The high cost of housing has led lenders to develop very creative forms of financing which while successful at getting someone into a home, don’t really consider the long-term well-being of the buyer. These creative forms of financing include 100 percent financing, interest-only loans, loans with balloon payments, and loans that extend beyond the traditional 30-year variety.
How the Lenders Make Money — Lots of It
Each of these types of loans has the objective of lowering the current monthly payment, but at the cost of maximizing the amount of interest borrowers will pay and the length of time they will be in debt.
Call me old-fashioned, but I’m a believer in making a substantial down payment (20 percent is a good objective) and in obtaining a loan that allows one to own the home outright as soon as practical. I encourage the use of 15-year loans, or at least committing to prepaying a typical 30-year loan over 15 years. Here’s why.
Once people buy their first home, they end up being surprised at how little equity they initially build, assuming stable prices. What they don’t realize is that very little of the monthly payment in the early years of a 30-year mortgage reduces the actual loan, because most of it is being applied to interest. As I mentioned earlier, for a 30-year loan of $200,000 at a 6 percent interest rate, only $2,400 goes toward the principle balance during the first year, out of total payments of more than $14,000. Your friendly bank appreciates the business!
Pocket That Interest
The most effective way to build the equity in your home more rapidly is either to take out a 15-year loan or “prepay” your mortgage. An added benefit to a 15-year loan is that interest rates will normally be about one-half of a percentage point less than similar 30-year loans. Based on the figures presented in the following table, the monthly payment required for the 30-year loan is $1,199.10. But if you took out a 15-year loan, your payment would only increase by $435.07 for a total payment of $1,634.17. You’d end up saving nearly $140,000 in interest
Exhibit 1—Effect of Prepaying Mortgage
30 Year Loan | 15 Year Loan | |
Original Loan Amount | $200,000 | $200,000 |
Interest Rate | 6.0% | 5.5% |
Monthly Payment | $1,199.10 | $1,634.17 |
Difference in Monthly Payments | N/A | $435.07 |
Total Cash Paid During Term of Loan | $431,676.00 | $294,150.60 |
Interest Saved | N/A | $137,525.40 |
Some financial planners will recommend paying your loan off over the standard 30-year period and investing the difference. While this can theoretically make sense, it depends on whether you will actually save the difference every month, and in this case, whether you can obtain a consistent return of about 9 percent. My experience tells me that very few people have the discipline to save that discretionary income every month. Instead they end up spending it on regular bills. They really need that tangible goal of owning their house in 15 years along with the forced discipline the 15-year loan gives them in order to stick with the plan. There is also no way to guarantee a 9 percent return on your investments, although it’s not an unreasonable long-term investment goal. From my vantage point, I’d take the freedom of owning my house outright, then developing an aggressive savings and investment strategy.
While it may seem difficult to come up with the extra money required, a can-do attitude combined with proper planning makes it possible. Most people find that as the years go by, increases in income disappear as a result of increased discretionary spending. Rather than wasting these increases, I recommend a large portion (say 30 percent) be applied as additional payments on your home loan. With the house paid off in 15 years, you’ll have the freedom to use the extra funds for other priorities, such as college education for the children or retirement savings. Even if you can’t afford to increase your payment to a level that would cut the length of your loan in half, I would encourage you to start with some amount, even if only $100 per month. As your income grows, the discipline will be in place to make a wise decision on how the increase should be allocated.
When Does Refinancing Make Sense?
When current interest rates are lower than those tied to your mortgage, refinancing can save you money in the long run, yet you’ll have to pay certain fees to achieve these savings, such as points, processing fees, title charges, escrow fees, loan prepayment penalties (if any), and other potential costs. As a rule of thumb, if you can reduce your interest rate by 2 percent and expect to live in the home for at least two years, refinancing may be a good idea.
Just as it is for any other major purchase, it will be a good idea to seek information from a number of lenders or brokers to be confident that you’re getting the best deal. Contact about ten lenders to obtain basic rate and cost information, and to get a feel for how comfortable you are working with them. A simple way to get started is to use comparison sites on the Internet (such as www.eloan.com and www.bankrate.com). Keep in mind the importance of comparing apples to apples. You might find one lender offering a low interest rate with higher up-front costs, and another lender with a higher rate and lower costs. Once you’ve run through the numbers, you can narrow the list down to the top three. Ask each of them to give you a solid proposal for refinancing with a complete estimate of closing costs so you can make a final decision.
Here’s one trap to avoid: Let’s say your current monthly payment is $1,000 and it’s expected to drop to $800 after refinancing. Some of this $200 in savings comes from the reduction in interest rates, but some of it probably comes from extending the payback period of your loan. In other words, if you bought your home 10 years ago and financed it with a 30-year mortgage, you now have 20 years remaining on the loan. Yet if you refinance with a 30-year loan today, your mortgage won’t be paid off until ten years later than your current loan. Much of the decline in your monthly payment is due to the extension of the loan for an additional ten years. While it may feel good today to have a lower monthly payment, in the long run it’ll cost you more because of the interest you’ll pay for those additional ten years. The solution is to obtain a loan with the same payoff date as your current loan (which may be difficult to do) or to refinance with a standard 15- or 30-year loan on which you make additional principal payments each month in order to maintain a consistent payoff schedule.
Phil Lenahan is Director of Finance at Catholic Answers and author of Catholic Answers’ Guide to Family Finances. If you have a question you would like Phil to address, contact him at [email protected].
