Mortgage Loan Comparisons
While we have a wide range of products available, we recommend a 30 year, fixed rate, amortizing first mortgage for most borrowers. This product has constant payments for the life of the loan. The only thing that changes the payment is a change in the escrow account for taxes and insurance. Since the rules for handling the escrow account are the same for all loans, we will leave escrow account items out of this analysis.
30 year fixed rate vs. 40 year fixed rate
30 year fixed rate vs. 10, 15, or 20 year fixed rate
30 year fixed rate vs. Adjustable after 1, 3, 5, 7, or 10 years
Interest Only vs. Amortizing Loan
VA vs. FHA vs. Conventional Financing
Jumbo Loans
First vs. Second Mortgages
30 year fixed rate vs. 40 year fixed rate
While we get periodic requests for 40 year loans from borrowers who want lower payments, they often don’t realize that the 40 year loan also has a higher interest rate. Past calculations typically show that the longer payment period is offset by the higher rate so that the actual payment is about the same for either a 30 year or 40 year loan. The only real change is that with the 40 year loan, the borrower makes payments for 10 more years.
30 year fixed rate vs. 10, 15, or 20 year fixed rate
While I believe it is prudent for all borrowers to pay off debt as fast as possible and become completely debt free including the mortgage, my observation is that few people are well served by these products.
A 10, 15, or 20 year loan can work fine for an “empty nest” borrower who has no other debts and a low debt ratio. My experience with other borrowers is that when they choose a short term loan, they are back in 2-3 years to refinance out of it because other debts have increased. If it isn’t because of consumer debt, it may be because they are facing college expenses or want to buy investment property. A better strategy than writing the loan for a short term is to write the loan for 30 years, but make the 10 or 15 year payments. The net effect is the same, except if there is a need to reduce payments, there is no need for the expense of a refinance.
The only borrower who truly seems to be well served with a short term loan is a borrower doing a rate and term refinance with no other debt and a debt ratio under 20%. This borrower is likely to really stay in the loan and pay it off. Others are likely to give back any interest rate savings when they refinance out of the loan.
30 year fixed rate vs. Adjustable after 1, 3, 5, 7, or 10 years
With adjustable rate loans, there is an initial fixed rate period before the loan starts to adjust. The common fixed rate periods today are 1, 3, 5, 7, or 10 years. On some loans, the initial fixed rate period can be as short as 1 month. After the initial fixed rate period, the common adjustment periods are monthly, every 6 months, or every year. If you choose an Adjustable Rate Mortgage (ARM), it is important that you understand when and how much the payments can change.
The biggest issue for people who choose adjustable rate loans is that they often worry about the coming adjustments. Part of this is resolved with the new Good Faith Estimate and HUD-1 Settlement Statement that will be used after January 1, 2010. These new documents will clearly show the maximum payments for any loan. The old documents only showed the payments if interest rates did not change from the level when the loan closed.
The other issue to consider is that as of today (December 2009), 30 year fixed rate loans are below 5% and the adjustable rate products don’t start much lower. When the spread in the start rate is small and the rate is likely to go up but not down, we suggest choosing the fixed rate loan. We are happy to provide exact numbers for various products as the market changes.
Finally, many people choose these products thinking they will be moving in a few years. My experience is that life often changes so the planned move may come either sooner or much later. In my case, I bought a home thinking I would live in it a minimum of 1 year and absolute maximum of 10 years. My job changed, I got married, and had a son. I lived in the house more than 20 years. Prior to this house, I had never lived in one place more than 4 years after leaving my parent’s home. I see similar things happen to our clients, so I prefer to recommend loans that are OK if they stay in the house or move.
With the rate fixed for the life of the loan, if interest rates go up, nothing changes, If interest rates stay constant, the payments are OK. If interest rates go down, the borrower can refinance to a lower rate. With the adjustable rate loan, if interest rates go up on the adjustable loan, rates will also be higher for the fixed rate loan. Once in an adjustable rate loan, it can be difficult to refinance out because it almost always results in a higher payment.
Interest Only vs. Amortizing Loan
Two advantages to an Interest Only loan are lower initial payments and the ability to lower the minimum payment by prepaying the loan. The benefits of the automatic payment reduction are particularly attractive for anyone expecting a large amount of money during the interest only period. The money can come from the sale of a residence after buying a new one, an inheritance, a large bonus, or other large sudden income. As described above, we recommend paying down the first mortgage only after paying off other higher interest debts.
The disadvantage of Interest Only loans is that the lower payments only last for an initial period, and then the loan pays off with higher payments than a fully amortizing loan.
A loan that amortizes from the beginning will have constant payments for the life of the loan. If the loan is prepaid, it will shorten the term, but will not lower the payment.
The relative benefit of each is affected by the rate difference between them. In past years, the difference was small. In recent months, it has become greater, which negates much of the advantage of the interest only product for most borrowers. We are happy to provide specific comparisons for any borrower’s situation.
VA vs. FHA vs. Conventional Financing
VA financing allows a military veteran to buy a home with 100% financing. This program can be used for typical urban or suburban housing. It requires documentable income and a history of paying obligations on time. Closing costs can be paid by the seller, but depending on the veteran status there may be a VA funding fee that is added to the loan balance. We offer VA financing. This is an excellent way for a veteran to buy a home with minimal cash. It is not as attractive if the veteran has significant money for a down payment or significant equity in a property being refinanced.
FHA financing is a government insured program that allows almost anyone to buy a home with as little as 3.5% down. Borrowers can use gift funds for an FHA purchase, where they generally must save money for a conventional purchase. FHA allows co-signers, commonly referred to as non-occupant co-borrowers, where conventional loans generally require the borrower to have enough income to qualify for the loan. FHA allows borrowers with credit issues to buy when they might be rejected for a conventional loan. As an example, borrowers can qualify for an FHA loan after a foreclosure much sooner than they can for a conventional loan. FHA loans generally require a 1.75% funding fee plus monthly mortgage insurance.
For borrowers who can qualify, a conventional loan is typically the lowest cost option. This is particularly true if the borrower has money for a down payment or equity in a home being refinanced. With conventional loans, the minimum down payment is 5% because of requirements from the Private Mortgage Insurance companies.
Following is a comparison between FHA and Conventional financing. For this purpose, I have assumed the purchase price, interest rate, closing costs, taxes, and insurance are the same for both loans. I assume the closing costs will be paid by the seller.
| FHA | Conventional | |
| Purchase price | $200,000 | $200,000 |
| Down Payment | $7,000 | $10,000 |
| Base loan amount | $193,000 | $190,000 |
| Funding Fee | $3,378 | $0 |
| Total Loan Amount | $196,378 | $190,000 |
| Payment at 5%, 30 year fixed | $1,054.20 | $1,019.96 |
| Mortgage Insurance Rate | 0.5% | 0.78% |
| Mortgage Insurance Payment | $80.42 | $123.50 |
| Total PI & MI | $1,134.62 | $1,143.46 |
| 5 year payoff | $180,331 | $174,475 |
| 5 year payment difference | $530 | |
| Savings after 5 years | $5,326 | |
| Estimated Total Payments | $389,403.96 | $381.635.95 |
The important difference to note is that while the conventional loan requires $3,000 more cash for a down payment, the beginning loan balance is $6,378 higher. If the borrower makes the minimum payments, the loan balance will remain higher on the FHA loan for the life of the loan. As a result, the private mortgage insurance drops off sooner from the conventional loan and $3,000 extra down payment saves about $8,000 over the life of the loan.
Many people assume an FHA loan is always less expensive than a conventional loan. What this analysis shows is that the difference may not be as great as is often assumed. Depending on the borrower’s income and savings rate a typical borrower may save the difference in the down payment within a matter of months. We do not offer FHA loans, but we do suggest comparing prices between an FHA and a conventional loan. Some borrowers will qualify for a lower rate or fees with the conventional loan.
Jumbo loans
Jumbo loans are loans larger than the Fannie Mae/Freddie Mac lending limit, currently $417,000. Fannie Mae and Freddie Mac have temporary authority to make larger loans in certain high cost areas. These loans are available up to $460,000 in Boulder County. The remainder of the Denver Metro area is limited to $417,000.
First vs. Second Mortgages
First mortgages get their name from the fact that they are recorded first against a property and are first to get the proceeds of any foreclosure sale. Second mortgages are in line behind the first mortgage in case of a foreclosure. Because of the payment order, the lender’s risk of loss is greater with a second mortgage than a first mortgage. Given the lower risk, first mortgages will normally have lower rates and better terms than second mortgages.
