Choosing the Right Mortgage
Buying a home will be the biggest investment one will make in their lifetime. For the average homebuyer, a home is far too expensive to pay off all at one time.
In most situations, the homebuyer will have to borrow money from a lending institution such as a bank in order to purchase a home. A mortgage is an instrument needed to purchase a home with borrowed funds. A mortgage loan, simply called a mortgage, is paper, usually secured by the property, which becomes a form of collateral against the borrowed money. There are many different types of mortgages for homebuyers to choose from. Below is an explanation of the different types of mortgages.
The most popular mortgage product offered by lending institutions is the fixed mortgage loan. The borrower will pay a monthly fixed amount instead of paying one large sum upfront. The most popular term (loan life) is the 30-year loan in which payments are spread over 360 months and constitutes the life of the loan. There are other fixed mortgage products such as 5, 10, 15 and 20-year fixed loans. For this type of loan, the borrower will pay off the principal (the actual cost of the home) and fixed interest payments that the lending institution will impose as the ‘cost’ to borrow the funds. Additionally, most banks will require that a down payment is paid upfront by the borrower before the loan is approved. The down payment is usually a percentage of the loan amount and typically ranges from 10% to 20% of the loan value. The benefit of this mortgage product is that the monthly amount is fixed and does not increase for the life of the loan. The disadvantage of this type of loan is that it is typically only offered by some of the larger institutions that rely heavily on the borrower’s income and credit worthiness thereby making these types of loans more difficult to qualify for. The down payment is usually higher with these loans.
Another mortgage product offered by lending institutions is the adjustable rate mortgage loan, known as an ARM loan. This ARM product offers a lower down payment and a very low interest rate during the first 1, 5, or 7 years which is the called the initial fixed period of the loan. In many cases, lending institutions offer ‘interest-only’ payments during this period and the remaining unpaid principal is amortized. Monthly payments during this period are paid to the bank similar to the fixed mortgage loan described above. After the initial fixed period expires, the loan becomes a variable-rate loan which means that the interest rate will vary depending on a certain rate index. The formula is determined by the banks and is always higher than the initial fixed period rate. The obvious advantage of this loan type is the very low payments during the initial period and benefits borrowers who do not plan to live in the property beyond the initial fixed period. The disadvantage is the uncertain variable rate after the initial period expires. A balloon payment is usually due at the end of the loan period.
Borrowers who already own an existing home can take advantage of a home equity loan or a home equity line of credit which allows for the borrowing of money against the appraised value of the home. The terms and repayment of the loan resemble the fixed loan product described above. The advantage of this loan type is that no down payment is typically required because the home’s value (minus the mortgage owned, if any) represents the equity built on the home and this serves as the collateral for the loan. The disadvantage is that homebuyers will usually pay a variable or high rate for the life of the loan.
Choosing the right mortgage depends on the following factors (based on the loan types described above):
- Deciding on fixed monthly payments (longer fixed term loan) or initial fixed rate period only (ARM loan);
- The amount of down payment the borrower can afford; and
- The amount of monthly payment the borrower can afford to repay the loan.
The borrower will have to consider these items upon choosing the right mortgage.