Different Mortgage Types
Buying real estate usually requires help from a bank in the form of a mortgage. Even if home buyers are able to pay cash, it is usually advantageous to use a mortgage since banks see real estate as relatively low risk, so interest rates on the loan are going to be fairly low. Property values almost always rise over longer time spans, and the cash freed up by the mortgage can be used to purchase other investments.
The interest rate on a mortgage is not always easy to understand, and most borrowers have several options on how they can pay the interest. Having a good understanding of how these loans work is crucial for both the buyer looking for their next new home, and the investor looking to build a portfolio of income-producing rental properties.
Fixed Rate Loans
Fixed-rate mortgages are the simplest to understand and are most commonly used by borrowers who are purchasing the home they intend to live in. Depending on the Federal Funds Rate, which is the interest rate set by the Federal Reserve Bank, that banks must use when lending money to other banks, and the bank’s own underwriting, which includes the buyer’s credit report, income, and other factors decided on by the bank, the interest rate on the loan that the bank offers will be in place for the entire term of the loan..
Usually, home mortgages are thirty or fifteen years in length. Thirty-year mortgages have smaller monthly payments and are easier to qualify for, while fifteen-year mortgages have higher monthly payments and thus are harder to qualify for, but you will end up paying it off in half the time with significantly less accumulated interest.
Regardless of the loan length, it’s rare for mortgages to have a prepayment penalty, so they can be paid up quicker, and accrue less interest overall if the borrower makes an extra payment each month. Mortgage Calculator with Additional Payments can help you calculate amount of time and money you would save with additional monthly payments on your mortgage.
Variable rate mortgages adjust the interest rate at certain points during the loan. Common types of variable interest residential mortgages are the 5/1, 7/1, and 10/1 Adjustable Rate Mortgages (ARM).
In a 5/1 ARM, the loan length is still thirty years, but after five years, the interest rate adjusts every year based on the Federal Funds Rate. The 7/1 and the 10/1 adjust after seven and ten years, respectively. To compare multiple mortgages it is advised to use a Residential Mortgage Comparison Calculator.
If that sounds dangerous, it certainly could be. It’s a lot more complicated, but these types of loans are one of the several factors that led to the housing crisis of 2008, when many borrowers were foreclosed upon when they were unable to afford their monthly mortgage payments due to adjustable-rate mortgages.
The interest rate is usually adjusted based of the 5 year treasury, which is regarded as a benchmark for low-risk investments. If the rate on a treasury note rises, lenders will demand a higher rate for their mortgages.
Why Choose a Variable Rate Mortgage?
There can be significant advantages to variable rate mortgages. The interest rates tend to be lower than on a fixed-rate loan to compensate for the extra risk that is being taken on by the borrower as opposed to the lender.
If you are not planning on staying in that house forever, a variable-rate loan may be preferred since you will be getting a new loan for your next house anyway.
Variable loans can also make a lot of sense for investment properties. Rents have historically been loosely tied to interest rates. If rates rise and push up the monthly mortgage payment when the rate adjusts, the property owner will generally be able to raise the rent as well.
Of course, they will still have to wait for the current lease to renew, and still, there is no guarantee the tenant will stay as opposed to finding housing elsewhere. But generally speaking, the property will likely be able to demand a higher rent.
Bottom line, when choosing a loan, it’s crucial to be educated on what the interest rate is and how it will affect the payment through the life of the loan. It is also important to calculate your payment affordability on these different mortgages using an affordability calculator.