For most people, committing to a mortgage is one of the scariest moments of their lives. Our cave man ancestors would be stunned to see people working for thirty years just to own a home. Back in the old days, you just found a cave, chased the bats out of it, and moved in. We didn’t need a stinkin’ mortgage!
However, in the modern era, the vast majority of home purchasers are going to require a mortgage. Not only is a mortgage expensive, but it can be frustratingly complex for many people. Let’s take a look at some common questions about mortgages.
Note: the interest rates used in this article are for the purpose of illustrating the concepts, and are not intended to reflect the current market rates.
1. Should You Opt For A 15 or 30 Year Mortgage Loan?
Mortgages come in many different varieties, but most people opt for either a 15 or 30 year fixed mortgage. The major benefit of a 30 year mortgage is the lower payments you shell out each month. The benefit of a 15 year mortgage is that you pay less total money (due to significantly lower interest costs).
How much less money will you end up paying with a 15 year mortgage? Set up an amortization schedule and find out.
Which option makes sense for you? If you have the financial flexibility to make the higher payments of the 15 year mortgage, then this might make sense — although some people feel that they’d rather use their savings elsewhere, say to get a better return on it in the stock market.
If you don’t feel you can make the 15 year payments, then the 30 year becomes the obvious choice. You might also opt for the 30 year if you’re planning to have kids in the immediate future, since they can suck up extra cash like a ShopVac plugged into a 220 outlet. You may want to anticipate situations down the road which may require you to have more cash on hand.
2. PMI vs Piggyback Loan?
If you’re unable to put 20% down, your lender may still be able to offer you a couple of options to allow you to secure the property you’ve been eyeing.
Option 1: PMI
The first is to pay for mortgage insurance. This is commonly referred to as PMI. This is actually an insurance policy that reimburses your lender if you default on the mortgage — but you pay the premium.
Option 2: Piggyback Mortgage
The second option is to have a first mortgage for 80% of the home’s value and a second mortgage for 10% of the home’s value. This can be referred to as an 80-10 or an 80-10-10 (with one of the 10s representing the down payment), but I like the informal name of “piggyback” mortgage. The interest rate on the second mortgage is going to be higher than the rate on the primary mortgage.
So which is better? It depends. Let’s look at a scenario that can illustrate the kind of analysis you’ll need to do in order to make a decision. Let’s say you have this situation:
- Home value of $100,000
- $10,000 down payment (10%)
- First mortgage rate of 4.5% (30 year fixed)
- Second mortgage rate of 5.25% (30 year fixed)
- PMI cost of $60/month
Basically, you can either borrow $90,000 at 4.5% and pay an extra $60 / month in PMI, or you can borrow $80,000 at 4.5% and $10,000 at 5.25%. Let’s assume that you pay the exact amount due every month, without any extra principal payments. We’ll also assume that there are no reassessments (which could allow you to hit 20% equity sooner and drop PMI).
The cost of the 90% loan + PMI will include:
- $74,166.04 in interest ($90,000 at 4.5%)
- 69 months of PMI at $60 (per month) = $4,140. This is the point at which you have 20% equity and can drop PMI.
- Interest + PMI = $78,306.04
The cost of the option with the piggyback loan will include:
- $65,925.37 interest on the first mortgage ($80,000 at 4.5%)
- $9,879.33 interest on the second mortgage ($10,000 at 5.25%)
- Total interest = $75,804.70
In this case, the piggyback is less expensive by about $2,500. Even better, the extra mortgage interest is tax deductible, whereas PMI is not.
But each situation is different, and you should analyze your own situation to determine which is best for you. To find the interest amounts, simply work out an amortization schedule for the 90% mortgage, 80% mortgage, and 10% mortgage (remember to bump up the interest rate on the second mortgage). Finding the point where you can drop PMI is a little trickier. You need to watch for the point where the balance of the mortgage drops below 80% of the value of the home. This is not the same as the 80% of the start balance of the mortgage. In our sample $100,000 home, the initial mortgage balance was $90,000. We had 20% equity when the balance dropped below $80,000.
A few final thoughts on PMI vs. the piggyback loan:
- If you have a piggyback mortgage and are making extra principal payments, ALWAYS have them applied to the second mortgage, since this is at a higher rate. Be explicit when you give instructions.
- Lenders must automatically cancel PMI when the balance drops below 78% of the value of the home. However, the point at which they do this automatically may actually take longer than a year after the balance drops below 80%. So be proactive and inform the lender when you have 80% equity.
3. Should You Pay Mortgage Points To Lower Your Interest?
A point is simply 1% of the loan balance, to be paid at closing. Points allow you to drive down the interest rate. For example, you may be able to pay a point in order to drop the interest rate by 1/8%. The break-even on points will be slightly larger than the inverse of the fractional interest rate drop you get for each point, expressed in terms of years.
Huh? Run that by me one more time, Kosmo.
In our example, you pay one point (1% of $100,000, or $1,000) and get a 1/8 point drop. The break-even will be slightly longer than 8 years (8 is the inverse of 1/8). In our specific case, around 9 years.
Why isn’t it exactly 8 years? It would be, if you continued to pay interest on the entire $100,000 each month — but as your balance drops, so does the interest paid, and this has the effect of making the break-even a bit longer. This is a relatively minor point, and if it’s not clicking for you, don’t worry about it.
If you plan to keep the mortgage for a while, it might make sense to buy points. If you plan to move — or refinance — in the near future, then points probably don’t make sense.
4. Should You Consider an Adjustable Rate Mortgage?
Adjustable rate mortgages — referred to as ARMs — have received a lot of bad publicity in recent years. The basic concept of an ARM is that you get a really good rate for a few years, and then the interest rate resets to a new rate. This can become a problem when the new rate is considerably higher than the old rate.
I’m not going to suggest that an ARM is the right solution for everyone. It is not. But if you are almost certain that you will be moving before the ARM resets, then they can be a cheaper option.
5. When Should You Refinance?
There are a couple of rules of thumb regarding refinancing events, which you may have heard:
(1) The first is that you should wait at least a year to refinance.
(2) The second is that interest rates must drop by at least a full point before you refinance.
But like many rules of thumb, these are wrong. The first one is easily dismissed. If you could refinance your mortgage from 4% to 1% the day after you closed (say due to some weird market shakeup), would you do it? Of course! The second seems to make sense (suggesting that a one percent drop allows you to recoup closing costs); however, it’s also flawed. If you cut one percent off a $20,000 mortgage, you save about $200 in the first year, and a smaller amount each subsequent year. If you cut a quarter of a point off a million dollar mortgage, you save around $2,500 in the first year. The amount of the mortgage plays a large role in the break-even calculation.
How do you know whether or not to refinance? The first thing to do is to calculate the closing costs of the refinance. You will want to exclude prepayment of interest and pre-funding of the escrow account. You would have had to make the interest payment on your old mortgage if you had not refinanced, so this is a wash. You’ll receive the balance of your escrow account from your older lender after you refinance, so this should also cancel out.
To clarify this point: let’s say that the last payment on your old mortgage was on February 1. You refinance on February 25, and your first payment on the new mortgage is on April 1. There’s the chunk of time between Feb. 25 and April 1 where you have the money in your possession, and you need to pay interest on this. That’s what the pre-paid interest is for. If you hadn’t refinanced, you’d have had a payment due for the old mortgage on March 1, so the interest you save by not making the March 1 payment offsets the prepaid interest.
Or let’s say you pre-fund an escrow and have to pay $1,000. You should get a refund from the escrow on your old mortgage. So the $1,000 to pre-fund the escrow is cash that you need, but it’s not an actual cost, as the refund of the old escrow should offset this. (Note: similar to the interest above, you’ll also be paying a month’s escrow in advance, but this is offset by not having the next payment on the old mortgage).
For the sake of argument, let’s say the costs are $1,500 and you’re saving 0.75% on a $100,000 balance. You shave off about $60/month in interest payments, making your break-even point around 2 years. If your balance is $250,000, the break-even is closer to 10 months. You can develop an amortization schedule to find your break-even. Use the rate difference as the interest rate and look for the point where the accumulated interest is greater than your closing costs.
Here’s an example. In the amortization schedule, plug in 0.75% as the interest rate along with correct principal and length. If you have a column for cumulative interest paid, what this really does is track the amount you’re saving each month versus the old rate. At some point, this will exceed the closing costs. There’s your break-even point. Basically, the “interest paid” column is converted into an “interest saved” column.
If you do choose to refinance, perhaps you’ll consider paying the original amount towards your old mortgage balance on an ongoing basis, so you can apply the excess to the principal. You’ll want to discuss the options for this with your lender. By doing so, your payment will stay the same, but you’ll pay off the mortgage much more quickly!
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