How to Choose the Right Mortgage
For most people, the single largest purchase they’ll ever make is their home, and with a mortgage commit to the endeavor for several years or decades. Just as a large purchase like a home or property is nothing to undertake lightly, so too are the terms and structure of the mortgage, to which the buyer will be financially bound over the course of paying off the property. Whether you’re an investor or a homeowner, the mortgage on your property is going to be a part of realizing your goal, whether it’s ownership of the home or selling it for a profit. When choosing a mortgage, there is a wide range of personal factors you need to be aware of and weigh against current and anticipated economic realities. For example, your personal finances may experience periods of advance and decline, interest rates will rise and fall, and the strength of the economy varies every few years. To put your loan selection into the context of both these factors and your overall goal, you’ll want to consider several things such as the amount you currently can afford per payment, how large your down payment is, how long you intend to live in or hold the property, and – particularly if you’re an investor – the direction in which interest rates are heading and where you anticipate they’ll be for the amount of time you expect to hold the property.
Prior to choosing the mortgage structure that’s right for you, there are a few timeless truths that remain the same regardless of your plan. For one, make sure your credit score is at least above 700 across all three reporting outlets. A low credit score will increase the amount of risk a lender assumes by taking you on as a borrower, meaning they’ll have to lend to you at a higher interest rate and over the course of a mortgage the difference can cost you tens of thousands of dollars. If your credit score is low, it’s a lot cheaper and quicker to build up good credit before buying a home than it is to be locked into a high-interest loan for the next few decades. A second necessity is to save up for the largest down payment you can afford; not only will this necessarily lead to a lower loan principal to pay off, it can also reduce the amount of time you’re in debt and, by extension, lower the total amount of interest you pay over the lifespan of the mortgage. Larger down payments are also more reassuring to lenders, meaning you can also potentially get a lower interest rate as well. Finally, as with every other financial decision made by a savvy investor or consumer, buy under what you can afford. As we say around the office, “Rich people get rich by living like they’re broke, and broke people stay broke by living like they’re rich.” Don’t make decisions based on the hope of earning more money in five or ten years (especially without a concrete plan to do so!), and be realistic regarding the practical concerns of your current financial situation. Could you still afford the mortgage if you received a pay cut? Had to deal with an illness? For the investor, could you continue paying the mortgage if the property took longer to sell than anticipated, or if it remained vacant of tenants for longer than planned?
The next step is understanding the financing terms, how they relate to your ultimate goal, and where they fit within the context of that goal in your overall plan. While adjustable-rate mortgages or ARMs offer lower initial payments, they are unfortunately often used to enable buyers to get into homes they cannot actually afford, and most homebuyers would do well to look past the surface appeal of these and avoid the potential trap. That being said, for an investor who may be looking to only hold the property as long as it takes to be renovated and resold, an adjustable-rate mortgage may work in their favor. As with most aspects of real estate, what works depends on the individual’s unique set of circumstances and goal, and often the effectiveness of their choice depends on the quality and thoroughness of their overall plan. Fixed-rate mortgages, on the other hand, are more common and do not feature rate increases, allowing greater predictability for a stable and no-surprises payment plan. For the disciplined property owner, this should be appealing, especially if they plan to hold the property for the entire duration of a fifteen or twenty-year mortgage. If your plan is to get out of debt as quickly as possible as either a landlord or a homeowner, a fixed-rate mortgage provides the most predictable path to that goal through a steady interest rate, and it can always be refinanced if rates fall.
So what’s the difference between adjustable-rate and fixed-rate mortgages, and why does it matter?
As we mentioned earlier, ARMs or adjustable-rate mortgages are loan structures for which the interest rate varies over time. The initial interest rate on an ARM is generally below the market rate on a comparable fixed-rate loan, which then continues to rise as time goes on. It’s important to understand that if the ARM is held long enough, the interest rate will be much greater than the going rate for fixed-rate loans, meaning that while it’s often attractive to anyone who may be shortsighted or unprepared financially and logistically for home ownership, it can also carry devastating consequences for the same buyers who may find it appealing in the first place. If lower initial payments are attractive to you, you need to take an honest look at why that’s the case: is it because you’re drawn to the initial low payments without regard for the full term of the mortgage, or are you an investor who knows from experience that the property can be rehabbed and sold within a predictable time period? For the investor, the ARM’s fixed period of time during which the initial interest rate remains constant can be a plus. For the long-term homeowner, the subsequent rate hikes can be disastrous, as they can be extreme and catch the owner unprepared. The fixed-rate period can vary significantly – anywhere from one month to 10 years – and shorter adjustment periods generally carry lower initial interest rates but proportionally greater rate increases. If interest rates are high and expected to fall, an ARM may afford the investor or owner lower interest rates without the need to refinance, but if interest rates are climbing or a steady, predictable payment is important to a long-term homeowner or a landlord intending to rent the property for several years, a fixed-rate mortgage may be the way to go.
Fixed-rate mortgages, as the name implies, charge a set rate of interest that remains constant, or fixed, throughout the entire lifespan of the loan. This is preferable to almost all homeowners and investors – even those with a relatively short timeline to their plan – because while the amount of principal vs. interest paid each month varies from payment to payment, the total payment remains the same, meaning budgeting and planning is easier for just about any purpose. The main advantage of a fixed-rate loan is that you as a borrower are protected from sudden and often significant increases in monthly mortgage payments if interest rates should rise. Fixed-rate mortgages are also easy to understand and largely identical across the board. In other words, what you get from one lender is about what you’d expect from any other. This should hold a certain appeal to the smart homeowner or conscientious investor, because the predictability in fixed-rate mortgages allows for better planning and a clearer path to accomplishing the overall goal, and in real estate, having reasonable goals and appropriate, details plans to achieve them is the difference between success and failure. For the average homebuyer, predictability and easier financial planning should be the way to go. If you’re an investor intending to flip the property, is the success of your plan predicated on a narrow window in which to sell the property? If selling the property took longer than expected, could you afford the rate increase of an ARM, or would it be more feasible to continue to pay the steady rates of a fixed-rate mortgage?
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– Get It Right Solutions