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Buying a home can be scary. It is likely to be the largest purchase one makes in his or her lifetime. Adding to the confusion, there are a variety of financing options. We’ll try to add some clarity to make your decision a little less burdensome.
There is a fixed rate mortgage. This gives comfort since the interest rate on your loan will never go up for the entire term, meaning your mortgage payment (principal and interest) will not change. But, if you pay property taxes and insurance through your monthly payment, these will change. Of course, this is a double-edged sword. If rates go down, your payment will not, unless you refinance.
A mortgage can be for a variety of lengths. A common one is for thirty years, but there can be ten, fifteen twenty, even a forty year (the longest we’ve seen), or some other term. It is important to keep in mind that the longer the mortgage, the lower your payment, despite a higher rate, generally speaking. But, you will pay more in interest over the life of the loan.
A short numerical example will illustrate the point. Using the website bankrate.com, and plugging in the Metro New York area, it returns a number of banks offering mortgage rates. Bank of America has a 4.15% interest rate. Assuming a $500,000 mortgage, your monthly payment will be $2,430.52. Over the life of the loan, you will pay $374,985.98 in interest. Most of the interest will be paid in the first half of the loan. If you prepay a portion, you can reduce the number of years, and the interest paid.
Examining 15-year rates, there are two available at 3.125%. Using the same $500,000 mortgage, the monthly payment for principal and interest is $3,483.05. This is $1,052.53 higher than the 30-year mortgage, despite an interest rate about 1% lower. But, the total interest paid over the 15 years is $126,948.41, almost $250,000 less than the 30 years.
Which is better? It comes down individual preference and personal finances. While it is easy to jump at the 15-year mortgage in our example, which has the added benefit of owning your home in half the time and save interest charges, the monthly payment is much higher.
There is a way to lower your interest rate, besides having a high credit score. You can pay points, which involves a trade-off. Each point is 1% of the mortgage amount and paid upfront at closing. For our $500,000 mortgage, paying 2 points would equate to $10,000. In exchange, you receive a lower interest rate on your loan. If you plan on staying in the house for a number of years, this could pay off. Your monthly payment would be lower, and after a certain amount of time, you will recoup your upfront payment, and then the savings kick in.
Banks will quote an APR (Annual Percentage Rate), in addition to the interest rate. This can create confusion, but the payment is based on the interest rate, not the APR. But, the latter is important for comparison purposes. It allows a borrower to compare loan terms on an apple-to-apple basis. It includes fees and other costs associated with the loan. These typically include items such as points paid upfront, application fees, and a property appraisal.
There are also adjustable rate mortgages (ARM). As the name suggests, the rate floats, usually based on a short-term benchmark such as one-year Treasury securities, the Cost of Funds Index, or LIBOR. A margin, usually constant, is then added to the index rate. There is a period where the rate will not change, called the adjustment period. After that, the rate will change based on the benchmark stated in the contract. Although the interest rate is typically lower than a fixed rate mortgage initially, it usually increases. In addition, the borrower bears the risk of a rise in interest rates. This should be kept in mind since interest rates are currently very low, meaning an increase at some point appears inevitable. There might also be caps, limiting how much the interest rate can rise from one period to the next or over the life of the loan. Another type of mortgage is a hybrid, which is a loan with a fixed rate for a period of time, which then changes to a variable rate. There are many varieties, such as interest-only ARMs.
For New Yorkers, there are special considerations for co-ops and condos. First, the board may examine your financial information closely. Co-ops and condos may also require a larger down payment, along with sufficient liquid assets. Mortgage rates from banks may be higher, as well.