There are many different flavors of mortgages in the marketplace. These are the three most common:
- A fixed-rate 30-year mortgage
- A fixed-rate 15-year mortgage
- A three-year adjustable rate mortgage
The thirty-year-fixed-rate mortgage is by far the most common type, and I recommend this for your principal residence. In this case, be conservative. Take out a conventional or FHA fixed-rate thirty-year mortgage loan when you buy your house. A thirty-year fixed-rate mortgage has a consistent monthly payment. This gives you a specific amount you need to budget each month. Also, the longer the term of the loan, the lower the amount of principle that must be paid back (or amortized) every month; that means a smaller monthly payment. As with any loan, the interest you pay is on the outstanding principle. But if the outstanding principal changes every month (along with the interest) as you pay down the loan, how do you end up with a consistent monthly payment? Simply put, the paydown of the principle of the loan changes every month. Here is a typical relationship of interest to principal each month in a thirty-year fixed rate constant payment mortgage:
Figure 11.1. Amortization of a $200,000 loan for 30 years at 5.9% by The Federal Reserve Board is in the public domain.
A fifteen-year fixed rate mortgage is similar to a thirty-year fixed rate mortgage, but you repay the principle over fifteen years instead of thirty. The only major advantage of a fifteen-year loan is that you pay off the principal sooner, which, in addition to being satisfying, saves a lot of interest. However, the monthly payment is larger. Below, you can see an example of how much interest you can save. The loan amount in each case is $200,000, and the interest payments are shown in orange on the chart.
Figure 11.2 Mortgage Total Cost 15-year vs. 30-year
Now let’s compare payments between a thirty-year and a fifteen-year fixed-rate mortgage. Here is a 95% Loan-to-Value loan for a thirty-year and a fifteen-year fixed-rate mortgage on the median home price in the United States:
- Median home price: $227,000
- Down payment (5%): $11,350
- Closing costs (2%-3%): $4,900
- Mortgage amount: $222,450
For a $222,450 mortgage, here is what your monthly payment would be:
Since rates and home prices vary, you can use an online calculator to calculate a mortgage. Generally, younger people buying their first or second house cannot afford the higher payment on a fifteen-year mortgage, so they choose the thirty-year instead. My advice is to go with the thirty-year mortgage with the lower monthly payment. This will help your cash flow.
A three-year adjustable rate mortgage (ARM) has an interest rate that is adjusted upward (or downward) based on a certain designated financial index after three years or to a predetermined rate. The principal payment is usually based on a thirty-year amortization. The advantage of this loan is that the interest rate is lower at the beginning. For example, on September 17, 2019, the rate on a five-year ARM ranged from 3.00% to 3.25% while the rate on a thirty-year fixed rate mortgage was 3.97%. However, when the interest rate is adjusted the payment often is higher, and this can create a cash flow problem for the borrower.
There are many different types of adjustable-rate mortgages, but they all have common elements. For example, if the mortgage is a five-year ARM, it will be tied to some index of interest rates, such as the five-year U.S. Treasury Note. Then, after the first five years, the interest rate will be changed once a year in accordance with any changes in the five-year Treasury Note. This also means that the monthly payment will change (up or down) as the interest rate of the index changes. The lender will also specify how much above the index interest rate your mortgage interest rate will be. This is called the margin or markup. As an individual, you cannot borrow money at the same rate as the U.S. government, as you represent a higher risk for the lender. The higher risk is reflected in the higher rate. If we look at the rates in the previous paragraph, we see that the five-year ARM mortgage has a margin or risk premium of 1.4% over the five-year U.S. Treasury Note (3.00% 5yr ARM – 1.6% 5yr Treasury = 1.4% risk premium).
The likelihood is that once the first five years is over, the rate will increase and, as a result, your monthly payment will increase. The assumption here is that five years from now your salary will have increased, and you can afford a higher monthly payment. However, the ARM interest rate will have what is known as caps on it. Caps are limits on how much the ARM interest can rise in any one year or over the life of the loan. Here is a hypothetical example:
- 5-year Adjustable Rate Mortgage: 5.25% will not adjust more than +/- 0.5% in first 5 years then adjusts to market rate at the time
- Constant monthly payment: $1,190
- Principle amortization based on 30-year amortization: 30-year amortization
- Rate for five years: 5.25%
After five years, the rate will adjust every year on the anniversary of the loan to a rate that is 2.00% above the rate of the five-year U.S. Treasury Note.
- Annual cap: Upon adjustment, the rate will not go up (or down) more than 0.25% each year it is adjusted or go up more than 1% total for the life of the loan.
With an adjustable rate mortgage, you may end up doing a partial amortization or a negative amortization of your principal. Partial amortization or zero amortization in a mortgage will occur if you take out an interest-only mortgage. If you are paying only the interest on the loan, it reduces the monthly payment. However, the downside is that the principal does not decrease and must be paid off if you sell the house or refinance the loan. If you are paying only the interest on your home mortgage plus a little bit of the principal (in order to reduce the monthly payment) the amount of the loan paid off will not decrease as rapidly as it will with a thirty-year or fifteen-year home loan.
If you take out an adjustable rate mortgage, you may also end up with negative amortization of the principal of your home loan. A negative amortization loan is one in which you are not even paying the market interest on your home loan. Any interest above the market interest is added to the balance of unpaid principal. Negative amortizations can be offered with certain types of mortgage products. Although negative amortization can help provide more flexibility to borrowers by reducing the monthly payment, it can also increase their exposure to interest rate risk and actually increases the amount they owe.