As you start to search for a mortgage loan, you will probably receive a lot of advice from friends and relatives about the loans they think are best. While personal recommendations can be helpful, you should keep in mind that, while your friend's mortgage worked for them, it may not be as practical for you.
With this guide, you will understand how different loan terms affect your monthly payments and long-term investment. That way, you can balance your budgetary concerns in the short-term with your long-term goals as you search for homes.
To determine how a mortgage may work for your specific situation, first speak with your lender or financial advisor.
What Types of Mortgages Are Available?
Although there is a great deal in the news about 30-year fixed-rate mortgages, it is not the only type of mortgage you should consider. Mortgage loans come with varying rate structures and also different lengths of time to pay. You should understand the benefits for each type of mortgage, so that you can better articulate your needs to your mortgage broker or lender.
- Fixed-Rate Mortgages: A fixed-rate mortgage is typically the most predictable. With a fixed-rate loan, there is one interest rate for the entirety of the loan. The monthly payment may also remain the same until the very end, as well - though if you have an escrow account, the payment may change due to changes in property taxes and insurance. If you obtain a fixed-rate mortgage when interest rates are higher, you can sometimes refinance to a lower rate if they drop.
- Adjustable-Rate Mortgages: Unlike fixed-rate mortgages, adjustable-rate mortgages (ARMs) may change the interest rate and monthly mortgage payment at a set interval. With an ARM, the loan usually opens at a set rate for a specified period of time (e.g. 2, 5 or 10 years), after which the interest rate will fluctuate. Once that initial term is over, your payment on an ARM would reset on another interval, often six months, one year or five years. The rate usually goes up but could also go down, depending on the index that is used to establish the rate. You may notice significant changes in monthly payment after each adjustment. ARMs are beneficial in that they usually have a lower initial interest rate than a fixed-rate mortgage, which leads to a lower monthly payment. You may choose an ARM if you think you will refinance quickly, or plan to sell the home after a few years.
- Interest-Only Loans: Most loans are designed to pay the interest accumulated monthly, as well as a portion of the principal. Over time, the amount of interest decreases until the principal is paid off. With an interest-only loan, you only pay the interest on the principal for a certain term at the beginning of the loan. Afterward, the loan converts to a fixed-rate loan or ARM, depending on your lender’s terms. Since you are only paying the interest at first, the monthly payment may be significantly lower. However, once the loan resets, you could face a large increase in the monthly payment to account for principal, as well as any changes in interest rate for an ARM. Since you usually do not accrue any equity by payment during that first period, interest-only loans are ideal for areas where you can reliably expect steady market appreciation.
- Two-Step Mortgages: Many people like the lower interest rate of an ARM, but would prefer to avoid the unpredictable fluctuations in interest rate after the initial term has ended. A two-step mortgage may be an option in this situation. With a two-step mortgage, the rate only adjusts once. For example, a 5/25 mortgage holds one rate for five years, then adjusts based on current rates and remains fixed for 25 years. If you are looking for a loan that offers you a lower monthly payment while you grow a business or follow a career path, a two-step mortgage may offer you that initial flexibility, balanced with a steady payment later on.
- Balloon Mortgages: When you imagine making a very large down payment on a home and then paying small amounts thereafter, you can understand balloon loans to be a similar concept, only in reverse. Balloon mortgages start with very low payments, sometimes only concerning the interest on the loan. After a shorter period, such as 5, 10 or 15 years, the remainder of the loan is immediately due. Balloon mortgages are more common for mortgages of smaller amounts. Some consider a balloon mortgage for a second mortgage, or in cases where they are very confident they will sell the home or refinance long before they need to make the payment. Otherwise, it may be a struggle to make that last larger payment.
What Are the Benefits of Various Mortgage Terms?
There are two reasons to carefully consider the length of time you have the loan: monthly payment and total interest paid. If you select the industry standard term of 30 years, make all payments on time and do not refinance the loan, you will, in most cases, pay off your mortgage in 30 years. Since the length of the term affects the amount of principal you must pay each month, a shorter or longer term may yield dramatic changes in the monthly payment.
For example, a $240,000 fixed-rate mortgage with a 10 percent down payment and an interest rate of 4 percent would require the following principal and interest monthly payments:
- 15 years: $1,597
- 30 years: $1,031
- 40 years: $902
If you have limited means when you open the loan, a higher monthly payment may be a hardship. However, paying off the loan more quickly also saves a lot of money over time. By the conclusion of that 30-year fixed-rate loan, you would have paid over $155,000 in interest. With a 15-year loan of the same amount at the same interest rate, you pay about $71,000 in interest.
How Much Will I Pay for My Mortgage?
Comparing monthly payments based on loan type and term requires precision, especially since each factor also affects interest rate. With the same $240,000 mortgage and a 10 percent down payment, you can expect these initial monthly principal and interest payments:
- 15-year fixed at 3.5 percent: $1,544
- 30-year fixed at 4.2 percent: $1,056
- 5/1 ARM at 3.5 percent: $970
As you can see, the change in loan type, term and interest rate contributes to a difference of $674 every month, depending on the loan you select.
There are many reasons to choose different mortgage loans, but monthly payment is one of the most common. With these numbers in mind, you can look at various mortgage terms and decide which one is right for your current needs and your future plans.