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If you’re purchasing a home for the first time, you may be overwhelmed by all there is to learn. From different mortgage types, insurance, taxes and more, your head is probably spinning. However, once you compare the different types of mortgage strategies to your situation, you will be able to determine which one is right for you, dependent on approval. There are many ways that you can decrease your mortgage costs to get ahead in the financial game.
This article discusses how debt can be appropriately used, and how it is analyzed. You will learn about the different types of debt for mortgages, such as fixed-rate mortgages, adjustable rate mortgages, federal housing administration mortgages, veterans administration mortgages, interest-only mortgages, reverse mortgages, and home equity loans. There is also a comparison of the costs between renting and owning a home.
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General Debt Concepts and Principles
While debt typically is considered a negative financial situation, it can be appropriate when it is matched with the economic life of the asset and the ability to repay. For example, the purchase of a car that is expected to be used for 5 years/ 60 months has a maximum realistic economic life of 7 years/84 months. Therefore, the car should be financed over 36 months but certainly not longer than 60 months.
Debt should be measured by the cost to take on the debt (acquisition fee, interest rate, prepayment penalties), and the estimated useful life of the asset. You should not take on debt to fund an extravagant lifestyle that you cannot afford. If you have a high consumer debt balance, consider implementing a debt management program. Typically, you should prioritize debt with the highest interest rate first. This will save you money in the long-term.
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Types of Home Mortgages
There are many types of mortgages available. It’s important to understand how each will affect your monthly payments and interest over time. However, there may be a few options that you don’t quality for depending on your credit score. Here are seven types of mortgages for you to understand.
A fixed-rate mortgage is one that exhibits the same interest rate for the duration of the loan. It has a fixed payment amortization schedule as well. If two mortgages have the same interest rate, the one with the shorter term length will have the higher monthly payment.
Adjustable Rate Mortgage (ARM)
This type of mortgage has changing interest rates. Usually, in relation to an index, monthly payments will go up and down accordingly. Interest rates and payments may also change from month to month. However, interest rate caps place a limit on how much the interest rate can fluctuate. Negative amortization occurs when the monthly payments are not sufficient to cover the interest due on the mortgage. The unpaid interest is then added to the principal.
Federal Housing Administration (FHA)
This mortgage is guaranteed by the federal government. It has a low down payment, and sometimes even lower interest rates because of the federal government’s guarantee of repayment. However, it has a mortgage insurance requirement.
Mortgage insurance is a policy that protects lenders against losses that result from defaults on home mortgages. FHA requires borrowers to include mortgage insurance primarily for borrowers making a down payment of less than 20%.
Veterans Administration (VA)
This type of mortgage is saved for veterans of the United States Armed Forces only. There is no down payment or mortgage insurance required. It includes the same federal guarantee of repayment as FHA loans.
This mortgage is where only the interest is paid monthly for a specific time (5-10 years). This keeps the mortgage payment to a minimum, but the principal balance will remain unchanged. It is suitable for homeowners with a short time horizon for ownership and those with more liquid assets. However, if housing prices fall, the home may not be worth as much as the mortgage balance. This type is difficult to refinance in result.
This mortgage type is characterized by the lender paying the homeowner an income stream secured by the home. The amount of the payments are based on the fair market value of the home and the age of the borrower. The borrowers must be age 62 or older with a home that is free from debt.
The homeowner retains the title of the home but incurs an increasing amount of debt each time a payment is received. If the homeowner dies. Repayment of the outstanding mortgage is required.
Home Equity Loans/Lines Of Credit (Second Mortgage)
This mortgage type is essentially a second mortgage on the same home, using the current equity in the residence to provide funds. In a home equity loan, the borrower receives the money in a lump sum. In a Home Equity Line Of Credit (HELOC), the borrower is only given a certain amount of credit to borrow.
The debt can be used for any purpose, and it still won't affect the deductibility of the mortgage for tax purposes. The qualifying debt may be deducted for the lesser of $100,000 for those who are married filing jointly or single filers ($50,000 if the taxpayer files married filing separately). The fair market value of the primary residence is reduced by the amount of current indebtedness.
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Mortgage Selection Issues
When choosing a mortgage, the main issue is the length of ownership. An ARM may best suit a short length of ownership because the initial rate on the ARM is typically less than a fixed rate mortgage. However, rates on the ARM reset annually and could increase in the long run.
It’s also important to take your disposable income and risk tolerance into account as to whether or not to take a fixed or variable payment. Depending on your credit, you may have no choice but to take the ARM because it's the only loan you qualify for.
However, you may be able to get a lower interest rate if you pay “points,” or payments to the lender, at settlement. You should conduct a cost-benefit analysis, or work with a financial planner to complete one, to determine if this is an appropriate option for you. When comparing a 15-year to a 30-year fixed-rate mortgage, the interest rates will typically differ 0.5% assuming the same down payment.
Savings Due To Mortgage Selection
You can get ahead financially by choosing to pay off your home strategically with the right mortgage. Look at an amortization chart to understand how making extra payments on your mortgage affects the term length for paying off your house as well as the savings on interest.
Compared to a 30-year mortgage, a 15-year mortgage will take less time to pay off, and will usually have a lesser interest rate, saving you thousands of dollars. As a result, if you have a 30-year mortgage and no prepayment penalties exist, you should try paying off your house according to a 15-year amortization schedule instead.
Keep in mind that a mortgage combines the following main components to give you one monthly payment:
Principal - This is the cost of the home without any other expenses or fees added. As you continue to pay off the loan, your monthly principal payments will increase (without paying any additional funds).
Interest - This is what you pay the mortgage lender for the risk of giving you a loan. It is included in each payment.
Taxes - Your mortgage payment will also include real estate or property taxes that are held in escrow until paid to the government on your behalf.
Insurance - Your homeowner’s insurance as well as your private mortgage insurance may be held in escrow and paid on your behalf as well.
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Buying vs. Renting a Home
There are many advantages and disadvantages to consider when choosing to rent or buy a home. The main differences revolve around the cost responsibility and benefits. While it may be easier to rent a home, you should consider home ownership as well.
Purchasing a Home
When purchasing a home, you will make mortgage payments including principal and interest. You will also pay fees such as a downpayment, closing costs, mortgage insurance, property insurance and taxes, maintenance, and operating expenses.
Purchasing a home requires heavy upfront charges. However, mortgage interest, property taxes, and possibly mortgage insurance are tax-deductible expenses. Different types of mortgage payments can affect your cash flow in the long-term and short-term.
Renting a Home
When renting a home, the cost is fixed in the short-term, and there is no long-term commitment. You don’t have to pay property taxes. Maintenance and repair costs are usually included in the rent as well. Additionally, the cost of insurance is usually lower than owning a house. However, you need to consider saving to purchase a home.
Renting a home is beneficial if you are not looking to stay in the same area for a long period of time. However, if you are looking to settle for a long period of time, purchasing a home is more likely to be advantageous due to the tax deductions and home equity.
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Be Financially Smart When Buying Your Next Home
There are many ways to save money on your mortgage. Selecting the right mortgage type and term length for your situation is a great place to start. Consider making extra payments as well to pay your loan off sooner and save thousands on interest in the process.
If you want a second opinion on your options and what is right for you, consider reaching out to your financial planner, accountant, or even a mortgage loan officer. Overall, the effort you’re putting into learning about mortgages is a financially smart way to buy your next home. You will be ahead of the game as a result.