If you are house hunting right now you are probably spending a great deal of time looking for just the right home. But if you are like most people you probably won’t spend much time at all thinking about what kind of mortgage is best. If so, it could be a costly mistake.
I’ll admit that this is a confusing topic – especially now. One day the news reports that real estate prices are cooling. If that’s true, it will drag rates down. The next day they report that property is heating up and higher rates are on the way. Should lock up a low rate for 30 years or go with an adjustable rate?
My experience tells me that you can drive yourself crazy trying to get this right. But you can also keep it very simple and come to a very good decision between fixed or variable rate loans if you only ask yourself a few simple questions:
How Long Will You Stay?
Of course nobody can predict the future but whenever you make large investments (like buying property) you have to make some assumptions. And the most important one is how long you plan on holding the property.
You might think that you’re never going to move but the fact is that most people sell their homes after only 7 years. If you know that you won’t likely be staying too long, why take a mortgage that extends beyond that term? A 30-year mortgage as of 9-9-14 will cost you about 4.25% on average if you eye ball the chart below (Bankrate.com)
A 7 year adjustable loan is about 25% cheaper coming in at about 3%.
If you are looking at a mortgage of $165,000, you’ll pay an extra $7896 over 7 years in higher interest costs with no benefit if you take the 30 year fixed loan.
Of course you have to consider your particular circumstances. Even though the average tenure is 7 years, you might stay in your home much longer. You can’t know for certain, but think about your family’s situation and try to estimate how long you want to stay in your home before making a mortgage decision.
What Is Your Goal?
Some people need to keep their loan payments as low as possible. Others want to eliminate risk. Still others want to pay off their mortgage as quickly as possible. Which camp are you in?
People who have limited cash flow often flock to the lowest rate loan they can find. But that could backfire. The lowest rate is usually the most volatile. For example, you can get a 3 year ARM at about 2.5% right now – but what happens in 3 years? And what happens every year thereafter?
What happens is the rate could go up. True, it will be great loan for the first 36 months but after that your rate could start climbing and you could find yourself with a mortgage you can’t afford. That could spell financial disaster for you down the road – just like it did for millions of homeowners who lost their homes to foreclosure in the real estate bust that started in 2006.
If I was mostly focused on cash flow, I might take a mortgage with an adjustable rate. But I’d make sure I knew how the rate could climb over what period of time (the cap rate) and I’d make sure I could afford the payments if the rate did go up.
And here’s the kicker. I wouldn’t just hope for the best. If I couldn’t afford those potentially higher payments, I would remain a renter. At least that way, I wouldn’t jeopardize my good credit and my down payment.
How Much Risk Are You Willing To Take?
Remember – your home is likely to be your biggest investment. That being the case, it’s important to protect that investment and keep risk to a minimum.
In order to do that you have to know how much house you can afford under the worst case situation.
In my mind, risk should be your most important focus. What happens if you stay in your home longer than you think and rates climb? If you can make the payments, no problem. If not, that mortgage that looks so attractive right now might turn into your biggest financial headache. Stay clear.
What kind of loan are you considering right now? Would you take an adjustable rate? Why or why not?
My husband and I paid off the mortgage on our home several years ago when I finally understood why Dave Ramsey harped on doing so like he does – instead of paying the lender interest, we got to keep it for ourselves and invest it.
Neal Frankle, CFP ® says
Nice job Emily!