What’s the Best Loan Product for You?
Most times when I get a phone call and the person on the other end is asking for a rate quote, they want the “30 year fixed” option. While there’s nothing wrong with that type of loan, it doesn’t make much sense for a lot of people. It also inspires me to ask questions. “How long will you live in your home”? “Do you think you’ll rent it out or sell it when you move”? “Is your income expected to change in the future”?
Fact is, different types of loan products offer different benefits for different situations. Responsible lending includes the process of matching the right product with the right borrower, and informing potential borrowers of their options – along with the positives and negatives of each.
Here are some of the more common loan options, along with the benefits, potential pitfalls, and scenarios where each product can make sense:
The Fixed Rate Loan
Fixed rate loans come in all different terms, with the most common being a 30 year fixed rate. This means you’ll have 360 payments due in the exact same amount until the loan is paid off. Other common terms are 10, 15, and 20 years. These loans are deemed ‘safest’ based on the fact that the rate will never unexpectedly change, but just because they’re simple & safe doesn’t mean there aren’t considerations to factor in.
Typically, the longer the term, the higher the rate on fixed rate products. A 30 year fixed rate will almost always have a higher rate than a 15 year term. However, a 30 year loan has the option of paying off the loan in 15 years if a borrower makes extra payments. The 15 year doesn’t allow someone to make 30 year payments. For this reason, even if a 15 year fixed rate offers a better rate than a 30 year loan, a 30 year loan might be a better idea for someone that wants additional cash flow.
Another instance where term should be factored in is when considering retirement – perhaps a 30 year term offers a more friendly payment, but would a shorter term coincide with retirement? Often, financial advisors that we work with try to have their clients pay off their mortgage to correlate with retirement age, when income is often reduced. For this reason, it’s important to work with a mortgage banker who will help you weigh options and consider which loan term fits best for your scenario.
ARM stands for Adjustable Rate Mortgage, and often comes in terms of 3, 5, 7, or 10 year fixed rates, followed by a period where the loans rate can adjust. For example, a standard 5/1 ARM is actually a 30 year loan with a rate that is fixed for 5 years, then able to adjust every 1 year thereafter (whether the rate will adjust comes down to economic conditions and financial indexes when the adjustment period is reached).
ARM loans are perfect for people looking at short windows of home ownership, or those who have potential for income growth that would allow them to handle larger payments several years down the road. Rates are generally lower for ARMs than for fixed rate loans, so if someone lives in a home for 5 years, getting a 30 year fixed rate mortgage instead of a 5/1 ARM means that an awful lot more interest $$$ is going to the bank than necessary. For some people, that extra money is worth not having the risk of a rate adjustment.
Our team believes that with an ARM, a borrower should intend to reap the benefits of reduced interest that an ARM offers, but should also be able to afford the maximum payments an ARM can adjust to (a rate usually 5% higher than the initial interest rate). We also believe that time flies, so if you “think” you’ll be living in a home for just 3 years, it’s wise to take at least a 5/1 ARM (rather than a 3/1), and if you “think” you’ll live in a home for 5 years, a 7/1 or 10/1 ARM are likely the best options. ARMs offer tremendous benefit, and if the risks are understood, they can save borrowers a lot of money.
Interest-Only Loans (I/O products)
Interest-Only loans are, like ARMs, carry risk, but can provide tremendous financial benefit when used properly. With an interest-only loan, a borrower is only responsible for making interest payments on their loan, with no principal payment due for a given period of time (for example, with a 10/20 I/O product, a borrower would pay only interest for 10 years, then switch to principal+interest payments for the remaining 20 years). This is an excellent cash flow tool for those who know how to use cash flow.
I/O products are great to help with home renovations and improvements that will add substantial value & equity, and are also a tremendous option for those who can invest their money into financial tools that provide a higher return than the rate of interest on a mortgage.
With all of the benefits, IO products should NEVER be used simply to get a lower payment for affordability reasons or qualifying purposes. Borrowers using IO products should be able to afford their payments once the principal payments kick in.
ARMs, Interest-Only, and fixed rate loans all offer benefits and negatives. The safest products can often take the most money out of a borrowers pocket and give it to the banks (which is why the 30 year fixed rate loan is the most often advertised product), while the least expensive products can carry with them the highest risks. Savvy borrowers can use any of these products to match their financial situation, using their mortgage as not just a home loan, but as a monetary tool. After all, your house is your home, but real estate is also an investment, and it’s best to treat it as one. Knowing the differences between products and how they can benefit you is one way to get the best return on your investment.