodically. Borrowers can choose from a variety of payment options and index rates. A Combo Loan is when a person has both a first and a second mortgage. The first mortgage is usually for 80% of the principle, and the second loan can be used for home renovations/repairs or to pay down additional principle in order to avoid paying PMI. The first mortgage will always supersede the second mortgage, so if you default, the holder of the second mortgage gets repaid last. Finally, a Mortgage Buy Down is when borrowers pay an upfront fee (usually equivalent to 1% of the purchase price) to lower their interest rate by a set amount.
So which loan is right for you? It’s important to compare all of the types. Look at all of the deals, the fees associated with taking any one of these mortgages out, and the terms of the rates that you’re being offered. And always, always be sure to check in with a few different lenders to compare your options. When I was shopping for my home loan, I talked to three lenders before speaking with a fourth who had a loan product (a Combo Loan!) that much better met my needs!