By Nick Heckman
My friend Lisa was the first person in my group of friends to announce that she was getting married. She and her boyfriend had been dating for almost four years and most of us saw it coming, but as the rest of us were trying to figure out whether we were going to school, finding a job, or travel, Lisa was also talking about housing markets and mortgage rates.
Not only was marriage a sign of her maturity, it was a major financial milestone in her life. She readily acknowledged that buying a house was probably the largest purchase she would ever make. Fortunately, it's an asset that will likely increase in value over time- so it was a wise investment on her part.
building a budget
While she was searching for her first new home, Lisa designed a budget to see how much money she could spend each month. She had read a book by Jane Bryant Quinn called "Making the Most of Your Money" where Quinn suggested that no more than 28% of a person's gross monthly income should be devoted to housing expenses, including mortgages. Also, when combining a mortgage with consumer debt, it should be no more than 35% of the gross monthly income.
Just like any big purchase, it was important for Lisa to shop around and find the best mortgage rates. She began her search by talking to her credit union and other lending officers. She also did some research on the internet, making sure to be careful that she was only dealing with trusted and secure websites.
When she decided on a credit union to sign a mortgage with, she needed to contribute information like tax records, sources of income and account numbers. This all went into figuring out the length and type of the loan. And as she quickly discovered, choosing the perfect mortgage wasn't as simple as signing the first document that came in front of her. In fact, there are several types of mortgages that are useful for people in different situations:
Fixed-rate is the traditional mortgage a repayment schedule is created based on current interest rates. Often, these loans will last for up to 20 or 30 years. The appeal of this loan is that it has fixed monthly payments for those that can't afford, or don't want, variation in their monthly budget. Despite the stability of a fixed interest rate over the life of her loan, Lisa decided to look at other options.
adjustable-rate mortgages (ARMs)
ARMs have low initial costs and interest rates that are generally two-to-three percentage points below a fixed-rate mortgage. The interest rate and monthly payment will vary every year, three years, or five years based on index rates. Lisa asked her lending officer which index would be used and how often the rate would be calculated before she ultimately decided that this wasn't the option for her.
A balloon loan is basically a short term loan - usually five to seven years - with small monthly payments and then a very large payment due at the end of the term. That large payment is called a "balloon" payment. This loan has the appeal of low monthly payments that don't change, until the final balloon payment is due at the end of the loan. Most people refinance the loan when it's time for the "balloon" payment. For Lisa, even though she could afford the monthly payments, she wasn't comfortable with a large balance due at the end of the loan, and refinancing is not always guaranteed.
These loans are called "hybrids" because two types of loans are combined into one. In this loan, a fixed interest rate is established for a period of time, anywhere from 3-to-10 years. Then the loan matures into an ARM. Because of this, the monthly payments are higher than an ARM but lower than a fixed-rate mortgage. Lisa felt this was the best choice for her situation. She anticipated starting a family and may end up moving on to a bigger house before her hybrid mortgage switched over to an ARM. If she sticks to this decision, she'll get the benefits of lower payments on a fixed-rate mortgage before the hybrid switches to an ARM and varying payments. Of course, by moving to another house, she'll need to find another mortgage.
While there's a lot of time and work involved in purchasing a house, there are many resources available to help educate beginners and make process easier. With a little research into rates and options it can become a happy memory and not a stressful experience. Just ask Lisa.