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| The Basics | What length mortgage should you get?
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When it comes to the length and type of mortgage, consumers have more choices than ever.
By Bankrate.com
Shopping for a mortgage is like buying a suit: One size does not fit all.
When it comes to choosing the length of a mortgage, consumers have more choices than ever. The most popular loans are still the 15- and 30-year fixed mortgages, but few buyers realize that they can also shop fixed-rate loans in other five-year increments that span 10, 20 or 25 years. Or they can adjust the length of their mortgage by paying additional principal as they go along. And some elect a 40-year mortgage to capture the house of their dreams.
About 35% of home buyers are going for hybrid loans, which offer a few years of a fixed rate before switching over to an adjustable rate, says Doug Duncan, senior vice president and chief economist with the Mortgage Bankers Association, an industry trade group.
With so many options, how do you select the right one for you?
The three basic things to consider: What's the best rate you can get? How much is the monthly payment? And, most important, how does the payment and payoff date fit in with your financial plans?
"The basic issue is one of affordability," says Jack Guttentag, author of "The Mortgage Encyclopedia" and professor emeritus of finance at the Wharton School of Business. The shorter the term, the lower the interest rate. So the shortest term the consumer can afford is often the best overall deal, he says.
Ask yourself what payment you can comfortably afford when you allow for savings, retirement and other obligations, says Eric Tyson, author of "Mortgages for Dummies."
"The bigger issue that needs to be examined is, how good a job is the person doing in saving money," he says. "One of the drawbacks of a shorter-term mortgage with higher payments is it may cause you to neglect savings into a retirement account."
Which mortgage length fits?
Here are some of your options:
15-year fixed-rate mortgage: You'll get a lower rate than with a 30-year mortgage, but a stiffer monthly payment to go with it because of the shorter term. Is it something you can handle comfortably and still meet all your other financial obligations?
It can be a great strategy, but it's not for everyone. It's riskier, so if you do it, you want to be prepared.
"You've got to have the emergency reserves and the financial wherewithal that you can handle job loss or any other curve balls that come your way," says Tyson. "It's a good thing, but a riskier strategy."
30-year fixed-rate mortgage: The old reliable. It offers a higher interest rate than the 15-year mortgage, but sweetened with a lower payment. If you're really risk averse, you may want a 30-year fixed loan, says Chris Farrell, author of "Right on the Money!" "Then you lock in today's low rates forever."
40-year fixed-rate mortgage: You have to shop it to see if it makes any sense for you. Is the monthly debt that much lower to make it worth paying an extra 10 years of interest? "Impact on the payment is very small," says Guttentag.
Guttentag's example: At a 6% rate, going from 10 years to 20 years on your mortgage will reduce the monthly payment by 35.5%. Extend the loan to 30 years, and you slice an additional 16.3%. But going from a 30-year to a 40-year mortgage only cuts the payment by 8.2%. At a 10% rate, the difference in payments would be only 3.2%, and that could easily be offset by an extra quarter-point increase in the rate, he says.
All in all, a 40-year plan is "hardly worth bothering with," Guttentag says.
Nontraditional term fixed-rate mortgages (such as 10-, 20- and 25-year mortgages): While you can log on to any computer and shop 15- and 30-year fixed mortgages, you might not be able to do that with a nonstandard-length mortgage. And you may well have to approach your lenders individually to ask what they would charge for a loan term with the length of time you need.
"A lot of lenders offer them," says Guttentag. "Often they're not priced very well."
Here's why: Mortgage holders often will resell your loan, and there is a ready market for 15- and 30-year mortgages. But that's not the case with nontraditional-length loans. Since they can't make money reselling them, lenders may not offer those attractive rates for nontraditional-length loans.
So if you want a mortgage length outside the standard 15- or 30-year term, shop carefully, do the math and make sure it's the best deal for you.
Hybrid adjustable-rate mortgages: The most popular types of hybrids give the borrower a fixed rate for one, three, five, seven or 10 years, then convert to an adjustable-rate mortgage. The upside: The rate is often cheaper than your typical 30-year fixed rate, and most people stay in one home for about eight years.
Five- and seven-year ARMs are particularly good for first-time home buyers and people who are planning on being in their homes for a short period, says Farrell. The idea: Sell while you still have a fixed rate.
Shop the rate caps, too, says Guttentag. When the loans move into the adjustable phase, the rates usually can change annually. The first-year hike can be capped at anywhere between 2% and 5%, he says. Successive years are usually capped at 2%. You also want to understand what the rate is based on, he says. What index does the lender use to decide whether the rate will go up or down?
And what happens if you don't move? "If interest rates have gone up, you may not be able to find [a rate] that's more attractive," says Tyson. So before you sign for that adjustable-rate loan, ask: "What's the maximum payment of this mortgage, and could I afford that?"
One other caution about adjustable-rate mortgages: Ask if the loan includes negative amortization. How it works: The interest rate goes up, but your payment is capped. When the payment isn't enough to cover the interest expense and principal, the shortage is added to your loan balance.
Result: Even when your loan term is up, you could still be paying.
Farrell's advice on loans with negative amortization is simple: Don't get one.
But some don't necessarily see negative amortization as a bad thing. "Rates go up, but the payment doesn't necessarily go up with it," says Guttentag. "Negative amortization loans have their advantages. It's a way to get the initial payment down."
But it comes at a cost, and it's important that the borrower understands and feels comfortable with those terms.
"There are no free lunches in mortgage design," Guttentag says.
Make-your-own mortgage: One other option allows homeowners to easily adjust the length of their mortgage -- by making additional principal payments. Assuming you have no prepayment penalties, every extra dollar of principal you pay shortens your payoff period. For example, you could take out a 30-year mortgage and pay it off several years ahead of time by making one extra payment a year (just tell the lender to apply it to the principal).
You can figure out how much extra to pay to reach your goal by using Bankrate's amortization calculator.
What are you buying?
You also want to consider what you're buying. In a house, you can shape the length of your financing around your needs. But if you're buying a different domicile, such as a condo, you also want to look at what the market is doing -- and what it's done in the past.
A condo offers a couple of financial unknowns. While a fixed-rate mortgage can guarantee you regular payments, in a condo association fees can go up and there's always the possibility of an unplanned assessment. And while you may plan to sell and get out in a few years, what happens if the condo market takes a nosedive? You can either sell for less than you want or pony up larger payments for a home that's not appreciating the way you'd like.
Because of the extra risks, "I think with a condo, I'd be leaning much more toward a traditional mortgage," says Farrell.
Where are you on the road of life?
When you choose a loan length, you also need to leave yourself some breathing room. Do you have an emergency fund? Savings? Retirement funds or investments?
The top reasons families lose their homes are unexpected financial disasters: A spouse becomes ill or dies, or there is a job loss, divorce or other calamity, says Duncan.
For that reason, you want to make sure that you've put up some financial safeguards to protect your family. While now you might be able to stretch to meet that 15-year mortgage payment, what happens if you go from two incomes to one? You might be better off taking the longer mortgage and putting the difference into a life insurance policy or emergency fund.
But that also means you have to have the discipline to realize that "extra" money is not disposable income, says Tyson.
Some buyers try to plan it so that the mortgage will be paid off in advance of some anticipated financial event, like sending kids to college or retiring.
David Reed, president of The Reed Group, an Austin, Tex., mortgage-banking firm, remembers one client with a three-year-old child who opted for a 15-year mortgage. When the homeowner's daughter heads off to college, he "wants to be mortgage-free," Reed says. "That's one consideration."
Another big one is retirement. "There is some logic to matching the mortgage's payoff to approximately when you're going to retire," says Tyson.
Another factor to consider: If you are living on a relatively fixed income after retirement, it might be wise to choose a mortgage that will give you fixed payments during that same time.
"If you're approaching retirement, in your late 50s or early 60s, I would suggest getting [a fixed mortgage]," says Reed, also the author of "Mortgages 101." That way, he says, you know what your payment will be each month.
Some older buyers debate the wisdom of taking on a 30- or 40-year debt. Balderdash, says Guttentag. For a wide variety of reasons, "Very few people pay off their mortgages anymore," he says.
Instead, Guttentag says, making the best choice comes down to the matter of your finances. "The general rule is, what is the shortest term you can afford?"
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